Insolvency Special Report: Chain reactions

The shift to a just-in-time model of supply has seen businesses achieve greater efficiencies, but has also left them vulnerable to the downturn. Alastair Lomax and Dan Kelmanson explain what to look out for to protect your business from the ‘weakest link’

Insolvency Special Report: Chain reactionsAs the ripples of global ­recession spread from the front line in retail, property and ;construction ;to ­manufacturing, more UK businesses are having to face up to the ­reality that the links in their supply chains are being stretched to breaking point.

During the past 15 years, business (and particularly manufacturing) in the UK and globally has increasingly shifted to a low-stock, just-in-time model of supply. In relatively benign economic conditions ­businesses have achieved greater ­efficiencies by rationalising their supply arrangements through the use of increasingly ­sophisticated and integrated systems. By outsourcing ­specialist expertise – often globally – ­businesses have outsourced risk and used the global market and exclusivity terms to drive down prices.

However, all this has come at a cost. Exclusivity and tough pricing have forced many suppliers to become leaner, more reliant on volume ordering and, as a consequence, more vulnerable to the downturn.

In the current economic climate, long integrated supply arrangements have become fragile, leaving manufacturers ­particularly exposed. In these difficult times the buyer’s risk has become the risk of the weakest link in the chain. The failure of one link can have significant impacts on the customer, such as increased management time, disruption, delay, inefficiency and, ultimately, increased costs.

In some cases the knock-on effects can include penalties and breach-of-contract claims from customers and, possibly, ransom payments from the insolvent supplier, ­particularly if its supply is business-critical.

The administration of Woolworths is a case in point. The subsequent sudden cessation in supply was hugely disruptive for customers of the company’s market-leading DVD distribution business Entertainment UK. In at least one instance a retail ­customer was reportedly forced to suspend online sales because of stock outages at a time of peak pre-Christmas sales activity.

In a worst case scenario, the insolvency of one link could create a ‘domino effect’ of insolvencies both up and down the supply chain. The downturn in the automotive industry recently led to the administration of parts supplier Wagon Automotive. Without the support of a key customer, Sonas ­Automotive, a major supplier to Wagon, quickly followed it into ­administration.

Warning signs

So what can businesses do to protect ­themselves in this environment? Forewarned is forearmed, and there are often early ­warning signs for those who are vigilant. Missed deliveries, requests for deposits or payments up front, unexpected price rises or attempts to renegotiate pricing or terms, and silence and aversion tactics are all signs of a supplier experiencing difficulties.

Gossip and market intelligence must be treated with caution, but can also provide valuable information on the position of a supplier. A reduction in credit insurance cover, county court judgments and winding-up petitions are all clear indicators of serious problems. Such information is available from a variety of sources, both formal and informal, from public registers such as ­Companies House to credit agencies and fellow customers. Sometimes the word even comes from staff on the shop floor who have not been paid that week.

It is one thing to spot the signs of supplier distress and another to use that information effectively. Prior to any insolvency, and indeed from the start of the relationship, the ­customer should ensure that it is dealing on robust contract terms, particularly as regards the passing of title, set-off, withholding and direct payment, payment and performance security (including bonds and guarantees) and, crucially, termination.

To the extent possible, the customer should also conduct ongoing due diligence ­(commercial, legal and financial), ­systematic risk assessment and contingency planning which may prove invaluable in the event of supplier insolvency, and take action to reduce exposure early.

If a supplier goes bust, the first thing to establish is whether the insolvency ­practitioner (IP) will trade on and whether you wish to deal with them. If trading is to continue, customarily the IP will seek to exclude set-off against payment of further supplies, and the cost of secured supply may involve price rises or ‘loss sharing’ ­payments. It is worth considering ­alternative strategies such as acquiring the supplier’s business, if this would achieve a better outcome than costly support (which includes payment of the IP’s fees). If ­termination is preferred, the focus will be on enforcing any proprietary claims to paid-for stock and other materials such as tooling. If there is any other security, this will also be key to mitigating potential ­exposure.

Many businesses have reaped the benefits of just-in-time supply arrangements. ­However, the particular vulnerability of ;these ;arrangements ;to ;current market ­conditions may have catastrophic ­consequences throughout the chain. In this climate it is likely to be those businesses that have thought ahead and prepared for the worst which will avoid becoming hostages to the misfortunes of the weakest link in the supply chain.

Alastair Lomax is a partner and Dan ­Kelmanson a senior associate at Pinsent Masons