Brexit – preparing for financial uncertainty

United Kingdom

This article was produced by Olswang LLP, which joined with CMS on 1 May 2017.

While views on the long term impact of a Brexit continue to be debated, the short term impact is somewhat clearer. Coming at the same time as a period of global economic volatility, the fact of the vote itself is having a detrimental effect. Last month, the IMF cut its growth forecast for Britain for this year to 1.9 per cent, noting that the uncertainty caused by the referendum was already hurting the domestic economy. There can be little doubt that investment and other key decision making is being put on hold.



In this climate, it might be seen as surprising that a poll published shortly after the IMF’s warnings indicated that three quarters of the UK’s FTSE 250 companies had not discussed contingency planning for a possible Brexit(1). Companies and their directors should also be aware that while they might have done their contingency planning, their business partners, suppliers and customers, might not be so prepared.



In this article, we consider some of the practical contingency planning that companies might consider at this time, to prepare for possible distress among their key counterparties.


Insolvency

In the UK, the point of financial insolvency is not a precise concept (unlike the position in other European jurisdictions) and the duties of directors at this time are also not prescriptive. It is therefore possible to be dealing with parties in a state of insolvency for some time, potentially without knowing it.



There are two generally accepted statutory insolvency tests which may be applied in corporate insolvency cases. A debtor may be said to be insolvent if:



(a) it is unable to pay its debts as they fall due (known as the “cash flow” test); or



(b) the value of its assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities (known as the “balance sheet” test).



The cash flow test is concerned, not only with whether a debtor is able to pay its debts that are immediately due and payable, but also with debts falling due from time to time in the “reasonably near future”. Once the court has to move beyond the “reasonably near future”, any attempt to apply the cash flow test will become “completely speculative” and the balance sheet test becomes the “only sensible test”.



The balance sheet test is not whether the debtor has reached “the point of no return”. Nor will it be satisfied by simply checking whether the debtor’s most recent balance sheet shows that its liabilities exceed its assets. Instead, the test requires the court to decide whether, on a balance of probabilities, it has been established that, looking at the debtor’s assets and making proper allowance for its prospective and contingent liabilities, it cannot reasonably be expected to be able to meet all of its liabilities. The burden of proof lies with the party seeking to satisfy the test.



Neither test is an exact science. It can therefore be difficult to identify whether your counterparts might be insolvent, but specialist advice can be sought to assist is spotting the signs. This also means it is important to adequately protect yourself against the risk of counterpart insolvency, by having properly drafted and structured contracts.


What can be done to contractually mitigate the risk of counterparty insolvency?

The impact on your company of a business partner or counterpart becoming insolvent can be significantly diminished by the terms of the contract that governs your relationship with them. There are several factors to consider when looking at whether your contracts contain sufficient protections against counterparty insolvency, including:


  1. Whether appropriate insolvency related triggers have been included – these need to capture not just all insolvency and insolvency related processes that could be relevant for the counterparty but also any steps taken towards such insolvency processes. The contract should also include appropriate information undertakings. This will enable you to be aware of financial difficulty early and consider you options and/or take action before the company is put into a formal process;
  2. Some more technical considerations around whether retention of title and/or set off apply. If you are supplying goods to another business it should be clear that ownership of those goods stays with you until you have been paid in full, and should restrict the counterparty's ability to deal with the goods in the event of pending insolvency. In relation to set off, although the insolvency set off rules are mandatory and cannot be contracted out of, the way any set off mechanics are drafted can affect the amount you can recover;
  3. Developments in legislation mean that the protection of essential supplies for insolvent companies has been extended and now includes various IT supplies and private suppliers of basic utilities. The new legislation renders some of the standard contractual protections ineffective where the insolvent party enters into administration or a company voluntary arrangement. If the services your business provides are caught by the essential supplies legislation you can ask the office holder to personally guarantee the payment of any charges in respect of the supply during the insolvency. Failure by the office holder to give a guarantee means you can terminate the contract by written notice. There are other limited circumstances in which you may be able to terminate your contract with an insolvent counterparty, and the termination provisions should be drafted with these in mind to give you the maximum options should counterparty insolvency occur.

Olswang can offer a high level audit of your material contracts and provide a colour coded report summarising your exposure to counterparty insolvency risk. If this might be of interest, please click here or for more information or to discuss further please contact one of us.

For more information, please contact:

Alicia Videon
Partner
London

Julian Turner
Partner
London

Emma Bardetti
Senior Associate
London

Caroline Dodman
Associate
London

_______________________

(1) survey conducted by the Chartered Institute of Internal Auditors