More pressure on financiers – the demise of the ‘Insolvency’ event of default

From July 2018, amendments to the Corporations Act commence which significantly limit the ability of financiers to rely on the occurrence of a traditional ‘insolvency event’ to terminate a credit contract.

The new laws are informally known as the ipso facto clause amendments. This phrase is lawyers’ shorthand borrowed from the Latin, and means ‘by the mere fact’.

Combined with the recent enactment of the ‘safe harbour’ provisions, the intent is to give company directors scope to turn their businesses around before the full weight of insolvency law descends on them and their businesses.

The ipso facto label is applied to a clause that deems a party to be automatically in default simply by the occurrence of a certain event affecting that party.

For example, in equipment leases and other finance contracts, it is common to see a customer being found to be insolvent because of a default. “Insolvent” is invariably defined elsewhere in the contract, usually at length, to include things like a company being put into administration, having an external controller appointed to most or all of the company’s business, or the company entering into an arrangement to avoid being wound up.

The occurrence of such an insolvency event typically creates an automatic right for the financier to terminate its lease or loan contract. From July 2018 that right (except in the case of liquidation), will no longer be available.

In the case of operating and finance leases the ‘insolvency event’ is usually described as one of the ‘fundamental’ or ‘essential’ terms of the contract. Although seemingly of no practical effect, the classification of an insolvency event in this way gives the financier the lawful right to say that the contract had been repudiated and is therefore terminated.

The deemed ‘repudiation’ of the lease or rental contract comprises the trigger for the financier to demand an actuarial or early termination payout. Long established case law says that a financier is only entitled to demand rebated future instalments if the customer has first repudiated the contract.
Regarding straight loan contracts, upon the occurrence of an ‘insolvency event’ the lender is typically granted the right to ‘accelerate’ the loan, such that all outstanding principal becomes immediately due to be repaid.

To counter what might possibly lead to the disruption of business finance and commercial dealings generally, the government has belatedly put out draft regulations to confine the operation of the new laws. The proposed regulations (and a ‘declaration’) purport to exempt virtually every conceivable banking and finance product, as well as key provisions in major commercial contracts like ‘step-in’ rights, termination rights and sale of business rights.

Laws are meant to bring predictability to commerce and economic activity generally. Yet what is happening with the ipso facto and the safe harbour laws is the opposite. Together with the recent unfair contract terms law, these new Corporations Act amendments will present a further risk to the willingness of financiers to provide credit, and in the case of their lawyers, impose the need to check government regulation before they begin drafting.