There is no doubt Australia has done well in its response to the COVID-19 pandemic. Many companies and individuals have been able to obtain some economic relief through a range of Government policies and initiatives, and some generous concessions in relation to financing arrangements, which may have otherwise crippled some businesses.
As we move into the next phase of the crisis, insolvent trading and loan repayment holidays will end and the Government support packages will wind down. It is likely that many more companies will face a tough financial road ahead, with more insolvency or administration to come. Before this happens, companies will need to look carefully at their supply chain arrangements and reliance on key third party providers of business critical systems. Of particular concern will be providers of technology solutions that allow companies and government to operate.
Ipso facto reforms and their impact on supplier contracts
Almost two years ago, the ipso facto reforms to Australia's insolvency laws were introduced. These reforms apply to contracts, agreements and other arrangements entered into after 1 July 2018. In short, those reforms were designed to prevent a party from exercising certain contractual rights (for example, a right to terminate a contract), if the other party became subject to certain insolvency events.
Typically, a contract will allow a party to exercise particular rights when the other party is about to restructure itself to avoid insolvency or enter into receivership, or administration. However, the ipso facto reforms take away or modify those rights in certain circumstances, allowing the affected party to be administered in a way that "maximises the chances of the company, or as much as possible of its business, continuing in existence".
The application of these reforms is, in practice, quite complex, and two years after their introduction, it is likely that more and more arrangements will be subject to their application. As part of business continuity planning, a company should review existing arrangements with key suppliers and determine what rights are available to them if a supplier suffers an insolvency event, or if the company itself is facing financial difficulty.
Key considerations to ensure resilient supply chain
Set out below are some key considerations that we recommend entities and government consider when thinking about the susceptibility of its supply chain to insolvency events, either happening to the entity itself, or to one of its suppliers.
Many contracts aren't subject to the reforms
There is a long list of exemptions to the ipso facto reforms (see section 5.3A.50 of the Corporations Regulations 2001) meaning the restrictions imposed as a result of those reforms will not apply to all contracts. Some examples relevant to technology solutions include contracts related to:
- “material outsourcing” arrangements for the purposes of APRA Prudential Standards CPS231 and SPS231;
- the keeping of source code, object code, passwords for software or material associated with such code or passwords, in escrow;
- the supply of essential or critical information technology or communications technology to government, or to the public on behalf of government; and
- the supply of goods or services to or for public hospitals or public health services (which would include technology solutions).
The ironic corollary of these exemptions is that if the party receiving the services is subject to an insolvency event, the reforms will not prevent a supplier of the services from exercising a termination right based on an insolvency event. This seems at odds with the apparent purpose of these types of arrangements being excluded, that is, to make sure a customer can put in place alternative arrangements when a supplier of critical services may become insolvent. A potentially unintended effect of the exemption is that a supplier could walk away (if the contractual right exists) from providing critical technology services at a time when they are most needed by a customer.
Some rights which assist in maintaining business continuity are still available where your supplier becomes subject to an insolvency event
Even if your contract with a technology supplier is subject to the ipso facto reforms, and your right to terminate that contract due to your supplier's insolvency may be stayed, you may still have other rights under that contract which are exempt from the reforms and which can mitigate the effect of a potential insolvency. The full list of exemptions is contained in the Corporations (Stay on Enforcing Certain Rights) Declaration 2018.
One notable exemption helpful in ensuring continuity of technology solutions is the operation of (usually heavily negotiated) 'Step in Rights'. These provisions typically permit a party (or its nominee) to 'step in' and assume control of the responsibilities of the other party. This can occur under certain circumstances, ultimately related to supplier non-performance, including where the relevant supplier is subject to an insolvency event. A party will also often have a corresponding right to cease payments for services not rendered by the supplier during the period of step in.
You may also be able to rely on acts, omissions or defaults of the other party which give rise to a termination or other right which might otherwise be caught by the regime. The key is to properly exercise the right relevant to the act or omission, and not by reference to the insolvency event.
10 tips to help you apply the ipso facto regime
How to prepare
- Analyse which contracts are excluded from the regime (e.g. Is the contract a 'material outsourcing' for the purposes of CPS 231).
- If an agreement is caught by the application of the reforms, understand what rights will be affected if your supplier suffers an insolvency event. If your company is likely to suffer an insolvency event, be aware that a supplier may be able to rely on provisions relating to termination for insolvency.
- Contract to keep your options open, termination or 'step in' might not always be the best option. However, it is good to keep that option available if needed, and renegotiate contracts which don't deliver the tools you need to maintain business continuity.
- Ensure any rights to source code which are held in escrow include a licence to use such material on and from the date of contract, not from the date of an insolvency event.
- Ensure contracts require suppliers to keep communication lines open to enable your company to make informed and timely decisions.
What action to consider
- Ensure contract managers and internal lawyers understand the ipso facto reforms and how they affect contractual rights. Improper exercise of rights could lead to wrongful termination (repudiation), so the reforms could potentially amplify the risks that arise with a supplier who may be in financial difficulty. Ensure contracts and business continuity plans take into account potential delays to exercising termination rights which would exist without the ipso facto reforms in place.
- You may be able to obtain the consent of the external administrator to exercise your rights or applications to the courts may be made to circumvent the statutory stays on the execution of these rights, but these should not be relied on as they may prove hard to obtain.
What to do in the case of your own financial difficulty
- Assess agreements with key contractors and keep the dialogue open with them.
- Understand your rights and pay attention to provisions which may allow a supplier to terminate an agreement without relying on an insolvency clause which may be stayed under the ipso facto regime. For example, there is commonly a right to terminate for non-payment of fees. In the current environment it is advisable to ensure that any non-payment or non-performance is documented and appropriate communications sent reserving your rights. In this way you can avoid arguments that you have waived the right to rely on any defaults following an insolvency.
- Assess which agreements are business critical and which could be renegotiated or exited in an orderly manner to preserve key parts of the business.
Essential services
One final point to note is the application of Section 600F of the Corporations Act. This section prevents "essential services" from being "turned off" when a company is being wound up, provisionally liquidated, is under administration, has executed a deed of company arrangement that has not yet terminated or a receiver, or receiver and manager, of property has been appointed.
Essential services are defined as electricity, gas, water, or a carriage service. It is worth asking the question as to the urgent need for reform in this area. In this age of reliance on technology it is easy to see a range of technology which may properly be classified as essential to the operation of a business, for example the technology systems of an online retailer, but these are not included.
In this regard Australia has lagged behind the United Kingdom where, in 2015, the list of essential services was expanded to include technical support for information technology, data storage and processing, and website hosting, which could not be "turned off" provided the administrator gives a personal guarantee for post administration charges.
How we can help
If you have questions about the application of the ipso facto regime to your particular situation or if you need assistance in analysing your business continuity planning with key technology providers, please contact us.