Safe harbour legislation impacts right to terminate leases for insolvency events
|Services:||Corporate & Commercial, Real Estate & Construction, Restructuring & Insolvency|
|Industry Focus:||Financial Services, Real Estate & Construction|
|Date:||29 November 2017|
|Author:||Masi Zaki, Senior Associate|
What you need to know
- Australia’s new safe harbour legislation includes important reforms relating to ‘ipso facto’ clauses that allow one party to a contract to terminate or modify the agreement based on the other party entering into an insolvency event.
- When these reforms come into effect in 2018, there will be major restrictions on the enforceability of ipso facto clauses.
- Landlords and tenants of commercial and retail premises are among those who will need to consider the way their future lease agreements, and their future commercial dealings, will be impacted by the moratorium that will soon apply to the enforcement of termination rights based on insolvency.
The newly enacted Treasury Laws Amendment (2017 Enterprise Incentives No.2) Act (Cth) 2017 (Safe Harbour Legislation) is primarily concerned with giving company directors breathing space in circumstances where a restructure is being pursued. In particular, directors who meet the appropriate safe harbour criteria can benefit from protection against insolvent trading liability while they seek to work through the company’s financial difficulties and implement a restructure plan.
Consistent with the overarching objective of enabling more businesses to turn themselves around, the Safe Harbour Legislation will soon protect contractual parties by restricting the enforcement of ‘ipso facto’ clauses, which allow one party to terminate or modify a contract based on the counterparty experiencing an insolvency event. When it comes into effect next year this change is likely to significantly impact numerous organisations, given that ipso facto clauses are common in a range of commercial contracts such as supplier agreements and service contracts. Ipso facto clauses will also be familiar to landlords and tenants, as they frequently appear in commercial and retail leases (where they usually provide the landlord with rights to terminate a lease on the basis of the tenant’s insolvency event).
It is important for landlords and tenants to understand how the changes to the enforcement of ipso facto clauses may impact their general commercial dealings and, more specifically, their rights if and when tenants (or landlords) experience insolvency events in the future.
Recap on ipso facto clauses
The general argument in favour of ipso facto clauses is that they protect the rights of potentially significant and vulnerable creditors in circumstances where their counterparties can no longer perform their contractual obligations and the risks to the creditors would increase if an insolvency were to ensue. For example, if a landlord’s major tenant were to experience an insolvency event, an ipso facto clause in the lease would expressly entitle the landlord to terminate and therefore avoid the risks that might arise from the lease continuing with the tenant in a precarious position.
From a restructuring perspective, however, the argument against ipso facto clauses is primarily based on the potentially irreparable damage that can be done to the value of a business. That damage arises from a contract (or lease) being terminated on the basis of an insolvency event and the flow-on effect that such termination would have on the ability of external administrators to maintain company value and realise assets (including the relevant business as a going concern) in a distressed scenario.
The automatic stay
The Safe Harbour Legislation seeks to address these issues by mandating an automatic stay or ‘pause’ on a party's right to enforce a provision to terminate or amend a contract solely because:
- the counterparty enters administration
- the counterparty has a managing controller appointed over all or substantially all of its assets
- the company is undertaking a compromise or arrangement for the purpose of avoiding liquidation.
In any of these scenarios, the stay would only operate whilst the formal restructure process is ongoing and would automatically cease when the company is wound up by resolution or order of the court.
The ipso facto moratorium under the Safe Harbour Legislation will only apply to rights under contracts or leases entered into after 1 July, 2018, meaning that landlords and tenants entering into leases between now and then will still be able to include and enforce ipso facto clauses in those leases.
Even when the stay does come into operation next year, a landlord could potentially still enforce its right to terminate a lease on the basis of an ipso facto clause if:
- it obtains the prior written consent of the relevant insolvency practitioner, or
- the termination is pursuant to an order of the court
although both of these avenues would likely take some effort for the landlord to pursue.
