Small and medium-size enterprises (SMEs) are the lifeblood of the UK economy. According to UK Department for Business, Energy & Industrial Strategy, they account for 50% of the total revenue generated by UK businesses and 44% of the country’s labour force.

Supply chain issues have been making headlines at present, and these issues are unlikely to disappear anytime soon. Many different entities make up a supply chain, including suppliers, manufacturers, freight forwarders, warehouses, distributors, and retailers. These entities facilitate the movement of information and resources around the UK and the world. Broadly, the UK’s current supply chain issues stem from global shortages of materials, staff shortages and transport delays occurring at the same time as sharp spikes in demand, particularly for consumer goods and construction materials.

One of the best ways to mitigate against third party insolvency risk is to be alive to those issues before they happen.  Things to look out for will vary depending on the business you need to scrutinise.  Some key red flags to watch out for include:

• Late payment of invoices/stretching of supplier credit
• Late delivery of goods
• Failure to meet deadlines/deteriorating service levels or quality standards
• Re-negotiating agreed terms such as price/request for money on account/upfront payments or deposits
• Changes in leadership/management team
• Unusually high turnover of staff
• Closures of office/other premises
• Pending winding up petitions/CCJs (there are services that monitor companies for signs of insolvency – court claims/winding up petitions etc.)
• Late filing of accounts
• Level of credit exposure/new security
• Press reports/market rumours/word of mouth warnings about an employer or contractor’s financial position

Even the most seemingly stable of relationships can be at risk. One of the key ways of dealing with potential insolvency issues is to keep an open dialogue with your suppliers and customers. Adequate cash reserves will allow SMEs to manage rising supplier costs without impacting the consumer. Unfortunately, in some cases, SMEs will have no choice but to pass the increases on to the consumer.

For the immediate future, higher prices are expected to be the norm and, as firms look towards different financing options to manage costs and their suppliers, it is vital they maintain an open dialogue with their customers.

Another important aspect of mitigating this kind of financial threat is for SMEs to review their system of working through an adaptation of a business diversification strategy. A means of reducing risk to businesses during times of financial crisis, diversification takes place when businesses venture into new markets or industries. This is a great way for SMEs to compensate on aspects of the supply chain that have declined. Diversification can also be applied to the supply chain. By sourcing new supplier partners SMEs can mitigate supply chain risks even further – the more suppliers on hand, the more available streams for goods to be supplied. Courage and careful planning are key to successful diversification.

Where there are concerns with regard to a customer or supplier, early action is key to avoiding potentially large exposure as an unsecured creditor upon an insolvency.

Key steps can be taken at an early stage, including:

• Reduce risk by undertaking enhanced due diligence before embarking on any new relationship, looking out for any profit warnings or signs that sub-contractors are being paid late. A careful review of the latest accounts may reveal details as to their relative financial health, the status of their project finance arrangements or over-reliance on any key customers;
• Enhancement of protective provisions in your terms and conditions of trade (for example, retention of title clauses and early triggers where financial distress appears);
• As mentioned above, diversification of the supply of key goods and services;
• Audit and inventory of stock held by the customer where title has been retained;
• Recovery action in respect of stock/suspension of credit terms in the absence of payment of outstanding debts;
• Written reminders of directors’ duties/potential personal liability for directors acting in breach of duties to creditors and/or threat of early enforcement action/commencement of insolvency proceedings to apply immediate pressure for payment;
• Procuring payment on account/personal guarantees from third parties for continued supply/ parent company guarantee, or alternatively make use of a retention bond or project bank account to ring-fence funds (or materials in the case of construction)
• Securing provision of relevant financial information; and
• Early engagement with a key supplier in financial distress to identify options to secure continuing supply, including potential financial support to the current supplier or by procuring continued supply from an alternative.

As can be seen, while challenging trading conditions are likely to continue, retailers and businesses in the supply chain can enhance their resilience to supplier and customer distress by being proactive in a variety of ways outlined above. Early monitoring of warning signs and maintaining connection with market intelligence to identify the potential insolvency of businesses in the industry and/or supply chain can and should be used to reduce risk, protect continuity of supply and identify opportunities for strategic acquisition.

As always, the earlier you seek professional advice the better. In doing so, you will be better placed to preserve value, avoid the potentially significant damage that an insolvency can do to your business and importantly, protect your position – not only as a director personally, but also to protect the company’s position as a whole. When insolvency looms, it is worth remembering that the duty to act in the best interests of the company switches to acting in the best interests of its creditors as a whole. All the more reason to seek advice early, not least since pinpointing the time when a director knew or ought to have concluded that there was no reasonable prospect of avoiding insolvent liquidation.

Tania Clench, Legal Director in the restructuring and insolvency team at law firm Cripps Pemberton Greenish