Legal briefing | Commercial Law, Finance, Restructuring & Insolvency, Commercial & Technology, Supply of goods and/or services |

Terminating supply contracts on insolvency: what's changed?

Overview

On 25 June 2020, new legislation came into force in the UK which makes it much more difficult for suppliers to terminate contracts where the customer is subject to an insolvency procedure. In this briefing, we highlight the key issues that both suppliers and customers should be aware of and consider whether you should amend termination provisions in new contracts.

What does the new legislation do and why?

The Corporate Insolvency and Governance Act 2020 ("CIGA") received Royal Assent on 25 June after an accelerated passage through Parliament. Among a slew of other changes to insolvency and corporate law (click here for more detail), the Act prevents suppliers relying on any contractual provision which would allow the supplier to terminate or to do "any other thing" as a result of its customer becoming subject to a "relevant insolvency procedure." This includes provisions where the consequence occurs automatically on the customer's insolvency, as well as those which only occur if action is taken by the supplier (such as serving a notice to terminate). Such provisions are sometimes referred to as "ipso facto clauses."

The Act also prevents suppliers from terminating supply contracts based on past breaches which are unconnected with the customer's insolvency, where the right to terminate was not exercised before the start of the relevant insolvency procedure affecting the customer.  The impact of these measures is to make it much more difficult for suppliers to terminate contracts once a customer is subject to an insolvency procedure.

What is a relevant insolvency procedure?

The definition of a "relevant insolvency procedure" includes situations where the company (i.e. the supplier's customer):

  • is subject to a moratorium,
  • enters administration or liquidation,
  • has an administrative receiver or provisional liquidator appointed,
  • enters into a voluntary arrangement such as a "CVA"; or
  • is subject to a court order for a meeting relating to a compromise or arrangement.

The restrictions in CIGA are intended to prevent rescue efforts for companies in financial difficulty being undermined by suppliers.  For example, a company which is reliant on a particular supplier may be forced to cease trading if that supplier is able to terminate when the company becomes subject to an insolvency procedure. Similarly, rescue efforts may be hampered if a key supplier refuses to continue to supply unless all outstanding payments are met immediately (thus potentially putting itself ahead of other creditors).

Do the restrictions in CIGA affect any party wishing to terminate on insolvency?

Although the restrictions in CIGA have a broad ambit, there are several important limitations on their scope: 

  • First, CIGA only restricts the ability of suppliers to terminate when their customer has become subject to an insolvency procedure; if you have contracted as a customer and you are looking to terminate your agreement with an insolvent supplier, CIGA will not affect you. 

  • Second, the restrictions in CIGA also only apply to suppliers of goods and services. As a result, termination and other rights in, for example, an IP licence which allowed the licensee to produce goods for distribution to third parties in return for payment of royalties to the licensor would not be affected (unless the licensor was also providing services to the licensee).

Other exceptions

  • The restrictions in CIGA will generally not apply to most financial services suppliers (or financial services contracts) and certain Public-Private Partnership project companies;
  • Suppliers such as utilities and communications and IT service providers which are already covered by the "essential supplies" regime in sections 233 and 233A of the Insolvency Act 1986 are also excluded from CIGA – but they are already subject to similar restrictions (so it was not felt necessary to include them within CIGA's ambit);
  • There is a temporary exclusion until 30 March 2021 for "small" suppliers meeting at least two of the following criteria in their most recent financial year: (i) turnover no more than £10.2m; (ii) balance sheet no more than £5.1m; and/or (iii) average number of employees no more than 50.

Does CIGA mean that suppliers are forced to continue to supply, come what may?

Whilst it's true that CIGA makes it much more difficult for suppliers to terminate when a customer becomes subject to an insolvency procedure, there are still some cards that suppliers can play, depending how the situation develops.

As noted above, CIGA prevents a supplier making further supply conditional on payment of any outstanding amounts and effectively wipes the slate clean during the insolvency procedure in respect of pre-insolvency events (of any type) giving rise to termination rights. However, if a breach which would have entitled the supplier to terminate prior to the customer's insolvency recurs after the insolvency process begins, it would be regarded as a fresh breach and the supplier could (depending on the terms of the contract) terminate on that basis. 

Suppliers which are prevented from terminating on insolvency must also continue to be paid for the supply provided during the insolvency procedure, failing which they will be able to terminate according to the terms of the agreement. So even in a situation where pre-insolvency, some invoices have gone unpaid, the supplier may find that once an insolvency procedure has commenced (and assuming the insolvency office holder wishes to continue the contract), the funds will be found to pay it going forward in order to avoid termination – albeit that any unpaid pre-insolvency invoices may have to wait until the customer emerges from the procedure.

In some cases, suppliers may also find that the insolvency practitioner or the customer (depending on the type of insolvency procedure) does not wish to continue the contract and is therefore content to allow it to be terminated (indeed, CIGA expressly provides for this). Lastly, CIGA allows the supplier to apply to court for permission to terminate on the basis that the continuation of the contract would cause it "undue hardship".

What is undue hardship?

Government guidance on this option suggests that the supplier would need to show a real risk that it would become insolvent itself if it were required to continue supply. It's possible that courts will be willing to interpret the "hardship" test more generously, for example, in circumstances such as a liquidation of the customer, where the prospect of ever being paid is remote. On the other hand, a court may be less willing to allow the termination of so-called "Relational Contracts", for example and, in the near-term, the recent Cabinet Office guidance on responsible contractual behaviour suggests that a dim view may be taken of attempts to terminate contracts which are impacted by the fallout from Covid-19.

