Rapid progress through Parliament
The government announced its intention in March 2020 to drive through legislation to make significant changes to the insolvency regime. A bill was introduced to Parliament on 20 May 2020 and has already become law as the Corporate Insolvency and Governance Act 2020.
What are the key changes?
There are three key areas for permanent reform. Briefly, these are:
- A new debtor in possession (i.e. directors remaining in control) moratorium procedure under the Insolvency Act 1986 (the New Moratorium Procedure)
- A ban on the operation of contractual termination provisions in certain circumstances; and
- A new arrangement and reconstruction procedure modelled on the existing scheme of arrangement procedure under the Companies Act 2006 but permitting “cram down” of dissenting classes (the New Arrangement Procedure).
We will focus on the second of these changes.
Termination clauses triggered by insolvency
Commercial contracts commonly contain termination clauses that are triggered automatically or can be triggered at the choice of a contracting party where its counterparty suffers therein defined insolvency events. These are sometimes called ipso facto (“by the fact itself”) clauses as they permit termination on the ground of insolvency alone without any need for there to be breach of the contract, eg failure to pay.
The ability of a contracting party to terminate on the ground of a counterparty’s insolvency alone has widely been viewed as being contrary to the rescue culture. It enables counterparties to demand payment in full of supplies made prior to the insolvency procedure as a condition of continuing supply - in effect giving them a quasi-security for the prior sums owed at the expense of the creditors more generally if the supply is needed for the counterparty’s ongoing business.
The new legislation provides that:
- where a customer goes into any of the various formal insolvency procedures (eg administration, liquidation (including provisional liquidation), company voluntary arrangement (CVA) and either of the New Moratorium Procedure and the New Arrangement Procedure (but not – interestingly – a scheme of arrangement)) any clause permitting a supplier of goods or services to that customer to terminate the contract by reason of the customer’s entry into the insolvency procedure is nullified
- any clause providing for “any other thing” to happen by reason of the customer’s entry into the insolvency procedure (eg an increase in prices or the charging of default interest) is also nullified
- where a supplier is entitled under the contract to terminate the contract or “do any other thing” because of an event occurring before the start of the insolvency procedure; and that entitlement arises before the start of the insolvency procedure but was not exercised before the start of insolvency procedure, that entitlement cannot be exercised during the insolvency procedure. For example, if the counterparty is entitled to terminate by reason of non-payment and that right to terminate arose prior to commencement of the insolvency procedure but was not exercised prior to commencement, that right of termination will be suspended during the insolvency procedure
- finally, a supplier cannot make it a condition of continuing supply during an insolvency procedure that it be paid outstanding sums arising in respect of supplies made before the insolvency procedure commenced
The legislation does not, however, prevent the supplier from terminating the supply where the right to terminate arose and was exercised before the commencement of the insolvency procedure. (This gives rise to a potential lacuna discussed below.) Nor does it prevent the supplier from terminating the supply where the right to terminate arose during the insolvency procedure for a reason other than the mere fact of entry into the insolvency procedure, eg for failure to pay the costs of the ongoing supplies made during the insolvency procedure.
Carve outs and exclusions
The legislation applies only to suppliers of goods and services. It would not therefore appear to prevent a customer from terminating by reason of a supplier’s entry into an insolvency procedure.
In addition, the legislation permits termination by suppliers as follows:
- The company or insolvency officeholder consents to termination.
- The court is satisfied that continuation of the contract would cause the supplier hardship and grants permission for termination. Hardship is not defined in the legislation and so will need to be fleshed out as cases come up.
- Suppliers that qualify as “small entities" are excluded from the restrictions, but only on a temporary basis. Initially this has been set down to end on 30 September 2020 but may be extended by the Secretary of State. Detailed provisions determine whether a supplier qualifies as a “small entity” for these purposes, based on turnover, assets, employee numbers etc, and a careful assessment will be needed before relying on this exclusion.
- Many kinds of financial services are completely excluded from the rules. Insurance and loan contracts, for example, are not within its scope.
It should also be noted that there is pre-existing legislation applying similar but not identical restrictions to utilities and certain IT suppliers. The pre-existing legislation will continue to apply to those suppliers.
Areas of uncertainty?
Perhaps unsurprisingly with legislation that has been rushed through Parliament at breakneck speed, the legislation gives rise to a number of uncertainties:
- As noted in (3) above, the legislation has the effect that where a supplier is entitled under the contract to terminate a contract because of an event occurring before the start of the insolvency procedure (eg for non-payment) but that entitlement is not exercised prior to the insolvency procedure, that right of termination will not be able to be exercised during the course of the insolvency procedure. Does this suspension of the right to terminate apply to a right to terminate for repudiatory breach arising under the common law? Under a straightforward reading of the Act, the suspension detailed in (3) above applies to termination rights arising under the contract not under the common law and so the Act would not appear to suspend a right of termination for repudiatory breach under the common law during the course of the insolvency procedure even where that right arose prior to the insolvency procedure.
