In the current climate of economic uncertainty, businesses need to consider the risks they face in dealing with other parties. Whether you are a customer or a supplier, there is a risk of business interruption or an inability to collect funds or goods owed if a counterparty is in financial stress. This paper outlines some of the matters that businesses should consider when contracting with third parties.
Right to terminate on insolvency
It is important to ensure that any agreements you enter into contain an appropriate right to terminate for insolvency. What is "appropriate" will depend on the circumstances.
The definition of "insolvency" should be sufficiently broad to enable you to terminate the agreement as soon as an event occurs that could lead to the counterparty actually becoming insolvent. The earlier you are able to terminate an agreement entered into with a distressed company, the greater your ability to reduce the risk of exposure.
Alternatively, you do not want a counterparty to obtain a termination right against you based on insolvency in circumstances where in fact you are not insolvent. This can arise where the insolvency clause is drawn too broadly (eg. insolvency is triggered where a statutory demand is merely served on you, rather than where you have failed to comply with it).
Expiry of contracts / not strictly applying contractual terms
Parties often continue to do business with each other following the expiration of the agreement they have entered into. In times where you might want to exercise rights against the counterparty, having adopted the above course can be problematic. This is because it can lead to uncertainty as to the actual terms of the contract that exist post expiration of the written agreement. In particular, as there is no applicable written contract to refer to, it can be easy for rights not to be strictly enforced or to be overlooked, and for new rights or obligations to come into existence as a result of the conduct of the parties. If you are continuing to transact post the expiration of a contract, or have contracts approaching the expiration of their term, new agreements should be negotiated, or extensions to the existing agreements agreed, to avoid this uncertainty risk.
In the recent buoyant times, parties to contracts may not have enforced strictly certain terms of that contract which have been included for their benefit. For example, they may be allowing a counterparty 45 days credit rather than the 30 days strictly required under the agreement. It is important to assess whether you have adopted any such practices, as doing so, and continuing to do so, may jeopardise your ability to rely on the strict terms of the contract and potentially increase your level of exposure to your counterparties.
Exercise of termination rights
Almost certainly your contracts provide you with rights to terminate in certain circumstances. In tough times, you may find that you need to rely on these rights. Care needs to be taken in doing so. There are many factors which, if not complied with, could lead to a notice of termination being ineffective. These factors include: assessing whether the type of default is one that leads to a right to terminate; whether the default entitles immediate termination or only after giving notice; the form of such a notice and its content; the period of notice required to be given; and when and how that notice can be given. Making an error in respect of any of these factors may invalidate the termination or, worse still, lead to you being in default for having unjustifiably terminated the relevant agreement. Accordingly, it is important to obtain advice before acting to terminate an agreement.
Exclusivity clause / force majeure
Businesses that have entered into exclusive supply arrangements with suppliers for key products or services should carefully monitor the financial stability of their supplier. If your exclusive supplier were to fail, that could have a significant knock–on-effect on your operations (consider the issues the car industry has faced in recent times due to parts suppliers closing unexpectedly). Accordingly, caution should be exercised before entering into exclusive arrangements in these times. Consideration should be given to whether it is necessary or appropriate to enter into exclusive arrangements - having more than one supplier can allow for business continuity. If commercial reality necessitates entering into exclusive supply arrangements, you should ensure that your exclusivity obligation is drafted such that it allows you sufficient flexibility should the supplier subsequently fall into financial difficulty.
Additionally, suppliers often have the benefit of force majeure clauses – clauses which allow their obligations to be suspended where events beyond their control prevent them from performing. Such events may include the insolvency of a third party they are reliant on. You should be mindful to ensure that if one of your suppliers is subject to such an event, the contract provides you with sufficient flexibility so that the event does not unduly impact on your business (rights to obtain alternate supply or to terminate). If you are a supplier, you should also ensure that you have the benefit of such a clause in case you are prevented from performing by events beyond your control.
Retention of title clauses
A retention of title clause entitles the vendor under a sale contract to retain title to the goods until the purchaser has paid the full purchase price for those goods, thus protecting the vendor. More sophisticated versions of these clauses can operate where the goods have been used in a manufacturing process or to trace the proceeds of the sale of the end product manufactured using the goods. To increase the likelihood of being able to successfully rely on a retention of title clause, it is critical that they are carefully drafted and that certain supportive procedures and practices are adopted in the supply process – failure to do so may mean the clause is ineffective. For example, these types of clauses should contain an express licence to enter the purchaser's premises to collect the goods if they are not paid for.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.