Corporate Insolvency and Governance Act 2020: freezes on contract terminations

Corporate Insolvency and Governance Act 2020: freezes on contract terminations

This news analysis provides an in-depth consideration of the changes to termination clauses introduced by the Corporate Insolvency and Governance Act 2020. It is based on a webinar given for PRIME Finance on 27 July 2020. Written by Philip Wood CBE, QC (Hon)*.

Introduction

The UK nullification of what are called ipso facto clauses (these are clauses in a contract which provide that a counterparty can terminate the contract on the commencement of insolvency proceedings against the other party) has been one of the permanent changes introduced by the Corporate Insolvency and Governance Act 2020 (CIGA 2020). For further analysis of the changes introduced by CIGA 2020, see News Analysis: Corporate Insolvency and Governance Act 2020—the rise of the moratorium and restructuring plan and the fall of the Scheme? The freezes on these terminations represent quite a major change to UK insolvency law.

Ipso facto clauses as events of default are typical of most formal contracts except the most ephemeral or short-term. In addition, English case law has held that the insolvency of a counter-party will be treated as a repudiation if the insolvency puts it out of the power of the insolvent party to perform the contract.

Statutes nullifying these clauses are widespread internationally. The statute follows the usual pattern of a provision for the nullity of insolvency events of default, followed by carve-outs for financial markets and other exclusions. These exclusions are wide in the UK case.

The freeze is one of the most intrusive of the stays on creditors which come into force on an insolvency and is controversial.

The first major freezes appeared in the US Bankruptcy Code of 1978 and in the French redressement judiciare of 1985. The UK introduced them in 1986 but only for essential utilities, to keep the lights on.

The issue has extra significance because of the role that English law plays as effectively an international public utility as a chosen governing law of major contracts and because the direction of a jurisdiction’s insolvency law is an important indicator of the credentials of its legal culture.

The freezes are contained in a new sections 233B and 233C inserted in the Insolvency Act 1986 (IA 1986). The exclusions are contained in a new Schedule 4ZZA to the IA 1986.

Three main new stays

The first and main stay is that any provision of a contract for the supply of goods or services to the company ceases to have effect when the company becomes subject to insolvency proceedings if and to the extent that the supplier would be entitled to terminate the contract, or do any other thing, “because the company becomes subject to the insolvency proceeding” or if there would be an automatic termination or if any other thing would happen, including presumably acceleration or increases in the interest rate.

So an event of default sparking on insolvency is void for those supply contracts and the supplier is contractually bound to continue to supply. But the supplier can terminate for post-commencement defaults, including payment defaults. The statute does not nullify rights to terminate for other reasons, subject to what is said below. Payments will enjoy the priority of administration expenses.

The object is to maintain the company’s contracts so as to increase the assets available to creditors

IA 1986, s 233B applies to all the main corporate insolvency proceedings—including the new moratorium, administrations, administrative receiverships, liquidations and company voluntary arrangements. But it does not apply to resolutions and the like of banks and other regulated institutions which are subject to their own special stays.

It applies to contracts for the supply of goods and services. This would not include land contracts of contracts for the lease of land. Whether it would include intellectual property licences remains to be seen, but it is considered doubtful that these are contracts for services. There are wide exclusions, discussed below.

Secondly, if the supplier is entitled to terminate for any event before the commencement of the insolvency, not just insolvency, , then the supplier cannot terminate once the insolvency starts. So if the supplier does not pounce in advance, the right is lost for the duration of the insolvency.

Thirdly the supplier cannot condition the supply after commencement on the payment of prior charges incurred pre-insolvency.

Exclusions

The above freezes do not apply if either the supplier of the debtor company is one of the main regulated institutions in the financial sector, such as banks, insurers, electronic money institutions, investment banks, collective investment schemes, custodians, alternative investment funds, payment systems, recognized investment exchanges and securitisation providers, each as defined in the relevant regulation. There is an overseas activity exemption for the foreign equivalents.

There are wide exclusions (safe harbours) for financial contracts including for example, lending, factoring, financial leasing, giving guarantees, securities contracts, derivatives, financial commodities contracts, interbank deposits of three months or less, and master agreements for these, securities financing contracts such as repos, and contracts for traded capital market investments.

There is also a blanket exclusion for ‘set-off and netting arrangements’ and exclusions for settlement finality in clearing systems and financial collateral.

Intercreditor agreements are probably not contracts for services and so should be outside the freeze.

The debtor can consent to termination, and also the court can allow termination in the case of hardship.

Note that there are different regimes for security interests, including stays and exclusions from the stay.

There is a temporary coronavirus (COVID-19) exemption for small company suppliers up to 30 September 2020.

The government can amend the exclusions by regulation without primary legislation.

Commentary—is the law better off?

The freezes are not just rescue provisions because they apply also to liquidations. It appears that they are intended:

  • to increase the assets of a company so that the business can be sold as a whole
  • to prevent a supplier from cancelling a contract which is in the money (profitable) and therefore an asset of the estate
  • to decrease the bargaining power of contracting parties as hold-out creditors or as creditors able to negotiate a better deal than other creditors because the company relies on the supplies

As is so often the case with insolvency law, choices must be made between advantages and disadvantages, the pros and the cons. The fact that this choice cannot be avoided on insolvency is one of the reasons that insolvency law is an effective litmus test of commercial law, eg whether the law protects debtors or creditors.

