Suppliers – Think Carefully Before You Stop Supplying an Insolvent Customer

Michael Hiscock, Partner and Head of Construction at Wright Hassall, urges suppliers to think carefully before ending a supply contract with an insolvent customer.

THE CONSTRUCTION sector continues to struggle, as evidenced by the more than 60 companies that fell into administration in the past four months, and recently introduced legislation changes could make things worse for businesses in the extended supply chain.

The most significant change comes in Section 233B of the Insolvency Act 1986 (introduced by the recent Corporate Insolvency and Governance Act), which prevents businesses from ending a supply contract with a customer, on the grounds the customer has become insolvent.

Contract Terminations

It applies to all contracts for supply of goods and (non-financial) services, so whether you supply tiles or time, this draconian legislation could impact your business. Customers are free to terminate contracts if it is the supplier that becomes insolvent.

The bad news continues, as you are also now prevented from demanding that outstanding charges are paid, as a condition of continuing to supply, which is likely to go against your business instincts.

In the construction market place, industry standard form contracts (JCT, NEC) allow termination by a contractor due to employer insolvency, so the statutory position cuts across the contract and removes a right that the industry has accepted as normal practice.

That contractual right allows immediate suspension of work and submission of a final account, both of which help to protect cash flow.

If this contractual right is removed, the contractor can still use its statutory right to suspend work for non-payment on 7 days’ notice and ultimately terminate for breach of payment obligations but the period between doing the work and getting paid may be weeks or months, extending the risk.

Does this legislation override all reasons to terminate supply?

In short no, there are plenty of valid reasons to terminate supply. You can terminate a supply contract at any point leading up to the insolvency proceedings, or you can terminate after the proceedings began, as long as the reason you cite is not triggered by that proceeding.

You can also terminate with the consent of the insolvency administrator or with the permission of the Court, if it agrees with your argument that continuing to supply will cause your business hardship.

Formal Insolvency Procedure

If a customer enters a formal insolvency procedure, you can wait for another reason to end the contract, like non-payment for supplies made after the commencement of the insolvency. You may also be able to exercise other contractual rights, like contractual set-off and netting rights.

Although rare in the construction sector, your contract may allow you to terminate for convenience, as long as you continue to supply during the notice period.

You can also terminate supply, if the existing contract is a single-purchase order, when means you can reject new orders, particularly if the contract has been structured as a framework agreement that treats each new order as a separate contract. Also, once an existing supply contract expires, you can refuse to renew it.

Will the legislation change future contracts?

You rely on your supply contracts to regulate your relationship with your customers and it makes sense to change your contracts to reflect the legislation change and protect your own business.

It will be important to seek the advice of a lawyer experienced in construction contracts about how you structure your contracts in future and what they contain, but a few considerations might include:

• Reducing the contract term to ensure you are not locked into supplying your customer for a considerable period in any insolvency procedure.
• Structuring contracts as framework agreements ensures each supply is treated as a separate contract, allowing you decline future orders.
• Managing the payment process more closely to pick up the warning signs that a customer is experiencing financial problems, before insolvency is triggered.
• Shortening payment periods and increase the number of interim payment applications permitted under the contract.
• Requiring regular financial information from your customers to assess continued solvency.
• Utilising project bank accounts that facilitate direct payment
• As an interim step falling short of termination, consider a provision allowing you to suspend further supplies under the contract, for repeated or lengthy periods of non-payment a customer.
• Reapply fiduciary duties to retention sums to create a form of trust fund.
• Allowing termination for convenience, including as short a notice period as makes commercial sense–this solution is rare due to the duration of a construction project, the resource commitment and forward ordering of goods and labour.

How can I insulate my business from the legislation change?

There will be businesses in the supply chain, large and small, impacted by this legislation change and in future, it will pay you to choose your customers wisely, it could protect you from the consequences of having to honour a supply contract with a customer trading insolvently.

You should undertake more detailed due diligence on a customer’s financial position before agreeing any contract and pay careful attention to their payment performance. This way you may give you the necessary early warning of their difficulties, before they become insolvent.

Warning Signs

Training your account managers about the legislation change and what it means for the business will be prudent, as will explaining what warning signs they need to look out for, like ensuring invoices are paid on time, while considering whether to tighten your debt collection procedures.

You must understand your contractual rights and be ready to exercise them immediately to terminate a contract and stop supply, when one of your customers begins to exhibit clear signs of financial distress. Even if you have known them for years. Act to protect your business.

While we are on the subject of contracts, review your standard terms and conditions to ensure as far as possible, they offer your business protection against a customer’s insolvency.

And finally, if you are worried by any of what you have read and want real peace of mind, seek help from an experienced construction lawyer or expert in supply contracts. A few small changes now, could save you a lot of trouble in the future.

For more information about Michael Hiscock and information regarding insolvency, visit the Wright Hassall website.

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