Handling termination of contracts with an insolvent customer

Upon hearing that its customer that has become insolvent, it would be a natural response for a supplier to query whether it can exit its commercial relationship with that customer. The potential concern over non-payment for supplies necessarily looms large. Suppliers must tread carefully when seeking such an exit as insolvency legalisation limits their options, but there are ways to navigate the situation, with careful drafting of supply contracts.

Sections 233, 233A and 233B of the Insolvency Act 1986 (IA 1986) prevent certain supply contracts from being terminated by the supplier simply because the customer enters an insolvency process. The intention behind these provisions is to prevent an insolvent company being cut off by a supplier, or being subjected to forced, unfavourable contract changes to keep supply flowing.

“Insolvency” is defined broadly in the IA 1986 and includes where a customer: (a) is subject to a moratorium; (b) enters administration or liquidation; (c) has an administrative receiver or provisional liquidator appointed; (d) enters into a voluntary arrangement such as a “CVA”; or (e) is subject to a court order for a meeting relating to a compromise or arrangement.

The restriction on termination

Section 233A limits termination of contracts for the supply of “essential supplies”, but section 233B is far broader-ranging and protects all goods and services supply contracts already in force at the time of the customer’s insolvency, subject only to limited exceptions. The supplier’s restriction on termination is triggered if the customer enters into any of the ‘collective corporate insolvency procedures’ under the IA 1986; in effect, covering all forms of insolvency.

This bar on terminating applies to suppliers only. A customer can still terminate a supply contract if its supplier became insolvent. Suppliers also cannot vary the contract or make payment of outstanding pre-insolvency sums a condition of continuing the supply.

A supply clause that purports to automatically terminate the agreement, or grants a supplier the right terminate, upon the customer entering into insolvency proceedings is, in effect, inoperable. However, it is still market standard to see termination provisions that appear to grant such rights. Understanding the subtleties of these termination clauses is vital to ensuring that a clause properly protects a supplier.

How a supplier can protect its position with drafting

While a supplier cannot terminate for the customer insolvency itself, it can still terminate:

• for a pre-insolvency breach of contract (which may include non-payment) provided that the termination right is exercised before the customer’s insolvency proceedings have begun; and
• for a fresh breach that occurs after the insolvency proceedings have commenced.

Suppliers must therefore ensure that their written contracts give them enforceable termination rights.

1. Triggers before insolvency proceedings: A termination clause should capture pre-insolvency distress scenarios which are not limited by the legislation. The clause should allow the supplier the right to terminate (a) for customer non-payment within specified timescales; (b) if the customer commits a material breach (which might include non-payment); (c) if the customer suspends or ceases all or part of its business (or threatens the same); and (d) if the customer’s financial position deteriorates to such an extent that the supplier considers the customer may be unable to pay (but is not yet in insolvency proceedings
2. Triggers on new grounds that arise after the insolvency proceedings have begun. For example, if the customer or its insolvency office-holder fails to make payment that arises after the insolvency began. This again demonstrates the value of a termination trigger for material breach.
3. Terminating for convenience / on normal notice. This should be permissible after insolvency, provided that the contract grants the supplier a free option to terminate on notice, and any notice periods and other timeframes are properly observed. The supplier must continue to supply during the notice period to avoid the prohibition on suspending supply under the IA 1986.

The above tools can help suppliers to steer a route through the difficult situation of a customer’s insolvency. Our Commercial Contracts team have a wealth of experience in drafting supply contracts and terms and conditions across a wide range of sectors and industries.

For further information or advice please contact Becky Cooper on 01494 932614 or email becky.cooper@blasermills.co.uk.