When does failure to pay trigger a termination right?

In commercial contracts, the terms of payment are usually a key element of the parties' bargain – so if a customer fails to pay a material sum on time, then surely the supplier should have a right to terminate the contract? Quite possibly, but in practice it may not be as straightforward as this – and if the supplier reaches for the "big red termination button" prematurely, without a careful assessment of its rights, it can be a costly mis-step. We also look at drafting tips for both suppliers and customers when it comes to payment obligations and termination rights.

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Do you have a contractual right to terminate?

Repudiatory breach

Repudiatory breach gives a supplier the right at common law to terminate a contract immediately and claim damages for loss of bargain. A breach is repudiatory when it is so serious that it deprives the innocent party of potentially the full benefit of the contract, either because the term is a condition or because it goes to the heart of the contract. This is a high threshold, and one which a missed payment may fail to satisfy. The consequences of terminating for repudiatory breach when this threshold has not been met can be significant, as demonstrated by the recent case of OCA v Novans (2022)

OCA v Novans: is non-payment a repudiatory breach?

In an aircraft lease-to-purchase contract, OCA had disputed an invoice and refused to pay it. Novans took the view that this amounted to a repudiatory breach and terminated the contract on this basis. OCA argued that the termination itself was a breach of contract, as the failure to pay did not constitute a repudiatory breach. The High Court decided in favour of OCA and ordered Novans to pay damages for breach of contract, considering the following points:

OCA had made attempts to move past the issue, offering to pay funds into an escrow account until the dispute was resolved, and therefore there was no evidence that OCA intended to abandon the contract. This meant that there was no repudiatory breach in the form of renunciation; and
OCA's default in payment did not deprive Novans of substantially the whole benefit of the contract, as when considering the whole of the contract, the missing payment was relatively insignificant (the total amount payable under the contract was $14.4 million, of which OCA had already paid $9.67 million – whereas the disputed invoice only related to $200,000).

Material breach

In addition to the right to terminate for repudiatory breach at common law, most commercial contracts will include an express provision allowing a party to terminate if the other party is in material breach. The threshold for material breach is not as high as repudiatory breach but, for the right to be triggered, the breach still needs to be more than merely trivial or insubstantial. Consequently, a failure to pay on time is more likely to be found to amount to a material breach than a repudiatory breach. However, determining whether a material breach has occurred is dependent on the context of the contract and the consequences of the breach – as shown by the case of Dalkia v Celtech (2006):

Dalkia v Celtech: when does non-payment amount to a material breach?

Dalkia entered into a contract with Celtech to provide energy services to Celtech. This contract was intended to last an initial period of 15 years.

The contract provided Dalkia with an immediate right to terminate if Celtech was in material breach of its obligation to pay the monthly instalments. Celtech subsequently failed to pay three consecutive instalments totalling £350,000. As a result, Dalkia sought to terminate the contract. Celtech argued that, as the total amount payable under the contract was £15 million, a failure to pay a mere £350,000 was neither a repudiatory nor a material breach.

The High Court agreed that the breach was not repudiatory but found that it was material, noting that there had been three consecutive missed instalments and the total outstanding did not amount to a trivial sum of money in absolute terms.

However, unlike termination for repudiatory breach at common law, material breach often won't give rise to a right to terminate immediately. This is because material breach clauses typically state that if a breach is capable of remedy, the aggrieved party should give notice of the breach and the breaching party has a period to remedy the breach - for example, by paying the outstanding sum, together with any applicable late payment interest to which the receiving party is entitled (for more on late payment interest, see Late payment clauses: time for a review?).

What if the other party is insolvent?

A failure to pay sums due will often occur where the customer has got into financial difficulty and may be insolvent. A supplier's normal termination rights in this situation may be significantly impacted by the Corporate Insolvency and Governance Act 2020 ("CIGA"). CIGA makes it difficult for suppliers of goods and services to terminate contracts once a customer is subject to a relevant insolvency procedure. The restrictions in CIGA are intended to prevent rescue efforts for companies in financial difficulty being undermined by suppliers.

CIGA prevents a supplier making further supply conditional on payment of any outstanding amounts; it 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 is regarded as a fresh breach and the supplier can (depending on the terms of the contract) terminate on this basis.

Will I still be paid if I can't terminate?

Suppliers which are prevented by CIGA from terminating due to a customer's insolvency must still be paid for any supplies they make to the customer during the insolvency procedure, failing which they will be able to terminate in accordance with the terms of the agreement. So even in a situation where invoices issued pre-insolvency 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 insolvency procedure.

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". UK Government guidance on this aspect suggests that such applications will only be allowed in limited circumstances – effectively, the supplier would need to show a real risk that it would become insolvent itself, if it were required to continue to supply. For more information, see our detailed briefing on terminating supply contracts on insolvency.

Drafting tips

        Key drafting tips for suppliers
    
If possible, state that timely payment is a condition of the contract, or that time is of the essence in relation to payment. However, customers may resist drafting of this nature, especially if the contract is being entered into on negotiated terms. 

Where a customer resists the above drafting point, consider providing that non-payment of invoices above a specified amount counts as a material breach. Alternatively or in addition, consider including an express right to suspend services until payment is received from the customer. 

Consider including a parent company guarantee (if the customer is able to provide one from a guarantor entity of substance). Alternatively, consider requiring the customer to have insurance for a specified amount which can be called upon in the event that it becomes unable to meet its payment obligations.

Consider imposing obligations on the customer to provide more information about its financial position during the life of the contract; this can provide early warning of payment problems and may assist with the exercise of termination rights for insolvency.

Key drafting tips for customers

Resist attempts by the supplier to characterise timely payment as a condition of the contract or the inclusion of any provision that states that time for payment is of the essence.
Include provisions allowing payment obligations (and remedies for late payment) to be suspended where there is a dispute over payment (for example, where there is a genuine disagreement over whether the correct amount has been invoiced). The suspension would only apply to the disputed payment and only last until the relevant dispute has been resolved.
Following on from the above point, payment triggers need careful consideration. If a customer wishes to be able to withhold payment where work has not been carried out properly, payments should be conditional on milestones having been achieved by the supplier. For more information on payment triggers, see our briefing Payment terms: what to watch out for.