Suppliers beware: New limitations on rights to terminate a contract for customer insolvency

The Background

The rationale for the prohibition is that a supplier’s contractual right to terminate a contract with a customer on the basis that the customer has entered into an insolvency process significantly jeopardises the prospects of rescuing the struggling business. However, on the flip side, this restriction must therefore logically increase a supplier’s exposure to loss arising from a customer insolvency event.

Before June 2020 there was already a more limited form of restriction in place: sections 233 and 233A of the Insolvency Act 1986 restrict suppliers of “essential services” such as energy, communications, IT and data processing, from terminating a contract for such essential supplies, or from demanding the payment of outstanding charges as a condition of continuing such supplies, where the customer enters into administration or a creditors voluntary arrangement (CVA).

Sections 233 and s.233A continue to apply in relation to “essential services”, but from June 2020 the new section 233B applies to the supply of any goods or services (except for financial services which are already separately regulated).

The New Restrictions on Supplier Termination Rights

Under section 233B a provision in a contract for the supply of goods or services ceases to have effect when the customer becomes subject to a ‘relevant insolvency procedure’ if and to the extent that under that provision:

• the contract or the supply would terminate, or any other thing would take place, because the customer becomes subject to a relevant insolvency procedure; or
• the supplier would be entitled to terminate the contract or the supply, or to do any other thing, because the customer becomes subject to a relevant insolvency procedure.

In addition, where the contract permits the supplier to terminate the contract or the supply because of an event occurring before the start of the insolvency period (for example, termination for non-payment or for material breach) and that entitlement does in fact arise but is not exercised before the start of the insolvency period, then that termination right cannot then be exercised during the insolvency period.

Nor can the supplier insist on the payment of any outstanding arrears as a condition (or do anything else which has the effect of making it a condition) for continuing to supply the goods or services after the start of the insolvency period.

It will be noted that a provision ceases to have effect when the customer becomes subject to a ‘relevant insolvency procedure’ if and to the extent that “any other thing would take place” or the supplier would be entitled to “do any other thing” under that provision because of the customer’s insolvency, and this wide scope of Section 233B will accordingly restrict the application of provisions which have the effect of increasing contract pricing, or changing credit periods or payment terms, or similar matters, upon the customer’s insolvency – but with the scope of “any other thing” being presently uncertain.

A ‘relevant insolvency procedure’ under section 233B encompasses basically any type of insolvency event under the Insolvency Act 1986 and any form of restructuring under the Companies Act 2006 and accordingly is considerably wider than the ‘administration or CVA’ scope of sections 233 and 233A.

When Can a Supplier Terminate?

There are a limited number of exemptions, which might be regarded as safeguards, available to a supplier. A supplier may be able to terminate a contract for the supply of goods or services after its customer has become subject to a ‘relevant insolvency procedure’:

• for grounds other than the occurrence of that relevant insolvency procedure’ where that right to terminate arises after the occurrence of that procedure (e.g. the supplier has a right to terminate for material breach and the customer commits such a material breach after occurrence of the relevant insolvency procedure);
• by obtaining a court order where the court is satisfied that continuing to supply  the goods or services would cause the supplier “hardship” (which is not defined);
• with the consent of the administrator or liquidator of the customer; and
• for a limited period (until at least 30 September 2020) if the supplier is a “small supplier” (turnover less than £10.2 million, balance sheet total less than £5.1 million, and less than 50 employees) it may be excluded from the new provisions.

What steps can a Supplier take to protect itself?

Suppliers can do a number of things to help mitigate their exposure to the consequences of a customer insolvency:

• Keep the insolvency termination clauses in its contracts –  a supplier can apply to the court for permission to terminate on ‘hardship’ grounds, but the court seems unlikely to grant permission if the supplier does not have such a contractual termination right in the first place.
• Review its customer agreements to ensure that its payment terms, credit periods, contractual rights of termination for non-payment, and title to goods provisions are sufficiently robust to protect its position if they continue to apply for the duration of a customer insolvency procedure;
• Whilst ‘contract for the supply of goods or services’ is not defined, where there are doubts as to a customer’s financial strength, considering making supplies on an ad hoc basis under individual orders rather than entering into an ongoing supply contract.
• Where a right to terminate arises on other grounds, consider whether an impending customer insolvency may be the underlying cause and take into account the effect of a future customer insolvency in deciding whether or not to exercise that termination right.

It should also be noted that, at least in relation to an administration, a supply of goods or services to a company in administration will be deemed to be an ‘expense’ of the administration and so at least the supplier will rank ahead of most creditors (except for fixed charge creditors) in terms of being paid for the supplies made to its insolvent customer.