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When does “Together we stand” become “I’m taking you down with me”?

A new Act, the Corporate Insolvency and Governance Act 2020, restricts many suppliers’ rights to exit commercial agreements due to restructuring or insolvency-related causes, even where those rights are expressly set out in the contract.

Since the release of the film Titanic in 1997, debate has persisted whether Rose could have shifted over slightly to let Jack onto the driftwood after they found themselves thrown from the sinking ship into the North Atlantic. Was there space? Would they both have frozen? Who knows.

Our economy now finds itself in an oddly analogous scenario, with supply chain relationships thrown into economic turmoil. Suppliers are now faced with the prospect of keeping potentially insolvent customers tenuously afloat with them, rather than allowing the customer to succumb to the economic elements and saving themselves.

There is no doubt about it, COVID-19 has upended our economy. The Government has been busily putting in place attempted corrective measures and as a result, we’ve seen a flurry of laws being passed by Parliament at breakneck speed. One such law, the Corporate Insolvency and Governance Act 2020, amends the treatment of insolvency and restructuring in contracts in the UK on both a temporary and permanent basis.

In particular, the new Act, which came into force on 26 June, has introduced permanent changes to the way termination clauses work in supply contracts.

Commercial supply contracts typically contain clauses in them which state, in one way or another, that a supplier can terminate the agreement if an insolvency-related event happens to a customer, or even, in some cases, if such an event is threatened. These types of clauses - sometimes called ipso facto clauses - are added by legal advisors because, in the absence of an express contractual right to terminate for such events, a party has no common law right to do so.

If you are a supplier, you’ll often find that your template contracts are peppered with such rights. However, under the Act, many of these clauses may cease to have effect, despite what the parties have agreed and committed to on paper.

What does the Act say on termination clauses?

The Act has introduced rules that mean:

  • if a termination event has occurred pre-insolvency, but the supplier has not yet acted on it by the time the customer enters an insolvency procedure, then the supplier will lose the right to exercise its termination right
  • once the customer enters an insolvency process, any rights in the contract to terminate or do any other thing on the customer’s insolvency will not be able to be exercised
  • if the supplier’s right to terminate arises after an insolvency procedure begins (for example, for non-payment for goods supplied after that time) then this right to terminate won’t be prohibited

However, as with most legislation, there are exemptions.

  • the supplier is entitled to terminate their contract:
    • where an officeholder or the customer in question (as applicable) consents to the contract being terminated, or
    • with the permission of the court, where the court is satisfied that the continuation of the contract would cause the supplier hardship
  • on a temporary basis these measures will not apply to suppliers that are ‘small entities’
  • contractual termination provisions are not invalid in relation to contracts for the supply of goods or services to a business in the context of certain financial services.

Suppliers will also be prohibited from making payment of outstanding charges a condition of any continued supply.

The Act only refers to certain types of ‘relevant insolvency event’ which would result in these provisions being triggered. For example, the filing of a notice of intention to appoint an administrator isn’t such an event, but the customer entering into administration is.

What impact will the Act have?

At first blush, this will be an additional burden for suppliers, but a gain for creditors:

  • for suppliers, there is the financial risk of continuing to supply to a customer that might subsequently ‘go bust’. The Government’s best estimate of the cost to suppliers is that it will cost them £292.9 million over ten years, although it is unclear how this figure has been arrived at. As a result, this may mean an increase in ongoing insurance costs and, where appropriate, possible legal costs in applying to a court to be exempt using the hardship exemption
  • for customers, they will need to be aware of these provisions and how they operate, although in most cases it will be the insolvency practitioner dealing with an insolvency procedure that will deal with such matters.

While the intention of the Act is to allow businesses in insolvency and rescue procedures to continue to trade through their difficulties, in future many suppliers might seek to be more pro-active in managing their contracts: they could well amend them so that they can terminate when they want (‘for convenience’) or if insolvency is merely threatened.

The law of unintended consequences means that suppliers who are more ‘on top of their game’ such as those who pro-actively manage their supply-chain ecosystem, could - perhaps inadvertently - push some of their customers into insolvency earlier than would otherwise be the case and, in so doing, stymie any rescue process which may have been possible.

The full impact of the Act is clearly unknown at the moment and, in many cases, we will need to wait until the courts pass their judgment on how certain sections work. For example, it looks pretty clear that the Act doesn’t apply to fixed-term contracts, but it is less clear whether it applies to contracts where a termination provision has already been triggered.

The consultation document on the Act also states that, ‘suppliers will retain the ability to terminate contracts on any other ground permitted by the contract. These would include: ... any other ground that gave rise to termination, save for those connected with the debtor company’s financial position, or the fact it had entered a moratorium, restructuring plan, or insolvency procedure’. 

However, ‘the debtor company’s financial position’ isn’t mentioned in the Act itself. It remains to be seen how any published guidance will help suppliers understand exactly what they can and can’t do under the new law.

What’s more, certain suppliers might simply take the risk of not supplying to a customer in trouble under any relevant contracts, calculating that, in a given case, the relevant insolvency practitioner might take the view that it is not worth the customer suing for breach of contract.

What’s next?

Suppliers should:

  • review their existing contracts, prioritising those contracts of greatest value or importance
  • amend, where necessary, their standard form contracts in light of the Act
  • consider their approaches to managing contracts and mitigating insolvency risk generally, including whether:
    • step-in rights or other enhanced supervision rights in their contracts are necessary
    • more due diligence is necessary on customers before a contract is entered into and, for larger contracts, throughout the lifetime of the contract
    • their contract management should be enhanced
    • termination rights for when a relevant insolvency event is threatened should be included in their contracts
    • termination ‘for convenience’ rights should be included in their contracts
    • shorter time periods should be set out in any termination provisions
    • guarantees such as parent company guarantees or performance bonds should be entered into
    • insurance cover should be changed

Conclusion

The new Act, with 50 Sections and 14 Schedules, was introduced to the House of Commons on 20 May and became law on 25 June, coming into force the day after. Was this timescale sufficient to give this legislation and its potential consequences proper consideration? Time will tell, but the odds seem stacked against it. As a result of this haste, it could well be that this Act doesn’t achieve quite what it was looking to achieve for customers or suppliers.

Typically, good suppliers seek to look after their customers, but customers ‘going under’ can also have a significant financial impact on suppliers as depending on credit terms their exposure to their customers can be huge. While a supplier is entitled to go to court under the new Act if continuing to supply a customer would cause them hardship, a lot of businesses will no doubt shy away from the cost and uncertainty of litigation. Typically they’ll seek to find alternatives to protect their position. It is these alternatives, and particularly terminating contracts earlier than would otherwise be the case, which may end up pushing customers into insolvency and creating a situation which this Act was looking to avoid.

Do get in touch if you need any further insight on this Act or if your termination clauses and contract management systems need to be reviewed in light of this new law.

Disclaimer

This information is for educational purposes only and does not constitute legal advice. It is recommended that specific professional advice is sought before acting on any of the information given.

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