Supplier Financial Distress - How to avoid sinking with the ship

Scotland
'Supplier squeeze' in the current economic climate is not something public authorities can ignore. Although spending in the public sector may be helping to bolster the economy, no public sector supplier is immune to the challenges of the recession, including reduced profitability, cash flow pressure and lending restrictions. This in turn directly impacts service provision, with knock-on effects to customers, including:
- material delays in service implementation due to reduction in supplier staff;
- service degredation, including supplier failure to upgrade and/or maintain key software;
- supplier refocus on service delivery, to drive payment milestones ahead of budgeted dates;
- lack of investment in service improvement leading to stagnation.
So how can you manage this potential problem?

Traditionally, the financial health of your supplier has only ever been relevant (from a contractual perspective) at the beginning and the end of the contract i.e. you undertake diligence prior to awarding the contract, and terminate in the event that the supplier becomes insolvent. In reality you are likely to have suffered many performance issues prior to your supplier becoming insolvent, with serious consequences for your organisation. You therefore need to consider what other contractual options you may want to rely on in the event that things start to go wrong. 

Contractual Options

There are a number of issues you should consider for your contract, including:-
Square Setting out what you mean by 'financial distress'

There are different signs or triggers that your supplier may be in difficulty. These would include:
- your supplier's credit rating being downgraded below an acceptable level;
- your supplier breaching any lending covenants;
- a fall in your supplier's share price;
- confirmation from a sub-contractor that they have not been paid by your supplier; or
- an action being raised against your supplier for payment of a debt.

Clearly, there is scope for these events occurring on different scales, e.g. a one point downgrading in credit rating, or a two or three point downgrading. You will accordingly want to ensure that any action you take is proportionate to the scale of the distress event that has occurred.
Square What rights do I need once a 'financial distress event' has arisen?

This will depend on the severity (or contractually defined 'level') of the event.  For example:

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in the case of a 'level 1' event, you may wish your supplier to meet weekly, provide updates and a business continuity plan setting out the arrangements in place to ensure continued performance;

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for a 'level 2' event, you may require your supplier to set up Escrow Accounts for any key software or data (to the extent you don't have such a commitment in place already), or to allow for payment of certain 'key' sub-contractors;

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for 'level 3' events, you may require an Escrow Account to be used in other circumstances, for example to cover the cost of the re-procurement of the services by you from another supplier.

Note that these rights are negotiated as additional rights to other rights you may have, such as step-in rights, rights to receive service credits, and termination rights and are aimed specifically at maintaining continuity of service.  Additionally, in many material outsourcings, the financial health of key sub-contractors is equally important, and the provisions can also be extended to include these sub-contractors.
Square Will suppliers sign up to them?

Customers and suppliers are often reluctant to have to thrash out 'what if' clauses, at the stage where both sides are keen to promote their expectations for a positive relationship, with good service delivery. Whilst there is scope in certain circumstances to renegotiate contracts where the contract has suffered repeated or material failures and you may have grounds to terminate a contract, it is usually very difficult to persuade a supplier to renegotiate terms before performance has become catastrophic.  The inclusion of these provisions can ultimately give you greater visibility in relation to your supplier's ability to provide the services and should be promoted as providing a formal mechanism for parties to work together to find workable solutions, and avoid the pain for both sides, of having to terminate. With insolvency on the rise, and suppliers having to compete harder for business, suppliers are being forced to share some of that risk.  As a result, more and more of these provisions are appearing in material outsource contracts.
Square What information is available to keep check on the financial health of suppliers?

There are a number of 'alert services' available which allow you to monitor the financial health of your suppliers. The scope of alerts varies widely, and could include alerts covering for example:
- any change in your supplier credit rating;
- any failure by your supplier to file accounts on time;
- details of any court judgments awarded against your supplier;
- any change to your supplier's credit limit; or
- details of any bankruptcy/winding up proceedings initiated against your supplier.

It is all very well subscribing to these alert services, but without the appropriate contractual rights, you may find there is very little you can do with the information to help secure continuity of service.
A final thought

Ultimately you can't predict when the contract is signed whether your supplier may face financial problems in the future.  Even the most reputable supplier or sub-contractor can find itself in difficulty in today's climate. However, contractual ground rules that set out each party's respective obligations if the worst does happen can help everyone manage the services efficiently, even in the worst of circumstances. They may also keep working relationships from becoming too frayed - this always helps if your supplier survives the distress event and the contract continues on with some time yet to run!

Finally, if the worst looks likely, having access to regular detailed information on your supplier's financial wellbeing, should help you identify more accurately and at an earlier stage in the process, the point at which you may need to start putting contingency arrangements in place.