In response to the COVID-19 crisis, the government has stated that new tools will be added to the UK insolvency framework, including a moratorium for companies to give them "breathing space from creditors enforcing their debts while they seek a rescue or restructure".
While there is a lack of detail at present about what exactly this means, the government is expected to take the following steps.(1)
New moratorium provision
The government has discussed and consulted on a moratorium provision for a few years. Under the moratorium, a debtor company will be supervised by an insolvency practitioner, but will remain under the control of the directors. However, the company will need sufficient cash to keep trading through this period.
The length of the potential moratorium is likely to last between one to three months. The moratorium is likely to be obtained by e-filing documents at court, with some qualifying criteria (eg, the company having sufficient cash to trade for the moratorium period) to be agreed by the insolvency practitioner. The moratorium is likely to be the same as an administration moratorium, so will prevent the enforcement of security or the presentation of a winding-up petition (unless the court gives permission).
Exclusion of ipso facto clauses
The government is expected to introduce an exclusion of ipso facto clauses, such as clauses that allow a supplier to stop the further supply of goods (and IP licences) because of a debtor company entering into an insolvency process. It remains to be seen what supplies will be caught by these provisions. Again, companies will likely be required to have sufficient funds to pay for new supplies.
Suspension of temporarily wrongful trading provisions
The government is expected to suspend temporarily wrongful trading provisions from 1 March 2020 until 1 June 2020. Presumably, this means that additional debts incurred by a company during that period would not form part of any award against the directors for wrongful trading. However, the directors could still (separately) be sued for breach of duty.
A number of high-profile brands in the leisure and hospitality sectors have entered into a formal insolvency process due to the COVID-19 crisis and more will follow over the coming months. Although failure rates among franchises are typically much lower than among non-franchised businesses, franchising will not be immune from this trend.
The government's announcement is thus good news for any business which is coming under pressure from its creditors, including franchisors and suppliers and their franchisees and distributors.
However, on the basis that the number of potential insolvencies will be greater among franchisees and distributors, franchisors and suppliers should consider how best to mitigate the risk of widespread failure within their networks. Part of the solution is to work closely with franchisees and distributors to try and preserve these relationships – and many are already doing this. However, this article considers the legal mechanisms of which a franchisor or supplier may need to avail itself at a later stage.
Terminating the right to terminate
Most franchise agreements and supply contracts contain either an automatic termination clause or a right to terminate on notice once a franchisee or distributor enters into formal insolvency (eg, administration, liquidation or a creditors' voluntary administration). It seems likely that the government will legislate to prohibit the enforcement of these termination clauses.
It is unclear whether this prohibition will extend to terminations where a party has not entered into a formal insolvency but is unable to pay debts or the terminating party anticipates that it will enter into a formal insolvency.
Will there be other ways to terminate contracts with a company in formal insolvency?
Franchisors and suppliers will likely retain the ability to terminate contracts on any other ground permitted by the contract, such as:
- non-payment of liabilities (eg, invoices) incurred following the entry into a moratorium, restructuring plan or insolvency procedure;
- giving notice in accordance with other terms of the contract (eg, a right to terminate upon giving fixed notice); or
- any other ground that gives rise to termination, save for those connected with the financial position of the debtor company or it entering into a moratorium, restructuring plan or insolvency procedure.
If termination is not an option, will there be an obligation to supply a company in a formal insolvency?
Franchisors and suppliers will likely have to continue to fulfil their commitments under their contract with a debtor company. This will help businesses to trade through the rescue and restructuring process, permitting a degree of stability in their operations so that rescue will be more likely.
A franchisor or supplier must seek permission from the court in order to terminate supplies. In rare cases where a supplier will be significantly and adversely affected by being unable to rely on a contractual termination clause, the supplier will be allowed to exercise such a right on the grounds of undue financial hardship. This right will be granted only if the supplier's own solvency is threatened.
It is unclear whether a franchisor or supplier can request pre-payment as a condition of continuing to supply. If the legislation is silent on this, the position will be subject to the express terms of the contract.
These changes highlight the need for franchisors and suppliers to assess their supply terms and ensure that the rights for termination are sufficiently detailed, clear and broad to enable the franchisor or supplier to take the necessary action when faced with an insolvent buyer.
It remains to be seen how helpful the proposed moratorium will be for most companies. If a company has insufficient funds to trade through the moratorium, these proposals will be of little benefit. If the government can deliver its other financial assistance packages within the same timeframe, companies may have a fighting chance. However, this is unlikely.
Most franchisors, or their affiliates, will act as suppliers of goods and services. As a franchise or distribution network grows, so does the systemic risk to the franchisor or supplier of default and failure within the network. It is therefore important that franchisors and suppliers invest in proper legal advice and legal contracts to ensure that they have the contractual rights to act quickly and effectively should the need arise.
Franchisors should consider the following takeaways:
- Franchisors should review the inter-relationship between their franchise or supply agreement and the standard terms of supply, paying close attention to termination rights and developing a clear process for dealing with franchisees or distributors which are in financial distress.
- The wording of termination clauses linked to insolvency should be examined. Do they include anticipatory terminations? Are they specific enough to cover rights to terminate for other breaches unconnected to entering into informal insolvency?
- Personal guarantees should extend to the supply of goods.
- Supply terms should be flexible to allow a switch to pre-payment.
- Franchise agreements should include an automatic revocation of a licence to sell products once a debtor company enters into informal insolvency, with an obligation to provide an inventory.
Endnotes
(1) For further details of franchisors' contractual rights in an insolvency context, please see "Retention of title – how can franchisors and suppliers best protect claims against insolvent companies?"
