On 25 June 2020, new legislation came into force in the UK which makes it significantly more difficult for suppliers to terminate contracts where their customer is subject to an insolvency procedure. In this update, we will look at the key issues for both suppliers and customers along with how such termination provisions might be used in the future.
The new legislation
The Corporate Insolvency and Governance Act 2020 introduces new measures into the Insolvency Act 1986 in relation to contracts for the supply of goods or services as follows:
- Clauses which enable a supplier to terminate a supply contract (or change other terms) upon an insolvency or formal restructuring procedure are ineffective.
- A prohibition on terminating a supply contract based on past breaches of the contract once the company enters an insolvency process or restructuring procedure.
- A prohibition on the supplier doing “any other thing” because the customer enters an insolvency process.
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 purpose of these new restrictions is to try and avoid suppliers undermining rescue efforts in relation to companies in financial trouble.
A relevant insolvency procedure includes situations where the company (i.e. the 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.
Who do the rules apply to?
Although the new rules have a wide scope, there are some key exceptions:
- Firstly, the new rules only prevent suppliers from terminating contracts where their customer is subject to an insolvency procedure. The new rules do not prevent customers from terminating contracts where their supplier becomes insolvent.
- Secondly, the provisions of the act only apply to supplier of goods and services. This means that contracts other than for the supply of goods and services, such as IP licences, are unaffected.
- Thirdly, suppliers of most financial services remain unaffected by the new regime.
- Finally, there remains a temporary exception for small suppliers until 30 March 2021. In order to qualify as a small supplier, the organisation must meet as least two of the following criteria in their most recent financial year:
- turnover no more than £10.2m;
- balance sheet no more than £5.1m; and/or
- average number of employees no more than 50.
How does this affect suppliers in reality?
The new regime introduced by the act makes it more difficult for suppliers to terminate contracts when their customer becomes insolvent, there is no doubt. However, suppliers do still have some options available to them.
As we have seen above, the new rules effectively wipe the slate clean in relation to pre-insolvency events giving rise to termination. That said, if a the customer was in breach of the agreement in a way in which would entitle the supplier to terminate, and that breach recurs after the insolvency procedure has commenced, it would be a ‘new’ breach and the supplier would be entitled to exercise termination rights – provided the contract allows it.
Where a supplier is prevented from terminating an agreement due to the customer’s insolvency, the supplier must still be paid for their goods/services during the insolvency procedure. Whilst unpaid amounts pre-insolvency may have to be put on hold until the insolvency procedure is concluded, if funds cannot be found for on-going supply, the supplier maybe able to terminate – subject to the terms of the agreement.
In some circumstances, the customer or the insolvency practitioner may not wish to continue the contract and therefore allow for it to be terminated. This is permitted under the new rules.
Finally, the rules state that if a supplier is going to experience “undue hardship”, the supplier may apply to the court in order to terminate the contract. Undue hardship seems quite a tough test in that the supplier appears to need to show that it would there is a high risk of it becoming insolvent itself if it must continue to supply.
As an aside to termination, the prohibition from doing “any other thing” is somewhat broad. The guidance notes to the legislation suggest this would include changing payment terms, increasing pricing or changing credit periods. Due to the wording being so broad, suppliers should be cautious in relation to parent company guarantees, particularly those which apply once insolvency starts, as these may be ineffective under the “any other thing” grounds.
Are insolvency termination clauses worth keeping?
In short, yes!
Whilst the new rules make these clauses ineffective, it’s important that the supplier still has the option particularly if the customer or insolvency office holder is prepared to allow a termination. Additionally, a supplier may need to rely on such provisions if they are able to meet the test for undue hardship.
What can a supplier do to protect itself?
There are a number of things we would suggest considering in light of these new rules.
One of these is to amend insolvency termination triggers so that they can be ‘activated’ before a customer enters an insolvency process.
Linked to the above, is carrying out more detailed due diligence in relation to a customer’s financial position and ensuring that this monitored during the course of supply, particularly if the contract is a long-term supply agreement. When done in conjunction with termination triggers which can be invoked pre-insolvency, the supplier could terminate prior to the customer entering an insolvency process when it becomes aware of the customer’s financial struggles.
Finally, suppliers could also consider offering less generous payment terms or taking out insurance policies to cover such eventualities.
For more information, please contact Ed Manning.