Countering counterparty insolvency

by Hogan Lovells

Hogan Lovells

These days, the threat of counterparty insolvency looms over the energy sector: whether it is a natural disaster or precipitous decline in the price of oil, perhaps no industry is more susceptible to the financial decline and potential default of contracting parties. 

The high volatility of valuations, the priority of senior creditor rights against unsecured suppliers, and the restrictions on enforcement actions in most jurisdictions can make protection of rights against a defaulting supplier or co-venturer challenging. Of particular importance is the effect on executory contracts, which can allow the debtor to assume or reject your contract, often on its own timetable, requiring you to perform while the decision is made. It is important to take proactive steps to protect against the potential for customers, suppliers or joint venture partners seeking insolvency protection, whether protection is sought in the United States, Europe,  Africa or Asia. 

In the United States, Chapter 11 of the Bankruptcy Code is often utilized by large companies (whose management can continue to manage the company during the bankruptcy) to reorganize company debts with the ultimate goal of returning to normal business operations. Chapter 7, in contrast, provides for the liquidation of a company under the supervision of a court-appointed trustee.

Many non-US jurisdictions lack a reorganization scheme similar to chapter 11, offering only trustee-managed liquidation proceedings akin to a U.S. Chapter 7. These are frequently initiated for the benefit of secured creditors, with unsecured creditor recoveries limited to the resulting surplus, if any, after the secured creditors are satisfied. In recent years, however, some countries, both in Europe and Asia, have begun adopting elements of U.S. Chapter 11 into their own insolvency laws. Critical differences in the insolvency laws of various countries remain, however, and when your counterparty is a multinational company, you may face multiple proceedings in different jurisdictions, each with its own unique set of laws and procedures.

To address these multinational jurisdictional concerns, many countries have adopted the Model Law on Cross-Border Insolvency promulgated by the United Nations Commission on International Trade Law (UNCITRAL). Under the Model Law, a company files a main proceeding, typically in the debtor’s home country, and one or more ancillary proceedings in other jurisdictions where it has assets or creditors. The U.S. has adopted the Model Law as Chapter 15 of the Bankruptcy Code and the Model Law has also been adopted (with certain variations) in the United Kingdom, Australia, Canada, Mexico, Colombia, Chile, Singapore, Romania, Serbia, South Africa and several other countries.

Identifying financially distressed suppliers and joint venture partners can be difficult, but the more obvious warning signs include: a company unexpectedly increasing or decreasing its orders; resisting cash-calls; conserving and stockpiling cash; requesting amendments to contract terms; or modifying its lending arrangements. However, there are also operational warning signs that can be indicative of distress: a company’s increasing reliance on affiliates; high staff turnover/employee layoffs; or changes in key managers or officers. Early preparation, constant attention and quick action at the first sign of trouble are critical to mitigating the costs of a business partner suffering from financial distress.

The best insolvency protections are created at the outset of the commercial relationship at the contracting stage. Proper identification of the adequacy of your counterparty’s assets is important. It may be equally important to ensure that performance and obligations are guaranteed by a solvent affiliate. A contract encompassing a broad range of events of default increases the ability to take protective action before the crippling effects of complete financial distress occur, and, depending on the applicable insolvency laws, could allow for creditor termination of the agreement. Beyond general contract provisions, the laws of most countries recognize anticipatory breach and enforcement of commercial remedies, such as the rights of sellers to stop delivery and recall goods en route to the buyer or to reclaim goods after the buyer has received them should they discover the buyer to be insolvent.   

In addition to foreign insolvency laws, even within the US, the applicable state laws designated in the contract may significantly impact the determination of a creditors’ claim, its priority status, or whether it can be assumed by a debtor, even beyond the impact of federal bankruptcy law.

Jurisdictions also vary significantly in the ability of an insolvent company to “claw back” payments made to creditors prior to seeking relief under applicable insolvency laws. For instance, the U.S. Bankruptcy Code allows insolvent debtors to avoid preference payments made within 90 days of the bankruptcy filing, with a few key exceptions – the most notably being contemporaneous exchanges for new value, which are not considered preferential payments and therefore are immune from claw back and payments made in the ordinary course of business between the creditor and the debtor. Other jurisdictions apply different tests to what constitutes payments susceptible to claw back. In China, for instance, the preference period is 6 months but, to the benefit of creditors, the bankruptcy administrator must prove that the debtor was insolvent during the preference period.

As always, anticipating warning signs, tailoring contracts to provide as much protection as possible, and thinking through potential remedies under the laws of the different jurisdictions in which your counterparty operates are critical to mitigating losses from insolvency. 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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