Protecting your business – spot the warning signs and take early action

As challenging trading conditions in the UK economy persist, insolvency is a real prospect facing many companies. Businesses are increasingly likely to find themselves dealing with other businesses that are in financial difficulties or even insolvent. In such cases, the need to plan ahead, develop strategies to minimise problems and manage relationships with customers and suppliers should not be underestimated.

New business

If you are considering entering into a new contract, it is vital that you undertake thorough due diligence on the other party at the outset and on an ongoing basis even if the contract is with a party with whom you have contracted before. Credit checks should be carried out and you should monitor the financial viability of your customers/suppliers regularly.

Contingency plans should also be made to replace suppliers if the worst happens. In addition to due diligence on the contracting party, a general assessment of the risk profile of the proposed contract should be made and kept under review.

Assuming there are no alarm bells at the due diligence stage, careful consideration of the commercial terms can help to reduce your exposure. Payment arrangements should be as robust as possible and should be geared towards reducing risk.

If you are a supplier, you may seek to be paid upfront before providing goods or services. Alternatively, consider negotiating shorter credit periods or introducing prompt payment discounts to encourage early payment. For buyers, retentions may be used with payment being held back until the goods or services are delivered.

Maximising security will also mitigate your exposure. Taking security needs to be planned early to ensure that it does not amount to a voidable preference (see below). Security can be in many forms and may include a requirement that sums be deposited into a ring-fenced trust or escrow account and held on trust pending payment becoming due to the supplier. In the meantime, the funds will not become available to the creditors of the supplier on its winding up or administration.

Alternatives

Alternatively, it may be possible to obtain performance bonds or parent company guarantees. Suppliers should also consider using retention of title clauses as these can ensure that title in goods supplied will not pass until the goods are fully paid for. Each of these options should be discussed with your legal advisers to ensure that your position is protected effectively.

The warning signs

If you are already in a contractual relationship with a party that is on the brink of insolvency, there are steps that can be taken to help minimise your exposure. The key is not leaving it too late. The following are some of the warning signs that a contracting party may be on the brink of insolvency:

• Slower or later payments.
• Not paying its other contractors, subcontractors and suppliers either in a timely manner or at all.
• Failure to perform contracts in a timely manner.
• Late or missed deliveries.
• Requests for payment up front.
• High staff turnover.
• Under-resourcing.
• Removal of materials from site.
• Late filing of accounts.
• Requests to amend terms of existing contracts.
• Silence and prevarication.

What should you do?

If you suspect that your contracting party is in serious financial difficulty it is essential that you do not waste time waiting for problems to materialise. 

Review your contract to ascertain your rights

Can you respond to non-performance by not performing your own contractual obligations? Do you have an on-going obligation to accept a new purchase order submitted under an existing contract? Can you recall shipments? Are there any set off rights? Do you have “step in rights” for the contract that enable you to perform any outstanding obligations? These are all questions that you should review with your legal advisers.

Review what termination rights exist in your contract

They may be based on breach of contract, non-payment or formal insolvency. If it is the latter, what stage does the insolvency procedure need to have reached before the right of termination arises? Does notice need to be served? In these circumstances, you will have to judge whether you would lose less by exiting the contract immediately or by holding out for the prospect of a solvent solution.

Issue regular statements

Send out regular statements to each customer who owes you money listing the invoices outstanding for payment with a balance of the amount due.

Press for payment

If you are owed money, consider whether you can apply pressure to be paid ahead of other creditors. However, where a paying company is on the brink of failure, be aware that you should avoid such payment being an unlawful preference (see below). Ensure your debtors know that a payment failure will not be ignored and spell out to them the consequences of their failure to pay.

Consider set off

If you owe money to the contracting party and it owes you money, eg for liquidated damages, consider whether you can exercise any set off rights straightaway.

Consider statutory demand

If you have an undisputed debt, consider a statutory demand accompanied by the threat of a winding-up petition.

Retention of Title rights

If you have the benefit of retention of title provisions for any goods and materials which form the subject matter of the contract, take advice about the best way of enforcing such rights.

As the primary aim of an administration is to give the company breathing space so that it can be rescued, there are restrictions on the enforcement of rights against companies in administration. It is, therefore, important that you take advice promptly if such a situation arises.

Above all, if you think a party is verging on insolvency, take legal advice as soon as possible as letting matters drift on will probably worsen your position.

What else could go wrong?

In trying to ease your position, note that there are several types of transaction which may be challenged by a liquidator or an administrator. These include, for example:

Transactions at an undervalue

A transaction will be at an undervalue if it was entered into within two years ending with a company either entering administration or liquidation and constituted either a gift by the company or a transaction under which the counterparty provided value which was significantly less than the value provided by the company.

Any such transactions at an undervalue can later be challenged and reversed as long as the company was unable to pay its debts at the time of the transaction or became unable to pay its debts as a result of it.

There is a defence if the company entered into the transaction in good faith for the purpose of carrying on its business and, at the time it did so, there were reasonable grounds for believing that the transaction would benefit the company.

Any party dealing with a company in financial difficulties who is concerned that a transaction could potentially be viewed as being at an undervalue should take steps, such as obtaining independent valuations of the assets, to show that the consideration received by the company is equal to the value provided by the company.

Preferences

If, within the same two-year period, a company has given a preference to any person who is connected with the company, that preferential transaction can be unwound. The period is shortened to six months where the preferred party has no connection with the company.

Preferences are caught if given to a person who is one of the company’s creditors, or a guarantor for any of the company’s debts or other liabilities, and the company puts that person into a position which, in the event of a company going into insolvent liquidation or administration, will be better than the position he would have been in if that thing had not been done. Again, it may be possible to avoid the application of this provision.

The key issue in this context is whether the company which gave the preference was influenced in deciding to give it by a desire to put the person into a preferential position, as opposed to simply acting in the normal course of business.

For instance, giving security to a lender that is providing new money – or simply agreeing not to call in an ‘on demand’ loan – should not give rise to a preference which can be challenged, even though the lender taking the security would, by virtue of that security, be put into a preferential position to other creditors.

Conclusion

When contracting parties are in financial difficulty, this can also place the solvent business in a precarious situation through the risk of lost revenue, bad debt and even reputational damage if it becomes unable to meet its own commitments.

Consequently, early attention to potential issues and – if warning signs are identified – seeking legal advice as quickly as possible will increase the prospect of mitigating exposure and protecting your business in these unprecedented difficult trading conditions.

Our highly regarded corporate team provides clear, pragmatic and practical advice to businesses large and small in the UK and around the globe on the corporate transactions and the legal issues they face. To find out more about our corporate team please click here.

This article is intended to provide a summary of the law in this area as at August 2022 and does not constitute legal advice. Should you wish to obtain advice based on specific facts and circumstances, please contact us.

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