Does your termination clause still work the way you think? Changes to insolvency law under the Corporate Insolvency and Governance Act 2020

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Parliament has now passed the Corporate Insolvency and Governance Act 2020 (Act), making some significant reforms to the insolvency regime, with some particular consequences for suppliers of goods and services.

While the Act contains some specific and temporary measures to help mitigate the effects of COVID-19 (such as the suspension of a director’s liability for wrongful trading) much of the Act was already in the works and is based on Government’s White Paper and consultation in 2018.

The Act raises some questions for assessing counterparty credit risk. It also raises specific challenges for suppliers of goods and services. The Act should make all parties consider the termination provisions they use in their agreements. The Act also raises uncertainties for regulated companies typically subject to special administration regimes.

One of the most significant measures includes the introduction of a ‘moratorium’. The moratorium will be a brand new, standalone insolvency procedure and will not be a gateway to any of the other statutory insolvency procedures.

Similar to the US ‘Chapter 11’ process, it is designed to increase flexibility in the insolvency regime and move it towards a system that better assists the rescue of companies as a going concern. Although always planned, its introduction has been expedited to assist companies, which were otherwise in strong financial positions that have seen revenues plummet during COVID-19. Nonetheless, it will have important consequences for suppliers of goods and services to insolvent companies.

Alongside the moratorium, the Act also provides for termination, and similar contractual provisions, upon the event of insolvency by the supplier of goods and services contracts to be suspended under certain conditions.

Part A – Moratorium

A moratorium precludes insolvency procedures, enforcement of securities and legal proceedings and forfeiture of leases for an initial period of 20 business days being used against the company in question. This initial period can be extended for a further 20 business days without creditor consent. Longer extensions are permissible with creditor consent or consent of a court. Effectively a moratorium is an alternative for a company in distress to an insolvency procedure. Unlike with other insolvency procedures such as administration the directors of the company will remain in charge during a moratorium but will be overseen by a “monitor”. During the moratorium, the company otherwise trades as normal with a ‘monitor’ (likely an insolvency practitioner) overseeing the company’s affairs.

A moratorium can only be sought where:

(i) a company is or is likely to become, unable to pay its debts; and
(ii) the monitor is of the view that it is likely a moratorium would result in the rescue of the company as a going concern.

Exclusions

Certain companies are not eligible for a moratorium, including financial institutions and PPP project companies. Companies already subject to an insolvency procedure and those that have been in a moratorium, CVA or administration in the previous 12 months are also excluded.

The PPP exclusion appears to be intended to protect lenders under PPP/PFI/PF2 projects – who will not be prevented from exercising their step-in and other rights of security as a result of this exclusion. Further HMG would be able to enforce against such companies. It is interesting to note this would apply even where a PPP company is suffering specifically as a result of Covid-19.

The moratorium also appears to be available in respect of regulated companies that are subject to special administration regimes (such as those in the energy and water industry). This is somewhat of an anomaly as special administration typically works to ensure such companies are preserved as going concerns in any event. The Act makes provision for the Secretary of State to make regulations in this regard. The Government can both modify the moratorium regime as it applies to such companies and potentially disapply the application of the moratorium regime to such companies (using wider powers in schedule ZA1).

There are also certain amendments to the moratorium regime applicable up to 30 September 2020 in Schedule 4.

Termination

The monitor must also terminate the moratorium when:

(i) the moratorium is no longer likely to result in the rescue of the company as a going concern;
(ii) the company has been rescued as a going concern;
(iii) as a result of directors failing to provide required information, the monitor is unable to carry out the monitor’s functions; or
(iv) the company is unable to pay any moratorium debts or pre-moratorium debts for which if does not have a payment holiday.

This, together with the exclusions set above, demonstrates that the moratorium is intended to be used by those companies, in temporary financial difficulties that have a genuine chance of recovery. In a sense, it is more of a ‘restructuring’, rather than an insolvency regime.

It is not designed to simply prolong insolvency for those companies with long-term financial problems and with no real prospect of recovery.

Payment holiday

While the moratorium offers companies protection from other insolvency proceedings, it also provides the company with ‘breathing space’ from creditors, though crucially only for some, not all, of the company’s debts. The Act separates debts into three:

a) pre-moratorium debts for which the company has a payment holiday;
b) pre-moratorium debts for which the company does not have a payment holiday; and
c) moratorium debts.

For debts in group (a), i.e. most debts incurred by the company prior to entering the moratorium, the company enjoys a payment holiday during the moratorium.

Group (b) includes:

(i) the monitor’s remuneration and expenses;
(ii) goods and services supplied during the moratorium;
(iii) wages or salary arising under a contract of employment;
(iv) redundancy payments;
(v) rent in respect of a period during the moratorium; and
(vi) debts or other liabilities arising under a contract or other instrument involving financial services – which includes a loan agreement.

Group (c) is any new debts arising during the moratorium period that would not otherwise be captured by those debts for which the company does not have a payment holiday.

Other effects

Aside from those restrictions noted above, in a moratorium, a company would also enjoy restrictions (unless there is permission granted by the court) against:

a) any steps to repossess goods in the company’s possession under any hire-purchase agreement; and
b) any legal process (including legal proceedings, execution, distress or diligence) against the company or its property except certain employment proceedings.

What should we do?

A moratorium is not obviously an insolvency procedure and so where a contractual counterparty enters in to a moratorium termination provisions that trigger on insolvency may not apply. As such businesses and public authorities may wish to consider revising their termination provisions to include a moratorium. When doing so they should take in to account the provisions of the Act that relate to limitation of termination in certain circumstances (see below).

