Is terminating a contract for insolvency about to get harder?

Under English law, there is no common law right to terminate a contract on a counterparty’s insolvency. As a result, in all well-drafted commercial contracts it common to see a contractual right to terminate on the event of a party’s insolvency. However, the effectiveness of these contractual termination clauses may be about to change as a result of the Corporate Insolvency and Governance Bill 2019-21 (the “Bill”) which was published on 20 May 2020.

What does the Bill do?

In light of COVID-19 and the impact it has having on businesses, the Bill provides for amendments to the Insolvency Act 1986 (IA 1986) and the Companies Act 2006 (CA 2006) on several key areas, such as the temporary suspension of wrongful trading and restrictions on the presentation of winding up petitions. Significantly for commercial practitioners, the Bill will also invalidate contractual termination clauses in contracts for the supply of goods or services where termination is triggered by the other party's entry into in insolvency proceedings. This restriction is not entirely new – for example, “essential suppliers” (e.g. providers of electricity, gas, water, communications services and information technology) are already subject to a restriction on their contractual termination rights on insolvency – but the Bill expands the scope of this restriction to capture new suppliers and significantly curtails the usefulness of contractual termination rights upon an insolvency event. Furthermore, the Bill prohibits suppliers from making the payment of pre-insolvency debts a condition of on-going supply to a customer that has entered into an insolvency procedure. In addition, it is important to note that while some of the provisions of the Bill are stated to be temporary to deal with the impact of COVID-19, the measures relating to contractual termination rights will be permanent.

Are there any exemptions?

For suppliers there may be some comfort in the fact that there are some noticeable exceptions where contractual termination rights for insolvency can still be relied upon. For example, if an administrator or liquidator appointed over the insolvent company agrees to the termination or if the company which is subject to a moratorium, CVA or Part26A plan (the new restructuring plan provided for under the Bill) agrees to it. But the most significant exemptions that are likely to be relied upon by suppliers in order to terminate a contract for insolvency are:

the courts being satisfied that the continuation of the contract would cause the supplier hardship (although what constitutes “hardship” in practice is unclear);
the exclusion of contracts for supply of goods and services for a company in the context of financial services (e.g. if the insolvent company or supplier is a bank, insurer or payment institution); and
in the short term, a temporary exclusion for “small suppliers” (as defined in detail in the Bill) which permits them to rely on the contractual termination provisions that would otherwise have been invalid: (i) between the date on which the Bill comes into force and 30 June or (ii) one month after the Bill comes into force (whichever is later) if they have supplied a company that has gone into insolvency.

So what to do on a counterparty’s insolvency?

Whilst many small suppliers will want to check the Bill to see if they can rely on the temporary exclusion, for larger suppliers it will be a case of reviewing their contracts and checking to see if there are any other termination rights that can be relied upon (e.g. termination for convenience). Although not an express statutory exemption, there does not appear to be a prohibition on terminating a contract where another type of termination event has occurred after the start of the insolvency proceedings. It would also be worthwhile to do these checks sooner rather than later as the government have stated they intend to use emergency powers to introduce the Bill quickly, with an aim of receiving royal assent in June 2020.

For the longer term, suppliers should protect themselves by carrying out regular due diligence on their customers’ financial health and also by means of insurance (although this may increase costs). An awareness and understanding of the criteria to apply to the court under the hardship exemption will also be beneficial (although how long and complicated this process will be remains to be seen). What is clear is that UK government, coupled with its recent (albeit non-binding) guidance on responsible contractual behaviour, is keen to stress that organisations should be looking to settle disputes and avoid pushing businesses into insolvency in these extraordinary times.