Terminating a contract due to insolvency – new restrictions

Terminating a contract to the insolvency of the other party is no longer permitted, despite an express clause to this effect.

New restrictions on terminating a contract due to insolvency

It is typical in commercial contracts to see the right for a supplier to be able to terminate the contract (or suspend its delivery obligations) in the event the customer is subject to an insolvency process (such as administration or liquidation) and historically, English law has been reluctant to interfere with the freedom of both parties to contract as they wish.

In this blog, we consider the now in force provisions of ss.14-15 and Schedule 12 of the Corporate Insolvency and Governance Act 2020 which broadly prevents contracts for the supply of goods and (non-financial) services from being terminated simply because a company enters into a formal insolvency process. These reforms are likely to lead to significant changes to how parties operate their contracts and credit lines. The aim is to allow companies to attempt to trade their way out of insolvency, but it is not good news for suppliers whom face increased risk.

Construction industry could be hit hard

All sectors will potentially be affected but the construction industry could be worst hit, where margins are particularly tight. If a main contractor enters into an insolvency procedure, its subcontractors and suppliers will have to continue working even though they may have many months of unpaid bills and their contract expressly gives a right to terminate or suspend.

What does the new law say

The new provisions ensure that supplies are not cut off when a company becomes subject to an insolvency process due to a supplier refusing to supply, terminating the contract or making other unfavourable changes to the terms on which they are prepared to continue supplying. Any clauses within a contract to the contrary are essentially rendered inoperable and this will apply to existing contracts already in force, not just the new ones.

Pre-insolvency breaches cannot be relied on

Further, a supplier cannot exercise a contractual termination right in respect of a pre-insolvency breach if the right is not exercised before the commencement of insolvency proceedings. So, for example, where the contract provides that the supplier may terminate for late payment, and the customer fails to pay an invoice on time, it will be too late to rely upon that “past” event once insolvency proceedings have begun.

Cannot make it a condition of supply that outstanding monies are paid

A supplier cannot make it a condition of continuing to supply that any outstanding payments are paid, or do anything that has this effect. This means that a supplier will need to continue supplying goods or services, even though the supplier may be owed significant sums of money from before the company went into an insolvency procedure. It does not mean, however, that the customer does not continue to owe the amounts outstanding under the supply contract. It is just that the supplier cannot make payment a condition of continuing the supply.

Suppliers only

Note that the provisions expressly apply to suppliers only and that customers are not prevented from exercising a contractual right to terminate a supply contract where it is the supplier who enters into an insolvency procedure.

Exception for small businesses

Until 30 September 2020, in England & Wales and in Scotland the prohibitions will not apply where the contractor is a “small entity” at the time when the employer becomes subject to the insolvency procedure. The relevant thresholds are set out in the legislation and relate to the contractor’s turnover, aggregate assets and average number of employees.

Express grounds upon which you can terminate

The new law expressly allows a supplier to terminate with the consent of the appointed office-holder (e.g. qualified insolvency practitioner) or with the permission of the court, on the ground that continuing the contract would cause the supplier hardship.

Although these provisions were brought in by the government alongside others which deal with the impact of the Covid-19 pandemic, they are not intended to be temporary.

So how can a supplier minimise the impact of the new law?

Options pre-insolvency

A supplier with grounds to terminate a supply contract with a customer in financial difficulties can still:

• Terminate for non-payment or on any other available grounds before the company enters insolvency proceedings. Cash flow and credit lines should be monitored closely.
• Terminate for an insolvency-related event but before the company enters into formal insolvency proceedings. For example, if a supplier is aware that administrators are about to be appointed, it could still terminate before the appointment is made if it has grounds to do so, as it might where, for example, the termination triggers in the contract include any step taken with a view to commencing insolvency proceedings. Likewise, if a supplier became aware that a statutory demand had been served on the company, it might be able to terminate on the basis that the company is unable to pay its debts as they fall due, before a winding up order is made. Suppliers will need to act quickly in such circumstances.

Options post-insolvency

Once a customer has entered into a formal insolvency procedure, a supplier can still:

• Wait for new contract termination rights to arise. For example, a supplier will still be able to terminate or suspend for non-payment arising during the customer’s insolvency process. Note as above that pre-existing grounds for termination under a contract provision are ineffective once the insolvency has begun.
• Exercise contractual rights to terminate for convenience if available.
• On the face of it, the new provisions do not appear to invalidate the common law right to terminate a contract, regardless of when the event giving rise to the repudiatory breach occurred.
• Decline to provide further supplies where the existing contract is a single-purchase order. It may be possible to achieve a similar result with a contract which is structured as a framework or umbrella agreement, and each new customer order constitutes a separate contract with the supplier free to decline orders.
• Refuse to renew an existing contract once expired. This is only likely to be a viable option with a short contract term or one nearing its expiry date.
• Negotiate with the appointed office-holder. The supplier may not be able to enforce its contractual rights, but they can still negotiate.

Going forward

Suppliers would be advised to operate all contracts in a robust manner, so as not to allow any build up of unpaid invoices. Terminating for non-payment earlier many become more common. For all new contracts being negotiated and signed, it appears that it is not possible to contract out of the new legislation. Instead suppliers should consider what other flexibility they can include in contracts, such as a right to terminate for convenience and shorter payment terms.

If you need any further information on this, please contact Emily Sadler.