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Contracting Against InSolvency

March 2009

Businesses face many challenges in what has become a difficult economic climate, one of which is a key supplier becoming insolvent. As the second part of Kemp Little’s three-part series focussing on insolvency, we will be considering some of the practical measures that a customer purchasing goods or services can take during the contracting process to deal with the risk of its supplier going into liquidation.

Due Diligence - Prior to entering into a contract with a supplier, due diligence should be undertaken to verify, to the extent possible, the supplier’s credit worthiness. Diligence can vary from carrying out public searches to obtaining a credit reference from the supplier’s bank. If the searches indicate that the supplier is in distress, the customer should consider securing an alternative source of supply or, if goods are being provided by the supplier, building up its inventory.
Performance Bonds and Guarantees - Depending on the importance of the supply arrangement, the customer should consider requiring a third party to provide assurances as to the performance of the supplier’s obligations. This could take the form of a performance bond from a bank or, if the supplier is a subsidiary of a substantial parent company, a parent company guarantee.
Payment Terms; and Minimising Financial Exposure – When negotiating the payment terms of a contract with a supplier, the customer should consider providing for charges to be paid in arrears or for a shorter period in advance than would otherwise be the case. If the customer pays a sum in respect of the future delivery of goods or performance of services and the supplier becomes insolvent before delivery or performance, it is unlikely that the customer will recover this sum in full (if at all). In negotiating the payment terms, the customer should remember that by paying in advance it may help the supplier avoid insolvency and that, as a matter of market practice, certain services (for example, annual maintenance and support) are usually paid for annually in advance.
Rights of Set-Off – A customer should consider including a term in its contract with the supplier which allows it to set-off any amounts for which it is liable to the supplier against any amounts owed by the supplier to the customer. If a supplier goes into liquidation the rules of insolvency set-off will come into play and displace any right of set-off in the contract (unless the set-off is exercised prior to the winding up of the supplier). Given this, it is important that contractual set-off operates before the winding-up of the supplier. Set-off where a company is in administration is considered in the previous article in this series.
Title and Risk – Customers should, if possible, ensure that ownership of goods passes upon delivery. If the contract is silent, the basic rule under English law is that title in the goods will pass when the parties intend it to pass. However, there are no rules to determine when title passes if no contract between the parties can be ascertained[1] . Unless the parties agree otherwise, risk in the goods will pass at the same time as title to them passes[2].
Termination – As a contract (including an IP licence) will not, as a matter of law, automatically terminate upon a supplier’s insolvency, the customer needs to consider the length of the contract, and the circumstances in which it has the right to terminate. If the contract survives the supplier’s insolvency, the customer could find itself in a situation where it has ongoing obligations (for example, to make payment) but the liquidator or administrator of the supplier has chosen to decline performance of the supplier’s obligations[3].

The customer also needs to bear in mind that if the supplier is in liquidation, the liquidator has the power to disclaim “onerous property”[4]. Onerous property includes an unprofitable contract. If the liquidator disclaims a contract, the other party will have an action for breach of contract but will join the list of unsecured creditors with its claim for damages. If the contract is disclaimed and it includes a licence of IP, the customer is likely to retain the right to use the IP, subject to making any payments that are required[5].
Consequences of Termination: Ownership of assets – In addition to requiring the return of customer owned assets on termination, the customer should consider whether ownership of any of the supplier’s assets (for example, hardware, know-how or intellectual property) needs to be assigned to the customer on termination (or earlier). Such an assignment could take a number of forms including a conditional assignment[6], trust[7] or a suspended assignment[8]. Also, security over the assets could be taken. There are often compelling tax, accounting or commercial reasons why an assignment or taking security is not feasible.

Even if an assignment is feasible, when structuring the terms of the relevant agreement the customer needs to bear in mind that the assignment might be characterised as a preference or a transaction at an undervalue and, therefore, liable to be set aside by a court[9]. Also, the assignment will need to take place before the commencement of the winding up of the supplier.

Coupled with this, the customer needs to consider whether post-termination services such as training are required. If the supplier has already invoked insolvency proceedings, the customer will, from a practical perspective, only be able to require that such services are provided if employees remain with the business.
Software/Intellectual Property Rights – Where the customer has taken a licence of IP which is of significant value to it, and the IP is not subject to an assignment, it should carefully consider what pre-emptive steps can be taken to protect itself against the supplier’s insolvency. The customer should also consider how it can gain access to the software, work product and other intellectual property rights used by the supplier to perform the services, for example, through appropriate licence terms. If bespoke software is being provided by the supplier, the customer may also want to consider entering into a tri-partite contract under which the supplier is required to deposit the source code to the software (and any relevant updates that have been made to the software)[10] with a reliable and reputable escrow agent such as the NCC Group.
Transferring Employees – In the situation where services provided by a supplier are transferred to a customer or a replacement supplier upon termination of a contract (e.g. for insolvency) there is a risk that the ‘transfer’ could constitute a transfer for the purposes of the Transfer of Undertakings (Protection of Employment) Regulations 2006 (a TUPE transfer). If this situation did amount to a TUPE transfer, then the employees currently providing the services are likely to transfer to the customer or replacement supplier (as applicable) by operation of law, together with their associated liabilities. Whether this situation would in fact amount to a TUPE transfer will depend on a variety of factors which will need to be considered at the time. In addition, it may, depending on the answers to these questions, be possible to rely on certain carve-outs to the normal TUPE rules. The customer should ensure that the contract addresses the potential application of TUPE. Obviously, in the event of insolvency of the supplier, any indemnities (or similar) from the supplier may be of little value.

If no TUPE transfer has taken place, a customer may want to consider including a term in the contract which allows the customer to offer key personnel who have a detailed knowledge and understanding of the customer’s business a position within the customer’s company.

Conclusion

Given the current economic climate, customers should consider reviewing key supplier contracts in light of the points we have raised above in order to understand the extent of its exposure to those key suppliers upon their insolvency, and any resulting business risk.

If you have any questions or would like to discuss anything in this article in more detail, please contact Charles Claisse, Chris Middleton or Rebecca Anderson at Kemp Little LLP on 020 7600 8080.

[1]Sections 16-20, Sale of Goods Act 1979.

[2]Section 20, Sale of Goods Act 1979.

[3]In these circumstances the customer would need to make an application to court for rescission of the contract.

[4]Section 178 of the Insolvency Act 1986..

[5]A disclaimer only operates to release the supplier from its onerous commitments.

[6]A conditional assignment operates so that ownership of the assets is transferred to the customer with an explicit provision for the assets to be transferred back in the future.

[7]If a trust were created, the assets would be held by a trustee on terms such that on certain events occurring the trustee may transfer legal ownership of the assets to the customer.

[8]A suspended assignment operates so that the assignment is triggered when certain pre-defined events occur.

[9]See sections 239 and 238 of the Insolvency Act 1986.

[10]Any source code that is deposited with the escrow agent should be accompanied by relevant design documentation and functional specification to ensure that a reasonably competent computer programmer is able to understand the source code.