Terminating supply contracts on insolvency: what's changed?

The Corporate Insolvency and Governance Act 2020 ("CIGA") received Royal Assent on 25 June after an accelerated passage through Parliament. Among a slew of other changes to insolvency and corporate law (click here for more detail), the Act prevents suppliers relying on any contractual provision which would allow the supplier to terminate or to do "any other thing" as a result of its customer becoming subject to a "relevant insolvency procedure." This includes provisions where the consequence occurs automatically on the customer's insolvency, as well as those which only occur if action is taken by the supplier (such as serving a notice to terminate). Such provisions are sometimes referred to as "ipso facto clauses."

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 impact of these measures is to make it much more difficult for suppliers to terminate contracts once a customer is subject to an insolvency procedure.

The restrictions in CIGA are intended to prevent rescue efforts for companies in financial difficulty being undermined by suppliers.  For example, a company which is reliant on a particular supplier may be forced to cease trading if that supplier is able to terminate when the company becomes subject to an insolvency procedure. Similarly, rescue efforts may be hampered if a key supplier refuses to continue to supply unless all outstanding payments are met immediately (thus potentially putting itself ahead of other creditors).

Although the restrictions in CIGA have a broad ambit, there are several important limitations on their scope: 

• The first and most important limitation is that, CIGA only restricts the ability of suppliers to terminate when their customer has become subject to an insolvency procedure; if you have contracted as a customer and you are looking to terminate your agreement with an insolvent supplier, CIGA will not affect you. 
  
  
• Second, the restrictions in CIGA also only apply to suppliers of goods and services. Whilst this may take some arrangements outside CIGA, it is unclear how broadly or narrowly this concept will be interpreted by the courts – so it may be that this limitation will prove to be less important in practice. For example, it could be argued that termination and other rights in, for example, an IP licence which allowed the licensee to produce goods for distribution to third parties in return for payment of royalties to the licensor would not be affected. This would be on the basis that these arrangements do not involve the supply of goods or services to the insolvent customer/licensee. On the other hand, it can equally well be argued that such a licence will often be key to the customer/licensee's business and therefore the legislative intent was for an IP licence of this type to be covered by CIGA. It should certainly not be assumed that all IP licences fall outside CIGA - not least because in practice, many also involve the supply of services by the licensor alongside the grant of permission to use the relevant IP.

Whilst it's true that CIGA makes it much more difficult for suppliers to terminate when a customer becomes subject to an insolvency procedure, there are still some cards that suppliers can play, depending how the situation develops.

As noted above, CIGA prevents a supplier making further supply conditional on payment of any outstanding amounts and effectively wipes the slate clean during the insolvency procedure in respect of pre-insolvency events (of any type) giving rise to termination rights. However, if a breach which would have entitled the supplier to terminate prior to the customer's insolvency recurs after the insolvency process begins, it would be regarded as a fresh breach and the supplier could (depending on the terms of the contract) terminate on that basis. 

Suppliers which are prevented from terminating on insolvency must also continue to be paid for the supply provided during the insolvency procedure, failing which they will be able to terminate according to the terms of the agreement. So even in a situation where pre-insolvency, some invoices have gone unpaid, the supplier may find that once an insolvency procedure has commenced (and assuming the insolvency office holder wishes to continue the contract), the funds will be found to pay it going forward in order to avoid termination – albeit that any unpaid pre-insolvency invoices may have to wait until the customer emerges from the procedure.

In some cases, suppliers may also find that the insolvency practitioner or the customer (depending on the type of insolvency procedure) does not wish to continue the contract and is therefore content to allow it to be terminated (indeed, CIGA expressly provides for this). Lastly, CIGA allows the supplier to apply to court for permission to terminate on the basis that the continuation of the contract would cause it "undue hardship".

It's important to keep insolvency termination triggers in perspective. For example, in many cases, a right for a supplier to terminate on its customer's insolvency is of limited practical use – termination of a contract isn't going to improve your chances of getting paid. It is, though, a useful defensive option, enabling the supplier to redirect resources towards more viable customers and to limit further losses.

Suppliers might also want to consider earlier triggers so as to permit termination before the "relevant insolvency procedures" contemplated in CIGA, for example if the customer gives notice of its intention to appoint an administrator (the trigger in CIGA is the actual entry into administration rather than the giving of notice). Withdrawal of a customer's credit insurance or downgrading of its credit rating could also act as useful proxies – if nothing else, requirements for the customer to notify in these circumstances should act as an early warning system. However, as termination insolvency rights are typically mutual, suppliers should bear in mind that these earlier triggers could also be relied upon against them by customers.

Without the safety net of termination rights on customer insolvency, it's even more important for suppliers to do proper financial due diligence at the outset, especially if there's a prospect of significant work being done before a payment obligation arises for the customer.

If financial enquiries raise specific concerns, the customer could seek to negotiate shorter payment terms, regular reporting obligations and/or parent company guarantees of the customer's obligations. That said, it's not entirely clear whether CIGA allows a supplier to call on a parent company guarantee following the subsidiary's relevant insolvency procedure – it is possible that this would fall within the concept of "any other thing" which the supplier is able to do as a result of the customer becoming subject to an insolvency procedure. Insurance against the risk of non-payment might also be available, though may not be practical or cost-effective in many cases.

Lastly, suppliers may want to review their procedures for responding to late payment by customers and/or picking up any other potential signs of financial problems. In relation to late payment, the sooner this is chased up the better, so as to avoid significant amounts going unpaid ahead of a customer going into an insolvency procedure. As regards monitoring for other signs of financial distress, the key objective is to be in a position to exercise insolvency termination triggers before the restrictions in CIGA "bite". In cases where substantial sums will be at stake, it may be worth seeking an obligation on the customer to provide additional information about its financial condition with a view to supporting such ongoing monitoring.

As noted above, if you have contracted as a customer and you are looking to terminate your agreement with an insolvent supplier, the restrictions in CIGA will not affect you. Broadly speaking, customers in financial difficulty should expect to benefit from these provisions in CIGA because they are intended to make it easier to rescue such businesses out of insolvency.

However, such customers may find that CIGA does not always have the protective effect that the Government intends. In particular, it may encourage suppliers to terminate earlier than they otherwise would – including in situations where it is unclear whether the customer will actually enter an insolvency procedure. It may well be that such a termination would be open to challenge on the grounds that the supplier has "jumped the gun" – but a customer in financial difficulty may well be reluctant to incur legal expenses in resisting such a termination or seeking damages for any loss suffered. It is also possible that some suppliers may decide that, even though CIGA effectively prevents them terminating on grounds of the customer's insolvency, they will do so anyway and take the risk being sued for repudiatory breach.   Suppliers may calculate that a customer in financial difficulty will be unlikely to pursue such a claim and therefore the risk of breaching the agreement is worth taking.

Finally, it is possible that some suppliers may decide that on balance, given the extent to which CIGA limits their effectiveness, insolvency termination triggers are not worth including in their standard contracts (even though we would not generally recommend this – see section 4). Customers may therefore need to be on the lookout for the removal of these triggers.