What do the ipso facto reforms mean for M&A transactions?

On 1 July this year, reforms to the Corporations Act 2001 (Cth) came into effect which will potentially have a significant impact on the operation of M&A transactions in Australia. The reforms impose a prohibition on the enforcement of rights against a company including, relevantly, contractual termination rights, arising because the company is in voluntary administration, receivership or subject to a scheme of arrangement. The reforms also capture broader insolvency-related events by preventing the enforcement of those contractual rights because of “the company’s financial position” at the time that they are under voluntary administration, receivership or subject to a scheme of arrangement.

Prior to the reforms, ipso facto clauses in contracts entitled a counterparty to terminate or exercise another contractual right under the contract on the occurrence of the other counterparty experiencing an insolvency-related event. The problem with these clauses was that when a company exercised its ipso facto rights, such as contract termination, it deprived the counterparty of any prospect of economic recovery. This result is contrary to one of the key statutory objectives of the voluntary administration regime, namely: "for the business, property and affairs of an insolvent company to be administered in a way that “maximises the chances of a company, or as much as possible its business, continuing in existence.”

Given that the core purpose of the ipso facto reforms is to preserve and enhance the value of distressed businesses, the reforms might increase the opportunities available to investors seeking to strategically invest in distressed businesses. Of particular interest to investors will be businesses with predominantly intangible assets who depend heavily on critical suppliers to create their enterprise value proposition. The ipso facto reforms will help preserve value for these businesses by “locking in” critical suppliers to ensure that the business can continue to deliver products and services of value to its customers during a formal restructuring process.

The ipso facto reforms emulate to some extent the ipso facto moratorium under Chapter 11 of the United States’ Bankruptcy Code. Section 365(e)(1) of the Code provides that a contract may not be terminated solely because of a condition in the contract “conditioned on the insolvency or financial condition of the debtor at any time before the closing of the case”.

In the United States, investors embraced the unique provisions of Chapter 11 to effect strategic mergers and acquisitions. Significant examples include U.S Airways acquiring Chapter 11 debtor American Airlines; Barclays Capital Inc. purchasing Lehman Brothers’ brokering business; and Wilbur Ross acquiring Burlington Industries Inc. in a bankruptcy auction after having purchased a significant portion of the company’s unsecured bonds and bank debt.

The Australian ipso facto reforms come at a time when many high-profile retailers, faced with innovative disruption and new market entrants are facing increased distress. While it remains unclear whether the ipso facto reforms will encourage more distressed mergers and acquisitions in Australia, it is a positive step for distressed companies that are attempting to negotiate a sale and avert going into administration.

The new regulations enacted and ministerial declarations made in late June 2018 set out over 30 different categories of contracts that are exempted from the prohibition on exercising rights under the ipso facto clauses. Relevantly for mergers and acquisitions, this includes: “a contract, agreement or arrangement for the sale of all or part of a business, including by way of the sale of securities or financial products.”

Therefore, in relation to a contract for the sale of a business, ipso facto clauses will operate in the same way they did prior to the reforms, including in situations where the purchase is made by way of securities or financial products in the entity being purchased including by way of share subscription agreements. A company with a contractual right to amend or terminate a sale agreement in circumstances where an insolvency-related event occurs, will be able to enforce that right.

One of the key reasons for mergers and acquisitions being carved out of the reforms is to instil more confidence in early negotiations around sales of distressed businesses. As outlined in the explanatory statement to the regulations, the sale and purchase of a business in financial distress is often negotiated as an alternative to a formal insolvency process. The prohibition on the operation of ipso facto clauses could significantly impact the sale price of a business in financial distress as prospective buyers would take into account the possibility of having to complete the transaction despite the occurrence of an insolvency-related event. Lower sale prices would restrict the capital inflow for businesses in financial distress thereby making it more difficult for the business to avoid formal insolvency processes. This would be contrary to the purpose of the ipso facto reforms which aim to maximise the chances of a company's continued success.

