Legal Briefing

Insolvency within the supply chain

The In-House Lawyer Logo

Corporate and commercial | 01 September 2015

All businesses are susceptible to risks in the supply chain and most businesses will come across insolvency issues as a result of supplier insolvency or customer insolvency at some point in their life. The insolvency of a key supplier or customer can have a significant impact on a business and in some cases it can even be fatal, so it is important for companies to be aware of those risks.

This article looks at some of the legal issues that in-house lawyers may need to consider in the context of insolvency within the supply chain.

All companies should have internal control systems in place to monitor and protect against the risk of supply chain vulnerability, regardless of where they sit within the supply chain. As supply chains become more complex it is increasingly important for companies to build resiliency into their supply chains as part of an overall risk management strategy. From a legal point of view there are a number of things that can be done to increase this resiliency.

Companies should remember that vulnerabilities exist on both sides of the chain. While many companies have systems in place to monitor the risk of customer insolvency, the risk of supplier insolvency is often overlooked. The financial failure of a critical supplier can place an enormous amount of pressure on a business and have a significant impact on costs, revenue, reputation and sales so it is important that a company’s risk management strategy considers the impact of supplier insolvency, as well as customer insolvency.


PROTECTING A BUSINESS AGAINST INSOLVENCY WITHIN THE SUPPLY CHAIN

There are a number of strategies that companies can adopt to manage risk and increase resiliency within the supply chain.

Preventative strategies tend to be the most effective, so companies should adopt a proactive approach. The first step is to identify where the risk lies in the supply chain. Before entering into a contract with a new customer or supplier, a company should take steps to investigate the finances, reputation and stability of the other contracting party so that it can identify the operational risk of dealing with that party. Evidence of the other contracting party’s financial position should also be kept on record so that changes can be monitored.

If the supplier or customer is a private limited company, company accounts will be publicly available from Companies House. If the information available from Companies House is not up-to-date, further enquiries should be made with the prospective supplier or customer.

Key things to look out for in the accounts include evidence of declining business performance, evidence of re-financing, changing management structures or discrepancies in the company’s filing history. Overdue accounts can be an indication of a company in financial difficulties so if a company’s filing history is not up to date further enquiries should be made with the prospective supplier or customer to establish why the accounts have not been filed on time.

If the supplier or customer is part of a group, companies should also look out for cross-guarantees and debentures in favour of lenders across the group. This will identify whether the default of one member in the group will impact on other members of the group. It is worth checking the register of charges for intra-group guarantees created before 6 April 2013 (although there is no requirement to register charges created on or after this date).

It is also worth looking out for evidence of financial support from a parent company. If financial support is provided by a parent company, up-to-date financial information about the parent company should be obtained. The parent company should also be asked to provide a guarantee, if necessary.

Companies should check that their existing contracts with suppliers and customers provide adequate protection against the effects of insolvency. Key contracts should be reviewed with a view to identifying the company’s maximum exposure in the event of the other contracting party’s insolvency. Companies should also consider whether the contractual terms can be amended or improved to limit exposure.

Contractual terms in relation to payment should be reviewed carefully. If goods are being supplied to customers prior to receipt of payment, a robust retention of title clause can provide additional protection against customer insolvency by ensuring that title to goods is retained until payment is made. If the customer subsequently becomes insolvent the company may be able to retrieve any unpaid goods providing they are distinguishable from other goods.

Companies should also put written agreements in place for any critical suppliers. The terms of the supply agreement will need to be carefully drafted. A company may, for example, wish to include an express clause in the supply agreement requiring the supplier to provide access to up-to-date financial information (such as books and records) on request. Including this type of clause within the supply agreement will make it easier to monitor the supplier’s financial status as the relationship develops. A well drafted supply agreement will also include clear termination clauses setting out when the company can terminate the relationship and what notice period is required, as well as clear payment clauses keeping the time between payment and delivery of goods or services as short as possible.

Companies should avoid being too dependent on one supplier and, where possible, risk should be spread across several suppliers. Where it is difficult for risk to be spread across several suppliers, for example because of the uniqueness of the goods or services supplied, companies may wish to use the services of a credit monitoring agency to monitor key suppliers. Companies may also wish to consider taking out insurance to protect against the risk of bad debt or delays in receiving payments from other businesses in the supply chain. Policies are available to cover specific accounts or entire books of debtors.

Key contracts with customers and suppliers should be kept under regular review. If there is any uncertainty about what contractual terms apply or if existing contractual terms become unworkable or unprofitable, companies should seek to renegotiate. Any amended terms should be recorded in writing. When reviewing key contracts, companies 
should look out for potential risks in 
the supply chain, as well as any potential costs savings. If potential risks are identified, corrective steps should be taken immediately, including re-modelling the supply chain if necessary.

