In the current economic climate, it is vital for in-house counsel to have a good understanding of both the powers that an organisation has to terminate contracts in the event that the other party to the contract enters insolvency, and the powers the insolvency practitioner (IP) enjoys in this regard.
Does insolvency have any automatic impact on the contract? Do the parties have any contractual rights to terminate the contract? Might the IP seek to disclaim the contract? If so, under what circumstances may this be done?
This article discusses these issues in the context of Scots law and concludes with some practical points that in-house lawyers may wish to think about when drafting termination clauses.
INSOLVENCY REGIMES
In the corporate insolvency arena, the main UK regimes are liquidation, administration, receivership, and company voluntary arrangements (CVAs). Each of these has its own statutory framework and specific rules. For the purposes of this article, I will focus on the two most common regimes: liquidation and administration.
Liquidation (also known as winding up) is designed so as to wind up the affairs of the company and bring its existence to an end. Liquidation always concludes with the dissolution of the company.
Administration is potentially more flexible. Originally designed as a rescue mechanism, it has a ‘hierarchy’ of statutory objectives, the most ambitious of which is achieving a rescue of the company and the least ambitious of which is achieving a better result than could have been obtained on liquidation. It is therefore possible that, in an administration situation, the company may survive and be returned to its directors.1
To assist the administrator in achieving its objective, the legislation gives a company in administration the benefit of a statutory ‘moratorium’ whereby legal remedies such as court action, diligence (distress) and irritancy of leases (forfeiture) may not be pursued against the company by anyone without either the consent of the appointed IP or the leave of the court.
The distinctions between liquidation and administration should be borne in mind when it comes to understanding how contracts entered into pre-insolvency are treated under Scots insolvency law.
DOES INSOLVENCY HAVE ANY AUTOMATIC LEGAL EFFECT ON CONTRACTS?
The mere fact that one party to a contract enters insolvency does not, in the absence of a specific term in the contract dealing with insolvency, have any legal effect on the contract.
It does not, of course, follow that insolvency has no effect on the parties to the contract or their ability to enforce their rights under it. Insolvency will often have a significant practical effect. Depending on what strategy the IP decides to follow, performance under the contract may cease, payments dry up, supply lines come to an abrupt halt and key assets may become inaccessible. For the solvent party, this can be disruptive, even devastating. This disruption can be particularly difficult to deal with in an administration case where the statutory moratorium may prevent the solvent party from taking steps to protect its position without the IP’s consent or court leave.
CAN ACTION BE TAKEN TO TERMINATE CONTRACTS IN INSOLVENCY?
Depending on the terms of the contract, yes. If there are insolvency termination provisions, these may be exercised by whichever party has the benefit of those provisions.2
However, the terms of any termination clause need to be carefully reviewed. Does the clause cover the specific regime that the insolvent party is subject to? How is the ‘event of insolvency’ defined and does it meet the current circumstances? Does termination occur automatically on insolvency or does an option need to be exercised by the other party? If termination is optional, what process is laid down in the contract for notifying the exercise of the option, and are there any notice formalities to be followed?
WHAT IF THERE ARE NO TERMINATION RIGHTS?
If the solvent party wishes to bring the contract to end and there are no termination rights, they will find themselves in a difficult position. However, if they reach the view that the insolvent party is in material breach of contract, they may feel justified in treating the contract as repudiated, intimating that this repudiation has been accepted and that the contract has thereby been brought to an end. Since the consequences of making the wrong judgment on this may be a significant liability in damages, this requires careful consideration.
If the party who wishes to bring the contract to an end is the IP, matters are rather different.
THE SCOTTISH IP’S POWER TO ‘DISCLAIM’ CONTRACTS
One of the key distinctions in English insolvency law between liquidations and administrations is the liquidator’s statutory power to disclaim onerous contracts under s178 of the Insolvency Act 1986. This statutory power is not, however, shared by Scottish liquidators.
So what do Scottish liquidators do when faced with a burdensome contract? Are they forced to continue with it? And what about Scottish administrators?
These questions were considered in an informative decision of the Court of Session last year.
CLARK AND WHITEHOUSE, JOINT ADMINISTRATORS OF RANGERS FOOTBALL CLUB PLC, NOTERS [2012]
This decision related to an urgent application made by the administrators of Rangers Football Club plc (RFC plc) for directions in relation to a variety of matters relating to a particular contract between RFC plc and one of its creditors, Ticketus. One of the questions posed by the administrators was whether they could be prevented from ‘causing the company to terminate’ the contract.
Lord Hodge was not prepared to give a specific direction in these terms in relation to the contract in question without the full factual background. However, he did agree to give general guidance as to the position of an administrator in relation to an onerous contract under Scots law and proceeded to do so with admirable economy.
Lord Hodge began by pointing out that the administrators’ formulation of the question to be answered by the court by reference to the notion of ‘termination’ did not reflect the correct legal analysis:
‘On a proper analysis of contract law, as I explain below, the administrators do not have power to terminate a contract in the absence of a contractual power to do so or material breach on the part of the other contracting party. Accordingly, the direction sought is shorthand for a request for a legal test to be applied by the court if, after the administrators had repudiated the Ticketus contracts, it were to be asked to compel the administrators to arrange that Rangers perform its contractual obligations.’
In other words, as we’ve already seen, insolvency does not confer any power to terminate contracts on IPs. The question is rather one of risk: might the IP be compelled by the court to perform the contract, or can they rest assured that the only consequence of them breaching the contract will be a claim for damages against the company?
In giving guidance on this question, Lord Hodge began by looking at the position of a liquidator:
‘There is no provision equivalent to s178 of the 1986 Act which allows the liquidator of an English company to disclaim onerous property. But that does not mean that a liquidator of a Scottish company cannot decline to perform a contract… Although he has no statutory power to disclaim a contract, the liquidator can choose to make the company in liquidation disaffirm a pre-existing contract by declining to perform it and thereby placing the company in breach of contract.
