Can I terminate my contract with an insolvent counterparty?

Can I terminate my contract with an insolvent counterparty?

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A raft of new legislation was introduced during the pandemic with the aim of shielding businesses from the full economic impact of lockdown. One such piece of legislation was the Corporate Insolvency and Governance Act 2020 (CIGA). Some of the protections implemented by CIGA were temporary – for example, restrictions on the presentation of winding up petitions or the suspension of liability for wrongful trading. However, a number of permanent changes to insolvency legislation remain in force.

One of the permanent measures implemented by CIGA was a restriction preventing suppliers of goods and services to insolvent companies from terminating their contracts by reason of the latter’s insolvency (or doing any other thing to amend the terms of the contract as a result of the insolvency). This measure was introduced to provide an opportunity for insolvent companies to continue to trade with a view to rehabilitation, and to safeguard against suppliers terminating contracts (or otherwise invoking unfavourable provisions), as a result of entering an insolvency process.  The restriction was inserted into a new section 233B of the Insolvency Act 1986.

Nonetheless, many standard terms and conditions still provide a right to terminate upon insolvency. We are regularly asked to advise on when this right can still legitimately be exercised, i.e. when is it possible to terminate a contract with an insolvent counterparty? We have highlighted some of the common circumstances in which companies can still rely on these termination rights below.

1. The contract does not concern the supply of goods or services

The prohibition on termination of contracts only applies to contracts “for the supply of goods and services”. Given this is relatively new legislation, there is limited guidance from the court on what could be construed as “goods and services”. Difficulties might arise where a contract that does not appear on its face to be a supply contract contains a goods or services element – for example, a licence or lease with a provision for the supply of specific goods or services. However, it is hoped that the courts will adopt a pragmatic approach and, in practice, many types of contracts will not fall within the scope of the prohibition (or at least only those parts which specifically relate to the provision of goods or services must be continued). It’s worth noting too that the restrictions apply only to suppliers; customers can still take their business elsewhere (for example, if a supplier goes insolvent).

2. The counterparty is not (yet) in an insolvency event

The prohibition on termination applies where a company becomes subject to a "relevant insolvency procedure". Broadly, this is where a company actually enters into a formal insolvency process, such as administration, liquidation, or a voluntary arrangement. However, many insolvency termination clauses are widely drafted and provide a right to terminate for pre-insolvency steps that are not caught by the prohibition in section 233B. For example, the restriction does not prevent termination of a contract where a company has filed of a notice of intention to appoint administrators. The rules do not restrict termination clauses triggered by a scheme of arrangement or where a fixed charge receiver (as opposed to an administrative receiver) is appointed over a company’s assets. Another example where a contractual right to terminate might arise is where a winding up petition has been issued or a statutory demand has been served against the company; whereas the prohibition on termination in section 233B does not apply until the company actually enters into liquidation.

3. The right to terminate does not relate to the insolvency AND did not arise until after the insolvency event

The impact of CIGA is to render suppliers’ termination rights arising as a result of its contractual counterparty’s insolvency unenforceable. However, other termination rights arising under the contract are not impacted in the same way. Other rights of termination (e.g. for non-payment or another material breach) which arise after the insolvency event are still capable of being exercised in the ordinary way. In practice, this might mean that suppliers are unable to terminate by reason of the insolvency but, as a result of the cessation of company operations (and payments in the ordinary course of business), they may nonetheless be able to terminate shortly afterwards.

4. Officeholder consent or court permission

Suppliers can still exercise their right to terminate contracts with an insolvent counterparty where the relevant insolvency officeholder (or otherwise the company itself) consents to the termination of the contract. Alternatively, suppliers can make an application to court for permission to terminate on the grounds of financial hardship.

5. Exceptions

Finally, there a number of exceptions to the application of section 233B, set out in Schedule 4ZZA to the Insolvency Act 1986 (slotted in between Schedules 4 and 4ZA, in case you wondered). Amongst other things, there are exclusions for essential supplies, contracts relating to financial services (and involving entities carrying on certain regulated financial activities), and contracts relating to aircraft equipment.

Although the new prohibition on termination for insolvency may seem widely drawn, often suppliers can still legitimately seek to terminate a contract for one of the reasons set out above.  

And finally, section 233B doesn’t just restrict termination for insolvency but the actions which are limited go further than that. For example, a supplier cannot make payment of outstanding sums (in respect of supplies made before the relevant insolvency event) a condition of continuing supply. Moreover, the supplier cannot do any other thing as a result of the insolvency event – this would appear to limit making changes to the contract pricing or credit periods, for example. But more on that on another occasion.

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