Changes are being made to Australian laws that will impact what occurs when businesses are experiencing financial trouble. But what are the changes, and how are they different to the current legislation? Find out how Safe Harbour will potentially change current business processes.

History

Until recently, Australian insolvency laws have made it difficult for businesses in financial trouble to re-establish themselves through restructuring. The problem is that because directors of companies can be held liable for trading whilst insolvent, they’ve tended to enter straight into voluntary administration to protect themselves from liability, but without considering other options.

When this occurs, suppliers and business partners decide they company is an unacceptable risk and use the ‘ípso facto’ clause to terminate their contracts, leaving the company with even less chance of survival. The ipso facto clause (also known as the bankruptcy clause) is a provision in a contract that permits its termination as a result of the bankruptcy, insolvency or diminished financial condition of a party.

Why the changes?

To overcome these issues, the Federal Government has drafted new legislation that will come into effect in July of this year. This legislation will not only offer a ‘safe harbour’ for directors, protecting them from liability for insolvent trading as long as they’re involved in legitimate reconstruction efforts, but it’ll also prevent suppliers from using the ipso facto clause to terminate their contracts on the basis of insolvency.

The reforms are the result of recommendations from the Productivity Commission in their Report on Business Set-up, Transfer and Closure. In this report, the Commission notes that Australia’s current insolvency laws don’t provide enough incentive for company directors to attempt to restructure when the company experiences financial difficulties.

The report recommended that the Corporations Act should be amended to include a safe harbour defence against insolvent trading and make ipso facto clauses unenforceable if a business is in administration, a scheme of arrangement, or receivership.

The details

Since the initial draft legislation, several amendments have been made and the final legislation now looks like this:

• Safe harbour applies from the time the director begins to suspect the company may become insolvent and starts working on a course of action that’s likely to lead to a better outcome for the company than immediate liquidation or administration would.
• The legislation also protects directors from insolvent trading liability as a result of any debts they incur in connection with taking this course of action.
• The stay on ipso facto clauses also applies to self-executing or automatic clauses in contracts which come into effect without the need for one party to enforce them.
• When the stay ends will depend on the type of restructuring the company is undergoing (i.e. administration – ends when the company is wound up. Receivership – ends when the receiver’s control ends. A scheme of arrangement – ends 3 months after being announced).
• The legislation won’t prevent parties from enforcing their right to terminate the contract for reasons other than insolvency, such as for non-performance.
• There’s a grandfathering provision, meaning the stay on ipso facto clauses only applies to new contracts entered into after the Corporations Act amendments take effect in July.

The result

One of the reasons for the amendments was that the Report highlighted the need for a cultural change in the way we view company directors who fail and stigmatise business failure in general. The Safe Harbour legislation will hopefully encourage directors to take reasonable risks to try and help their company to recover, rather than simply opting for administration or liquidation out of fear for their own liability.

There’s no such stigma surrounding business failure in countries such as the USA, where innovation and entrepreneurship are focused on far more than the penalties for failure. Our new legislation is aimed at encouraging a similar change in focus here in Australia.

The ipso facto termination of contracts can not only limit a company’s opportunities to undertake a restructure, but can actually cause business failure. So the new legislation will hopefully give struggling companies a much better chance to get back on their feet, or at the very least help them to maintain their value.

Of course, reforms such as these don’t take the position of creditors into account, who are the ones who need the most protection in the event of insolvency. So it’ll be interesting to see what the fallout is when the legislation comes under review in two years time.

One outcome could be that, without the protection of ipso facto clauses, some parties may implement measures to monitor key client performance against contracts, so they’ll have plenty of forewarning if a client is heading for financial trouble. Another may be that, because ipso facto stays don’t apply to contracts created prior to the new legislation, many companies may opt to alter their existing contracts rather than enter into new ones.