Further public and regulated bodies entering in to contracts with private sector contractors should take increasingly seriously procurement checks on financial resilience.

Part B – Suspension of termination provisions

In commercial contracts for the supply of goods and/or services, it is generally standard practice to include an automatic termination provision if the purchaser of the goods and/or services enters insolvency. There are other, similar, automatic provisions such as acceleration or amendment of payment terms. For example:

Widgets Ltd sells widgets to Globex Ltd under a widget supply agreement which Widgets Ltd supplies monthly.

Under the widget supply agreement, if Globex does not pay an invoice for widgets for a month, Widgets Ltd is able to terminate the widget supply agreement and/or make all outstanding debts immediately payable.

Similarly, if Globex still pays Widgets Ltd, but Globex goes into insolvency proceedings (such as administration) Widgets Ltd is able to automatically terminate the widget supply agreement.

These are commonly known as ipso facto clauses.

The Act imposes a limited ban on these clauses. Any contractual provision that allows a supplier to terminate will cease to have effect upon the purchaser entering a relevant insolvency procedure. ‘Relevant insolvency procedure’ for the purposes of this section as:

a) a moratorium comes into force;
b) administration;
c) an administrative receiver is appointed;
d) a voluntary arrangement takes effect;
e) liquidation;
f) a provisional liquidator is appointed; or
g) a court order is made under section 901C(1) of the Companies Act 2006.

Therefore, if entering into a moratorium, not only will the company enjoy a payment holiday for goods and services contracts, but it will also be protected from the supplier terminating the contract.

Furthermore, notably the ban extends to termination for breaches by the purchaser occurring before it entered insolvency and for breaches for reasons beyond insolvency. For example, a purchaser that has breached the contract by way of non-payment would also enjoy protection from termination. The Act similarly precludes the supplier from amending payment terms or suspending supply in such circumstances.

However, the ban does not appear to prevent termination if the breach occurs after the purchaser enters insolvency. For example, if the purchaser were to stop payment, or continuing non-payment, after entering insolvency, the supplier would be able to terminate the contract.

There is also provision for termination if the office-holder (the monitor in the case of a moratorium) or the company consents to the termination, or if so ordered by the court on the basis that the supplier would suffer ‘hardship’ without termination. This latter issue is likely to be a critical one going forwards as courts consider the definition of hardship.

So for Widgets Ltd imagine the following scenario:

Assuming the widget supply agreement has termination clauses for both material non-payment by Globex and Globex’s insolvency.

Globex does not pay Widgets Ltd’s invoice for 2 months, but Widgets Ltd does not exercise any termination or similar rights under the widget supply agreement.

Globex enters a relevant insolvency procedure. Widgets Ltd cannot terminate or suspend supply or exercise similar rights of enforcement, neither for the historic non-payment or because Globex entered insolvency. Furthermore, despite the arrears and Globex’s precarious financial position Widgets Ltd must keep supplying.

However, if Globex continues not paying Widgets Ltd during the period of the relevant insolvency procedure, then Widgets Ltd will be able to terminate or exercise similar rights.

Notably, the ban does not flow in the other direction. If a supplier of goods and/or services were to enter insolvency, the purchaser of the goods and/or services will still be able to terminate the contract if there are provisions for it to do so. This provision is also applicable only to long-term contracts, not those that operate on an ‘order-by-order’ basis. As per the moratorium, financial contracts are also excluded from this provision. So for Globex:

Under the widget supply agreement Globex is able to terminate if Widgets Ltd goes insolvent.

Widgets Ltd enters a moratorium, Globex is still able to terminate the widget supply agreement as normal.

This will be welcome news for purchasers under goods and services contracts, but they will need to be conscious that their suppliers may benefit from a moratorium and therefore will enjoy a payment holiday for any debts flowing from a supplier breach, such as a service failure. For example:

Under the widget supply agreement, Widgets Ltd must be Globex compensation payments if it delivers widgets 2 weeks late.

Widgets Ltd has entered financial difficulties, made redundancies and as a result has filed to deliver on time to Globex. It now has incurred compensation fees payable to Globex, but has not paid.

Widgets Ltd then enters a moratorium and those compensation fees are now subject of a payment holiday. Globex cannot enforce these debts.

If Widgets continue to incur further compensation fees during the moratorium through further late deliveries, these debts will not enjoy a payment holiday as they are ‘moratorium debts’.

What should we do?

If you are a recipient/purchaser of supplies/services and not a supplier there is no need for any changes.

The Act does raise new risks for suppliers. Suppliers will likely not be able to terminate supply and goods contracts with (or cease supply to) insolvent companies, even if there has been long-running non-payment. The risk is that suppliers may be required to supply throughout insolvency of a customer – which exposes a supplier to greater counterparty credit risk.

Insolvency-related termination clauses (common in suppliers’ standard forms) may no longer be effective. However we would not necessarily recommend their removal as the Act does allow termination in such circumstances in cases of supplier hardship.

However suppliers should focus on payment default provisions to continue to protect their position.

Suppliers may also wish to consider:

  • requirements for credit support; and
  • triggers for termination prior to insolvency such as non-payment.

More generally, in order based contracts, suppliers may wish to hardwire a discretionary right to reject an order. This could enable a cessation of supply notwithstanding customer insolvency and the new Act.

This blog does not contain legal advice.

If you have any further questions please contact Steve Gummer or Peter Collins.

Posted in Latest news and blog.