I was not referred to any instance in which the Scottish courts have ordered a company in insolvent liquidation to perform a contract which a liquidator had disclaimed. In my view that is not surprising… In my view, at least as a general rule, if a court were asked to order a company in an insolvent winding up to implement a contract it should refuse to do so because the company could not perform or because such an order would conflict with the statutory duties of the liquidator.’
Having neatly dealt with the position of a liquidator under Scots law, Lord Hodge went on to look at the position of an administrator.
In considering this question, he began by commenting on the character of administration and how it had changed since it was first introduced. While administration was originally designed as a ‘short-term process which would give a company protection from its creditors for a period when an administrator attempted to sort out its affairs’, it was now, Lord Hodge said, ‘used in many cases as a surrogate for receivership or for a winding up’.
Having made this observation, Lord Hodge concluded that the position of Scottish administrators was as follows:
‘Administration is, as I have said, a flexible process. It can accommodate a circumstance in which a company, which was thought to be or likely to be insolvent, turns out not to be so and can emerge from the administration without having reached a compromise with its creditors. In such a circumstance it is hard to envisage how an administrator could properly repudiate a contract in exercise of his function of attempting to achieve the objective of rescuing the company as a going concern. But where, as in the normal run of administrations, the company is insolvent and will not emerge from administration without a CVA or a scheme of arrangement with its creditors, the administrator has to consider whether he should decline further performance of a contract which would prejudice the achievement of an otherwise achievable statutory objective…’ (author’s emphasis)
So what must the administrator consider when deciding whether to ‘decline to perform’ a particular contract in the context of one of these ‘normal’ (winding-up) administrations?
In short, the administrator should consider the cost and benefit both of performing and of declining to perform the contract and take the course of action that is in the best interests of the general body of creditors.
It follows from this that Scottish administrators will generally (other than in the rare cases in which rescue is a real prospect) be in effectively the same position as Scottish liquidators. That is to say, they may choose to decline to perform the contract (if that is in the best interests of the general body of creditors), placing the company in breach of contract, and, in cases of this type, it will only be (in Lord Hodge’s words) ‘in exceptional circumstances’ that the court will order performance of the contract. The other party’s remedy for such a breach will be a claim in damages, and that claim will rank as an ordinary, unsecured claim against the insolvent estate, often with little prospect of any dividend being received.
WHAT EFFECT DOES A SCOTTISH IP’S ‘DISCLAIMER’ HAVE ON THE UNDERLYING CONTRACT?
While the situation described above is sometimes referred to as power to disclaim, as was pointed out by Lord Hodge in the RFC plc case, properly analysed, this ‘power’ is no more than a decision to decline to perform with little attendant risk of an order being made against the IP by the court requiring performance.
So far as the underlying contract is concerned, the breach, or repudiation, of the contract by the IP needs to be accepted by the other party to bring it to an end. Acceptance may be express or implied by actions (for example, where a landlord accepts the return of keys from an IP and proceeds to take possession of the premises).
In certain circumstances, the solvent party may wish the contract to remain in place, notwithstanding that it is not being performed. In that event, the solvent party may wish to make it clear that the IP’s repudiation is not being accepted.
PRACTICAL DRAFTING TIPS
As a general proposition, it is beneficial for a solvent party to have a contractual right to terminate when faced with an insolvent contract partner. It gives the solvent partner a way out of the agreement without having to wait for the IP to reach a view upon whether or not they want to retain the benefit of contract. In view of this, in-house counsel may wish to consider the following practical points when drafting contracts:
- Carefully review insolvency termination clauses to ensure that these accurately reflect up-to-date insolvency language and processes. It is staggering how often we see termination clauses that only include ‘the making of an administration order’ as a trigger for administration, despite the fact that out-of-court appointments have been available for a decade.
- For similar reasons, ensure that entering into analogous processes, whether domestically or in other jurisdictions, is also included as a trigger.
- Consider also including suitably defined pre-insolvency events as termination triggers. If you become aware that a contract partner is facing insolvency and you anticipate that the entering into of insolvency and/or any statutory moratorium may have a disruptive effect on your business, it may be preferable to have power to terminate the contract at an earlier stage. This may enable you to cut off or source new supply lines in a more orderly manner. It may also allow you to take control of key assets before an IP is appointed.
- To enable the need to act to be identified at the earliest opportunity, consider building information covenants into the contract; for example, regular disclosure of management accounts or notification of defined events. Failure to comply with such covenants may also be a sign of trouble and can be included as termination trigger events.
Where there is no contractual right to terminate, consideration might be given to whether there has been a breach of the contract that is sufficiently material to give rise to an opportunity to treat it as a repudiation and bring the contract to an end on that basis. The risks of this approach should be carefully considered.
Finally, it ought not to go unsaid that, in some circumstances, the IP and the solvent party may wish to work together to preserve and/or assign the contract to a third party. That, however, is a topic for another day.
By Joanna Clark, associate, Brodies LLP.
E-mail: joanna.clark@brodies.com.
NOTES
- In practice it is very rare for companies to come out of administration. There have been recent judicial comments that, since the Enterprise Act 2002 (which introduced out-of-court administration appointments as well as other changes), administration is now often used in a similar way to liquidation, ie to wind up the affairs of the company; eg see Goldacre Offices Ltd v Nortel Networks UK Ltd [2009] at paragraph 17.
- Although in cases where there is a statutory moratorium, any exercise of rights can only be undertaken insofar as it does not breach the moratorium or with the express consent of the IP or the leave of the court.