How should suppliers approach insolvency termination triggers in new contracts?

It's important to keep insolvency termination triggers in perspective. For example, in many cases, a right for a supplier to terminate on its customer's insolvency is of limited practical use – termination of a contract isn't going to improve your chances of getting paid. It is, though, a useful defensive option, enabling the supplier to redirect resources towards more viable customers and to limit further losses.

Insolvency termination triggers: worth keeping?

Given how difficult CIGA makes it for suppliers to rely on insolvency termination triggers, some might question whether it is worth suppliers continuing to include such provisions in their contracts. However, on balance, our view is that it's still worth including rights for a supplier to terminate on a customer's insolvency, both in standard terms and in negotiated agreements, if only to preserve the possibility that either an office-holder or the court would allow termination via the statutory route (see above). In some circumstances, the threat of court proceedings for hardship might be sufficient to persuade an office-holder to agree to termination.

Suppliers might also want to consider earlier triggers so as to permit termination before the "relevant insolvency procedures" contemplated in CIGA, for example if the customer gives notice of its intention to appoint an administrator (the trigger in CIGA is the actual entry into administration rather than the giving of notice). Withdrawal of a customer's credit insurance or downgrading of its credit rating could also act as useful proxies – if nothing else, requirements for the customer to notify in these circumstances should act as an early warning system. However, as termination insolvency rights are typically mutual, suppliers should bear in mind that these earlier triggers could also be relied upon against them by customers.

How else can suppliers mitigate the impact of CIGA?

Without the safety net of termination rights on customer insolvency, it's even more important for suppliers to do proper financial due diligence at the outset, especially if there's a prospect of significant work being done before a payment obligation arises for the customer.

It's now even more important for suppliers to do proper financial due diligence on customers and to monitor for signs of distress.

If financial enquiries raise specific concerns, the customer could seek to negotiate shorter payment terms, regular reporting obligations and/or parent company guarantees of the customer's obligations. That said, it's not entirely clear whether CIGA allows a supplier to call on a parent company guarantee following the subsidiary's relevant insolvency procedure – it is possible that this would fall within the concept of "any other thing" which the supplier is able to do as a result of the customer becoming subject to an insolvency procedure. Insurance against the risk of non-payment might also be available, though may not be practical or cost-effective in many cases.

Lastly, suppliers may want to review their procedures for responding to late payment by customers and/or picking up any other potential signs of financial problems. In relation to late payment, the sooner this is chased up the better, so as to avoid significant amounts going unpaid ahead of a customer going into an insolvency procedure. As regards monitoring for other signs of financial distress, the key objective is to be in a position to exercise insolvency termination triggers before the restrictions in CIGA "bite". In cases where substantial sums will be at stake, it may be worth seeking an obligation on the customer to provide additional information about its financial condition with a view to supporting such ongoing monitoring.

How will the restrictions on insolvency termination triggers affect customers?

As noted above, if you have contracted as a customer and you are looking to terminate your agreement with an insolvent supplier, the restrictions in CIGA will not affect you. Broadly speaking, customers in financial difficulty should expect to benefit from these provisions in CIGA because they are intended to make it easier to rescue such businesses out of insolvency.

Customers may find that suppliers terminate earlier than they otherwise would.

However, such customers may find that CIGA does not always have the protective effect that the Government intends. In particular, it may encourage suppliers to terminate earlier than they otherwise would – including in situations where it is unclear whether the customer will actually enter an insolvency procedure. It may well be that such a termination would be open to challenge on the grounds that the supplier has "jumped the gun" – but a customer in financial difficulty may well be reluctant to incur legal expenses in resisting such a termination or seeking damages for any loss suffered. It is also possible that some suppliers may decide that, even though CIGA effectively prevents them terminating on grounds of the customer's insolvency, they will do so anyway and take the risk being sued for repudiatory breach.   Suppliers may calculate that a customer in financial difficulty will be unlikely to pursue such a claim and therefore the risk of breaching the agreement is worth taking.

Finally, it is possible that some suppliers may decide that on balance, given the extent to which CIGA limits their effectiveness, insolvency termination triggers are not worth including in their standard contracts (even though we would not generally recommend this – see section 4). Customers may therefore need to be on the lookout for the removal of these triggers.

Checklist of points to consider

Suppliers

  • Consider amending insolvency-related triggers in new contracts so as to allow you to terminate on insolvency-related grounds before the restrictions in CIGA "bite". But bear in mind that as termination rights are usually mutual, customers could also benefit from such provisions if you get into financial difficulty.
  • Consider imposing obligations on customers to provide you with more information about their financial position during the life of the contract.
  • Consider carrying out more detailed due diligence on customers' financial position before you start supplying them.
  • Consider offering less generous payment terms and/or seeking additional financial protections such as parent company guarantees or insurance.
  • Consider stepping up your monitoring of customers' compliance with payment obligations (with a view to avoiding a substantial build-up of arrears) and their financial condition generally.

Customers

The restrictions in CIGA on termination rights in supply contracts are intended to benefit customers which find themselves in financial difficulty;  as a result, in many cases, no action is likely to be required.  However, customers should note that:

  • CIGA may prompt changes in the behaviour of some suppliers. For example, they may decide to offer less generous payment terms or demand parent company guarantees.
  • CIGA may also prompt some suppliers to seek to terminate on insolvency grounds earlier than they otherwise would, including in situations where it is not yet clear that the customer will enter an insolvency procedure.
  • It is possible that some suppliers may decide to remove any termination insolvency triggers from their standard terms – in which case customers wishing to rely on such triggers will need to reinsert them.

For more information, please contact

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