Construction contracts and changes to insolvency laws

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Reforms to insolvency laws will prevent contracting parties relying on certain clauses in construction contracts effective from 1 July 2018.

The reforms introduce changes to the Corporations Act 2001 (Cth) and are likely to impact significantly on construction contracts.

The laws aim to assist contractors who are facing financial difficulties by allowing them to trade their way out of the predicament rather than having the contract unilaterally terminated. A contracting party will no longer be able to rely on an ipso facto clause to end a contract in certain circumstances pertaining to the other party’s financial position.

Participants in the building industry should be aware of the effect of these changes and review their contracts and internal processes accordingly.

What is an ipso facto clause?

Ipso facto is a Latin phrase which, broadly interpreted, means ‘by the fact or act itself’. Ipso facto clauses are regularly used in contracts to enable a party to terminate the contract based on the existence of a fact or circumstance, rather than default by the counterparty.

The trigger allowing the party to invoke the ipso facto clause will generally be an insolvency event. In the construction industry, such clauses can be grounds for a principal to terminate a contract when the subcontractor runs into financial difficulty. The provisions are drafted broadly to encompass not only actual insolvency but precursors to insolvency such as the appointment of an administrator.

The benefit to a principal of invoking an ipso facto clause is its ability to mitigate loss by taking action once the risk of insolvency becomes apparent. The contract will allow the principal to exercise certain rights before an actual insolvency occurs, such as:

  • terminating or modifying the contract;
  • suspending works, stepping into the contract and / or engaging third party subcontractors to complete outstanding works;
  • calling on bank guarantees, securities or retentions;
  • setting off claims against payment claims by the subcontractor.

How do the reforms change ipso facto clauses?

The new laws restrict a party from relying on an ipso facto clause by reason of:

  • the counterparty entering a scheme of arrangement or voluntary administration;
  • the counterparty’s financial position, credit rating or possibility that it might be under administration.

Effectively, the reforms put a ‘stay’ on a party exercising certain rights on the basis of a potential or pending insolvency. The contractor benefiting from the stay has an opportunity to continue receiving the benefit of the contract and trade its way out of financial difficulty.

If the contractor company subsequently goes into receivership or liquidation, the stay is lifted, the protection no longer exists, and the ipso facto rights will be enforceable.

The reforms do not affect other termination rights (such as non-performance).

In some circumstances, the stay may be lifted – either by arrangement between the administrator and the party seeking to rely on the ipso facto clause, or on application by that party to the Federal Court where it would be appropriate and in the interests of justice to do so.

The new laws are mandatory and cannot be contracted out of, with special government intervention powers being granted to address any loopholes.

The laws are not retrospective, thus any ipso facto clauses existing in contracts entered before 1 July 2018 will remain intact.

Why make these reforms?

The laws are part of an insolvency innovation reform package. They follow safe harbour provisions recently introduced to give additional personal liability protection to directors facing cashflow issues who take certain steps to better the company’s financial position.

The reforms aim to find an appropriate balance between encouraging enterprise and protecting the community.

By imposing a stay on the exercise of an ipso facto right in certain circumstances, it is hoped that a distressed contractor will be in a better position to trade its way out of the financial predicament and remain solvent.

What should those in the construction industry do?

Managing financial risk during a construction project has always formed an integral part of management. Introduction of the ipso facto regime places even greater importance for principals to implement proactive risk-management processes.

Moving forward, construction companies should understand the potential effect of the ipso facto regime on future contracts and review processes to ensure that they:

  • carry out comprehensive pre-contractual checks on all counterparties including company and name searches, PPSR checks and inspections of financial records;
  • have systems in place to identify early signs of insolvency of the counterparty;
  • obtain director guarantees and / or parent company guarantees;
  • consider / check termination for convenience clauses in contracts; and
  • strengthen other termination clauses that are not affected by the reforms such as termination based on non-performance.

If you or someone you know wants more information or needs help or advice, please contact us on +612 9248 3450 or email [email protected].