Further, a landlord will also maintain its right to terminate or amend a lease on the basis of other monetary and non-monetary defaults. However, any attempt by a landlord to rely on historical default, particularly in circumstances where they might have agreed to forbear, might give rise to a dispute and court intervention.
Practical considerations for landlords and tenants
Although the stay on the enforcement of ipso facto clauses does not have immediate or retrospective application, landlords and tenants should consider the commercial and legal impact of the automatic stay on any new agreements entered into after 1 July 2018.
In particular, the following practical considerations should be borne in mind:
- The ipso facto moratorium introduced under the Safe Harbour Legislation does not alter any existing rights and entitlements under the Corporations Act 2001 (Cth) (Corporations Act) or related legislation concerning retail and commercial leases. As such, the restrictions on the exercise of third party property rights under section 440B of the Corporations Act, for example, remain unaffected. The stay on the enforcement of ipso facto clauses introduced by the Safe Harbour Legislation will simply add an extra layer of protection for tenants experiencing an insolvency event.
- Landlords should review their leases to ensure their rights to terminate on the basis of non-monetary and non-ipso facto clauses are clear and enforceable.
- As currently drafted the Safe Harbour Legislation will restrict enforcement of ipso facto clauses against the company which goes into administration. Arguably this still allows scope for the landlord to exercise rights against third parties who have provided guarantees (e.g. bank guarantees) or other surety for the company, provided those rights are sufficiently provided for in the drafting of the lease conditions. Certain guarantors (directors and some of their relatives) will still be protected during the period of voluntary administration under existing legislation, namely section 441J of the Corporations Act.
- If leases continue to contain ipso facto clauses after 1 July 2018 and a landlord was to inadvertently or mistakenly issue a termination notice on the basis of an ipso facto clause, it may be open for the tenant to accept such a notice as repudiation of the contract and sue for damages. Landlords should therefore take care in determining when and on what basis termination notices should be issued, particularly in light of the fact that the moratorium on enforcing ipso facto clauses is intended to protect the enterprise value of the party experiencing the insolvency event (in other words, the tenant). The potential consequences for wrongful default or termination notices (including ones issued inadvertently or mistakenly) may be significant once the new moratorium is in force.
- Some landlords may wish to consider implementing measures to monitor key client performance against leases in an effort to not to be caught off guard by the tenant’s announcement of a formal restructure. Landlords might monitor counterparties by scrutinising their financial health with reference to timely performance against contractual monetary and non-monetary obligations, and by:
- conducting periodic tenant audits
- obtaining trade reference checks
- conducting periodic searches of the Personal Property Securities Register
- obtaining credit ratings reports or third party financial reports.
- For landlords, active engagement with and monitoring of tenants will also be important in the context of historical defaults and landlords’ previous decisions to forebear on enforcement. If, for instance, a landlord were to:
- happily grant a forbearance only for a formal restructure to be announced at a later point in time, and then
- cease its forbearance and terminate or modify a lease by relying on the early monetary or non-monetary default (as opposed to the insolvency event)
it may be possible for the tenant (acting by its external administrators) to argue that the termination was wrongful in the circumstances and claim damages.
- The Safe Harbour Legislation actively encourages directors to pursue informal restructures. As such, landlords will have to be more vigilant in their dealings with directors who are seeking safe harbour protection and who might flag the potential risk of future formal restructures which would trigger the application of the automatic stay.
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The second half of 2018 will probably bring with it a flurry of court activity and decisions which will shed more light on how the Safe Harbour Legislation will be interpreted and applied in a practice. Until then, it is important for landlords to take pro-active steps in their management and monitoring of counterparty performance, and appropriately review and amend the terms on which they enter into new lease agreements post 1 July 2018.
For more information, please contact:
1. Corporations Act 2001 (Cth) s 415D.
2. Corporations Act 2001 (Cth) s 434J.
3. Corporations Act 2001 (Cth) s 451E.