Why suppliers can no longer rely on termination on insolvency rights

The Corporate Insolvency and Governance Act, which came into force on 26 June 2020, contains a fundamental change to the operation of most supply contracts. The provisions mean that termination on insolvency clauses in most contracts for the supply of goods or services will cease to have effect when the customer becomes subject to a "relevant insolvency procedure".

The intention is to help companies trade through an insolvency process and improve the prospects of a company's rescue. However, the changes put suppliers at risk and they should consider amending their contracts to ensure they have other levers to protect their position.

Permanent changes

The relevant provisions are not Covid-19 related (though the Act was fast-tracked through the legislative process as a result of the current pandemic): they represent permanent changes designed to benefit companies that are facing financial difficulties for whatever reason.

The government has previously acknowledged that these provisions may disadvantage suppliers but it believes that maximising the opportunities for preserving viable businesses, and protecting jobs, justifies the changes.

"Relevant insolvency procedure" is defined in the Act and includes administration, the appointment of an administrative receiver, liquidation, and the new moratorium and restructuring plan that the Act introduces. Suppliers will have to continue to supply, despite their customer entering one of these processes.

The provisions are broad. They nullify a supplier's right not only to terminate but also to "do any other thing" (such as amending its terms of supply, particularly payment terms) because the receiving company has become subject to an insolvency procedure.

The Act will also suspend a supplier's termination rights. Where an event permitting the exercise of a supplier's right to terminate (or to do any other thing) occurs before the restructuring or insolvency procedure commences, but the supplier has not exercised that right, its right is suspended once the customer enters the insolvency or restructuring procedure.

Therefore, a pre-insolvency failure to pay will not be grounds for terminating a supply contract once the customer has entered an insolvency process. However, if the supplier’s right to terminate arises after the insolvency procedure begins (for example, as a result of non-payment for goods or services supplied during insolvency) then that right can be exercised.

In addition, a supplier cannot make it a condition of any continued supply of goods or services that pre-insolvency arrears are paid.

Broad scope

The scope of supply contracts affected is very broad: the provisions apply to all contracts for the supply of goods or services (subject to specific exclusions) including professional services.

The Act does not state expressly whether these provisions also relate to suppliers and licensors of intellectual property. However, the Commons Briefing Paper on the reforms, which was published in December 2019, stated that the proposed rules would apply to clauses in contracts for the supply of goods and services "or under a contractual licence e.g. of software or patents". And so it seems to be the government's intention that the provisions apply equally to intellectual property (IP) licences, acknowledging the importance of IP licences to certain businesses and sectors.

Safeguards and exceptions

The Act includes some safeguards for suppliers. A supplier can still exercise a right that has ceased to have effect or a right that has been suspended, if:

• the office holder or the customer (as relevant) consents to the termination; or
• a court is satisfied that the continuation of the contract would cause the supplier hardship and grants permission for the termination.

The Department for Business, Energy and Industrial Strategy guidance sets the hardship bar at a high level and gives, as an example of hardship, a situation where the continued supply threatens the supplier's own solvency.

There is a short-term Covid-19-related exclusion for small suppliers. A supplier that meets the test will be excluded from the application of these provisions if its customer becomes subject to the relevant insolvency procedure between the date the Act came into force and 30 September 2020. (This protection has been extended during the legislative process, as the Bill provided for only one-month's protection for small suppliers.)

Some companies and services are excluded from these provisions in their entirety. The exclusions predominantly relate to financial services, and "essential services" such as the provision of utilities, communication and IT services. These essential services are already subject to similar provisions under the Insolvency (Protection of Essential Supplies) Order 2015 (which amended the Insolvency Act 1986). This exclusion simply avoids any overlap between the new and existing provisions that cover supplies such as gas, water, electricity, and communication services and IT supplies (for example, data storage, computer hardware and software, processing, and website hosting).

Osborne Clarke comment

These provisions represent a significant change to many supply contracts.

A supplier may continue to include termination on insolvency provisions in supply contracts – for example, in order to invoke the hardship or consent safeguards if required – but may also seek to include additional termination rights that may be relied upon well before its customer enters a relevant insolvency procedure but when, for example, the supplier reasonably believes that its customer is in financial difficulties.

Termination rights relating to non-payment are common in some types of commercial agreements, but not all. Suppliers may wish to consider negotiating these rights in relationships where it is not currently market practice to do so. These rights, if conceded by a customer, can require a number of months of non-payment by the customer, and one or more written notices being sent by the supplier to the customer to notify it that payment is still outstanding, before the right to terminate kicks in.

These periods of non-payment and notice may shorten as suppliers seek to strengthen their rights earlier in a customer's journey to potential insolvency. Remedy periods may also be tightened up. Will suppliers also seek to shorten payment terms? Or will they enter into shorter contracts? Or require payment in advance rather than accepting payment in arrears? In any event, suppliers would be well advised to keep on top of invoicing and any late payment in light of these proposed provisions.

Nevertheless, a supplier should balance against these concerns the fact that the recovery of its customer is more likely if its supply contracts continue. Moreover, similar provisions to those that this Act introduces already exist in a number of territories around the world, such as, Germany, Italy, Australia and the US.

In Italy, by way of example, despite similar provisions having been in place for some time, there has not been a general shift in suppliers' contractual terms. One reason for this is that, in Italy, any goods and services which are supplied after the filing for admission to an insolvency and restructuring proceeding (of which the most common is the Concordato Preventivo) are considered to be "super-senior". This means that they must be regularly and fully paid by the company subject to the proceedings in accordance with the relevant supplier agreement and that, in the event of non-payment and subsequent bankruptcy of the recipient business, debts arising from these supplies must be satisfied in preference to other debts (including those of preferential and secured creditors).

Similarly, while a supplier in Great Britain may not welcome being required to continue its supply to a company in financial distress, it may take some comfort from the fact that, in certain circumstances, payments for goods and services which are supplied after the company enters the relevant procedure are paid ahead of other creditors of the business. If a business enters administration, for example, and the administrators trade the business and adopt contracts for the supply of goods and services, all payments for the goods and services supplied post-administration are expenses of the administration. This means that they rank as priority payments (even above the administrators' remuneration) and there is a very good prospect of the supplier receiving payment.

Customers are likely to welcome the introduction of these provisions, which seek to increase their chances of recovery should they hit a challenging time.

As noted above, the position in relation to contracts and licences of intellectual property will need to be monitored. While the government's intent in relation to these may be clear, the legislative drafting is less definitive.

The question is whether these provisions will actually benefit companies that are going through an insolvency or restructuring process. There is surely a risk that they result in suppliers withdrawing services earlier, at the first sign of financial distress, which may have the effect of putting more companies at risk.