Dealing with contractors in difficulty

In the first of a two-part series, Kirsten Maslen and David Rawson look at what supplier insolvencies mean for local authorities. What can and should councils be doing to protect themselves? How can they spot the warning signs?

In difficult economic conditions, many companies and businesses will face financial difficulties, which affect not just the companies themselves, but also those who deal with them. Local authorities tend to feel the impact of businesses’ financial problems in three ways:

1. Lost revenue (for example, unpaid taxes).
2. Interruption to public services and the incursion of additional cost in putting in place alternative arrangements.
3. Incursion of additional liabilities (for example, unpaid pensions contributions when the contractor is or was an admitted body to the LGPS).

This is the first of two articles offering some suggestions about how to prevent or minimise the impact on the authority of supplier insolvency by:

• recognising the warning signs early and responding pro-actively to them; and
• outlining some of the steps a local authority could take to support businesses.

Insolvency defined

Many people think of insolvency in terms of one of the formal insolvency processes, like administration or liquidation. However, these processes are simply mechanisms to address an economic fact. A company can be insolvent (and, indeed, can return to solvency) without ever being in an insolvency process.

A company is insolvent if either (or both) of the following conditions apply:

• Its liabilities exceed its assets (referred to as balance sheet insolvency), and
• It cannot meet its debts as they fall due (referred to as cash flow insolvency).

The most common corporate insolvency procedures are administration and liquidation. In liquidation, a liquidator takes control of the company’s affairs in order to sell the company’s assets and distribute the sale proceeds to creditors. The company usually ceases to trade immediately upon the liquidator's appointment.

In an administration, the control of a company’s affairs passes to an independent insolvency practitioner (the administrator), whose job it is to either rescue the company as a going concern, or realise the assets of the company for the benefit of its creditors. Note that there is a difference between restoring a particular corporate entity to solvency (which is what rescuing the company as a going concern means) and preserving the company’s business by selling it as a going concern to a third party (which is just a means of realising the company’s assets).

In practice, it is rare for an administration to rescue a company as a going concern. For that to happen, creditors will probably need to agree to a significant write down (or write off) of the sums due to them. Such agreements are difficult to broker.

By contrast, if the administrator sells the company’s business to a third party, the third party takes the business free of the existing debts and the administrator distributes the sale proceeds amongst the creditors, who are obliged, essentially, to accept what they are given. For that reason, business or assets sales are the most likely outcome of an administration.

To the outside world, the difference between the two outcomes may appear slight, especially if the existing management control the third party purchaser. However, in terms of on-going trade, the distinction may be significant. It is unlikely that the local authority will have any contractual relationship with the third party that buys and takes on the business. So, whilst the supplier’s business may continue seamlessly, the local authority may need to enter into a new contract with the new owner of that business.

A company will often continue to trade in administration whilst the administrator negotiates a sale, or, if it has insufficient assets to fund trading, will conclude a pre-negotiated sale immediately upon the appointment of an administrator (a pre-pack sale).

From a creditor's perspective, the principal effect of an insolvency process is to crystallize losses. Unsecured creditors (such as those owed outstanding taxes or sums due under contracts) generally receive a few pence for every pound owed, if they receive anything at all. The sensible course, therefore, is to try to take action before the company enters formal insolvency.

Spotting the signs of a supplier in trouble

Look out for:

• A company becoming less prompt in paying sums that it owes. Companies with cash flow difficulties often look upon local government as being a "soft" creditor, whose debt collection systems take longer to chase outstanding payments and who are likely to take a less aggressive approach to collection when they do kick in.
• Departures of key management or employees, in particular those actively involved with the company's finances.
• Changes to service levels. If a company cannot pay employees or suppliers, or morale falls generally, the level of service it provides is likely to deteriorate.

Monitoring a company's position means keeping close to your main contacts and making best use of your own sources of information.

Managing the relationship with a troubled supplier

There are three key strands to successful management of a relationship with a troubled supplier:

• Understanding the power (both legal and commercial) that you have in respect of the company in question.
• Monitoring, as closely as you can, the company's performance for signs of deterioration (or improvement) in its financial position.
• Being aware of your own financial exposure to the company (both in terms of potential bad debts and in respect of the cost of sourcing alternative service provision) and being clear about the outcome you want to achieve.

Make sure that you review the terms of all contracts with that supplier at an early stage. You need to understand the circumstances in which you can terminate the contract and what the consequences of termination might be.

Make contingency plans. This process may inform your objectives. If it will be very difficult in practice to replace a supplier, it may make more sense to try to support that company than to press for the payment of debts.

