Ipso facto clauses, safe harbour for directors - our comments on the draft exposure legislation

In brief

The Federal Government has released draft exposure legislation designed to facilitate company reconstructions. Senior Finance Counsel Diccon Loxton, Senior Associate Alicia Salvo and Associate Frances Navarro-Towan discuss some of the implications and issues. 

Introduction

Australian insolvency law has two features which are widely recognised as making it harder to save and restructure businesses in financial difficulty. Voluntary administration is a formal mechanism designed to assist in reconstruction. But if a company enters administration, the company's suppliers and counterparties can terminate contracts, or threaten to do so, prejudicing the prospect of saving the business. As a result, directors often want to restructure informally. But if they do, they face potential personal liability under a draconian insolvency trading regime, which was partly designed as a big stick to encourage directors to grasp the carrot of putting the company into voluntary administration.

The Federal Government has issued draft legislation aimed at those two issues, providing a 'safe harbour' for directors involved in reconstruction efforts and preventing suppliers and counterparties from exercising termination rights on voluntary administration or in a scheme of arrangement (using so-called 'ipso facto' clauses). The Government has sought comments by 24 April 2017.

The ipso facto changes will significantly affect contracts in Australia.

How would the legisation affect you

• Under the safe harbour protections, directors can avoid personal liability for insolvent trading for debts incurred during the period that action is being taken which is reasonably likely to lead to a better outcome for the company and its creditors as a whole. As currently proposed, the safe harbour is drafted with tight objective tests to prevent abuse. Directors will continuously need to monitor and reassess their position, and they face a risk that the tests may not be satisfied, and they become personally liable for company obligations. This will be a disincentive. There are other difficulties.
• Counterparties will be unable to rely on ipso facto clauses — contractual clauses that terminate or modify a contract solely because a company enters into a scheme of arrangement or voluntary administration. The courts are given power to relieve counterparties from this, but on the other hand they are also given power to extend the prohibition's ambit, to restrict parties from exercising other rights in those circumstances.
• There will be exceptions from the ipso facto regime for a number of types of contracts, including swaps and other arrangements for managing financial risk, but under the current proposal loans and other credit contracts are not excluded, so lenders may be restricted from accelerating loans and enforcing security in those circumstances.
• There are some particular issues with the drafting of the legislation discussed below.

The background

Following the release of the Federal Government's Improving bankruptcy and Insolvency laws Proposal Paper on 29 April 2016 (which was discussed in a previous Client Update on 3 May 2016), the Minister for Revenue and Financial Services released draft legislation on Australia's insolvency laws for public consultation on 27 March 2017.

In the context of criticism of Australian insolvent trading laws as being skewed toward deterring directors from taking acceptable levels of risk to promote business rescue, the reforms to the Corporations Act 2001 (Cth) as proposed in the draft Treasury Laws Amendment (2017 Enterprise Incentives No. 2) Bill 2017 offer reforms to Australia's insolvency regime.

The safe harbour reforms do not yet have an implementation date, while the ipso facto reforms will take effect from 1 January 2018.

Safe harbour reforms

The goal

The safe harbour reforms are aimed at protecting directors from insolvent trading claims while engaging in a legitimate restructure of the company to avoid the director prematurely moving the company into formal insolvency to protect their own liability. The National Innovation and Science Agenda, which has spearheaded these reforms, asserts the safe harbour can encourage innovation and entrepreneurship by addressing the current overemphasis of insolvent trading laws on penalising and stigmatising failure, given that concerns over inadvertent breaches of insolvent trading laws are frequently cited as a reason early stage (angel) investors are reluctant to get involved in a startup.

The objective tests action for a 'better outcome'

Under the draft legislation, directors will have to satisfy the following objective two-limb test in order to avoid personal liability for debts of the company where there are reasonable grounds for suspecting that the company is, or will be, insolvent:

• first, the director must take a course of action that is 'reasonably likely' to lead to a 'better outcome' for the company and the company's creditors; and
• second, the debt must be incurred 'in connection with' that course of action and during the period of time when that course of action is continuing.

