Corporate Insolvency and Governance Act: construction sector implications

Out-Law Analysis | 17 Jul 2020 | 1:58 pm | 8 min. read

Construction companies' ability to terminate contracts with insolvent suppliers and raise claims against financially distressed companies will be impacted by legislation recently enacted in the UK.

The Corporate Insolvency and Governance Act (CIGA) in the UK, which became law on 26 June 2020, promises to be the trigger for the biggest changes seen in the insolvency world for almost 20 years, and it contains a number of temporary measures construction companies should also be aware of that are designed to support business recovery from the Covid-19 pandemic.

Provisions in the Act relating to termination rights and those offering distressed companies time to restructure are of particular relevance to the construction sector.

The new prohibitions on "ipso facto" or termination clauses in supply contracts will have a considerable impact on the rights of suppliers to insolvent companies, and how employers and main contractors respond to supply chain insolvency.

The new moratorium process provides significant power to directors of financially distressed companies to seek to restructure the company outside of a formal insolvency process. The moratorium will restrict the ability to bring or continue claims against the distressed company.

Supplier termination "ipso facto" clauses

What has changed?

CIGA extends existing protections for the supply of essential supplies to an insolvent company by prohibiting all suppliers of goods and services from terminating contracts or stopping supplies by reason of the company's insolvency, as long as the supplies continue to be paid for during the period of insolvency.

Standard forms of contract such as NEC, and JCT contain clauses allowing contractors to terminate for employer insolvency, and sub-contractors to terminate for contractor insolvency. These clauses may no longer generally be used by a supplier to terminate, subject to limited exceptions.

In addition, if another termination right exists on the date of insolvency, for example for reasons of default or non-payment, but has not been exercised by then, the supplier will not generally be able to terminate the insolvent party's employment under the contract.

CIGA also prevents a supplier doing "any other thing" as a result of the contractor/employer entering into an insolvency procedure.

Does this apply to all termination clauses?

No. CIGA only applies to termination clauses in a contract for the supply of goods and services, for example "upstream" contracts. It does not apply to any rights of an employer or contractor "downstream" as against its contractors, sub-contractors, or suppliers, as appropriate.

When can a supplier terminate?

CIGA prevents termination clauses generally being relied upon once an insolvent counterparty has entered into an insolvency procedure, such as administration, liquidation, company voluntary arrangement (CVA), or new moratorium. This is where the termination arises under an express insolvency termination clause, or where a pre-existing termination right has not been exercised at the time of insolvency.

Normal rights of termination for default or non-payment etc. prior to the counterparty entering into an insolvency process are unaffected. This is likely to lead to negotiations in supply contracts around earlier termination rights – for example where pre-insolvency events have occurred, such as presentation of a winding-up petition not disposed of within an agreed timeframe, the filing of a notice of intention to appoint administrators, or the launching of a CVA proposal – since these are not outlawed, as long as termination is effected pre-insolvency.

Otherwise, once an insolvency event has occurred, the supplier can only terminate where:

  • the company/insolvency practitioner consents;
  • the court grants permission on the basis that continued supply would cause "hardship" to the supplier, or;
  • where supply continues in the insolvency, but that continued supply is not paid for, excluding any outstanding sums pre-insolvency.

We may see a move towards suppliers contracting on individual purchase orders, individual call offs or pro forma terms in the run up to an insolvency in an attempt to retain some control over their obligation to continue to supply. Such arrangements may be interpreted as standalone, rather than as part of a wider contractual relationship. However, sub-contractors or contractors operating under established contract terms will not be able to be so flexible.

What does "hardship" mean?

Under the new regime, a supplier does not need to continue to supply if a court is satisfied that "continuation of the contract would cause the supplier hardship". Hardship is not defined, and we think that this may be an area which leads to future case law. The concept of "hardship" already exists in the current protection of the essential supplies regime under changes to the insolvency regime that came into force in 2015. However, we are not aware that it has been tested in the courts.

There are also temporary exemptions for "small companies", meaning they will not have to continue to supply, which remain in place until 30 September 2020.

What does "or do any other thing" mean?

This provision is widely drafted and is, we think, intended to catch any attempt to suspend performance or attach any further conditions to continued supply, such as ransom payments.

The practical effect of the provision remains to be seen if an insolvent company does require continued supply and the contractor or sub-contractor refuses to do so. The insolvent company will be left with a choice whether to apply to court for an injunction requiring specific performance, which will be expensive, or agreeing commercial terms for the continued supply, assuming no alternative can be found.

