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A Safe harbour and Relief from Termination Clauses

New Commonwealth laws which commenced on 1 July 2018 provide safe harbour protection to honest, diligent and competent company directors from insolvent trading and also render ipso facto clauses in contracts unenforceable, while a company is undertaking a restructure.

The reforms which amend the Corporations Act 2001 will only apply to rights arising under contracts, agreements or arrangements entered into after 1 July 2018.

The reforms will have wide application and will directly impact the operation of termination for insolvency clauses in construction contracts and the management of insolvent subcontractors.

Reasons for reform

Before the reforms, Australia’s insolvent trading laws imposed a personal liability on directors for debts incurred by the company if there were reasonable grounds to suspect that the company was insolvent.

The threat of insolvent trading together with the uncertainty as to the precise moment a company became insolvent have long been criticised as pushing directors to prematurely enter a formal insolvency, even where the company may have been viable in the longer term.

The risk of inadvertent breaches of insolvent trading laws have also been reasons for a reluctance by investors and professional directors to become involved in a start-up.

The reforms seek to redress the stigma and penalties of previous insolvency laws and seek to promote a culture of entrepreneurship and innovation, driving business growth and saving jobs.

According to the Explanatory Memorandum, the reforms will

“…. drive cultural change amongst company directors by encouraging them to keep control of their company, engage early with possible insolvency and take reasonable risks to facilitate the company’s recovery instead of simply placing the company prematurely into voluntary administration or liquidation……

 This reform is aimed at enabling businesses to continue to trade in order to recover from an insolvency event instead of these clauses preventing their successful rehabilitation…”

 New safe harbour for insolvent trading

Under the new safe harbour provisions, company directors will be protected from personal liability for insolvent trading if their company is undertaking a restructure outside formal insolvency.

The reforms provide that a director will only be liable for debts incurred while the company was insolvent where it can be shown that the director was not developing or taking a course of action that at the time was reasonably likely to lead to a better outcome for the company than proceeding to immediate administration or liquidation.

The safe harbour protection however will not be available in all cases.

For example, the safe harbour provisions will not apply to a director of a company which failed to pay its employees’ entitlements, did not fulfil its tax reporting obligations or withheld information or financial records from an insolvency practitioner during any formal insolvency that occurred after any attempted restructure.

Ipso facto clauses in construction contracts

The reform also introduces provisions which automatically stay and render ipso facto clauses unenforceable during and after certain formal insolvency procedures.

An ipso facto clause in a contract can allow the contract to be terminated for the sole reason that one party is, or might become, insolvent.

The stay of these types of clauses are intended to provide breathing space for a company to continue to trade through formal insolvency and improve the changes of the company being turned around.

The effect of the stay is that companies in external administration are not prevented from trading because of the operation of an ipso facto clause if the company continues to meet its other contractual obligations.

The length of the stay will depend on the form of external insolvency administration and will be subject to any orders of the court that may be in force.

A party’s rights to enforce their independent contractual rights to terminate the contract for other unrelated reasons such as non-performance or for convenience will not be affected by the reforms.

 What do the amendments mean for construction contracts?

There are number of implications arising from the new reforms for stakeholders in the construction industry including the following:

  • A contractor will not be able to rely on termination clauses where a subcontractor is experiencing certain types of insolvency.
  • A subcontractor will be able to retain existing contracts despite entering into voluntary administration where it is the goal of the subcontractor to trade out of insolvency.
  • A contractor should not to seek to enforce an ipso facto right in breach of the new legislation.
  • A wrongful termination of a contract in breach of the new laws by a contractor could amount to a repudiation of the contract, which could then entitle the subcontractor to terminate the contract and seek damages against the contractor.

The management of subcontractor insolvency will as a result of the new changes become more challenging for contractors.

To better protect their interests, contractors should perform proper and adequate due diligence on the financial position of a subcontractor before entering into any contracts with them.

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