If the debt is incurred when the course of action is no longer reasonably likely to lead to a better outcome, or when the company has been placed into voluntary administration or is being wound up, the exclusion no longer applies. Further, if the course of action is no longer viable, the director must adjust the course of action or place the company into administration or liquidation. This requires diligence on a director's part to continually re-assess the course of action they have adopted to ensure that action remains reasonably likely to lead to a better outcome at each point in time each debt is incurred during the relevant period.

The draft legislation focuses on the safe harbour only being available to directors who have acted honestly and diligently in restructuring the company, which is reinforced by the fact that directors who have failed to make provision for employee entitlements (including superannuation) and to comply with taxation reporting obligations will be ineligible from the safe harbour protections.

What is a 'better outcome' and what is 'reasonably likely to lead' to one

A 'better outcome' is one where the company and its creditors as a whole are better off compared to the company going into administration or being wound up.

The safe harbour can still apply to a director where the end result of taking on additional debts as part of a course of action is ultimately a worse outcome for the company and its creditors, so long as the course of action was reasonably likely to lead to a better outcome.

The draft legislation provides, by way of guidance only, an indicative non-exhaustive list of factors that the court may have regard to when determining whether a director has adopted a course of action that is reasonably likely to lead to a 'better outcome', which includes whether the director:

• is taking appropriate steps to ensure that the company is keeping appropriate financial records consistent with the size and nature of the company;
• is properly informing themselves of the company's financial position;
• is developing or implementing a plan for restructuring the company to improve its financial position; and
• is obtaining appropriate advice from an appropriately qualified entity who was given sufficient information to give appropriate advice.

No limitation is placed on what will satisfy the 'appropriate advice from an appropriately qualified entity' requirement. This is to ensure the safe harbour protection remains flexible and adaptable to all situations. As explained in the Explanatory Memorandum, a small business may only need to seek the advice of an accountant, lawyer or other professional while a large listed entity may retain an entire team of turnaround specialists, insolvency practitioners, lawyers and accounting firms.

Directors need to supply evidence backing their action

In order to rely on the safe harbour protection, a director needs to produce some evidence which demonstrates that a course of action was taken that was reasonably likely to lead to a better outcome for the company and its creditors. It is then up to the liquidator or any other party alleging a breach of the insolvent trading provisions to establish that the director did not take a reasonable course of action.

Further, a director will be prevented from relying on the books and records of the company as evidence of their having taken a reasonable course of action if they do not provide a liquidator or administrator with those books and records following an appropriate request (to ensure directors do not withhold such information in an attempt to undermine investigations into the company's or director's activities).

Differences from original proposal

Interestingly, the draft legislation does not include a subjective element, which, in the proposed Model B, required the director to have held an honest and reasonable belief that the debt was incurred in the best interests of the company and its creditors. Significantly, directors are also no longer required to 'return the company to solvency within a reasonable period of time', but may continue to act as long as the course of action continues to be reasonably likely to lead to a better outcome.

Some issues to consider

• The objective test increases the risk that directors activities may fall short of the requirement, and that they remain liable.
• Directors also face the test being assessed with the benefit of hindsight.
• When a company is in difficulty, directors may need to move quickly when signs of financial difficulty arise in order to be able to make an assessment as to whether their course of action is indeed reasonably likely to have a better outcome. Otherwise again directors face a risk.
• The safe harbour only applies to debts incurred 'in connection with the course of action'. It is not clear whether that includes normal ongoing trading debts, for inputs to the business, for example. A more reasonable position would be to apply the safe harbour to all debts incurred in good faith during that period.
• The ongoing monitoring requirement on directors is understandable, but may again be a disincentive on directors who do not have the resources to seek the relevant advice.
• With their personal liability at stake, directors tend to be risk averse, they may be deterred by the risks of falling outside of the various tests, and by the burdens imposed.

Reforms to ipso facto clauses

An ipso facto clause is a clause which allows one party to terminate or modify the operation of a contract upon the occurrence of an insolvency event, and are common to all types of commercial contracts. In some instances, enforcement of ipso facto clauses can lead to irreparable damage to the value of a business and makes it more difficult for receivers and administrators to trade on or restructure the distressed company as a going concern.

