Weakest link

Supply chain failure is an area of huge concern for businesses in this climate of global economic downturn. As the ripples of the recession spread from the front line in retail, property and construction into manufacturing, and with many businesses being dependent on goods, parts and services imported from overseas, nobody can hide from the effects of the economic crisis. As a result, more and more UK businesses are waking up to the reality that the links in their supply chain are being stretched to breaking point.

Customers exposed

During the past 15 years, business (and particularly manufacturing) in the UK and globally has shifted increasingly 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 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 price.

All this has however 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. 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; dealing with the issue can be a huge drain on financial and management time, and result in disruption in production lines, delayed deliveries to other customers, inefficiency and, ultimately, increased costs.

In some cases the knock-on effects can include penalties, breach of contract claims, and possibly even ransom payments to the insolvent supplier if their supply is business critical. In a worst case scenario, the insolvency of one link can create a devastating “domino effect” of insolvencies both up and down the supply chain.

The administration of Woolworths is a case in point. The subsequent sudden cessation in supply was hugely disruptive for customers of its market-leading CD and DVD distribution business, Entertainment UK. Zavvi had an exclusive supply agreement with Entertainment UK, and at a time of peak sales activity pre-Christmas, they were forced to suspend online sales and ultimately ended up in administration.

The UK and European automotive industry recently witnessed the administration of parts supplier giant, the Wagon group. Having lost the business of a key customer, Sonas Automotive, a major supplier to Wagon, quickly followed into administration.

The warning signs

So what can businesses do to protect themselves in this environment? There are often early warning signs for those who are vigilant. Missed deliveries, requests for deposits or up-front payments, unexpected price rises or attempts to renegotiate pricing or terms, and silence and evasion tactics, are all signs of a supplier experiencing difficulties. Gossip and market intelligence must be treated with caution but can also provide valuable information. A reduction in credit insurance cover, court judgments or decrees, and winding up petitions, are all clear indicators of a serious problem.

Such information is available through a variety of sources, formal and informal, from searches of public registers at Companies House and the Central Registry of Winding Up Petitions at the High Court (or in Scotland at the Court of Session and the sheriff court of the sheriffdom in which the company’s registered office is situated), to credit agencies and fellow customers. In Scotland a search of the Register of Inhibitions and Adjudications would also be advisable. Sometimes the word even comes from staff on the shop floor who have not been paid that week!

If the risk of supplier insolvency appears increased, it may be an idea to start building up stock levels, in order to buy time in the event of an interruption in supply. The customer should also look at the possibility of re-sourcing and the lead times involved – though care should be taken not to breach existing contracts by seeking to re-source).

Be prepared

There are various steps which can help a customer identify risks in their supply chain arrangements. An audit should be done of their supplier list, identifying those critical to the business. It should be considered how quickly, easily and at what cost these suppliers could be replaced. Further, to the extent possible, the customer should conduct ongoing commercial, legal and financial due diligence, systematic risk assessment and contingency planning.

From the very start of the relationship (prior to any insolvency issues arising), it is vital to check the applicable contractual terms, particularly those that will apply in the event of insolvency. The customer should ensure that it is clear which terms apply (i.e. that there are not multiple versions in circulation), and that these have been signed by both parties. The customer also should ensure that the contractual terms are robust, particularly as regards the passing of title, set-off, withholding payment, payment and performance security (including bonds and guarantees), and crucially, termination.

Termination clauses should be drafted carefully to ensure that the customer can terminate the contract immediately upon an insolvency event. Likewise “insolvency events” should be defined widely enough to catch events which occur prior to commencement of formal insolvency processes, such as the various forms of diligence, distraint in England, enforcement of security, issuing of winding up petitions, and filing of a notice of intention to appoint administrators, to give the customer maximum flexibility.

If possible, the terms should allow the customer to access real time and useful financial information on the supplier so that the customer can monitor the risks involved with continued trading. The customer should also try to incorporate terms which allow for the recovery of tooling, intellectual property or other essential materials or information which may be in the possession of the supplier in the event of supplier insolvency.

Finally, customers need to ensure that they have effective lines of communication internally. Whilst customers may have robust terms of supply in place, and all the vital information they need on their key suppliers, this will not assist unless the information reaches the attention of the right people within the customers’ organisation.

Crunch time

It is one thing to spot the signs of supplier distress, but it is another to be able to use that information effectively. If a supplier goes bust, the first thing to establish is whether the insolvency practitioner (IP) will trade on and whether the customer wishes to, or needs to, deal with them. If trading is to continue, customarily the IP will seek to negotiate new contract terms and exclude set-off against payment for further supplies. Accelerated payment terms may also be sought, and the cost of securing supply may involve price rises. The IP may also seek to enter into “trading agreements” or “loss-sharing agreements” with customers, so that the customers bear some or all of the trading costs of the business in exchange for continuity in supply.

It is worth considering alternative strategies such as acquiring the supplier’s business out of insolvency, if this would achieve a better outcome than costly support via a trading agreement.

If alternative supply is available and termination is preferred, focus should be on enforcing any proprietary claims to paid-for stock and other materials. If there is any performance or 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 the 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, and know how to deal with the worst case scenario if it happens, that will avoid being hostages to the misfortunes of the weakest link in their supply chain.