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No way out? Negotiating termination rights

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United Kingdom

Why you should reconsider your approach to negotiating termination rights.

‚ÄčAs many contract lawyers will be aware, on 28th March the UK Government announced its plans to fast-track certain changes to corporate insolvency rules to help companies undergoing a rescue or restructuring process to continue trading. The Corporate Insolvency & Governance Act 2020 has now received Royal Assent and  will, to a degree, bring the UK's approach into line with a number of other jurisdictions. Whilst the March  announcement was in response to challenges arising out of the current rapidly developing COVID-19 situation, these changes are here to stay.

How has the law changed?

Amongst the changes implemented in the Corporate Insolvency & Governance Act 2020 (“CIGA”) is making 'ipso facto' termination clauses unenforceable. This Latin phrase means "by the fact itself", and refers to a provision entitling a party to terminate a contract if the counterparty is insolvent, even if it continues to comply with all of its obligations.

It's typical to see these clauses in commercial agreements as they provide a pre-emptive mechanism for a party to reduce its exposure to the risk of the other failing to meet its obligations due to solvency issues. The main criticism levelled against these provisions is that they can reduce the prospect of a successful recovery of an insolvent or potentially insolvent party.

Subject to certain narrow exceptions (in particular relating to financial services), CIGA renders unenforceable any clauses in contracts for the supply of goods or services that allow termination by the supplier on the grounds that the customer has entered formal insolvency. This also prevents the exercise of rights which arose prior to the insolvency once formal insolvency procedures have started.

CIGA goes further still, preventing suspension or termination for non-payment of outstanding fees. As drafted, this will apply only to non-payment of fees which fell due prior to entry into formal insolvency procedures, and suspension or termination for non-payment of sums falling due during insolvency remains an option.

Some commentators expected the prohibition on enforcement to be limited to certain essential supplies, however that doesn’t appear to have found its way into the new legislation.

CIGA’s effects on ipso facto clauses are one-sided in favour of the customer. Some might argue that this undermines the purpose of allowing breathing space for successful recovery in circumstances where an insolvent supplier's revenue can disappear overnight when the administration process begins even if it continues to fully serve its customers.

How does this compare to other jurisdictions? In the EU, Directive 2019/1023 talks about preventing a creditor from withholding performance or terminating a contract during a stay period, if the debtor continues to comply with its obligations. For the prohibition to bite, depending on how each Member State implements the Directive, there may need to be a sum of money owed by the insolvent company to the party seeking to exercise the right. The upshot of this is that the prohibition would only apply to suppliers, and customers would remain free to terminate for insolvency of the supplier.

The European approach is somewhat different to that used in other jurisdictions however. In the US, Section 365(e)(1) of the Bankruptcy Code prevents termination of a contract based on a clause triggered by the insolvency or financial condition of the debtor. Under the Australian model, the Treasury Laws Amendment (2017 Enterprise Incentives No. 2) Act 2017 provides for a mandatory and automatic stay on a party's right to enforce a contractual provision by reason of the other party being subject to voluntary administration, receivership, or scheme of arrangement. This doesn't just apply to termination, but restricts the enforcement of any contractual right triggered by the insolvency. Therefore, ipso facto clauses are unenforceable in both US and Australian law (whether by customers or suppliers).

How might this affect contract negotiation?

These clauses are often included into contracts simply as a matter of course, and suppliers and customers alike will want to ask themselves the extent to which they want to include provisions in their contracts that are unenforceable (by one or both parties). Of particular concern is that a person managing the contract some time later might expect to be able to rely on the terms as they are set out in the documentation, without being aware of the wider legal context and the  unenforceability of the clause. In this case, a reliance on an unenforceable termination clause may result in the other (insolvent) party having its own right to terminate and claim substantive damages for repudiatory breach.

Ipso facto termination clauses are often drafted to be mutual. Even if the relevant provisions are severable, the change in law results in a different balance of risk to that which may have been intended by the parties. We may see parties wanting to retain a mutuality of risk in this area by addressing this in drafting.

Contract negotiators should consider alternative approaches to mitigating insolvency risk. For example, customers might consider enhanced supervision (or possibly step-in) rights to ensure continuity of supply in case of supplier insolvency. On the other hand, suppliers may wish to consider whether their payment structures give appropriate coverage (to avoid stranded costs in case a customer fails), or whether a right to require additional guarantees may be appropriate if there are warning signs of an impending insolvency event. Good governance mechanisms, due diligence, and active contract management are likely to become increasingly important. Alternatively, termination rights triggered by pre-insolvency financial hardship (which may still be effective if exercised promptly before formal insolvency) may become more common.

It may be that contracting parties can still protect themselves with suspension or termination rights in the event of an insolvency. For example, by using the insolvency event as a trigger to tighten the triggers of other termination rights, to alter notice periods, or impose additional obligations the failure of which would give a right to suspend or terminate. Whether and to what extent these would be appropriate would of course be dependent upon the nature of the contract and the relationship of the parties.

Recommendations

Until we see how this plays out in practice, we can only speculate as to what the impact might be. In the meantime, the change represents an important reminder for organisations to look again at their usual contracting practices, and to re-establish their approach to this type of clause.
If you decide to do so, here is a process you may find helpful:
 

Step 1: Consider the likelihood of the insolvency scenario arising. Is the counterparty (or typical counterparty) potentially an insolvency risk? If you are looking at a particular contract, do your due diligence.
Step 2: In the particular context of your agreement, think about how it would affect you if the other party suffers an insolvency event but otherwise complies with its obligations. Is this going to have an adverse effect on your business? What effects are you seeking to avoid?
Step 3: Consider the worst-case scenario. What are the breaches that could result from the counterparty's insolvency and what would your losses be? Would including a termination right help you avoid these?
Step 4: Consider what alternatives to termination might help avoid a breach or mitigate any adverse effects. Think about governance processes, enhanced supervision arrangements, options to step-in, payment profiles, parent company guarantees, performance bonds, and similar. If an insolvency event affects the counterparty, what measures could you sensibly include in the contract to help you mitigate your risk?
Step 5: In the absence of a breach, consider the likely impacts termination would have on your business. Would you enforce a termination right if one were to be included?
Step 6: Consider the position your counterparty is likely to take when it comes to termination for insolvency event (as well as any other measures which you think would be helpful), and whether you think it is likely to help or hinder the negotiation to take a particular approach.


 



 

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