Companies should also maintain a high level of communication with critical suppliers and key customers, as well as other businesses in the sector. Rumours and market gossip should be treated with caution, but they can be an indication of potential problems so where a company has concerns further enquiries should be made.


IDENTIFYING THE RISK OF INSOLVENCY IN THE SUPPLY CHAIN

Where a company identifies the risk of insolvency in the supply chain it is important to act quickly. 
Failure in the supply chain normally starts with a period of decline so companies should look out for the early warning signs. 
Companies that maintain a high level of communication with their suppliers and customers are often best placed to spot warning signs and take preventative steps.

The early warning signs of a distressed business are varied, but may include the following:

  • Deteriorating service levels or quality standards.
  • Inconsistent stock levels or deliveries outside of agreed schedules.
  • Unexpected attempts to renegotiate on price.
  • Rumours and market gossip.
  • Attempts to modify payment terms.
  • Changes in the management team.
  • Market changes (for example increased production costs or increased cost for raw materials).
  • Declining financial performance.
  • Evidence of refinancing or new funding being injected into the business.
  • Any other signs that a party may not be able to meet its contractual obligations on time.

>
If a company identifies that a critical supplier or customer is in financial difficulty it will need to seek protection, as far as possible, against the potential failure of that business. It is sensible to engage in an open dialogue with the distressed business at an early stage. The distressed business is often the best source of information. This dialogue also provides a useful opportunity to gather information and identify the likelihood of the distressed business entering a formal insolvency process.

One solution for dealing with a distressed business may be to renegotiate terms. For example, companies may be able to renegotiate terms to shorten payment terms, improve termination provisions or strengthen retention of title provisions.

In other cases, it may be better for the company to provide support and reduce the immediate financial pressure on the distressed business providing a sufficient degree of trust still exists.


DEALING WITH INSOLVENCY

If a critical supplier or key customer enters a formal insolvency process, the company will need to assess the impact on its own business and move quickly. Companies should take early advice on the implications of a critical supplier or key customer’s insolvency.

If an exit strategy has not already been put in place, the company should look at the contractual documentation to identify the best course of action. If the contract does not provide for the contract to automatically terminate in the event of insolvency or give the company the option to terminate, the contract will remain in place and may be enforced by any insolvency practitioner appointed.

Depending on the type of insolvency process the supplier or customer has entered, there are a number of additional issues that the company will need to consider.

If a supplier or customer enters administration, the statutory moratorium will prevent the company from taking certain actions (including legal proceedings) against the distressed business without the consent of the administrator or permission from the court. The moratorium will not prevent the company from enforcing its contractual rights (including termination rights and retention of title) providing these rights can be enforced without commencing legal proceeedings.

The most typical outcome of administration is a sale of all or part of the business to a third party so if title has been retained, steps should be taken to retrieve the goods as quickly as possible before any sale. If the business continues to trade, the third-party buyer may wish to retain the company’s business moving forward and may be open to negotiations about previous incomplete orders, so early enquiries should be made.

Companies should also consider what practical steps can be taken to secure and protect the supply chain. If a critical supplier has entered insolvency, the risk to the supply chain may be reduced or removed if the company can find a viable alternative supplier. If a new supplier is identified, the company will need to consider delivery periods for any resupply and consider how these fit in with existing orders or commitments. If a new supplier is not identified, the company may also wish to consider the possibility of purchasing all or part of the supplier’s business to ensure continued supply. Where this is a possibility, the company should enter into negotiations with the appointed insolvency practitioner quickly.

If a supplier goes into formal insolvency proceedings and the company has paid for goods which have not yet been delivered, unless the company can 
show title of the goods has passed, it is unlikely that the goods will be returned or that the company will be refunded any money paid in advance. The liquidator or administrator will only pay back a deposit if there are sufficient funds available and that is unlikely to be the case in an insolvency situation. It is far more likely that the company will rank as an unsecured creditor. The company should also be mindful of the fact that it will still 
be liable to pay any outstanding invoices 
for delivered goods or services, unless 
there are grounds to make a counterclaim or dispute the invoices.

Insolvency within the supply chain continues to present a real risk to businesses and dealing with this issue can be a time consuming and costly process. However, by identifying critical suppliers and key customers now and adopting careful planning businesses, can greatly reduce their exposure to this risk.

By Rachel Brown, associate, Druces LLP.

E-mail: r.brown@druces.com.