The increased level of financial risk within the major project, property and construction sectors has led to a spate of recent insolvencies. In such insolvencies, we are seeing government, regulators and other stakeholders, particularly subcontractors, taking a more active and aggressive role. For these reasons, it is becoming more important for financiers, owners, principals and contractors to manage counterparty insolvency risk as a key part of their project contingency plans.
With the new ipso facto regime due to commence on 1 July 2018 as part of the federal government’s insolvency innovation reform package, the position will become more complex. This is because many of the contractual protections owners and principals currently rely upon in an insolvency scenario are about to become unenforceable.
At present, when a counterparty becomes insolvent, owners and principals will typically exercise one or more of the following “ipso facto” rights under their contract to improve or protect their position:
- suspend the works or take the works out of the counterparty’s hands on the ground of the counterparty’s insolvency;
- terminate the contract on the ground of the counterparty’s insolvency;
- call upon a bank guarantee, cash retention or other security to reduce their loss;
- set-off their claims (whether liquidated or payable) against any payment claims by the counterparty; and/or
- step-in and pay or engage essential subcontractors directly to mitigate loss and complete the outstanding works.
However, once the new regime comes into effect, in the event that an administrator or receiver over substantial assets is appointed or a scheme of arrangement to avoid winding up is proposed, the above “ipso facto” rights will be unenforceable against the counterparty if they arise for the reason of:
- the administration, receivership or proposed scheme of arrangement;
- the credit rating of the counterparty;
- a breach of financial covenants such as net tangible assets or debt to equity ratios;
- a change of control or material adverse effect based on the counterparty’s financial position;or
- subject to court order, termination for convenience based on the counterparty’s financial position.
As a result, it is critically important for owners and principals to start to review the security, insolvency, breach, termination and set-off provisions of their contracts to ensure that they have the ability to identify the warning signs of counterparty insolvency risk and can act early to protect their position. One such early warning sign will be the directors of the counterparty seeking to rely upon the new safe harbour protections against personal liability for insolvent trading, which will also commence as part of the same federal government insolvency reform package.
As the proposed ipso facto regime will not have retrospective effect, owners and principals should also consider a variation or extension of their existing agreements, rather than new contracts, once the reforms commence.
King & Wood Mallesons is a full service firm with specialist project, construction and insolvency experts who are experienced in successfully restructuring projects and have participated in the law reform consultation process. We would be happy to assist in your contract review and developing your risk mitigation strategies and project contingency plans.