Under the standard forms of construction contract, supplying contractors or sub-contractors often have the right on termination to attend construction sites to collect and remove equipment, tools, materials, temporary works. This will be prohibited by the new prohibitions.

In addition, supplying contractors or sub-contractors that have the benefit of payment security, such as an employer parent company guarantee (PCG) or financial security, will need to review the terms carefully to understand the impact on their ability to immediately call upon such security.

What is the impact on collateral warranties or direct agreements?

Employers will often insist on collateral warranties or direct agreements from key sub-contractors or suppliers, to protect them in the event that the main contractor becomes insolvent. Often, these warranties will allow an employer to step in and protect continuity of supply from the sub-contractor or supplier in these circumstances.

As CIGA prevents a sub-contractor or supplier from terminating for reasons of customer insolvency, it will also prevent them from giving notice to the employer under the warranty. However, it will not prevent the employer from electing to step in under the warranty or direct agreement if it has the option to do so. As a result, we believe collateral warranties or direct agreements will continue to be prevalent on larger projects.

Company moratorium

What has changed?

Insolvent companies, or those likely to become insolvent, can obtain a 20 business day moratorium to allow a viable business time to restructure or seek new investment. The moratorium will apply to employers, contractors, sub-contractors and suppliers alike.

The moratorium is available to companies, with some exceptions, and is obtained either by lodging documents at court or by making a court application. The process is expected to be similar to the current process for appointing administrators. Once the moratorium comes into force the monitor must notify the registrar of companies and all creditors they are aware of.

How does it work?

The directors will remain in charge of running the business on a day-to-day basis. This is known as a ‘debtor-in-possession' process, with the company being the ‘debtor’.

In order to obtain the moratorium, the directors of the company will need to make a statement that the company is, or is likely to become, unable to pay its debts and the 'monitor' – an insolvency practitioner who will oversee the moratorium process – must make a statement that it is likely that a moratorium for the company would result in the rescue of the company as a going concern.

The initial period of the moratorium may be extended without creditor consent for up to 20 business days provided that certain criteria are met.  Beyond this the consent of the creditors or the court must be sought. The moratorium is automatically extended whilst a CVA proposal is pending.

The company must make it clear that it is in a moratorium by displaying notices at its premises, on its website and on every business document.

Creditors will have the ability to challenge the actions of the directors or the monitor on grounds that their interests have been unfairly harmed.

What is the impact on creditor claims?

The moratorium will bind both secured and unsecured creditors. It will be similar to the existing administration moratorium and includes restrictions on the enforcement or payment of pre-moratorium debts, for which the company has a "payment holiday" during the moratorium. This will include all sums payable by the company under any construction contract, or a contract for the supply of goods and services.

The moratorium will prevent formal legal proceedings being commenced or continued against the company whilst it remains in force. This will capture court proceedings and arbitration. It is also likely to capture adjudications against the company, as the existing moratoria on liquidation and administration do.

What about adjudication by the company?

It remains to be seen whether adjudication proceedings will be allowed to be commenced or continued by the company during the moratorium, or whether a stay of execution would be granted if the company subject to the moratorium sought to enforce an adjudicator's decision.

Unlike the moratorium that has effect in an administration, the referring company is not insolvent under the new moratorium process and is continuing to trade. Following the recent Supreme Court decision in the appeal of Bresco v Lonsdale, it is now clear that an adjudicator can determine disputes under a construction contract, where one of the parties is in insolvent liquidation.

The courts have also confirmed the rights of an insolvent party to enforce an adjudicator's decision where it is subject to a company voluntary arrangement. This new moratorium is much more akin to a CVA than an administration, in that the company remains outside of a formal insolvency procedure, the directors remain in control, the company continues to trade, and the aim is to rescue the company as a going concern. Therefore, we would expect the court to allow adjudication, and potentially subsequent enforcement, by a company subject to the moratorium.

Statutory demands and winding up petitions

CIGA includes temporary provisions to restrict statutory demands and winding up petitions issued against companies during the pandemic where the debt is unpaid for reasons relating to Covid-19.

A petition cannot be presented by a creditor during the period covering 27 April 2020 to 30 September 2020 unless the creditor has reasonable grounds for believing that either coronavirus has not had a financial effect on the debtor, or the debtor would have been unable to pay its debts even if coronavirus had not had a financial effect on the debtor.

As to the meaning of "financial effect", it appears to have a low threshold test. Coronavirus has a "financial effect" on a debtor if the debtor’s financial position worsens in consequence of, or for reasons relating to, coronavirus.