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“Ipso facto” escape hatch prohibited under insolvency reforms

122BusinessTaxEffectOfInsolvencyOnContractsThere was a time when, if a company got into financial difficulty the contracting party could terminate the contract, even if the company had been meeting all its obligations.

The “ipso facto” clause was the contract’s device that allowed this termination to take place. A Latin term that means, rather unhelpfully, “by the fact itself”, the ipso facto clause acted like a trip switch in a fuse box that the contractor could flick at the occurrence of an insolvency event, pulling the plug on the contract and bringing an end to the business trading. Not so now.

Contracts will no longer self-destruct at onset of insolvency

As part of the sweeping insolvency reforms that came into operation on 1 July 2018, new legislation has prohibited ipso facto clauses that once provided for a contract to self-destruct in the event of insolvency.

An insolvency event can include voluntary administration, receivership and schemes of arrangement. These are all processes where the company is trying to work its way out of financial difficulty.

The activation of the clauses has been particularly prevalent in the construction industry where parties seek to withdraw the obligation to continue providing their services in what they consider to be a risky business environment.

Ipso facto and safe harbour share common purpose

The new ipso facto provisions and the safe harbour reforms (discussed in previous articles) share a common purpose – to discourage directors and contracting parties from bailing down the escape hatch, and to get them to keep trading.

This essence of the ipso facto reform, that only applies to contracts, agreements or arrangements entered into after 1 July 2018, is to provide for a “stay” against the enforcement of those ipso facto clauses.

In other words, any action taken by a party relying on that ipso facto clause to weasel its way out of a commitment to stay the distance of the contract, would be suspended to allow the company to continue trading for the benefit of its creditors and employees, until the administration ends or the company is wound up.

A contracting party can apply to the court for an order that a stay on enforcement rights be lifted if it is appropriate in the interests of justice or, in the case of a scheme of arrangement, if the scheme was not for the purpose of the company being wound up in insolvency.

The very positive side of the change for creditors and employees is that the company experiencing financial difficulty can continue to trade while it still meets its obligations under the contract – without the other party pulling the contractual rug from under its feet.

Help at a time of change

With all the changes taking place in insolvency, we can guide you through the opportunities provided by the complex reforms.