Developments in contract: Termination on insolvency

Principles

• Common law provides no right of termination in the event of insolvency or financial difficulty. The situation must therefore be prescribed for expressly in the contract.

• Clauses in contracts which permit the termination of the contract by a party due to the bankruptcy, insolvency or financial condition of another party are often described as ipso facto clauses. They can provide for an event of default such that the contract automatically terminates upon the other party becoming insolvent, or merely providing an option to terminate in such circumstances.

• The reason for such clauses is obvious. Continuing to supply or provide services to a paying party who is insolvent, or likely to become so, puts the unsecured supplier or service provider at risk of receiving only pennies in the pound for any debt owed to it at the close of the insolvency process.

• Equally, if the paying party commits a breach of contract, the right to sue for the breach is likely to be worthless, given that any damages awarded would also rank low in the priority process as an unsecured claim.

• If the supplying party stops supplying out of concern at a mounting debt that may not be paid, the supplying party may itself be in breach and liable to pay damages in full (subject to rights under the Insolvency Act 2016 to set-off against amounts owed).

Recent Developments

• On 26 August 2018, the Government published a response to its 2017 consultation on Insolvency and Corporate Governance and its 2016 Review of the Corporate Insolvency Framework. The aim of these consultations was to look beyond Brexit and take steps to ensure that the UK remains a centre of choice when it comes to insolvency processes and restructuring.

• Amongst legislation proposed is a prohibition on the enforcement of clauses in contracts which allow for termination triggered by a party entering a formal insolvency process, with a view to preventing a supplier from undermining the company’s chance to restructure or be sold as a going concern. Suppliers will have to fulfil their commitments under the contract with the debtor company, allowing the company to keep trading.

• Rights to terminate, other than those connected to the debtor company’s financial position, will remain. This includes non-payment of liabilities following entry into a moratorium, restructuring plan or other insolvency procedure.

• A crucial exemption to this planned prohibition is contracts for certain (as yet unspecified) financial products and services. This was due to concern that otherwise banks would withdraw their products and services at a much earlier stage, before the directors of a company are even considering entering a moratorium.

• As a “safeguard of last resort”, the Government proposes that a supplier will be able to exercise their right to terminate if they are significantly adversely affected by the inability to enforce the clause and on the grounds of “undue financial hardship”. Before the clause can be enforced, however, the supplier will need to make an application to Court. On such an application, the Court will need to balance the risk of insolvency to the supplier if they are compelled to continue to supply, against the risk to the debtor company’s prospects of rescue should the supplier cease to provide its goods or services.

• The reference to a “moratorium” also includes a new 28-day pre-insolvency moratorium proposed in the Government’s paper, the criterion for which is that the company will become insolvent (on what test it is unclear) if action is not taken but that, by the appointment of an out of court ‘monitor’, rescue of the company is more likely than not. The prohibition on enforcement of ipso facto clauses will apply during this 28-day period, which can be extended upon an application to Court.

• Initial proposals that certain contracts be designated as “essential contracts” and be immune from termination or variation during the moratorium and any subsequent insolvency procedure, have been dropped.

What this means

• Efforts aimed at maximising the chances of rescuing businesses who rely upon contracts to continue to trade are clearly necessary and welcome. However, the devil will be in the detail of the legislation proposed and much remains uncertain at present.

• The non-enforcement of ipso facto clauses during an insolvency process is not a new concept. Such a ban on enforcement was recently enacted in Australia and has long been in place under the US Chapter 11 Bankruptcy Code regime for certain contracts.

• No date has been given by the Government as to when it plans to enact legislation to allow for this change. The consultations have moved at a fairly glacial speed thus far and Brexit adds further uncertainty.

• As yet, it is unknown whether the legislation would apply only to contracts entered into after the enactment of legislation or whether it would apply retrospectively. To apply such legislation retrospectively would significantly alter bargains already entered into by parties and lead to significant uncertainty and potential unfairness. The recently enacted Australian legislation applied prospectively and we expect England and Wales to follow that model.

• Supplier parties entering into longer term contracts should start giving thought to this issue now. If any changes are retrospective, the scope to vary a contract once the reforms are enacted may be limited. It is as yet unclear how any legislation might affect clauses other than ipso facto clauses but which in substance still allow a party to terminate for insolvency (material adverse change clauses, for example). Parties may now wish to consider bolstering other areas of their contracts not related to insolvency, such as the timing of milestone payments, more regular contract reviews or more robust provisions around termination for other reasons.