Dealing with a counterparty who is facing insolvency

The Office for Budget Responsibility has predicted that the UK will be in recession throughout this year, with the IMF forecasting that the UK will be the only major economy to contract in 2023. The Chancellor flagged in his Autumn budget the ‘difficult decisions’ that the Government are having to make.

After the first lock down began in March 2020, the UK government introduced an unprecedented package of financial support measures for businesses and individuals at a cost of hundreds of billions. This included grants, loans and temporary tax cuts. In addition, a number of temporary insolvency protections were introduced during the pandemic to protect business under the Corporate Insolvency & Governance Act 2020 (“CIGA”), almost all of these support measures and protections have now fallen away. Creditors can now present statutory demands and winding-up petitions (read more here). Company directors can be pursued for wrongful trading. The main remaining protection is the arbitration scheme for commercial rent arrears which arose during the pandemic.

Against this backdrop, with financial support at an end, it is unsurprising that insolvencies are on the rise from the low levels recorded over recent years. Company insolvencies reached their highest level in the second quarter of 2022 since 2009. One in 10 businesses reported a moderate-to-severe risk of insolvency in August 2022.

What can creditors and suppliers faced with a counterparty who is in financial difficulty or at risk of insolvency do to best protect themselves? We set out some helpful guidance below.

What can I do if the existing contract terms aren’t sufficient?

You could seek to re-negotiate your existing contractual terms with the counterparty (read more in our article “Are contract amendments made in an economic downturn legally binding?"). Much will depend on the circumstances and negotiating position of each party. However, practical changes you might seek include requiring shorter payment terms or payment in advance for the provision of goods or services.

You’ll need to check your existing contract to see if it contains any provisions setting out how variations are to be recorded and comply with these terms. In the absence of any such term, you will want to ensure that the variation is suitably recorded in writing, to evidence that both parties agreed to it. A note of caution: variations to improve one’s position, backed by a threat to end a contract (in breach of its terms) may be actionable as economic duress. In these circumstances a variation may be susceptible to being unwound.

What can I do to make sure my debt is high on the counterparty’s agenda?

It is likely that you will not be the only creditor seeking payment of monies owed. Assuming that you don’t have security for your debt, then your first step is to contact the decision-maker(s) at the counterparty to press for payment of the sums due to you. Do this in writing, so that you’ve got an evidential paper trail.

If the counterparty is a limited company, then its directors have a duty to consider the interests of the creditors if the company is bordering on insolvency. The law on this point has recently been clarified. Whilst a director does not owe duties to the creditors directly, an obligation to consider creditor interests is engaged and arises as part of the general fiduciary and statutory duty owed by a director to act in the company’s best interests. A director’s duty to have regard to creditors’ interests increases in relative terms (by reference to the interest of shareholders for example) as the company’s financial position worsens, ultimately becoming “paramount” once the company is “irretrievably insolvent”. Keeping the amounts you are owed at the front of the directors’ minds may help to ensure they consider your interests in line with the increasing threshold underlying the duty.

If the counterparty does enter into an insolvency procedure, then it may be possible that the office holder (liquidator or administrator) could seek to claw back the payment made to you as a preference (i.e. that you were paid out of a desire to put you in a better position than the counterparty’s other creditors). Having a paper trail showing that you were exerting commercial pressure to have your debt paid may help disprove that desire and fend off a claim.

What if I’ve delivered stock to the counterparty but they’ve not yet paid for it?

You should check whether your contract contains a retention of title clause which covers the stock concerned.

If so, you will need to bear in mind the exact provisions of the term and how it operates. Is it a basic or an all-monies clause? The latter provides that a purchaser will only get title to goods when they pay all amounts they owe under the relevant contract, rather than just for the specific goods in question. Does the clause require the counterparty to preserve or ring-fence the goods in a certain way so that you can repossess them?

Once you’ve checked the specific provisions in your contract, you’ll likely want to notify the counterparty of the existence of the clause, and, if you’re entitled to, require them to keep the goods covered stored separately and identifiably apart from other goods the counterparty possesses.

Your rights under a retention of title clause should survive the counterparty entering into a formal insolvency procedure, although you may not be entitled to repossess the goods without the court’s permission in certain circumstances.

What if the worst happens and the counterparty does enter into an insolvency procedure?

You’ll need to check the provisions of your contract, to see what the impact of the counterparty entering an insolvency procedure is. Does the process itself purport to terminate the contract? Does it give you a right to terminate the contract? You’ll need to check the specific provisions in your contract and take advice. So-called “ipso facto” clauses (which purport to give a right to terminate based on the fact of insolvency) may not be enforceable depending on the nature of the contract. In addition, it has for some time been the case that contracts for the supply of essential services, such as those for gas, water, electricity and for IT services can’t be terminated for reason of a counterparty’s insolvency due to statutory protections.

If you do decide to exercise a right to terminate the contract, ensure that you have the right to do so and comply with any set notice provisions in your contract, and notify the counterparty and the insolvency office holder, if one has been appointed.

A particular note of caution: it can be significantly more attractive financially not to terminate under a contractual term and instead to claim repudiation (so-called common law termination rights). The latter can give you a far greater right to damages by reference to the unexpired life of a contract. Termination under a contractual scheme on the other hand may extinguish the right to claim future losses which have not accrued. Sometimes the rights co-exist and advice needs to be taken before committing to a termination strategy. Read more in our article about the legal issues around terminating a commercial contract here.

If you have a retention of title claim, that should be raised with the office holder immediately, so your goods are not disposed of and your title is not interfered with.

If your counterparty is a company and it has entered into administration, then there will be a statutory moratorium in place which prevents creditors from starting any new claims against the company for the duration of the administration. If it’s a company and it has entered liquidation, it’s likely the liquidator can apply to court to have all existing actions against the company stayed and any future actions restrained.

As such, in these circumstances, rather than seeking to initiate any new action against the company, it’s best to contact the office holder to notify them of your debt. The office holder is likely to ask you to complete a proof of debt form, and may ask you to provide them with any further details or supporting documentation. Again, keep a record of all your communications with the office holder.

The office holder should provide updates on the progress of the insolvency process, and will notify you of the outcome once it has reached its conclusion.

Next steps

As economic pressures increase, it’s inevitable that more businesses and individuals will find themselves in financial difficulty. Keep abreast of the financial standing of those that you are doing business with, using suitable monitoring and notification tools. If a counterparty does become financially precarious, consider the position and the specific wording of your contract. Take appropriate early action to ensure that your interests are protected insofar as possible. Seek suitable legal advice if you’re in doubt of the course of action to take. Sensible planning for the potential failure of your counterparties will give you the best chance of safeguarding your own interests and ability to deliver.

LS Unlock

We have created an initiative called “LS Unlock” to help businesses access legal advice during the uncertain times ahead. LS Unlock comprises a free initial assessment of significant commercial claims together with a menu of alternative fee arrangements which can reduce and, in certain cases, eliminate the upfront cost of pursuing a claim. This initiative has been designed specifically to assist clients in this uncertain economic climate and is part of our commitment to working with clients to help them survive its effects.