Termination or “Ipso Facto” Limitations Under the Draft Insolvency Bill

This alert is up-to-date as of Friday 5 June 2020. The legislation remains in draft only at this stage.

The Corporate Insolvency and Governance Bill 2020 (the “Bill”) passed its second and third readings in the House of Commons on 3 June 2020 without significant amendment. The Bill has a number of additional hoops to pass through before it becomes law, where it will be further scrutinised and amendments to the detail may be expected, albeit we understand that the Bill has wide, cross-party support. Alongside several other key updates (see our alert on the updated directors' duties), the Bill seeks to expand the restrictions relating to "ipso facto" clauses (i.e. clauses which are triggered solely on the basis of a counterparty's insolvency), in contracts for the supply of goods and services.

A summary of the key proposed changes vis-à-vis the current position is as follows:

Current Position

Section 233A of the Insolvency Act 1986 ("IA86") provides limited scope to restrict the triggering of insolvency-related clauses in certain contracts by a contractual counterparty when a company goes into an insolvency process. Such clauses are currently only unenforceable where (i) a company is subject to certain insolvency and rescue procedures (namely administration, and CVAs^[1]), and (b) the contract is with a supplier of essential goods or services which is caught under s.233 IA86.

S.233 IA86 limits the terms that essential suppliers can impose (either directly or indirectly) as a condition for the continued supply of their services after a company goes into an insolvency process. This section has broader application and applies where a company goes into an administration, administrative receivership, s.1A moratorium (CVA moratorium for eligible companies), CVA and liquidation.  

In circumstances where s.233A applies, a supplier is unable to terminate the contract solely by reason of its counterparty's insolvency, and therefore obligations under the contract will potentially continue to run. Any outstanding payments due to the supplier up to the point of the company entering insolvency convert into unsecured claims, and a supplier will not be able to demand settlement of outstanding amounts as a pre-requisite for continued supply^[2].

The purpose behind the provisions under s.233 and 233A IA86 is to protect the operational capabilities of a debtor company, preserve company assets for the benefit of the creditors as a whole, and prevent the abuse of a monopoly position/opportunistic behavior from essential service providers.

In essence however, the ipso facto restrictions, as they currently stand, are quite limited:

1. They only cover essential supplies such as gas, water, electricity, and communication services and IT supplies (e.g. data storage, computer hardware and software, processing and website hosting).
2. They do not apply to any other insolvency procedures except administration or CVAs.
3. There are a number of carve-outs which are set out under s.233A(2) IA86, for example, contracts can provide for automatic or elective termination where the company is subject to an insolvency process other than administration or CVA (i.e. liquidations). Alternatively, the contract can designate other termination events (i.e. non-insolvency events) after the company has gone into administration or a CVA.
4. 233A IA86 was added pursuant to the Insolvency (Protection of Essential Supplies) Order 2015, which came into force on October 2015, and specifies that the ipso facto restriction only applies to contracts entered into from this date.
5. Finally, even where an insolvency-related term may be deemed unenforceable, it is still possible for the supplier to invoke termination rights on alternative grounds^[3], for example, a subsequent payment default.

A number of safeguards also apply to help protect the supplier:

1. Supplies provided after the point of insolvency are paid by the company in the insolvency process as an expense, covered by a personal guarantee from the office-holder which has to be provided within 14 days of the supplier's request (of course the benefit of such a guarantee is dependent on the creditworthiness of the IP).
2. Suppliers may still be able to terminate the contract provided that (i) the officeholder consents to such termination; or (ii) the court grants permission (and it may only do so if it is satisfied that continuation of supply would cause the supplier "hardship").
3. Amounts incurred as a result of continued supply post-insolvency which are not paid within 28 days of such payment falling due also allow termination of contract.

New Position under the Bill

The Bill substantially widens the ipso facto parameters. In summary, any contract for goods and services which is not expressly exempt under Schedule 12 of the Bill (i.e. which generally covers entities and contracts of a financial nature) may be caught. This will likely be problematic for a large number of goods and service providers/ suppliers, particularly where such obligations are of an ongoing or long-term nature.

The Bill proposes the following:

• The definition of "insolvency procedure" has been widened and includes administration, administrative receivership, CVA, liquidation and appointment of a provisional liquidator. Additionally, it also includes the two new restructuring tools, namely, the new moratorium and cross-class cram down arrangements and reconstructions. The ipso facto restriction now applies to the onset of any of these insolvency procedures.
• Relevant contracts for the supply of goods and services which fall in scope are now also considerably wider. IA86 already captured "goods and services" under s.233(f) IA86, however, currently these only relate to very specific IT-related services which are itemized under s.233(3A) IA86. Now, the Bill proposes to bring into scope all contracts which entail the supply of goods or services which have not been carved out under Schedule 12 of the Bill.
• There is also express suspension of any pre-insolvency breaches which give rise to termination^[4], so effectively a supplier cannot rely on such a breach after the onset of insolvency.

Although some of the previous safeguards have been replicated into the proposed s.233B, it is important to note that not all of the same protections or benefits will be afforded to suppliers of goods and services affected under s.233B of the Bill.

