Protecting your supply chain in times of difficulty

Protecting your supply chain in times of difficulty

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Coronavirus continues to disrupt the global economy, affecting consumer demand and the ability of many businesses to perform their services. As the government begins to lift restrictions and we adapt to the ‘new normal’, many businesses remain concerned about whether their suppliers or providers will be able to perform their contractual obligations - or their long-term solvency. Below, we discuss some of the key ways that businesses can protect themselves against the potential insolvency of their suppliers or failure of their suppliers and subcontractors.

At the time of writing, the Corporate Insolvency and Governance Bill is rapidly making its way through Parliament. The Bill proposes broad-ranging changes, restricting contractual provisions for the termination of supply contracts in the event of (or indeed, allowing any other thing to be done as a result of) a customer’s insolvency or entry into a pre-insolvency moratorium. If these changes become law, the ability of suppliers to terminate contracts or, for example, require amended payment terms will be significantly curtailed – although the Bill proposes a temporary exclusion for small suppliers.

Risk mitigation

There is an increased likelihood of businesses becoming insolvent or not being able to deliver as promised in the current economic climate. Therefore, businesses intending to sign new contracts or make expensive up-front payments such as deposits or committing to long term key projects (such as IT infrastructure or building projects) may seek to reduce some of that risk of loss by considering employing some of the following protection mechanics.

1. Due diligence of supply chain

It’s an old chestnut, but use of proper due diligence on suppliers is key. This includes reviewing the financial performance and trading history of any key subcontractors or other companies in the supply chain. Given the past may not be precise indicator of the present, it may be worth considering using a wider range of suppliers and not placing new orders until existing ones are fulfilled (as the cancellation of a smaller order may be less critical and disruptive to the business). 

2. Payment terms

Review the contractual position in relation to payments, deposits and invoicing. Of course, payment in advance is always a supplier’s preference, but it not always practicable. Payment by reference to milestones, or staged payment dates, can be helpful. The provisions of the Housing Grants Act 1996 for building contracts can also be helpful when there is a dispute or failure to pay.

3. Contractual Rights

Contracts can be reviewed and adapted to reduce credit exposure at an early stage and with stringent rights to suspend in whole or in part or terminate for non or delayed performance. However, given the potential implications of the Bill, the ability to suspend or terminate should not be exclusively linked to an insolvency event of a customer. Service credits and service penalties such as payments to be made for delays or failures to meet response times  whilst useful may only be theoretical if the supplier is not creditworthy so applying them may be difficult to do so.

4. Guarantees

Asking for a performance or monetary guarantee from the supplier’s owners or parent company can enhance your position by providing a right to pursue the guarantor if your counterparty defaults under the contract. Whilst personal guarantees can incentivise proper performance of the contract, they can be difficult and expensive to enforce. Similarly, bear in mind that the owner or parent must be willing to accept liability and, even then, may still not have sufficiently valuable assets to cover losses under the contract.

5. Escrow arrangements

In an escrow arrangement, one party deposits funds/assets with an escrow agent until the agreed supply contractual conditions are met, at which point the escrow agent will deliver the funds/assets to the other party. Businesses could make use of escrow arrangements to protect their payments to suppliers and make them conditional upon either receipt of the goods or receipt of evidence that the money is needed to meet costs. It will be a commercial assessment as to whether the value of the contract and the business relationship justifies the additional cost and process involved in putting such arrangements in place.  Further, the escrow agreement will need to set out who holds title to the funds in escrow at various stages of the transaction, which will govern what might happen to those funds in the event of one party’s insolvency.

6. Debentures

Debentures create a charge or charges over certain assets of a company. If the charges cover a wide enough range of supplies, the beneficiary of the debenture (i.e. the person to whom money is owed) may be able to appoint an administrator over the company which granted the debenture - without needing to apply to court. An administrator would then typically seek to rescue the company or, if that is not possible, sell its assets and use the proceeds to pay the company’s creditors in a prescribed order. As this is a very powerful remedy, most suppliers are unwilling to give debentures to everyday trade creditors. In any event, a supplier about whom there are potential solvency concerns is likely to have already given security over its assets to a funding bank or as part of asset financing arrangements.

7. Step in rights

Contractual step in rights allow the right to ‘step into’ the shoes of a party to a contract if that party has seriously breached the contract terms or gone insolvent, in order to fulfil the contract. For example, if you are reliant on performance of a supplier who has a contract with a third party which is essential to its performance of your contract, you may wish to stipulate step-in rights under that contract, so that termination by the counterparty is not possible without you being allowed to step into the contract to perform it yourself, or procure that another new entity performs the obligations. Step in rights are particularly useful in construction and service contracts with debt funding, as the funder can ‘step in’ and complete the project itself.

8. Additional protection from subcontractors

For further reinforcement, consider asking any key subcontractors for a separate warranty and/or additional step in rights, particularly in the context of services or where the subcontractor is the de facto actual supplier.

9. Retention of title

Retention of title clauses seek to ensure that the title to any goods supplied remains vested in the supplier until the customer has fulfilled certain obligations, such as the payment of the purchase price.

Customers will seek to protect themselves by ensuring that title to the goods passes to them from their supplier as early as possible in the commercial relationship – whereas suppliers will favour a position in which title only passes when all amounts owed in respect of any supplies to a particular customer have been paid in full. Where the parties land will ultimately be governed by their bargaining power and the circumstances of supply.

10. Credit insurance

Businesses may be able to insure against the insolvency of suppliers/customers by taking out credit insurance. Although not always available for smaller businesses, such insurance is designed to help businesses protect against losses caused when customers or suppliers default under a contract by transferring risk away from the business and onto the insurer. Of course, the merit of any policy will depend on its terms and such insurance will come at a cost, which can be expected to increase with the perceived risk of a counterparty’s default.

11. Bank guarantees/performance bonds and letters of credit  

Banks (and other providers) can issue guarantees, letters of credit and performance bonds, both of which guarantee payment in the event that a supplier defaults under the contract. Although it is worth raising the potential availability of bank guarantees with a supplier, these guarantees are generally used in high value contracts as the cost of obtaining such a guarantee can be uncommercial at the lower and mid-market level. In the current crisis, and for smaller businesses, it may be that this cost is prohibitive.

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