The impact of the new insolvency laws on leases

The Treasury Laws Amendment (2017 Enterprise Incentives No. 2) Act 2017 (Act) that received royal assent on 18 September 2017 contains major restrictions on the enforceability of ipso facto clauses.

The reforms will apply to contracts entered into after 1 July 2018.

Ipso Facto Provisions

The Act prevents a party from enforcing “ipso facto clauses” by mandating an automatic “stay”.

Ipso facto clauses (in this context) are contractual provisions that allow one party to suspend the performance of a contractual obligation or terminate the contract upon the occurrence of an insolvency event in respect of the other party.

Under the Act, a “stay” will be enforced on any term that gives a contractual right to suspend the performance of a party’s obligations under the agreement, or to terminate as a result of:

  • A company entering administration, receivership or where a scheme of arrangement is proposed;
  • A company’s financial position if in administration, receivership or subject to a scheme of arrangement;
  • A reason prescribed by regulation that relates to the possibility of the insolvency events above and the company’s financial position; or
  • A reason “that, in substance, is contrary to” the new intention of the new provisions.

The stay of contractual rights also applies to “self executing provisions” which are contractual provisions that apply automatically in the relevant contract.  For example, in a lease, the insolvency of a tenant will be an automatic default under the lease.

How long will the “stay” be effective?

The period of the “stay” will depend on the type of insolvency event that the party is experiencing.

Under voluntary administration, the stay begins when the company enters administration and ends when the administration ends or when the company is wound up.

Under receivership, the stay begins when the managing controller or receiver is appointed and ends when the managing controller’s or receiver’s control ends. The length of a stay arising from a receivership could be concerning as a receiver’s appointment can last a considerable period of time. In that case, another event of default (such as the failure to pay rent) could be relied upon by the landlord to end the lease.

In the application of a scheme arrangement, the stay begins when a public announcement or scheme application is made and ends three months after public announcement, when the application is unsuccessful or dismissed or when the company is wound up.

The stay does not affect an ipso facto clause that is agreed to between the parties after a company experiences an insolvency event.

The impact on leases

It is a standard lease term that a landlord can terminate a lease if the tenant experiences an insolvency event. Reliance on this ipso facto clause protects the landlord from being exposed to risks that may arise from continuing a lease with a tenant that is in a financially unstable and precarious position. 

Events commonly prescribed in Leases that give rise to an ipso facto right to terminate include:

  • The Tenant or Guarantor are insolvent under administration or insolvent (each defined by the Corporations Act1).
  • The Tenant or Guarantor has a receiver, manager, receiver and manager or a controller (each defined in the Corporations Act1)appointed in respect of its business or any of its assets. 
  • The Tenant or a Guarantor enters into (under section 435C(1) of the Corporations Act1) any form of administration.
  • The Tenant or a Guarantor are subject to any arrangement, moratorium, protected from creditors under any statute, or any other arrangement for the benefit of creditors. 
  • Any application or order has been made, resolution passed, proposal put forward, or any other action taken which is preparatory to, or could result in, any of the things referred to above. 
  • Something, or an event, that has a substantially similar effect to any of the above.

The new provisions aim to put a stay on the right to terminate on the basis of these reasons that are, in substance, contrary to the new regime.

From a tenant’s perspective, reliance by the landlord on the right to terminate and other ipso facto clauses, often has substantial impacts on the insolvent party’s business, cash flow and ability to turn its financial position around. For a distressed tenant this may result in irreparable damage to its business and the inability for external administrators to maintain company value and realise the tenant’s assets. The provisions deal with these issues and are an added protection for tenants experiencing an insolvency event.

Under the Act the Courts have the power to override a stay on one or more rights under a contract or agreement and may impose terms that the Court thinks fit.  This provides an avenue for a landlord to enforce its right to terminate a lease on the basis of an ipso facto clause. However, it will be a costly exercise for a landlord and will take time to achieve the necessary orders. Such a course of action would only be considered in extreme cases.  

Considerations for landlords and tenants

The stay on the enforcement of ipso facto clauses does not have immediate or retrospective application. The stay only applies to contracts entered into after 1 July 2018.

Therefore, landlords and tenants entering into leases between now and 1 July 2018 can still rely upon ipso facto clauses in their leases. However, the new regime will apply to option periods as an option constitutes a new lease.

If landlords are concerned about the financial strength of a tenant, the lease could provide that the tenant provide financial information to the landlord on a regular basis and when requested by the landlord. If the landlord is not satisfied with the capacity of the tenant to carry on its business (based on that financial information) the landlord could elect to end the lease. Turnover rent mechanisms are a good way to measure a tenant’s trading performance. By implementing a turnover rent component in the lease, together with appropriate remedies for the landlord, the landlord may be able to overcome some of the effects of these new insolvency provisions.

Care will be needed in drafting these provisions because the Act has provisions that are designed to ensure that the Act is not circumvented.

Landlords should also continue to insist on security deposits and bank guarantees from tenants to protect themselves in the event of an insolvency of a tenant. Clauses in respect of security deposits and bank guarantees in this context should be carefully drafted and give the landlord the right to rely on the deposit or present the bank guarantee without having to terminate the lease.

If landlords continue to include ipso facto clauses in their leases after 1 July 2018 they must be careful when issuing a termination on the basis of these clauses.  In those circumstances, it may be open for a tenant to treat a landlord's purported termination of the lease based on an ipso facto clause as a repudiation of the contract.  In that case, the landlord's purported termination of the lease may mean that the tenant is entitled to sue for damages.

The Act does not prevent a landlord from terminating a lease arising from other breaches, for example the non-payment of rent. Landlords should continue to take extreme care in determining when, and on what basis, termination notices are issued. Landlords should ensure that they are not inadvertently or mistakenly issuing termination notices on the basis of ipso facto clauses associated with other breaches or default of the lease. Despite these issues, other breaches (such as non payment of rent) may be a more effective basis for termination of the lease.

Moving forward, landlords should tread carefully and ensure that they are fully satisfied as to the tenant’s financial strength before the grant of the lease. Landlords could consider the inclusion of the following mechanisms in leases:

  • regular provision of financial documents to the landlord during the term of the lease and on the exercise of any option;
  • turnover rent provisions; and
  • security deposits or bank guarantees,

as ways to continue monitoring the performance of the tenant and overcome any surprises of insolvency.