Exclusions

Permanent Exemptions

Schedule 12 (which will insert a new Schedule 4ZZA into IA86) sets out the permanent exemptions. The exemptions apply at an (i) entity (or supplier) level, and (ii) contractual level.

Entities which are excluded include banks, insurers, investment banks and firms, and payment institutions etc. Contracts which are excluded include financial contracts, derivatives contracts, spot contracts, securities financing transactions, and capital market arrangements etc. Netting and set-off arrangements also remain unaffected.

It was considered that if financial counterparties and financial contracts were not excluded, the ipso facto ban may lead to withdrawal of certain financial products from the market altogether, or from companies as soon as there was any signs of distress.

Temporary Exemption

There is a temporary exemption relating to small suppliers. The exemption only lasts for 1 month after the Bill becomes law (unless this period is extended). A small supplier is a company that can satisfy at least two out of the three following tests:

Implications of the new changes

Whilst it is too early to tell how markets will react to these changes, we would query whether an unintended consequence of these amendments might be to make counterparties more "trigger-happy" in relation to termination or default provisions at the first sign of a company's distress, rather than adopting a wait-and-see approach. This could certainly speed up a company's demise, and have the opposite effect to what the Bill is trying to achieve, which is to facilitate an environment which maximizes the chances of recovery and turnaround. It remains to be seen whether the new section covers other contractual arrangements such as franchises and licenses, and the effectiveness of liens, though there must be a risk that the courts will give a wide and purposive interpretation to the provisions, designed, as they are, to enable a company to continue to trade.

For counterparties which do not terminate early, there are still limited windows just prior to insolvency when termination will be possible, for example, when notice of a meeting of creditors to consider a CVA has been received, or when a company has filed a Notice of Intention to Appoint an Administrator. Of course, these windows only apply to certain insolvency routes, and will not be applicable to all insolvency procedures. They also require a degree of vigilance and quick action which may not be possible for all counterparties, therefore having an established policy/action plan, and ensuring adequate contractual protections exist, may be the safest way forward for most commercial suppliers.

Implications of these changes on supplier chains, or suppliers who have utilized trade credit insurance or debt factoring/discounting, is unclear at this stage. One would presume that these changes will not, by themselves, cause a chain reaction of insolvencies in supply chains given the financial hardship safeguard - i.e. if a supplier can demonstrate that forcing continuity of supply will potentially cause it to tip into insolvency, it is anticipated that this will satisfy the hardship condition, although the court's general approach to hardship, speed and expense of going down this route, remains to be seen. Alternatively, suppliers may simply refuse to supply and place the onus on the company to apply to court and then raise a hardship defence at that point.

"Hardship" has not been defined in the proposed legislation, although from Parliamentary briefing papers it would appear that the threshold will likely be quite high, and the courts may need to consider^[5]:

• whether or not the supplier would be more likely than not to enter an insolvency procedure as a result of being compelled to continue supply; and
• whether exempting the supplier from the obligation to supply would be reasonable in the circumstances having regard to the effect of non-supply on the debtor company and the prospects of rescue.

Practical Pre-emptive Considerations

It is likely a range of suppliers of goods and services will want to generally review their long-standing or ongoing contractual arrangements, and also make updates to in-house templates, policies and procedures going forward. It may also be prudent to ensure suppliers have in place pre-insolvency and post-insolvency recovery/exit strategies which are both clear and appropriate under the new legislation.

• Consider whether an officeholder/company will consent to terminating the contract in question upon insolvency, or if they may insist on continued supply. This question will likely depend on whether the contract relates to goods/services which are key to the company's turnaround, or ability to continue trading.
• Reviewing and tightening up payment periods and applicable grace periods (and enforcing regular collections) may help to manage the risk of ending up as a major unsecured creditor.
• Reviewing events of defaults generally and understanding how they may be triggered (process, notification procedures, and grace periods) and how they may interplay with an insolvency scenario will highlight issues and weaknesses in advance. In particular, note that s.233B of the Bill does not preclude a supplier using the occurrence of a new breach post-insolvency to terminate the contract.
• Consider whether there are any set-off or netting arrangements in place which may apply to manage exposure.
• Take a holistic view of contractual arrangements and consider whether security or guarantees, for example, may be taken from the company or a third party to improve the supplier's position.
• If there are pre-insolvency breaches, and it appears as if the company may be heading into insolvency, a supplier will likely need to act quickly and assess whether it wants to invoke its rights (whether that is to terminate, or take any other steps).

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If you have any questions, or for further information please reach out to Charlotte Møller, Richard Obank, Monika Lorenzo-Perez or Colin Ashford.

The views expressed herein are solely the views of the authors and do not represent the views of Brown Rudnick LLP, those parties represented by the authors, or those parties represented by Brown Rudnick LLP.  Specific legal advice depends on the facts of each situation and may vary from situation to situation.  Information contained in this article is not intended to constitute legal advice by the authors or the lawyers at Brown Rudnick LLP, and it does not establish a lawyer-client relationship

^[1] s.233A (a) and (b) IA86.

^[2] S.233(2)(b) IA86.

^[3] s.233(3) IA86.

^[4] s.233B(4) of the Bill.

^[5] Commons Library Analysis of the Corporate Insolvency and Governance Bill [HC 2019-21] Number 8922 (1 June 2020)