The stay on enforcement

With a few exceptions, the draft legislation seeks to address this issue by mandating an automatic stay on a party's rights to enforce a provision to terminate or amend a contract (such as acceleration clauses) solely because the counterparty enters into voluntary administration or a scheme of arrangement. Importantly, the stay does not apply to liquidations or the appointment of managing controllers (ie receivers and managers). The stay will only operate while the administration or scheme of arrangement is ongoing, and ceases when a party is wound up.

Despite the operation of a stay, a counterparty will generally still maintain any other (non-ipso facto) rights to terminate or amend an agreement for any other reasons, including for a breach involving non-payment or non-performance. There is some uncertainty as to how these provisions would operate in practice in certain circumstances, such as where a company forbears from exercising its termination rights under a non-ipso facto clause (such as a breach for non-payment), but decides to cease its forbearance and enforce its rights at the time or shortly after its distressed counterparty enters into administration or a scheme of arrangement. The draft legislation also has broader application beyond strict ipso facto clauses. If a court is satisfied that a party is enforcing, threatening to enforce, or is likely to enforce any contractual right (such as a right to terminate for convenience or for a breach) merely because its counterparty entered into administration or a scheme of arrangement, the court may order that those contractual rights can only be enforced with leave of the court and in accordance with such terms as the court sees fit.

Carve-outs

Certain limited types of contractual rights are excluded from the stay provisions. This includes financial products where the primary purpose of the product is to manage risk, and for which an ipso facto provision may be 'commercially necessary' for the function of the relevant contract. For example, swaps, where the party is entitled to close out its position in order to manage counterparty risk. The regulations will ultimately prescribe the types of contracts in which rights may be enforced even if they are triggered by an insolvency event so that the list can be updated regularly in response to the development of new financial products.

Credit providers will be concerned to see that normal credit contracts are not carved out, and the stay on ipso facto clauses applies to credit contracts and their security.

The relevant provisions do provide some relief for credit providers who are not required to provide a further advance of money or credit while any one or more of their rights against a counterparty are rendered unenforceable by virtue of these new provisions.

Parties are also able to apply to the court for an order that a stay on enforcement rights be lifted if it is appropriate in the interests of justice or, in the case of a scheme of arrangement, if the scheme was not for the purpose of the company being wound up in insolvency.

 Finally, the Proposal Paper contemplated giving retrospective operation to parts of the legislation. However, the draft legislation will only apply to contracts or agreements entered into at, or after, the commencement of the amending provisions.

Some issues to consider

• The stay does not apply if a company goes into liquidation directly, without going through voluntary administration or a scheme. However, if it goes first into a voluntary administration, then liquidation, the stay continues until the company is 'wound up'. This seems inconsistent.
• Lenders will be concerned as to their inability to accelerate, and enforce security in the event of a scheme of arrangement or voluntary administration. They do have other events of default, like non-payment, but the court is given the ability to restrict that exercise.
• One common enforcement scenario which may be affected is where a creditor enforces security over all or substantially all of the assets of the company within the decision period after a voluntary administration. Under the Corporations Act, holders of such security interests have been given that right to enforce (and effectively replace the administrator) as they cannot appoint a receiver who can keep the business going.
• The regulations creating the carve-outs for swaps and financial transactions have yet to be drafted, but one concern is that the drafters will cross-refer to definitions from the remainder of the Act and other legislation, which will be subject to exclusions and complexities not appropriate in this context.

Conclusion

The Explanatory Memorandum states that the proposed safe harbour legislation is ...

aimed at driving a cultural change amongst company directors who encounter uncertainty over a company's solvency to be more willing to remain in control of the company and take proactive steps to address the situation and restructure a company in a way that is likely to deliver a better outcome for the company and its creditors without fear of being personally liable for any debts incurred as part of the process'.¹

 

It will remain to be seen whether the proposed reforms should achieve that goal.

Further, although there is no proposed retrospective application of these amendments, companies should, in anticipation of this legislation coming into force on 1 January 2018, be mindful of the enforceability of their contractual rights against counterparties that become insolvent. They must also reassess and consider any alternative options, besides ipso facto clauses, for protection against another party's insolvency.

* Prepared with the assistance of Lawyer Sarah Glynn and Law Graduate Ari Bendet.