​COVID-19: Contracting with third parties in financial distress

23 April 2020

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The current crisis which has stemmed from the outbreak of COVID-19 has given rise to a number of challenges which all businesses are endeavouring to navigate. One of these challenges is dealing with uncertainty surrounding the security and robustness of supply chains; both from a supplier and customer perspective. Businesses are not only having to contend with their own internal difficulties but are also having to be cognisant of issues which their suppliers and/or customers may be facing at this time. One of the key concerns which businesses should be aware of is the risk of contracting with a customer or supplier that is suffering financial distress as a result of COVID-19.

We have prepared the following briefing note which outlines steps businesses should consider taking where they believe a customer or supplier they are contracting with may be facing financial difficulties.

Steps to be taken if a supplier suspects a customer is in financial distress

If you are contracting with a customer and suspect the customer is undergoing financial distress as a result of COVID-19 there are a number of practical steps which we would advise taking to mitigate the potential risks. Some of these steps are as follows:

1. In the first instance, we would suggest conducting a review of the contractual documentation which you are entering into with the customer in order to determine your position in relation to a number of factors including:

  • whether you have the right to suspend your obligations under the agreement in circumstances where the customer is no longer able to fulfil its own contractual obligations (namely the obligation to pay);
  • whether the contract grants you a right of “set-off” whereby you can deduct any liability which you owe to the customer from liabilities owed by the customer to you; and
  • whether the customer has committed any breaches of its obligations under the contract and, if so, whether the contract contains a mechanism for you to terminate in light of those breaches.

2. You should also consider seeking to amend the payment terms which you have previously agreed with the customer in order to reduce the risk of providing goods or services which the customer subsequently won’t be in a position to pay for. For example, you could require payment to be made up front in advance of the provision of goods or services or, alternatively, you could seek to reduce the timeframe within which the customer must make payment in order that any difficulties the customer is facing in making payments will become apparent at an earlier stage.

3. Finally, we would suggest keeping a close eye on the High Court so that you will be aware at the earliest possible opportunity if any winding-up petitions or administration applications are on the horizon. The Bankruptcy Master has set out that no new petitions are to be issued unless the Petitioner can demonstrate in writing that the matter is urgent. It is likely therefore that there will be very few – and possibly zero – fresh petitions lodged since March 19th and therefore searches carried out will be up to date.

Steps to be taken if a customer suspects a supplier is in financial distress

If you are a customer and suspect you are contracting with a supplier which is undergoing financial distress as a result of COVID-19 we would suggest considering taking the following practical steps to mitigate the risk arising from such a scenario:

1. Carry out a review the contractual documentation which you are entered into with the customer to determine your position in relation to a number of factors including:

  • whether the contractual documentation contains any service levels or key performance indicators (“KPIs”). If so, you should analyse the supplier’s performance against those service levels or KPIs and determine whether it has met them. You should also continue to review the supplier’s performance on an ongoing basis in order to determine if there is a noticeable drop in service levels or KPIs being met which could be a strong indicator that the supplier is running into difficulties;
  • following on from the above, you should consider whether the contractual documentation contains any rights of terminations in circumstances where your supplier fails to meet any service levels or KPIs or, indeed, whether there are any other rights of termination for other breaches of contract which your supplier may have committed;
  • whether the contract grants a right of set off;
  • whether the contractual documentation contains any step-in rights whereby you may step in and take over performance of the contract or, alternatively, you may procure an alternative supplier to take over performance in circumstances where the supplier is failing to meet its obligations under the contract;
  • whether the contractual documentation requires the supplier to have a business continuity and disaster recovery plan in place and, if so, to seek a copy of the plan to ascertain whether it is fit for purpose and offers sufficient comfort;
  • whether the contractual documentation contains any audit rights whereby you can audit the supplier in a number of areas including the performance of its obligations under the contract as well as the right to audit the supplier’s financial status as it pertains to its ability to carry out its obligations under the contract; and
  • if you have entered into a contract with a software service provider you should ensure that you will have access to the software in circumstances where the supplier becomes insolvent. The most common way for this to be done is by entering into an escrow arrangement with the supplier whereby the source code for the software will be held by an independent third party and released to the customer upon a trigger events such as the insolvency of the supplier.

2. In a similar vein to our comments regarding software, you should also consider whether you use any of your supplier’s intellectual property and, if so, whether the licence terms contained within the contract for such use of the supplier’s intellectual property survive termination of the contract.

