All secure? Step-in rights and the Corporate Insolvency and Governance Act 2020

In our previous blog on the Corporate Insolvency and Governance Act 2020 (CIGA), Emma Schaafsma commented on various puzzles associated with the legislation. This blog picks up one specific issue: how (if at all) does CIGA impact on step-in rights? Such rights are a key part of the package required to enable projects to be financed and delivered.

What are step-in rights?

Step-in rights are designed to protect the interests of funders and others who are major stakeholders in construction or engineering projects. The rights will be contained in a collateral warranty, schedule of third party rights or direct agreement given by (say) a contractor or sub-contractor under its project contract or sub-contract.

Essentially, the rights allow the funder (or other beneficiary of the rights) to “step into” the relevant contract in place of the contractor or sub-contractor’s counterparty. In the case of a funder receiving the right to step into a construction contract, the counterparty would be both the contractor’s employer and the person borrowing finance from the funder to carry out the project. The step-in rights would be exercised to keep the contract to which they relate “alive”, in a situation where it might otherwise be terminated due to the insolvency or default of the borrower or the contractor.

Basically, there are two kinds of step-in trigger events, both of which appear in typical step-in clauses: “top down” and “bottom up”. Take, for example, the step-in rights included in the third party rights in favour of a funder in the JCT Standard Building Contract.¹ These provide that:

• if the finance agreement between the funder and the borrower/contractor’s employer is terminated, the funder may give the contractor a notice by which it steps into the contract; and
• if the contractor intends to terminate its employment under the contract, it must first give the funder prior notice of its intention to do so. The funder may, within the notice period, opt to serve a step-in notice. If it does, the funder becomes the employer and the contractor’s right to terminate ceases.

In either case, the funder becomes responsible for payments due to the contractor under the contract.

Impact of CIGA

Two of CIGA’s terms potentially impact on the operation of step-in rights in the construction and engineering sectors. These are contained in section 233B of the Insolvency Act 1986, which CIGA introduces.

First, section 233B(3) makes ineffective any provision in a contract for the supply of goods or services which allows the supplier to terminate the contract because the recipient company (e.g. the employer under a construction contract) has become subject to a relevant insolvency procedure. Construction contracts will almost invariably include a right for a contractor or sub-contractor to terminate for various kinds of counterparty insolvency falling with the scope of section 233B.

Second, under section 233B(4) a supplier’s right to terminate may not be exercised during the period which a company is subject to an insolvency procedure, if:

• the right arises because of an event (such as non-payment) occurring before the start of the insolvency period; and
• the right to terminate crystallised before that period.

A supplier may still ultimately terminate where either of these provisions applies, but only in limited circumstances (for example, on application to the court in the case of “supplier hardship”).²

The effect of these provisions, where they apply, is to prevent a contractor or a sub-contractor attempting to strike the second step-in trigger described above. In such cases, its right of termination is lost or suspended: as there is no exercisable termination right, the mechanism leading to a step-in cannot be engaged.

It follows that any notice which a contractor or sub-contractor attempts to issue in these circumstances, with the intention of engaging the mechanism, must be ineffective. Certainly, it would undermine express provisions of CIGA if a funder or other party could rely on such a notice as the basis for stepping into a contract.

Perhaps this is an instance of CIGA not entirely aligning with the dynamics of distressed construction and engineering projects. It may be that where an employer is in administration, the administrators would usually not object were a stakeholder to attempt to exercise its step-in rights and remove the burden of performing the contract from the insolvent company.³

But critically, CIGA does not stop the first kind of step-in trigger from being struck. A funder issuing a notice stepping into a contract because of breach of a finance agreement is plainly not a supplier exercising any kind of termination right under that contract.

Upshot for funders and main contracts

So CIGA does not qualify the right of a funder (or other person) to exercise a step-in right which is not triggered by the relevant company’s insolvency. That is the case even if the insolvency gave rise to the breach of the finance agreement entitling the funder to step in.

But it is perhaps open to question whether insolvent companies would be seriously prejudiced, if contractors (and sub-contractors) did retain their ability to set a step-in process in motion. However, the various questions CIGA poses for the construction and engineering sectors make it clear that their specific needs were not first in mind when the legislation was framed.

Sub-contracts and CIGA

A particular step-in issue arises in relation to construction sub-contracts.

Many such sub-contracts provide that if there is termination under the main contract, there is likewise automatic termination under the sub-contract. That is the position under JCT’s sub-contracts: termination of the contractor’s employment for whatever reason triggers termination of the sub-contractor’s employment.

Does this position survive under CIGA, where termination under the main contract is due to the contractor’s insolvency? Section 233B(3) makes ineffective a provision in a supply contract (for example, a sub-contract) which terminates that contract because the recipient company has become subject to a relevant insolvency procedure.

The answer is not entirely clear. But the better view is that the automatic termination under a sub-contract would remain effective. The reasons for this are:

• termination under the sub-contract would be because the employer has opted to terminate under the main contract; it would not follow automatically on from the contractor’s insolvency; and
• there is no obvious policy reason for keeping a sub-contract in place, the sole remaining purpose of which would be to enable a contractor to fulfil obligations under a now validly terminated main contract.

If this view is correct, CIGA would not prevent a person from exercising any right it may have to step into a sub-contract on automatic termination of the main contract.

_{[1]       The JCT Standard Building Contract Without Quantities (2016 edition). The funder third party rights are in paragraphs 5 and 6 of part 2 of schedule 5 of the contract.
[2]       Section 233B(5).
[3]       This may be particularly likely where (say) the insolvent company is a contractor whose employment under a building contract has already been terminated.}