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Freedom to Contract Lessened Further

Steven Brown
Steven Brown

Most business people start out thinking that in business, they have the freedom to contract. They have the view as stated by Sir George Jessel MR in Printing and Numerical Registering Company v Sampson (1875) LR 19 Eq 462 at 465, over 140 years ago:

[I]f there is one thing more than another public policy requires it is that men of full age and competent understanding shall have the utmost liberty of contracting, and that their contracts when entered into freely and voluntarily shall be held sacred and shall be enforced by Courts of justice.

Over the past 140 years, the concept of freedom of contract has been eroded by legislation. Another wave of erosion has come in the changes made to the Corporations Act in July 2018.

Business people often make contracts containing the right to terminate the contract upon the happening of specified events. For instance, as a protection mechanism, an owner of intellectual property may enter into a licence (contract) a company they control to use a trade mark or patent but having the right to end the licence if the company enters into any event of insolvency. Clauses that give rights of termination on specific event occurring are known as ipso facto clauses.

Other examples of ipso facto clauses include rights to:

  • End a contract because the company has entered into an insolvency process;
  • Call upon security, such as a bank guarantee;
  • Stop providing credit or advancing funds; or
  • Suspend services, works or the supply of goods.

Ipso facto clauses have been criticised for being one reason the administration regime has not seen the turnaround of many companies. When a company enters administration or receivership, the owner of the intellectual property ends the right to use the intellectual property, thereby putting the intellectual property away from an administrator or receiver. In doing so, the owner is adversely affecting the company by removing an asset of value. An asset that if not removed, might have saved the company from insolvency.

The changes are now as the Ipso facto amendments. The changes are modelled on the US Chapter 11 provisions.

The ipso facto amendments seek to stay the enforcement of a contracting parties contractual rights to end the contract when:

  • a company enters into a scheme or arrangement (or announcing it will enter into a scheme or arrangement) to avoid being wound up in insolvency (s415D);
  • a managing controller or receiver is appointed to a company (s464J); or
  • a company goes into voluntary administration (s451E).

The period of the stay depends on the type of insolvency that occurs.

An insolvency event of a compromise or scheme of arrangement. The stay begins when the company makes a public announcement or when a scheme application is made under s411 of the Corporations Act. The stay ends three months after the public notification, when the application for a scheme fails or when the company is wound up.

The purpose of the stay is to allow the company to restructure without the adverse effects of the company being wound up.

The stay period for an insolvency event of receivership or appointment of a managing controller begins when the appointment is made over the company's property. The stay ends when the appointment ends. The purpose of the stay is to allow the company with the help of the receiver or controller to restructure.

An insolvency event of administration. The stay begins when the company enters
administration. The stay ends when the administration ends either because the company is being wound up or the creditors become bound to a deed of company arrangement. The purpose of the stay is to allow the administrator to investigate the company's financial affairs and assess the viability of the enterprise, to see if the company can be rehabilitated and enable it to continue trading.

The purpose of the changes was to overcome the criticism that ipso facto clauses reduce the prospects of a successful turnaround of a financially distressed company; and otherwise adversely impact the value of the business that is considering entering formal administration.

The changes include ant-avoidance provisions. Parties cannot contract out of the rules.

The amendments are subject to exclusions.

The rights excluded from the stay are set out in the act and include:

  • a right to crystallise a security interest;
  • a right restricting dealing with the property under a security interest;
  • a right to perform obligations or engage another person to perform obligations or enforce rights under a contract (i.e. step-in rights to perform);
  • a right to appoint a controller; or
  • a right to terminate for reasons other than administration or insolvency - for example, other breaches, such as a failure to perform or pay: (refer to the wording of section 451E).

You can have a termination clause, but it must operate at the end of the stay period, i.e. on winding up (section 451E).

The diagram is a helpful tool.

Published on by BiziNet

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