Uncertain times have a knock-on effect on all aspects of life including business. The pandemic, Brexit, ever-rising inflation and now an energy crisis against the backdrop of war in Europe have made many businesses face financial difficulty.
Suppliers and customers alike are facing extraordinary pressures, and this can affect key supply contracts. This has meant the importance of insolvency law and practice in this area has risen considerably.
What happens if a customer becomes insolvent?
Over the years, insolvency laws have been brought in to protect customers that become insolvent from losing important supplies. First, the Insolvency Acy 1986 was introduced containing Section 233 and in 2015, Section 233A was introduced. Most recently, in June 2020, the Corporate Insolvency and Governance Act 2020 further amended the Insolvency Act bringing in Section 233B that made it even more difficult for suppliers to terminate contracts with customers undergoing insolvency proceedings.
Sections 233 and 233A
Sections 233 and 233A were introduced to provide a degree of protection for insolvent companies but they covered essential supplies and no other goods and services. The term “essential supplies” covers the supply of gas, electricity, water, communications and IT goods and services. In Section 233 (3) (f) and 233 (3A) IT goods and services are defined as supplies “for the purposes of enabling or facilitating anything to be done by electronic means”. This definition captures supply of computer software and hardware, information and technical assistance in connection with the use of IT, data storage and processing and website hosting. However, where an IT supply is not covered by Section 233, it is likely that it will be swept up under Section 233B – see below.
Section 233 prevents a supplier from demanding that outstanding charges incurred pre-insolvency are paid as a condition of continuing its supply. However, the section also allows the supplier to require the insolvency office holder personally guarantees payment for the ongoing supply after insolvency. Section 233 is triggered when:
a company enters administration
an administrative receiver is appointed
a CVA has taken effect
a company has gone into liquidation, or
a provisional liquidator has been appointed.
Section 233A expanded Section 233 by adding a restriction on the supplier terminating essential supply contracts captured under Section 233 where the customer has entered into administration or a CVA has taken effect. It does not apply to the other insolvency scenarios that apply to Section 233 listed above.
So essentially, Sections 233 and 233A together ensure suppliers continue to be paid for essential supplies that they must continue to provide when a customer enters into administration or a CVA takes effect, and they prevent the supplier from terminating the contract if that is the case. The supplier also has a right to require the administrator or CVA supervisor personally guarantees that they will be paid in the future.
Section 233B was brought into effect on 26 June 2020 and applies to insolvency proceedings after that date. It goes further and precludes termination of the supply of all services (except financial services) and goods in the event of a customer insolvency. Any contractual right of the supplier to terminate for a customer’s insolvency or an automatic termination clause in the event of a customer’s insolvency are no longer enforceable as well as any contractual consequences triggered by a customer becoming insolvent. It also prevents a supplier from terminating the contract for a pre-insolvency breach after insolvency proceedings have started. Section 233B applies to a broad range of insolvency procedures under the IA 1986 and Part 26A restructuring under the Companies Act 2006.
Section 233B further prevents a supplier from “doing any other thing or allowing any other thing to happen” based on the customer becoming insolvent. An example given by the Department of Business, Energy & Industrial Strategy in its explanatory notes of “doing any other thing” is changing payment terms. A supplier also cannot make it a condition of continuing its supply that the customer makes any outstanding payments. Therefore, the supply must continue even if the customer owes the supplier outstanding sums that date back to before the commencement of insolvency proceedings.
Section 233B applies to existing contracts for the supply of goods and non-financial services and it is not confined to essential supplies like Sections 233 and 233A. It essentially should sweep up situations where:
the supplies are not essential supplies within the meaning of Sections 233 and 233A (except financial services); and
the insolvency procedure is not an administration or a CVA.
However, the Section doesn’t provide any personal guarantees to the supplier that future payments will be made like Section 233.
In the absence of clear guidance within the legislation, there has been some discussion on whether IP licence agreements such as software licence agreements come within the remit of S233B given a licence may simply be permission to use something. There are arguments for and against treating a software licence as the supply of goods and services. Given the intention of the legislation is to protect important supplies and terminating a critical software licence could cause as much disruption as terminating a contract for the supply of goods and services, it has been argued the phrase “goods and services” should be interpreted in the broader sense. The line is further blurred with SaaS arrangements as the software is by definition a service in that situation. It has also been suggested that documents issued during the consultation period when the Bill passed through Parliament mean the Government intended “goods and services” to include IP licences. This is clearly an area that could do with some clarification.
But what else can a supplier do to protect itself?
Given the legislation, it is clearly important from a supplier perspective that it gives itself the best chances of becoming aware that a customer is in financial difficulty before insolvency proceedings commence. So, what can be done?
First, before even entering the contract, the supplier should undertake sufficient due diligence on the customer’s financial status and its key supplier contracts. As much upfront information the better.
In negotiating its contract with the customer, a supplier should seek provisions requiring the customer to provide regular financial information on its financial position and the ability to terminate the contract if certain trigger points are hit i.e., there is a clear sign the customer is in financial trouble such as a downgrading of its credit rating or similar.
Pro-active contract management and governance will also play a key role in ensuring the supplier is aware of any issues. Supplier staff will need to be able to quickly pick up on issues of concern and have an understanding the implications of the legislation. The supplier will also want to ensure it has robust payment provisions in place that protect the supplier from late payments and the ability to terminate in the event of non-payment with cure periods being as short as the supplier can negotiate.
A supplier could also consider whether structuring the contract differently, for example, having multiple short-term contracts is a safer alternative to a single long-term contract. Giving itself the right to terminate for convenience is also something a supplier could opt for. However, suppliers will need to balance customer insolvency risk with the revenue commitments they normally seek from their customer contracts.
But what if it’s the supplier that becomes insolvent?
A customer doesn’t enjoy the legislative protection mentioned above in the situation where a supplier becomes insolvent i.e., there is nothing in statue to require a supplier to continue its supply. A customer may want to terminate the agreement with a supplier facing insolvency and there is nothing to stop the customer from exercising its right under an ipso facto clause. However, there will be many cases where the customer needs the supply to continue. What then? By the time the supplier is facing insolvency is far too late for a customer to look to protect itself, it therefore becomes all the more important for a customer take appropriate steps to protect itself particularly at the supplier selection, pre-contractual and contractual stages.
First, comprehensive due diligence on the supplier’s financial status as well as their key supplier and customer relationships will be necessary. A customer will also need to negotiate adequate contractual protections such as financial reporting requirements on the supplier and properly drafted trigger provisions that give customers sufficient time and warning of any supplier financial difficulties. In outsourcing agreements, well drafted step-in rights clauses may be a useful tool and in software licence agreements, a robust escrow clause and agreement may become more pertinent. Like suppliers, customers will need to ensure they proactively manage and govern their supplier contracts and that staff are able to pick up on issues and escalate swiftly.