Be open with the supplier about your concerns. In many cases, the directors will take advice about the options available to them and the company. Many restructuring strategies rely upon the support of key stakeholders. By being up front and encouraging open dialogue about potential problems, you may find that you become an active participant in the creation of a restructuring plan. Stakeholders who participate in this way tend to suffer fewer losses as the "price" of their support is made an integral part of the plan being implemented.

Negotiating with a struggling company

The old adage about squeaky wheels and oil holds true to companies in financial difficulty. A company with limited cash resources is likely to apply them to meet the claims of those creditors most likely to take action against the company.

As a company's financial position deteriorates, it has neither the time nor the money to engage in legal arguments, so strict contractual terms become less important than the commercial strength of your continued support for the business.

Do not be afraid of playing the cards in your hand, but be aware, in doing so, of another old story: that of the boy who cried wolf. Threats of action that never, in fact, materialise reduce your credibility and lessen the prospects of them working. Only threaten something that you are prepared to do (be it contractual termination or legal proceedings), set a clear deadline for action and then stick to it.

Be clear, too, about what you want to achieve. Consider:

• Renegotiating the terms of your contract, to widen the circumstances in which you can terminate or to allow you to pay for services rendered in arrears.
• Demanding the discharge of some or all of the debts due to you, as a condition of continuing with the contract.
• Requiring the company to provide you with on-going information about its financial position.
• Seeking performance bonds or guarantees from directors or shareholders of the company's obligations.

Negotiating with the purchaser of a supplier’s business

Even the most careful monitoring of the position of supplier cannot insulate a local authority from the risk that a supplier enters a formal insolvency process. Contingency planning can reduce the impact of a business failure, but what if there is a sale of the company’s business, as a going concern, to a third party?

Somewhat counter-intuitively, the absence of an existing contractual relationship between the local authority and the purchaser may be the strongest negotiating tool in the authority’s armoury. A purchaser of a business from an insolvent company takes something of a leap of faith. It has a business, equipment and employees, but all existing customer contracts will be with the insolvent company. One of the key first steps for the purchaser will be to try to agree new contracts with customers or negotiate the assignment of the existing contracts from the insolvent company.

Most supply contracts with local authorities will restrict or prohibit assignment and, as set out above, most will be terminable upon the supplier’s insolvency. Consequently, a local authority can often create a strong bargaining position by requiring certain commercial concessions as a condition of contracting with the purchaser. This bargaining position is particularly strong where the insolvent company’s management are involved with the purchaser and so can be said to have some “moral” (if not necessarily legal) responsibility for the insolvent company’s liabilities.

Note that the award of a new contract will be subject to the procurement rules; if the authority lacks time to carry out a formal process, it will probably enter into an interim arrangement pending the outcome of a formal procurement.

Chasing debts and winding up petitions

The winding up petition is a misunderstood weapon in the debt collector's armoury. Many people see it as a debt collection tool, but, as a strict matter of law, it is not. Used with care, a winding up petition (or, more accurately, the credible threat of the issue of a winding up petition) can be a very effective means of persuading a recalcitrant debtor to pay. However, the threat of a winding up petition carries with it the strong possibility of unintended consequences.

A winding up petition is, essentially, an application to court brought by an individual creditor on behalf of all the creditors of a company. The most common basis of a winding up petition is that a company is insolvent and it is in the interests of the company's creditors as a whole that the court appoint a liquidator to sell the company's assets and distribute the proceeds amongst the creditors.

The consequences of the issue of a winding up petition are so significant that a threat to issue one is potent. Once a winding up petition is issued, a company cannot make any payments from its bank account (or any other disposition of it assets) without the approval of the court. That presents obvious difficulties in terms of continued trading. These difficulties mount once the petitioning creditor advertises the petition in the London Gazette (as all petitions must be before the court hears them). Banks monitor the pages of the London Gazette very closely and as soon as they see the advertisement of a winding up petition, they freeze the current account of the company in question, pending the hearing.

Consequently, many companies would rather discharge a debt than risk the presentation of a petition, so the threat of issue is a powerful one. Of course, the issue of a petition does not make the company any more able to meet its obligations, so, essentially, all that threatening a winding up petition does is motivate the recalcitrant debtor to pay or persuade the struggling debtor to use its limited cash resources to discharge a particular obligation (possibly instead of another).

Kirsten Maslen is an Editor in the PLC Public Sector team and David Rawson is an Editor in the PLC Restructuring and Insolvency team.

The second article in this series will examine how local authorities can manage the risk of supplier insolvency, and what proportionate protections can be put in place.

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