Ancillary agreements

Despite the exemption under the regulations, the ipso facto reforms may still have an impact on mergers and acquisition transactions through the application of the reforms to ancillary agreements to transactions for the sale of a business. It remains unclear whether such agreements will be caught by the exemption. If the exemption does not apply, the reforms could have a significant impact on the operation of a variety of agreements which facilitate mergers and acquisitions or govern the relationship between the buyer and seller after the transaction has taken place.

Some examples of ancillary agreements which could be affected include transitional service agreements, IP licence agreements, lease agreements and escrow agreements. The key consideration will be whether the subject matter of the ancillary agreement can be properly characterised as a “contract, agreement or arrangement” for the sale of a business and therefore captured by the exemption. A broad interpretation of “arrangement” would suggest that the exemption would apply provided the terms of the ancillary agreement clearly establish that it supplements the sale agreement or governs an aspect of the relationship between the buyer and seller in respect of the sale agreement.

It remains to be seen how broad an interpretation the expression “arrangement” will be given and it may well be that many types of ancillary agreements are construed as being separate to the sale of business transaction and therefore falling outside of the ipso facto exemption. A cautious approach to contractual drafting will likely be required, particularly if there is any element of distress in the acquisition target.

Put and call arrangements

Another area of uncertainty is the application of the reforms to put and call arrangements which often include clauses allowing the parties to bring forward their put or call in circumstances where the counterparty experiences an insolvency related event. The question of whether the exemption in the regulations applies to put and call arrangements is complicated by the fact that the arrangements do not provide for the sale of a business unless and until the put or call is exercised. Again, adopting a broad interpretation of “contract, agreement or arrangement” would suggest that put and call arrangements might be caught by the exemption.

Any contracts entered into under pre-1 July 2018 option arrangements are unlikely to be subject to the reforms. This is because the better view in Australian law is that a put or call option is to be characterised as a conditional contract which becomes unconditional upon the exercise of the option by the grantee and the satisfaction of any other conditions prescribed by the option terms (Laybutt v Amoco Australia Pty Ltd (1974) 132 CLR 57 at 76 and Grepo v Jam-Cal Bundaberg Pty Ltd [2015] QCA 131). According to that line of authority, no new contract is entered into on the exercise of the option.

The reforms might have a significant impact generally on the operation of clauses within contracts where a right or obligation arises on the basis of a counterparty experiencing an insolvency-related event. Shareholder agreements for example often include clauses obliging a shareholder, in circumstances where the shareholder experiences an insolvency-related event, to transfer its shares to the other shareholders. If the shareholder refuses to do so, the agreement will often provide for a deemed appointment of a power of attorney to that shareholder in order to affect the share transfer on the shareholder’s behalf.

Although the full extent of the impact of the ipso facto reforms remain to be seen, there are a few things that businesses can do to ensure greater contractual certainty around their commercial relationships. For contractual counterparties, consideration should be given to:

• The ‘ipso facto’ provisions in your business’s contracts and any contractual or other mechanisms that might mitigate the risk to your organisation if any counterparties enter into external administration;
• If possible, varying existing contracts rather than entering into new contracts after 1 July 2018. However, it should be noted that a substantial variation to the terms and conditions of an existing contract may be deemed to be a new contract. While a contract variation could allow for the continued enforcement of ipso facto provisions contained in the existing contract, care will need to be taken to ensure that the varied contracts do not fall foul of the anti-avoidance provisions which prevent parties contracting out of the provisions;
• Strengthening default clauses and covenants in contracts bearing in mind the commerciality of such provisions;
• When entering into a new contract, ensuring that you have performed adequate due diligence on a counterparty concerning its financial position and also ensuring that appropriate Personal Property Securities Act 2009 (Cth) registrations are in place; and
• Reviewing business policies and processes for dealing with counterparties to detect and deal with counterparties in financial distress before they enter into external administration.

Moving forward, contractual counterparties will be required to adopt a different approach in managing counterparty insolvency and should consider the terms of their contracts, policies and procedures for dealing with those situations.