Legal Update – Removing Rights of Termination – Insolvency

18 JULY 2016

It has been reported that the construction industry accounts for 20 to 25 per cent of all insolvencies in Australia. So when the Federal Government recently proposed new laws aimed at making legally unenforceable clauses which allow contracts to be terminated solely due to an insolvency event, it is arguably the construction industry that stands to be most affected.

Why reform?

The Federal Government argues that clauses which allow for the termination of contracts due to an insolvency event diminishes the value of a business entering insolvency and may reduce the scope for a successful restructure or prevent the sale of the business as a going concern, with a flow-on effect to the returns to creditors in a liquidation. The current voluntary administration scheme has been criticised for failing to protect contractors from these types of clauses. The proposed laws reflect some of those already adopted in the United States

What will change?

The proposed new laws would make legally unenforceable a clause which seeks to vary or terminate a contract if the contractor suffers an “insolvency event”. These events include:

  • An administrator being appointed to the company;
  • The company undertaking a scheme of arrangement to avoid administration or insolvent liquidation;
  • A receiver or controller being appointed; and
  • A company entering a Deed of Company Arrangement.

The proposed new laws do not, however, seek to make legally unenforceable a clause which allows a contract to be terminated if the insolvency event is a company entering liquidation.

It is also important to be aware that the proposed laws seek to make unenforceable certain clauses which penalise contractors for insolvency events. An example of an offending clause is one which requires a party to provide further security if it suffers an insolvency event.

Significantly, the Federal Government is also seeking that the proposed new laws apply to contracts entered into both before and after the laws are passed.

What to do?

While the proposed new laws are in their infancy and are not expected to be passed until about mid-2017, it may be prudent for businesses to consider their likely impact now and plan for the risk of the laws applying to contracts entered between now and then. Many standard form construction contracts contain clauses allowing the principal to terminate for the types of insolvency events targeted by the new laws.

A practical effect of the new laws is that principals could be legally obliged to persist with a contractor in financial difficulties, where they previously enjoyed a right to get out of the contract. This carries a greater risk to completion and recourse in the event of construction defects. In approaching new contract negotiations, principals should plan for this greater risk by seeking balancing protections in other areas (e.g. lower price, greater security upfront etc) and being bullish about insisting on its usual protections.

Interestingly, the proposed new laws do allow for a principal to apply to the Court to vary the terms of a contract in the event that they are experiencing hardship as a result of an insolvency event. However, applying to Court can be a costly exercise with no guarantee of relief.

We would be pleased to assist you in planning for the potential impact of the proposed new laws including by drafting appropriate balancing protections into construction contracts now.

We will keep you updated on the progress of the new laws.

Contact Partner: Michael Coe
Direct Telephone : 07 3210 5709
Mobile Telephone : 0408 983 876
michael.coe@kinneallymiley.com.au

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