A mixed bag for the construction industry in the exposure drafts of Ipso Facto Regulations & Declaration

An important part of last year's package of amendments to the Corporations Act 2001 (Cth) were the ipso facto reforms which will stay the exercise of certain contractual rights relating to a counterparty's insolvency or financial position. What, if any, contracts would be exempt from the stay has been a major question, not least for the construction industry.

This has now been answered, with the release of exposure drafts for public comment by May 11 2018 of the:

• Corporations Amendment (Stay on Enforcing Certain Rights) Regulations 2018; and
• Corporations (Stay on Enforcing Certain Rights) Declaration 2018.

The Regulations and Declaration will be proclaimed by, and are likely to commence on, 1 July 2018.

The ipso facto reforms at a glance

These changes, which come into effect on 1 July 2018, were introduced by Part 2 of the Treasury Laws Amendment (2017 Enterprise Incentives No. 2) Act 2017 (Amending Act), which preclude the exercise of rights consequent upon:

• the appointment of a voluntary administrator;
• the appointment of a receiver or managing controller over all or substantially all of a company's property; or
• a company undertaking a scheme of arrangement for the purposes of avoiding being wound up in insolvency.

The Amending Act also includes strong anti-avoidance and integrity mechanisms; the statutory stay will apply if the reason a party seeks to exercise a right is "in substance" contrary to the Amending Act.

The potential reach and application of the ipso facto reforms is uncertain and has been the subject of much commentary. Relevantly, the "financial position" and "in substance" concepts are indeterminate and may introduce a degree of unpredictability into contractual arrangements.

The Amending Act, however, stipulates that certain types of contracts and rights may be exempted from the stay regime by regulation or declaration. The Government's release of drafts of these documents has therefore been eagerly awaited.

SPV arrangements to be exempt

In a positive outcome for participants in the public private partnership market, subregulation 5.3A.50(2)(l) does exempt from the ipso facto reforms contracts, agreements or arrangements that are entered into by a "special purpose vehicle" (SPV). In the PPP context, this should mean the reforms will not apply either to contracts between the relevant government agency and the SPV consortium of equity investors, or to other downstream agreements to which the SPV is a party (relevantly, contracts with construction contractors).

What is potentially less clear is the extent to which this particular exemption will create inconsistent or irreconcilable risk allocations, noting a PPP typically involves a complex matrix of contractual arrangements between numerous parties, and that the SPV will not be a party to all of those arrangements.

It is also unclear whether this exemption will be used by parties wishing to avoid the effect of the reforms. For example, if a construction industry participant wished not to be bound by the reforms, could it create project-specific SPVs for each of its projects, and thereby avoid the application of the reforms to its contracts?

Exemptions for arrangements entered into before 1 July 2018

The Regulations also exempt contracts, agreements and arrangements entered into or renewed on or after 1 July 2018 as a result of arrangements entered into before 1 July 2018:

• the novation of, or the assignment of one or more rights under, a contract, agreement or arrangement entered into before 1 July 2018;
• a variation of a contract, agreement or arrangement entered into before 1 July 2018.

The Explanatory Statement accompanying the Declaration clarifies that it was "not intended for the ipso facto stay to capture arrangements entered into as a result of rights exercised in arrangements on foot prior to the commencement of the stay provisions."

This perhaps recalls submissions made by the Law Council of Australia to the Senate Economics Legislation Committee in July 2017. Noting that "many commercial dealings …allow for numerous individual amendments over many years (even decades) without entering into a new contract", the Law Council expressed the concern that restricting the application of the ipso facto reforms to new contracts would "create a competitive imbalance in the economy" as contracting parties "will have radically different rights in restructuring" depending on when their subject contract was entered into.

The rights of a principal upon the insolvency of a contractor

If a contractor suffers an event of insolvency, typically a principal may do one or more of:

• suspend the performance of the works;
• take work out of the contractor's hands;
• terminate the contract;
• call on security; or
• exercise a right of set off.

Again because of the anti-avoidance mechanism and the catch-all 'in substance' provision, there has been some doubt about whether the principal is still able to exercise those rights upon the insolvency of a contractor.

The Declaration would seem to resolve at least some of that doubt. The types of rights that would be excluded from the stay regime are contained in subsection (4) of the Declaration and, importantly for principals, protect the exercise of "step in" rights. According to the Explanatory Statement, such rights are seen to be consistent with the "overarching policy objectives" of the reforms as they are designed to "keep the contract on foot where it might otherwise be terminated". Principals and head contractors could therefore consider revisiting their usual contracting arrangements to ensure they include a step in entitlement that arises on the insolvency of a contractor or subcontractor (as relevant).

Additionally, the Declaration exempts:

• a right to payment as indemnity for any liability or loss arising from, and any charges and expenses incurred by another person in, preserving or enforcing its rights (whether or not the indemnity is limited in any way); and
• a right of set-off or a right of combination of accounts.

If these exemptions are applied in the context of a construction agreement, this will go some way to mitigating the adverse consequences to a principal of being effectively compelled to continue a contractual relationship with an insolvent entity.

Related Insights

• Exemptions to the stay on ipso facto clauses released for comment