Some of the downsides include:

  • the debtor can cherry-pick contracts, eg cancel the unprofitable ones by repudiating them, and keep the profitable ones; take the cherry but not the pip. There does not seem to be any provision or rule of law which stops the company or the insolvency representative from selective performance, eg perform all or none. Indeed the whole idea is that a debtor can relieve itself of onerous contracts which cost money—albeit at the expense of one creditor 
  • very few contracts are specifically enforceable and, if the company does repudiate, the supplier is left with a usually worthless claim for damages. So the supplier has to perform on one set of contracts but the insolvent does not perform on another set. Most insolvent estates do not pay out more than a small dividend. It is a question of justice whether an insolvent should be in a better position than the solvent counter-party. The sense of injustice is at the root of the need for insolvency set-off because, without the set-off, the debtor gets paid by the creditor, but does not pay 
  • set-off and netting require that the counter-party can cancel a string of contracts with the insolvent, calculate the losses and gains each way and then set them off so as to reduce exposures: cancel, calculate, set-off. There is an exclusion for ‘set-off and netting arrangements’. The overall effect is that a party has to read the impenetrable carve-outs to see if there is an exemption. In this case, if you are not within a financial market exemption, you must have a contract to net, whereas before it was a right enjoyed anyway. There are dozens of these obscure carve-outs internationally and it is not feasible for traders in international markets to understand them all. Even experts struggle to keep up. So effectively deals are chilled and people suffer losses simply because the law has got out of control 
  • the ‘must pounce early’ clause inhibits work-outs which are the main way of resolving financial problems. This is the section which stays termination rights which have arisen before commencement of the insolvency procedure but have not been exercised 
  • it is considered that suppliers of goods and services are not commonly hold-out creditors who disrupt rescues in any event. Essential suppliers, for gas, water and electricity, are already restrained 
  • in the ordinary case, an insolvent debtor is unlikely to be able to perform their contractual obligations 
  • contractual freedom is the fabric of commercial life 
  • a supplier may have to supply post-insolvency without getting paid, even though the supplier is entitled to terminate if not paid post-commencement 
  • the legal system becomes increasingly layered internally with different laws applying unequally according to the class of creditor or the contract. There are about 321 jurisdictions. England has about eight tiers for security interests. Multiply 321 by eight and you get 2568 legal systems. The UK has maybe 25 insolvency regimes or thereabouts. Multiply 321 by 25 and you appreciate how complex the position can become 
  • English law offers a legal system which tends to respect the position of creditors. As mentioned, jurisdictions must decide which side they will back. The members of the international business community can then make up their minds as to which legal system best suits their preferences. Competition between legal systems is no bad thing

So the question here is whether the advantages outweigh the disadvantages or whether these new provisions are disproportionate.

The international picture

If you take the view that the new provisions are inconsistent with the approach of English law, it would seem that they are not inconsistent with international trends amongst most highly developed countries.

According to my researches** and subject to recent changes, the following is very broadly the position on the take-up of statutes generally freezing ipso facto clauses, by region:

  • North America: Both the US and Canada have freezes 
  • South America and the Carribbean: No freezes, with a few exceptions eg Chile, Puerto Rico (which has the US Bankruptcy Code 1978) and Barbados (influenced by Canadian legislation). The noes include Bermuda and Cayman 
  • Europe: The EU Restructuring Directive requires member states to enact the freeze. Switzerland and Turkey do not have the freeze, unless there has been a recent change. Jersey, no freeze 
  • Middle East and North Africa: Usually, no freeze eg Israel. However, the freeze is found in the new Saudi Bankruptcy Law 2018 
  • Africa: Africa is split on this issue. The 17 members of the Napoleonic Ohada group have adopted the freeze, via their harmonized adoption of a slimmed-down version of the 1985 French insolvency law. It seems rare elsewhere eg in the English common law group (Nigeria, Kenya, Tanzania, Ghana Malawi, Zambia etc) and is not found in the five Southern African cone jurisdictions 
  • South and East Asia: Mostly no eg no in China, Japan, Indonesia, Malaysia, Vietnam, Thailand, India, but yes in Singapore, Australia, and Afghanistan (since 2018) 
  • Former USSR: The freezes seem to be absent in Russia and Ukraine. They seem also to be absent in other former USSR territories, eg the Central Asian stans, except Kazakhstan

The scope of the freeze and the exclusions vary.

The overall result is North America and Europe versus the rest of the world—except for the African split and a few other exceptions. This remarkable division cuts across the background families of law inherited from the twentieth century and before.

**International data is based on volume 2 of my series in nine volumes on the Law and Practice of international Finance published in 2019.

*Philip Wood CBE, QC (Hon) is the author of over 20 law books and former head of Allen & Overy's Banking Department and Global Intelligence Unit. He is also a P.R.I.M.E. Finance Expert. Philip has spoken about the new Corporate Insolvency and Governance Act for PRIMEtime, P.R.I.M.E. Finance's virtual events programme. To see this and other PRIMEtime Virtual Events, see:

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About the author:
Kathy specialises in restructuring and cross-border insolvency. She qualified as a solicitor in 1995 and has since worked for Weil Gotshal & Manges and Freshfields. Kathy has worked on some of the largest restructuring cases in the last decade, including Worldcom, Parmalat, Enron and Eurotunnel.