A creditor’s guide to dealing with a distressed company

Why should a creditor be vigilant when dealing with a company in financial distress?

A company in financial distress poses a significant risk to its creditors. The company will have a limited pot of money with which to pay its creditors, meaning that it is unlikely to be able to pay all creditors in full, or at all.

The further the company slips into financial distress, the less chance a creditor has of being paid in full, or recovering the goods or services they have supplied. This is a particular problem for unsecured creditors, who are the last to receive payment under the priority rules contained in the Insolvency Act 1986 (IA).

However, when a company is in financial difficulties, but not yet formally insolvent, a creditor has several options available to them that might help to minimise the risks of doing business with a distressed company, and protect themselves going forward.

Here are five things to consider when you are dealing with a business in financial difficulties:

1. Terminating the contract

The first step to take as a creditor is to review the contract for the supply of goods / services to see if you can terminate the contract as a result of the company’s financial difficulties. Termination clauses often have several possible triggers, which may include: (A) the formal insolvency of one party; (B) threatened cessation of trade; (C) their inability to pay debts under s123 IA; or (D) even a material adverse change in one party’s circumstances.

It is important to understand how any termination clause works and if it has been triggered by a party’s financial difficulties, and to be mindful of the Corporate Insolvency and Governance Act 2020 (CIGA 2020), which restricts the ability to terminate contracts when a company enters an insolvency process.

It is, therefore, often unclear if the termination clause has been satisfied, and the consequences of terminating the contract when you are not entitled to do so can be serious, as you may be in repudiatory breach of contract and liable to pay damages for wrongful termination. If you are entitled to terminate, be careful to comply with any notice periods for termination.

Terminating the contract is not always the best course of action. In some circumstances, the company may genuinely be experiencing temporary cash flow difficulties. Where this company is a key customer, it may be beneficial to continue to support them and help them trade out of financial difficulties, which will allow you to eventually be repaid in full.

Terminating the contract in these circumstances may force the company into further financial difficulties, which reduces your chance of receiving payment. It is important to carefully consider this option as if you are entitled to terminate the contract and do not do so, you may be treated as having affirmed the contract and lose your right to terminate on these grounds in the future.

2. Re-negotiating contract terms

If you continue to supply the contracting company with goods / services, re-negotiating the terms on which you do so can be extremely beneficial to you as a creditor by reducing your exposure to the possibility of non-payment.

Examples of changes to make may include:

• Shortening the time for payment to be made, perhaps payment in advance or on delivery
• Including a term providing you with the right to suspend deliveries or services in the event of non-payment
• Including or improving any Retention of Title provisions.

3. Guarantees

Obtaining a personal guarantee from the director(s) of the contracting party or a related company will strengthen your position as a creditor (assuming the guarantor remains solvent). This is because the financial health of the contracting party does not affect the creditor’s ability to call on the guarantor for payment.

The creditor has two options where the contracting party is in financial distress: (A) pursue the company for payment of the sums due under the contract; or (B) pursue the guarantor for the contractual sum they guaranteed.

The creditor can pursue both parties in parallel to maximise their chances of being paid in full. Even if the contracting party is wound up or dissolved, this does not affect the creditor’s ability to pursue the guarantor under the terms of the guarantee.

4. Applying pressure

Attempting to get a company in financial distress to pay you the sums you are owed in full can be difficult. Threatening to apply to the court for a winding up petition or threatening to refuse to supply any more goods / services could persuade the company to settle the debt in order to keep the company going. However, you need to be mindful of the risk that such a payment could be clawed back by a liquidator as a preference payment. For more information on preference payments, read our previous article here.

In any event, this option should be considered carefully as it is likely to do long-term damage to the trading relationship between the parties, and can drive the company into insolvency if unsuccessful, which would reduce your chances of being paid even further.

5. Continuing to trade – retention of title rights

If you are continuing to supply goods to a company in distress, retention of title rights may protect you in the event of the company’s insolvency. Retention of title rights prevent title in goods passing to the buyer of the goods unless and until the buyer pays for them. This means that if the company has not paid for the goods, they do not belong to the company.

This prevents them from being used to pay off other creditors as they do not form part of the insolvent estate. Ideally, any retention of title clause will include the following features, for example:

• A requirement for the buyer to keep the goods separate from other similar goods and to ensure that any identifying features on the goods are preserved
• A licence for the seller to enter the buyer’s company premises to retrieve the goods
• Specific drafting to avoid the clause being too wide and construed as a charge over the company’s assets, in which case it will be void and unenforceable.

If you do have the benefit of a retention of title clause in your contract and the company enters into a formal insolvency process, you should notify the insolvency practitioner of your right to retrieve your goods as soon as possible, in order to avoid the goods being used or sold on to a third party.

Conclusion

Ultimately, the best thing you can do to protect your business from a counterparty’s financial difficulties is to be proactive. This should include carrying out effective due diligence at the outset into a potential customer’s financial history and that of its directors, and any companies associated with its directors or the business (including previous insolvency issues).

This will help you to determine their creditworthiness and ability to pay your invoices. It is good practice to collate as much information as possible about your potential customer from the outset, as this will increase your chances of successfully recovering a debt.

Our experienced and dedicated team at Thomson Snell & Passmore are here to help explain your options and the most cost effective steps to take in your circumstances.