My customer is insolvent – get me out of here!?

Your customer has become insolvent and your typical reaction might be “get me out of here!” Well, maybe not. While most commercial contracts contain the right for one party to terminate in the event of the other party’s insolvency, new legislation makes it more difficult to exercise such rights.

What has changed and why?

Prompted by the Covid-19 pandemic the government has introduced a range of measures to support businesses in financial difficulty – primarily in a bid to save those struggling businesses which, but for the pandemic, would have been viable.

Some of the changes are temporary but others are permanent, reflecting a shift towards a greater rescue culture similar to Chapter 11 in the USA. From a commercial contracts perspective one of the most notable changes introduced by the Corporate Insolvency and Governance Act 2020 (CIGA) is the prohibition of ipso facto termination clauses (ipso facto referring to a right of termination arising automatically or due to the “very fact” that a party is insolvent).

The Insolvency Act 1986 already prevents suppliers of essential goods and services (such as utilities and certain IT services) from terminating their contracts with a customer who goes into administration or enters into a company voluntary arrangement (CVA) unless the relevant insolvency office holder either consents to the termination or declines to provide a personal guarantee in respect of the charges for the continued supply of the goods/services. The rationale for this is that it would become more difficult for the customer to find a way out of administration or CVA if these essential goods and services were cut off.

From 26 June 2020 the prohibition on ipso facto termination clauses has been extended to contracts for non-essential goods and services. The following are also prohibited:

• Clauses in contracts allowing for other things to be triggered by a party invoking an insolvency procedure, e.g. clauses allowing the supplier to increase its prices or reduce its payment terms.
• The other party exercising a right of termination (e.g. for breach of contract) during the insolvency period if the right arose (e.g. the breach occurred) before the start of the insolvency period.
• A supplier from employing the often-used tactic of making the supply of further goods and services (i.e. after the customer has entered into an insolvency procedure) conditional on payment of outstanding (pre-insolvency) invoices. It should be noted, however, that this doesn’t impact on the existing right of utilities providers to ask the insolvency office holder to guarantee payment as a condition of continuing supply.

This prohibition doesn’t mean that all clauses permitting termination for insolvency should be abandoned but parties negotiating contracts should think about how the prohibition will impact their arrangements and about what changes should be made to the contract to take account of it.

 Are there any exceptions?

• There is some breathing space for “small suppliers” to whom the prohibition won’t apply to until 31 March 2021. A “small supplier” is a company that satisfies 2 out of the following 3 tests:

(a) Turnover of not more than £10.1 million.

(b) Balance sheet total of not more than £5.1 million.

(c) No more than 50 employees.

• The prohibition doesn’t apply to contracts with a wide range of financial services companies (whether they are the supplier or the customer), e.g. insurers, banks, electronic money institutions, payment providers, etc. Nor does it apply to various financial services contracts (whether or not the parties to them fall within the above list of excluded financial services entities).
• An overseas company may be outside the scope of the prohibition.

What does it mean in practice?

• If a party to a commercial contract uses CIGA’s new moratorium process, calls a meeting to consider a restructuring plan, goes into administration or liquidation, has an administrative receiver appointed or enters into a CVA, the new prohibition will take effect, meaning that the counter-party cannot rely of such insolvency events as grounds for termination.
• When negotiating a contract, the parties should consider what other provisions might mitigate against the risks created by the legislative change. As always, what is appropriate depends on the particular circumstances of the contract:

a) For example, should the contract be for a shorter period of time and/or could the parties include more agile rights to terminate for convenience (always the lowest risk option when wanting to exit)? If so, then make sure the process for terminating for convenience, and the notices clause, are clear and unequivocal.

b) Alternatively, consider whether rights of terminate in circumstances short of the start of any formal insolvency process can be included, such as where a party is unable to pay its debts and/or undergoes a material adverse change. In negotiating such clauses, the parties will need to agree both that the provision is commercially acceptable and the threshold when it applies (and should ensure that the tests for deciding whether the right to terminate has arisen are drafted in sufficiently clear and unequivocal language).

At FSP we are continually monitoring contract law developments and if you have any questions about issues raised by this article or on contract issues more generally, please do not hesitate to contact us by emailing [email protected].