Can we create a business rescue culture in Australia?

This article was written by Michael Brereton and Sean Wengel, Directors and Registered Liquidators at William Buck Chartered Accountants and Advisors, Business Recovery Services

Will the recently introduced restrictions on Ipso Facto clauses improve the prospects of a distressed business being restructured and saved?

Several insolvency law reforms have been introduced in the past 12 months, most of which are compliance focussed, but important changes have been included which attempt to improve the prospects of distressed businesses being restructured and saved.

How did we get here?

The seed that germinated into the Treasury Laws Amendment (2017 Enterprise Incentives No. 2) Act 2017 which introduced certain restrictions on the enforceability of Ipso Facto clauses, can be traced back to Qantas’ poor financial performance in 2013 which culminated in Qantas’ announcement of a shocking full-year loss of $2.8 billion, which was far worse that the most dire predictions at the time.

Serious concerns were raised whether the Australian insolvency laws at the time would be able to cater for the potential insolvency of Qantas. Much debate focused on whether the business could be resuscitated, reorganised and saved using Australia’s existing insolvency laws, or whether consideration should be given to introducing a form of Chapter 11 Plan of Reorganisation based on the US Bankruptcy Code.

Promoting a business rescue culture – Voluntary Administration versus Chapter 11?

The core purpose of the Voluntary Administration process and the Chapter 11 Plan of Reorganisation process are remarkably similar, but in practice the outcomes being achieved by each are markedly different.

The purpose of Voluntary Administration is to work out a way to save either the company or its business, and if that is not possible, the aim is to administer the affairs of the company in a way that results in a better return to creditors than if the company had instead been placed straight into liquidation. In contrast, Chapter 11 provides for reorganisation, with the insolvent company (Debtor) usually proposing a plan of reorganisation to keep its business alive and pay creditors over time.

Both processes set out to:

  • Provide relief to a company unable to pay its debts
  • Maximise value
  • Reorganise business
  • Keep business alive (if possible)

The generally held view is that the prospects of a distressed business being rescued and saved is significantly greater in the US compared to Australia, and this view is supported by recent statistics published by the US Bankruptcy Courts and by the Australian Securities and Investments Commission.

In the US, in the 12 months to 30 June 2018, 27% of businesses which filed for protection under the US Bankruptcy Code filed for Chapter 11 protection which is designed to reorganise and resuscitate a business, while 61% of businesses filed for Chapter 7 protection which is designed for the immediate liquidation of businesses.

In contrast, in Australia in the 12 months to 30 June 2018, only 14% of companies which filed for some form of insolvency appointment, filed for voluntary administration, while 79% of companies filed directly for liquidation (whether court liquidation, creditors voluntary liquidation or provisional liquidation).

Our expectation, is that a large proportion of the companies which entered Voluntary Administration were ultimately liquidated and that the true number of businesses which were rescued or resuscitated is a small sub-set of this number.

The challenges of today – continuing to trade

The existence and use by suppliers of Ipso Facto clauses is one of the major impediments restricting the ability of a voluntary administrator from continuing to trade a business after his or her appointment as voluntary administrator to a company, which limits the prospects of rescuing, resuscitating or saving a company and or its business.

An Ipso Facto clause is a provision in an agreement which permits its termination due to the bankruptcy, insolvency or financial condition of a party. In practice these clauses are standard across most supply contract and provide the supplier with the absolute discretion to terminate the contract as soon as the Debtor enters into administration.

It is perfectly reasonable and understandable that each individual supplier will wish to include Ipso Facto clauses in any supply contract that it has with its customers. Suppliers who are suddenly faced with non-payment of debts owed to it, will not want to increase their exposure to the customer, particularly given the customer’s risk profile has clearly changed following the appointment of the voluntary administrator.

In practice, the administrator, shortly after his or her appointment, faces a situation where suppliers generally, as a matter of course, terminate their existing contracts with the company, and may or may not agree to enter into new supply arrangements with the administrator. If suppliers do agree to continue supplying the Debtor they often do so on materially different terms, with the Debtor offered significantly inferior terms involving cash up front, increased pricing, and short-term contracts.

The administrator is often forced to extinguish multiple fires at the same time as suppliers independently terminate existing contracts, and the administrator is obliged to re-enter negotiations with multiple suppliers across the business, in his or her attempts to continue operating the business. These negotiations can be extremely challenging, time consuming and volatile.

It should not be surprising that administrators often form the view that the prospects of continuing to operate a business while in administration are low, given these difficulties in continuing to source supplies for the Debtor.

The administrator’s ability to continue trading a business is significantly more difficult in the case of businesses without a large proportion of hard assets. It is one thing to attempt to continue trading a property holding company or a steel mill, and another thing altogether to continue operating a business with few hard assets, and a large intangible asset base. In many cases, the value of these types of businesses evaporate immediately on the appointment of an administrator. In the modern economy fewer businesses have a large tangible asset base, and more and more businesses are based on intangible assets. It is exactly these businesses which are the most difficult for an administrator to continue operating following his or her appointment to the Debtor.

