In the current economic climate, the risk of companies becoming insolvent is rising rapidly. The move of Oilexco into administration has sent shock waves through an industry that has rarely seen insolvencies among operators.
The impact of insolvency extends not only to the company itself, its shareholders and employees, but also to suppliers and customers who have entered into contracts with the insolvent company. What sort of protections might they put in place to safeguard their interests in the event that a party to one of their contracts becomes insolvent?
During the economic downturn, companies need to be particularly proactive in monitoring the financial health of their customers and suppliers. There are some very obvious signs of trouble, such as profit warnings, a credit-rating drop, public investigations into alleged improper financial accounting or fraud, or reports of breach of lender covenants.
Other indications may be the failure to provide or renew letters of credit or other security, or evidence of litigation against the company.
One of the earliest warning signs in relation to customers is a delay in settling undisputed debts (although this is not invariably evidence of serious financial distress – it may simply be a way of improving cash flow when times are tough).
In the case of suppliers, late delivery of goods and services or an unexpected fall in standards of service may indicate underlying financial problems.
If the company is actually insolvent, your contract may entitle you to terminate and cut your losses.
This protects you from incurring further losses but does not help you recover money already paid to an insolvent company. For this, you need some form of security, such as a guarantee or letter of credit.
A letter of credit is traditionally the strongest form of security, other than immediate payment. However, parent company guarantees are only as valuable as the credit of the parent providing them, while letters of credit can also be costly and difficult to obtain.
Companies may also be unwilling to seek letters of credit because of the impact this would have on the company’s balance sheet. They are also unlikely to be useful for regular customers with variable debts as they are generally inflexible in amount.
Bank credit ratings have been under pressure in recent months and that adds to the problem of obtaining an acceptable letter of credit. If you are very lucky, you may have had the forethought to obtain credit insurance, which protects against bad debts (though that is getting harder to obtain in the current climate and is not always reliable).
What if you are just concerned that your customer may be insolvent but the triggers for termination under your contract are not met?
You may have the right to charge interest on your invoices (either by virtue of an express term or under the statutory regime), but a claim for interest is of no value if the debtor is insolvent.
If the warning signs are spotted early, you may be able to exercise contractual rights to limit your exposure – for instance, you may have the right to suspend the provision of goods or services if payment is late.
In good times, this right might not be exercised, and it runs the risk of souring a customer relationship – but when the risks are high, suspending work will mean that the company is not incurring debts to you which it may never be able to pay.
The simplest way of ensuring you are not left with unsecured debts is to ensure that you are paid up front for goods or services, and many companies are now reducing their credit period or requiring payment in advance.
This is very good if you can negotiate it but, in the current climate, companies with cash-flow problems may struggle to do this. They may also be concerned about the reverse risk – that they pay in advance for services and you then become insolvent before being able to supply the services.
In this situation, escrow accounts may be useful: the money is set aside and is safe from the customer’s other creditors but is only paid to you once the services have been delivered.
However, take care – these have to be carefully set up to be effective. Liens over customer property and retention of title provisions can also provide useful bargaining tools to ensure payment but will generally not be enforceable against the administrator without the consent of the court.
What if you are a customer worried about the potential failure of a critical supplier – your contract may have many provisions in it designed to protect you in such a case, but do you know what they are and have they been implemented properly?
How early does title transfer under the contract, and what steps should be taken to establish title?
What is your contingency plan in the event of an insolvency? What would you need from the supplier (documents, licences to intellectual property, access to unfinished work) to enable you to get a third party to finish the work, and have you got contractual rights to obtain it?
Penelope Warne is a partner and practice group manager for energy projects and construction at CMS Cameron McKenna