3. You should keep a close eye on the High Court in order that it shall be aware at the earliest possible opportunity if any winding-up petitions or administration applications are on the horizon. The Bankruptcy Master has set out that no new petitions are to be issued unless the Petitioner can demonstrate in writing that the matter is urgent. It is likely therefore that there will be very few – and possibly zero – fresh petitions lodged since March 19th and therefore searches carried out will be up to date.

4. Finally, you should consider undergoing a business continuity exercise to identify ways in which you could mitigate business interruption which would arise from your supplier no longer being able to perform its obligations under the contract. For example, it would be prudent to consider the following:

  • whether there are other suppliers the customer already in contract with or you could enter into contract with and who could take over the suppliers obligations; and
  • whether internal staff could be upskilled to take over from key personnel employed by the supplier.

Now that we have considered what you should consider doing in circumstances where you consider your supplier and/or customer may be at risk of financial distress we will now turn to practical steps which could be taken in circumstances where you are entered into contract with an entity which has actually undergone an insolvency event.

Insolvency – What To Do Next?

Quite often you will be tipped off about an insolvency event affecting a customer or competitor before it happens. Once this happens or you have been served with a formal notice of insolvency you should consider the following steps (for the sake of consistency we shall work on the basis that the company is in administration):

  • Locate someone within your organisation who is familiar with insolvency issues to conduct communications with the Administrator. If no such person exists please speak to us for advice.
  • Make a calculated assessment as to your risk exposure resulting from the insolvency of this customer. Identify the value of the orders fully and partly completed at the date of the appointment and conduct an immediate goods audit.
  • Not only should you not supply any further goods until a resolution has been reached with the Administrator but also withhold any payments due to the Company unless and until a settlement has been reached with the Administrator.
  • If you have supplied products which are subject to retention of title clauses contact the company and the Administrator to notify them that you expressly forbid the re-selling of the products you have supplied and that you are exercising your right to recover the goods. Make arrangements with the Administrator to visit the company’s premises, identify the goods supplied and remove them.
  • It should not be assumed that once you notify the Administrator of a retention of title clause that they will immediately release the goods. The Administrator will take his or her own advice as to whether the claim is valid and may put up a bit of a fight. If the goods supplied are of critical importance to the business – in other words the return of the goods would lead to the loss of a key customer or impaired business functionality – the Administrator may decide to use or sell the products supplied and then consider a commercial resolution.
  • If at the conclusion of discussions with the Administrator you have an unsecured balance outstanding, submit a Proof of Debt Form to formalise your claim.
  • Is It Possible to Continue Trading With an Insolvent Company?

Depending on the nature of the business it is common practice to trade with a company in administration, both as a customer and a supplier.

You should however only do so with prior agreement with the Administrator, be that in the form of a brand new contract or an affirmation that the Administrator can comply with the existing terms. This agreement with the Administrator will ensure that future liabilities arising are treated as expenses of the Administration, giving your liabilities from the company a much higher ranking than ordinary unsecured creditor.

In the event that the business is sold to a third party you of course have the option of entering into a new contract or simply novating the existing agreement.

Latest Developments

The UK government has announced changes to insolvency laws in response to the current crisis, giving firms extra time and space to attempt a return to normal trading conditions:

  • Wrongful trading: There will be a temporary suspension of wrongful trading provisions for company directors to remove the threat of personal liability during the pandemic, applied retrospectively from 1 March 2020.
  • New restructuring plan and moratorium: The Government previously announced plans to introduce new restructuring procedures in August 2018 which are now being pushed forward. These include:
    • the option for a company in financial difficulty to obtain a new pre-insolvency moratorium to give it time to explore alternative options; and
    • a prohibition on the enforcement of so-called ipso facto clauses i.e. termination clauses which permit one party to terminate a contract due to the insolvency or financial condition of the other party.

It remains to be confirmed whether companies that are already insolvent will be eligible for the new moratorium. The government’s proposals in August 2018 excluded companies that were already insolvent from the scope of the moratorium, opening it only to companies with sufficient liquidity to pay their debts for the proposed moratorium period as they fall due.

There will naturally be an argument as to whether a company’s insolvency results directly from the COVID-19 crisis or whether it was already insolvent, its demise accelerated by the downturn in business. For example, there was no great surprise when Debenhams appointed administrators this week and they would have difficulty in attributing their demise to the current situation.

If you have any queries please contact the Commercial Law or Insolvency team at Carson McDowell for further information.

*This information is for guidance purposes only and does not constitute, nor should be regarded, as a substitute for taking legal advice that is tailored to your circumstances.

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