- What happens if the contract is terminable at will by the supplier? Being as it is an “at will” right in existence throughout the course of the contract’s existence, such a termination right arises prior to commencement of the insolvency procedure. Furthermore, it is a right under a provision of the contract and so at first sight it could be argued that it is caught by the suspension provision detailed in (3) above. It is likely that a court would find however that the Act does not prevent termination here because the “at will” right to terminate within the insolvency procedure arises anew and is unconnected with any prior “at will” right arising before commencement such that the suspension provision does not apply to it. What of a right to terminate for failure to remedy a material breach of contract where the notice to remedy was served prior to the insolvency procedure but the notice period only ran out within the insolvency procedure?
- The Act in effect nullifies clauses permitting termination by reason of a counterparty’s entry into an insolvency procedure. However, there are often steps taken by a counterparty prior to commencement of the insolvency procedure that relate to the insolvency procedure, e.g. circulating proposals to creditors for a CVA, filing a notice of intention to appoint administrators etc. Furthermore, a company can become insolvent on a cashflow or balance sheet basis prior to (and sometimes long before) commencement of an insolvency procedure. Termination clauses in supply contracts often permit termination not only by reason of entry into an insolvency procedure but also by reason of one of these “pre-insolvency” steps having occurred or by reason of the counterparty’s becoming cashflow or balance sheet insolvent. The Act does not appear to nullify termination clauses permitting termination on the ground of these “pre-insolvency steps” being taken or on the ground that the counterparty has become insolvent. The Act thus appears to give rise to a lacuna that may be able to be exploited by a supplier assuming the contract on its terms permits termination for the taking of such pre-insolvency steps. However, the counterparty will likely need to act fast if seeking to exploit this lacuna. If they do not exercise the termination right before the commencement of the insolvency procedure, the provision detailed in (3) above will kick in suspending the termination right.
- Could a right to call on a guarantee from a third party guarantor by reason of the counterparty’s entry into an insolvency procedure be suspended during the course of the insolvency procedure? On a straightforward reading of the Act such a right might be suspended if it was contained in the contract of supply but not if it was contained in a separate contract with the guarantor. However, this seems to be an arbitrary distinction. A court may instead seek to limit the scope of the Act so as not to affect rights against third parties other than the insolvent whether or not such rights were contained within the supply contract?
Take away points
- Suppliers of goods and services under long-term contracts must take note - they cannot necessarily terminate just because the termination clause says that they can. Subject to the exclusions set out above, once one of the defined insolvency procedures commences, suppliers will need to continue to supply and work with the insolvency practitioner (the administrator, for example) to resolve any problems. As a last resort, suppliers can consider an application to the court to terminate by reason of hardship.
- Regular monitoring of customer payments, good financial hygiene and fast action where problems are first noticed may help to head off substantial exposure.
- Where a supplier has concerns about a customer’s financial standing, the contract may provide for termination rights on grounds other than insolvency. For example, a failure to meet payment schedules might trigger a right to terminate. Great care is needed here. False exercise of a termination right can cause a world of pain, with the possibility of being on the receiving end of a damages claim for breach of contract. Termination rights are often tightly defined, around specific breaches or material breaches, for example, and there may be a period for the customer to remedy the default.
- For substantial contracts, and particularly where there are concerns about the financial standing of customers, suppliers might wish to revisit their existing supply contracts to reconsider their termination rights clauses under them. There is clearly still value in having a termination right on insolvency in order to exploit the potential carve-outs and exclusions in (a) to (d) above. Indeed, there may be value in reconsidering the termination right on insolvency clause to see if it gives a termination right by reason of “pre-insolvency” steps being taken by the counterparty, or on the counterparty’s becoming insolvent, in order to be able to exploit the potential lacuna identified in "Areas of uncertainty", above.
- Existing contracts will often set out the insolvency procedures that give rise to a right of termination expressly, eg liquidation, administration, CVA etc. There will then often be a “by analogy” clause permitting termination for entry into any procedures that are analogous to the expressly set-out procedures. Clearly, existing contracts will not refer to the New Moratorium Procedure or the New Scheme Procedure as they were not in existence at the date these contracts will have been entered into. Is the “by analogy” wording sufficient to capture these procedures or should the termination clause be amended to expressly refer to them? Whatever the answer to this question (which may require a court to decide) the termination clause in any new contracts should refer expressly to these new procedures.