New insolvency rules may shake-up construction supply chains

posted by Kate Onions
11 August 2020

On the 26 June, the UK government introduced significant changes to the insolvency regime under the Corporate Insolvency and Governance Act 2020. 

Prohibiting termination clauses that engage on insolvency, the new rules effectively require a supplier to continue supplying a company that has entered insolvency, potentially damaging their own financial position.

While the changes will undoubtedly impact all kinds of supply chains, the construction industry’s common reliance on sub-contractors could mean that it is hit particularly hard. So, what exactly do the reforms mean for construction contracts and what options are left open to contractors when an end-customer falls into financial difficulty?

‘Section 14’ was added to the Insolvency Act 1986 with the aim of facilitating attempts to rescue UK businesses, by mitigating the impact of a break in supply. Moving forwards, it will be very difficult for a contractor to terminate where an employer has entered into a formal insolvency procedure, or for a sub-contractor to terminate where a contractor has entered into a formal insolvency procedure.

An important point to bear in mind is that the new rules only apply to “upstream” insolvency; they are designed to give added protection to the company receiving the benefit of the works. On the other hand, if there is a “downstream” insolvency, an employer will still be able to exercise their contractual rights by terminating a main contract and a contractor will also be able to terminate a sub-contract in the same way.

Despite these fundamental changes, contractors or sub-contractors affected by the insolvency of an end customer should be aware that they still have options. In the event that either the insolvency practitioner or the insolvent party agrees, or with the court’s permission, they will be able to protect themselves from exposure by ceasing works.

While in reality it is unlikely that the parties involved will give their consent for a contractor to stop supplying them, it may be possible to persuade the court to allow termination. However, in order to be successful, it would be necessary to demonstrate that continuing with the works would cause “hardship” to the company carrying them out. As this term is not defined under the new rules and no cases in this area have come before the courts, there is a lack of certainty around exactly what it means. However, on the face of it, larger companies may have more of a struggle arguing that continuing the work will cause them “hardship” than their smaller counterparts.

It’s worth noting that some construction businesses may also be able to take advantage of a temporary suspension in the application of the new rules for small suppliers, until 30 September 2020. To count as a “small supplier”, a company must satisfy two of the following criteria:

  • Have a turnover of less than £10.2m

  • Have a balance sheet total of less than £5.1m

  • Have fewer than 50 employees

June’s amendment to the insolvency regime has also cast uncertainty around contractors’ rights to suspend for non-payment. Under the Construction Act, a party to a construction contract has the right to suspend the performance of their contractual obligations for non-payment once they have given seven days’ written notice of their intention to suspend, and if there is a failure to pay the sum due by the final date provided for payment.

There is currently debate as to whether this right can be validly exercised in light of the new insolvency rules. This is because the reforms specifically prohibit doing anything which has the effect of making continued performance conditional on outstanding sums being paid.

On the other hand, it’s worth noting that the new insolvency rules make no specific reference to invalidating a contractor’s statutory right to suspend. This right is also a statutory right rather than a contractual right, and relates specifically to non-payment, rather than insolvency situations. Given these factors, it seems fair that companies should be able to exercise their statutory right to suspend for non-payment and, ultimately, terminate following a period of suspension for non-payment (provided the contract entitles this) after the start of the insolvency procedure.

When entering into contracts going forwards, contractors and sub-contractors should keep a careful eye on the negotiation of key clauses relating to their statutory right to suspend and termination, taking into account the provisions of the new insolvency rules. They should also seek advice at an early stage of negotiations, from an expert experienced in advising companies on construction disputes. This will help them to reduce their exposure during insolvency situations, while protecting their commercial position.

Kate Onions is a construction partner at law firm, Shakespeare Martineau.

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