The insolvency of a key supplier can have a significant (and potentially catastrophic) impact on a customer’s business. It can affect the customer’s ability to meet obligations it owes to its customers and other counterparties as well as regulatory requirements. All customers should ensure that they have robust internal processes and controls in place to monitor their supply chain risk and ensure their operational continuity. This is particularly important for customers in the financial services sector, where operational resilience is subject to increased regulatory focus. 

In the current economic climate, we are seeing an increased number of solvency related situations impacting the provision of regulated services and services to customers. Where a supplier suffers from financial difficulties it possibly means they will end up in administration or in a winding up scenario, but it also possibly means that the ability to perform won’t be properly funded, and the customer will see an impact more immediately in its receipt of the services. The contract between the customer and its suppliers can play a crucial role in managing this risk, however relying on rights as and when an insolvency actually occurs is inadequate. Customers should instead carefully consider a broader range of financial distress scenarios (not just formal insolvency proceedings) and put in place a range of contractual mechanisms to ensure that they have access to the right information to monitor performance and financial risk on an ongoing basis, spot issues early and take the appropriate steps where needed.

Ongoing monitoring

Customers that spot the early warning signs of distress will be best placed to manage the insolvency risk and reduce their own exposure. Examples of the early warning signs include publicly available information such as the supplier issuing a profit warning or significant changes in management but also issues that don’t tend to receive public attentions, such as subcontractors complaining about not being paid, market insights, the supplier seeking to renegotiate payment or other commercial terms, and deteriorating performance against service levels.

Contractual requirements enabling the customer to monitor the supplier and its performance, coupled with regular and open levels of communication, can help customers to understand a supplier’s financial position and in turn their ability to continue to properly perform the services.

Financial health

A customer may wish to include specific requirements for the supplier to provide financial information (including books and records) on a regular basis in respect of itself and, if applicable, its group. Parent company guarantees should be required if applicable, to guarantee the supplier’s performance and financial obligations.

There may also be active requirements to notify the customer upon the occurrence of specific financial distress events, including for example:

• any issue of profit warnings;
• material non-payment of a sub-contractor; or
• worsening of certain financial ratios past a certain threshold.

The ability to require meetings with the supplier’s chief financial officer and the supplier’s external accountants to discuss the financial health of the supplier, including a commitment to participate in such conversations openly, would bolster these information rights and allow the customer access to key supplier stakeholders at critical times. It will be important for customers to not just rely on what it is told by a supplier (who naturally might be reticent to highlight an issue that it thinks might “blow over”) so the customer ought to have the ability to validate information and to assess financial health by reference to objective standard such as the solvency ratios.

Performance

Deterioration in service performance may be an early indicator of financial difficulty. Ensuring that the contract includes comprehensive and robust service level and governance regimes will help to identify issues and trends as early as possible, giving the customer the opportunity to take preventative steps, seek remediation or consider alternative options.

Customers may also wish to include a general requirement for the supplier to notify the customer promptly of any event having (or likely to have) an adverse impact on the supplier’s ability to perform the services or comply with its obligations under the agreement. This is in any event a regulatory requirement for those subject to financial services regulatory regimes in the UK and Europe.

Remediation

Where a financial distress event applies (irrespective of service performance), enhanced customer rights should be considered. These may include:

• root cause analysis;
• remediation plans that are subject to the customer’s approval;
• senior stakeholder engagement;
• non-prioritisation clauses (with regards to the supplier’s other customers);
• personnel attrition monitoring and restrictions;
• the ability to manage the supplier in its provision of the services, or to direct the supplier’s personnel; and
• the ability to step-in and take over the provision of the services (or a part of them).

Termination and exit

If the supplier is in financial difficulty and the remediation steps have either not been complied with or failed to steady the ship, the customer may need to rely on its ability to terminate the contract. It is important that the customer has a range of options available to it, so that it does not need to wait until formal insolvency proceedings have begun before taking steps to exit the arrangement. There may be several other termination routes available to the customer (e.g., financial distress event triggers, material breach, service level failures and convenience), each with varying notice periods. These should be carefully assessed to determine the best route for the customer in the specific scenario. The timing of notice being served can also be significant, and the supplier’s likely reaction (and resulting impact of service performance) factored into the decision-making process.

The customer may be entitled to engage an alternative supplier before termination, but this will depend on the nature of the contract and whether the customer has made commitments around exclusivity, minimum spend or volume.

Contracts with key suppliers should of course include detailed exit obligations, and customers should ideally be entitled to require the provision of exit assistance at any point (not just upon notice to terminate) to ensure the orderly transition to an alternative supplier. In the case of a stressed exit however it is likely that the customer is already experiencing service disruption, so its ability to benefit from these exit assistance obligations in real terms will be limited. It is crucial therefore that exit plans are put in place at the outset of the contractual relationship and reviewed and updated regularly thereafter, to ensure that the customer has a clear route to extract its data and effect the transition as smoothly as possible.

As supply chains become more complex, the risk of supplier insolvency and the impact this may have on a customer’s business requires careful consideration, planning and mitigation. Used correctly, contractual mechanisms can play a pivotal role in of managing that risk and forming part a robust risk management strategy.