The challenges of today – selling a business in administration

In the event that an administrator is unable to continue trading a business, the value destruction can be significant. The value to potential purchasers is severely diminished when it is only able to acquire the trade mark or brand of a discontinued business.

Even if the administrator is able to successfully continue trading the business, the administrator’s ability to sell a business is often compromised as the company has no long-term supply arrangements in place, as the new arrangements entered into by the administrator with suppliers are often short-term arrangements, on uncompetitive terms.

What’s the alternative?

It is enlightening to consider how the US Bankruptcy Code treats Ipso Facto clauses. The US Bankruptcy Code introduces the concept of an Executory Contract, which in its simplest form is any contract that has not yet been fully performed or fully executed.

The US Bankruptcy Code, then provides that either the Trustee or the Company in Chapter 11, namely the debtor in possession has the unilateral ability to decide whether to assume any prepetition executory contract or unexpired lease of the debtor, preserving obligations of both the debtor and the counterparts by the bankruptcy process.

In contrast, the supplier to the Debtor has no ability to terminate a contract simply because the counterpart has entered into Chapter 11. In short, Ipso Facto clauses are void.

The approach adopted by the US Bankruptcy code preserves the estate of the Debtor and allows the business to continue operating on a business as usual basis while the Chapter 11 process progresses.

Executory Contracts – a step too far?

There are valid arguments that the balance of power in the US is too much in favour of the Debtor (insolvent entity), while suppliers to the Debtor have too little power, when a Debtor files for Bankruptcy protection.

Debtors are arguably able to misuse the Executory Contracts legislation to ‘clean up’ any unfavourable out-of-the-money contracts or leases, thereby reducing their cost base, which provides a competitive advantage over other industry competitors. In time the Debtors competitors follow suit and also utilise the Chapter 11 process for the same purpose.

One anomaly in the US, is that all major US airlines and most retailers have at some stage filed for Chapter 11 Bankruptcy protection to enable them to clean up their balance sheets and terminate unprofitable contracts.

However, despite these complaints on the potential misuse of the Executory Contracts provisions in the US Bankruptcy Code, there is no doubt that the legislation, in favouring the Debtor over its suppliers; provides an environment which preserves the estate of the Debtor; allows the business to continue operating, and improves the prospects of a Debtor’s business being saved which preserves employment and value for all stakeholders.

Restrictions on the use of Ipso Facto clauses?

The recent Australian legislation focussed on introducing certain restrictions on the enforceability of Ipso Facto clauses with the aim of improving the prospects of a company continuing to trade while in administration.

The purpose of the reform is to protect the value of the company by restricting the ability of the company’s suppliers from terminating contracts solely due to the insolvency or financial position of the distressed company.

Will the restrictions on the use of Ipso Facto clauses improve the prospects of saving a distressed business?

The new Australian legislation on the restriction of Ipso Facto clauses came into effect on 1 July 2018.

The new legislation initially only applies to new supply contracts entered into after 1 July 2018, and includes a five-year transition period for existing supplier arrangements. Leading up to the introduction of the new legislation on 1 July 2018, we anticipate that many suppliers would have been conducting a review of their supply agreements and arrangements. We expect that suppliers will now be actively seeking to extend their existing supply arrangements so as to obtain the benefit of the Ipso Facto clauses, which no doubt are included in existing supply agreements for the full five-year transition period.

The recent legislation contains extensive exemptions which need to be carefully reviewed and assessed and there is no doubt that the corporate lawyers will be very busy interpreting the nuances of the legislation for the parties who may seek to rely on the exemptions.

Our expectation is that an administrator when considering whether or not to continue to trade a business following his or her appointment, is unlikely to place much reliance on the new legislation, at least during the five-year transition period.

An administrator who is faced with attempting to preserve the value of a business, and is attempting to continue operating the business, is unlikely to be persuaded to incur personal liability in trading the business while faced with disputes with some key suppliers who rightfully or not refuse to continue supplying the company. While in practice, an administrator may elect to take legal action to compel one or two suppliers to honour the terms of the pre-existing supply agreements, unless a critical mass of suppliers continue to honour their pre-existing contracts, we would be surprised if an administrator would be prepared to continue trading while litigating with key suppliers.

Accordingly, we do not expect the legislation will achieve its objective in the short term, particularly during the five-year transition period.

Looking to the future

We expect that, in the medium term, the introduction of the restrictions on the use of Ipso Facto clauses should improve the ability of an administrator to continue operating a business while in administration, which may enhance the prospects of the Debtor being saved, resuscitated or restructured.

We are hopeful that the introduction of this legislation is just the first small step towards improving the prospects of companies continuing to trade while in administration, which may improve the prospects of businesses being rescued.

In the interim, credit managers should be aware that the introduction of the restrictions on the reliance on Ipso Facto clauses has materially changed the risk profile of their customers.