Tackling the domino effect of supplier insolvency

Research this summer by R3, the association of business recovery professionals, found that over a quarter (26%) of UK companies had suffered a hit to their finances following the insolvency of a customer, supplier or debtor in the last six months.1 in 10 companies described the financial impact of the insolvency of another business as ‘very negative’. 

The insolvency of any entity with which a business has a relationship is always a concern – not least because of the risk of a ‘domino effect’, where one company’s insolvency will increase the insolvency risk for others. High profile insolvencies such as those of Carillion, Toys R Us and BHS are particularly worrying given the number of businesses potentially linked down the supply chain. At the time of House of Fraser’s collapse, suppliers were owed more than half the retailer’s debts of almost £1bn. More than 1,000 suppliers were expected to receive little or no monies from the process. The risk of being affected by a customer’s insolvency is particularly concerning given the rising levels of corporate insolvencies. According to the Insolvency Service, there were 8,390 new company insolvencies in the first half of 2018 – a rise of 12% on the same period last year.

The Government is aware of the problem of supply chain impact from insolvencies. Regulations have already been introduced requiring larger companies to publish certain information about their payment practices and performance. The department for Business, Energy & Industrial Strategy (BEIS) has also been consulting on a range of measures intended to improve the governance of companies when they are in or approaching insolvency. These measures could include improving protection for company supply chains – particularly small and medium-sized suppliers – in the event of a customer’s insolvency. As BEIS has noted, SMEs are particularly vulnerable because they have less leverage to extract payment from a large company.

The BEIS consultation document considered various options, including:
  • Increasing the use of specific ring-fenced mechanisms to prevent the abuse of contractual clauses, such as Project Bank Accounts (PBAs). A PBA is a ring-fenced bank account from which payments are made directly and simultaneously by a client to members of its supply chain down to second-tier suppliers. PBAs have trust status so, in the case of the main contractor’s insolvency, monies in the account due for payment to the supply chain would be secure and could only be paid to supply chain members.
  • Preventing the misuse of certain payment provisions (e.g. the withholding of retention payments, or a proportion of the contract value being used as a surety against defects).
  • Revising the amount of the ring-fenced funds in an insolvency known as the ‘prescribed part’ – an amount to be paid to unsecured creditors (including supply chain businesses). This is currently capped at a maximum of £600,000.
The Government’s analysis of responses to the consultation noted that there were issues to be addressed and that protecting suppliers in cases of insolvency was also linked to a wider problem with late payment practices. Several respondents to the consultation had commented that in practice, SME suppliers were reluctant or felt unable to make use of the legal remedies available to them including statutory interest, recovery action through the courts or a winding-up order. 

As a result of the consultation, BEIS has confirmed that steps will be taken to increase the prescribed part cap in line with the impact of inflation since these provisions first came into effect in 2003. It is also expecting to issue a call for evidence focussing on how to eliminate unfair payment practices to small businesses and what further steps could be taken to create a responsible payment culture. However, any legal or regulatory changes will take time to have an impact. So what steps can suppliers to large – or any other businesses – take to protect themselves in the meantime?
   
Firstly, businesses should try to avoid becoming overly dependent on one or two suppliers. It’s far better to spread risks by maintaining a broader portfolio of customers if possible. Secondly, suppliers should ensure that their terms of trade sufficiently protect them in the event of a client insolvency. This could include the use of clauses whereby title to commodities supplied does not transfer to the client until they have been paid for in full. Such clauses can often be subject to challenge and suppliers should, therefore, seek professional advice to ensure their terms and practices are enforceable.  

Finally, businesses should establish sound protocols for monitoring the stability of their core customers. The extent of information about businesses that is available in the public domain, particularly in respect of larger entities, is continually increasing and suppliers should take advantage of this. If a pattern of late payment begins to emerge, this should be a warning flag. Being aware that a particular business may be getting into trouble and seeking professional advice where appropriate could inform future decisions about whether to do business with them in the future and on what terms.

For more information on how we can support you with business rescue & insolvency solutions, please contact Christine Francis.  
 

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