Administration and the protection of essential supplies: a word of warning to IT Suppliers

This article was produced by Nabarro LLP, which joined CMS on 1 May 2017.

Summary and implications

The Insolvency Act 1986 (the IA) has for some time prevented suppliers of essential supplies such as gas and electricity from holding insolvent companies and insolvency practitioners to ransom by demanding payment of outstanding invoices as a condition of continued supply.

Amendments to the IA that took effect on 1 October 2015 expand the definition of "essential supplies" to cover a wide range of IT-related goods and services.

The amendments will also hinder the ability of an affected supplier to terminate its supply contracts if customers enter into certain insolvency processes.

Background

It is very important for suppliers to have a right to terminate a supply contract if their customer becomes insolvent. This is often achieved by including a clause in the contract that allows termination by one or both parties if the other enters an insolvency process or if there are earlier indicators of insolvency.

Such events often include winding up (liquidation), which is almost always terminal for a company. Other triggers of termination rights might include where the company enters into:

• administration - a process whereby an insolvency practitioner is appointed with the aim of rescuing the company as a going concern or achieving a better result for creditors compared to a liquidation; and
• a company voluntary arrangement (CVA) - an arrangement whereby the company's creditors agree an arrangement for repayment of debts by the company under the supervision of an insolvency practitioner.

Whilst a supplier will want to extricate themselves from a contract under which it has no prospect of getting paid, an insolvency practitioner who is continuing to operate the company will often want to ensure that essential supplies remain in place in order that trading can continue, either until a purchaser can be found or until assets are realised.

The IA has always acknowledged the importance to an insolvent company of supplies such as gas, electricity and water by preventing suppliers of these services from making it a condition of continuing supply that outstanding charges are met by the company. As of 1 October 2015, the range of supplies protected by this prohibition is extended to include IT-related goods and services.

In addition the IA now restricts the validity of insolvency-related termination clauses by such suppliers.

Which IT services are affected?

The definition of essential supplies has been expanded to cover a wide range of products and services used in connection with a company's IT and communications systems. It includes:

• computer hardware and software;
• point of sale terminals;
• communication services by a person whose business includes providing communication services;
• information, advice and technical assistance in relation to the use of information technology;
• data storage and processing; and
• website hosting.

We would expect mobile phone networks, internet providers and suppliers of ICT hardware, software and related services to be affected by the changes.

The changes recognise that few modern businesses can function without their IT systems and that the goods and services that constitute or support these systems are critical if a struggling business is to be rescued or for an insolvency practitioner to achieve a better realisation of the company's assets for the company's creditors.

Insolvency-related contract terms

The changes to the IA also render void any contract term that allows a supplier of essential supplies to terminate the contract or the supply if the customer enters administration or a CVA.

A contract term which allows the supplier to do "any other thing" in response to the customer entering into administration or a CVA will also be void. This is likely to restrict suppliers from taking certain steps such as increasing prices.

Should IT suppliers be concerned?

Suppliers of affected IT supplies will no longer be able to terminate supply contracts or suspend supplies if their customers enter administration or a CVA. Nor will they be entitled to demand that outstanding bills are paid as a condition of continuing the supply.

The changes clearly restrict the rights of affected suppliers to determine how they deal with an insolvent customer.

However, there are certain safeguards for suppliers.

Safeguards for suppliers

If, because of the changes in the legislation, an insolvency-related contract term ceases to have effect, the supplier can nevertheless terminate the contract if:

• the insolvency practitioner consents;
• the court gives permission on grounds that continued supply will cause hardship to the supplier; or
• charges that are incurred after the company entered administration or from the commencement of a CVA are not paid within 28 days of the due date.

In addition, suppliers of essential supplies can terminate the supply if the insolvency practitioner fails, within 14 days of notice from the supplier, to give a personal guarantee in respect of payments that are incurred after the date of the administration or CVA.

An insolvency practitioner is very unlikely to give a personal guarantee, given the personal liability that this would create. In practice, other ways of securing payment may be found.

Because of these safeguards, suppliers can have some confidence that future bills will be paid or that the contract can ultimately be terminated if they are not.

Are insolvency-related termination provisions in contracts no longer of use?

At first glance, it might appear that there is no longer any benefit to including clauses in essential supply contracts that allow the supplier to terminate on the customer's insolvency. However, we would advise supplier clients to retain such clauses.

The safeguards referred to above are stated only to apply if the contract includes an insolvency related termination clause that has ceased to have effect because of the legislation. Therefore, if the contract does not have an insolvency related termination clause in the first place, the safeguards would not apply and, for this reason, an insolvency-related termination clause should be included.

In addition, only termination clauses in respect of a CVA or administration are stated to be void and, on the face of it, they will only become void once the company has actually entered administration or a CVA. It seems likely, therefore, that clauses which allow termination on other insolvency-related events, such as liquidation, will remain valid.

Furthermore, it appears that the changes do not invalidate contract terms that allow termination on events that are pre-cursors to a company entering into an insolvency process or are indicators that a company is likely to enter into administration or a CVA. For instance, it is arguable that a contractual right to terminate if a notice of intention to appoint an administrator is filed at court, or if a meeting with creditors is convened, will remain valid. This area has yet to be tested in the courts.

Responding to the changes

Suppliers of essential supplies should be aware of the possibility that if their customers enter administration or a CVA, they could be obliged to continue to supply the customer, regardless of the terms of the contract.

Suppliers can take steps to ensure that, if their customer enters into an insolvency process, they are in the best possible position. These include:

• ensuring that the contract contains a right to terminate upon the occurrence of a broad range of insolvency-related events (rather than merely the appointment of an administrator or the placing of the company into a CVA);
• including in the contract termination rights provisions to cover pre-insolvency triggers such as a non-payment of invoices or a deterioration in the customer's financial performance;
• requesting payment or security for past and future payments if pre-insolvency events occur; and
• reducing credit periods for customers to limit the supplier's exposure should a customer enter into an insolvency process.

Whether or not some of these steps can be achieved will depend of course on the relevant bargaining position of the parties when the contract is being negotiated and will therefore not always be available.

The efficacy of many of the above steps will also depend to a large extent on the supplier keeping abreast of its customer's financial circumstances so that it can act quickly if insolvency appears likely. Whilst this is not without difficulty, making sure you know your customer well could prove to be the best protection against an insolvent customer.

If you would like to discuss this further please contact: Oliver Jackson or Mike Friend