Fashion retail: Strengthening your business against supply chain disruption and customer insolvency risk

The onset of COVID-19 has precipitated and accelerated substantial change for businesses in fashion retail, adding to particular headwinds already facing the sector in the UK. While many brick-and-mortar fashion retailers were already experiencing challenging trading conditions at the start of 2020 – ranging from rent and rates overheads to increased online competition – restrictions on and changes to consumer preferences resulting from the pandemic have intensified the challenges facing many fashion retailers and businesses operating in the supply chain.

The UK’s government-mandated lockdown signalled immediate cash flow impacts for retailers forced to shut their stores and re-position for remote outlet channels which, in turn, has had a knock-on effect for businesses in the supply chain. It is no surprise, therefore, that several retailers in this sector have been forced to turn to insolvency processes in recent months, and there is potential for further financial distress in the coming period as temporary government support measures and tax deferral arrangements are withdrawn and deferred liabilities become payable. Meanwhile, there is uncertainty as to how consumer confidence and disposable income levels will hold up as we enter Q4 and move into 2021.

In addition, new UK legislation (the Corporate Insolvency and Governance Act 2020) brought into force in June has rendered ineffective the operation of a range of contractual clauses in both new and existing supply contracts which a supplier would commonly expect to rely on in a customer insolvency/restructuring scenario. It is likely that many suppliers will only be alerted to this new position when next seeking to enforce those terms, expecting that they will operate effectively, as they had previously (see further details below).

Nonetheless, the industry continues to evolve and adapt quickly to a substantial shift in retail trends. There are significant opportunities for businesses to enhance value by implementing effective protections against disruption from supply chain shock and the adverse financial impact of key commercial customer distress. Well-positioned fashion retail businesses will also have the potential to seize strategic opportunities to enhance their offerings and implement operational efficiencies by being alert to competitors and supply chain businesses facing insolvency.

Enhancing resilience

Businesses in the sector are advised to protect themselves by (i) taking early action to critically assess their potential exposure to supplier and customer insolvencies; (ii) reviewing whether legal protections in supply contracts may be ineffective in light of new legislation; and (iii) implementing enhanced legal and operational protections. Specific legal and operational planning and ongoing monitoring processes, tailored to the jurisdictions in which the operations/exposure may arise, will significantly mitigate the risks of customer or key supplier insolvency, increase optionality from an early stage and enable resulting business costs to be minimized.

This article outlines a number of legal and practical solutions within the legal and operational toolkit for manufacturers, suppliers, retailers and other businesses in the fashion retail supply chain to enhance their resilience to supplier and customer distress, mitigating potentially costly risk of disruption to supply and financial loss from key supplier failure.

Warning signs of supplier/customer financial distress

Businesses in this sector should implement structures to identify warning signs of counter-party distress, including:

• delayed payment/stretching of supplier credit;
• re-negotiated payment terms sought/requests for deposits and upfront payments;
• store and office premise closures;
• deteriorating service levels;
• spurious/unjustifiable claims;
• county court judgments (CCJs), late filing of accounts, withdrawal of credit insurance, pending winding-up proceedings;
• auditor’s reports subject to qualifications;
• new/additional security being granted to an alternative funding provider;
• market rumor/industry specific challenge/ external shock;
• over-leveraged business; and
• significant changes in management.

Corporate Insolvency and Governance Act 2020

The Corporate Insolvency and Governance Act 2020 came into law in June and affects a number of typical rights and protections of suppliers:

• The legislation precludes the operation of a range of supplier contractual rights where they arise by reference to a customer entering an applicable insolvency process (e.g. a right to terminate supply). Additionally, a supplier’s rights are effectively suspended if they arise in relation to a breach of contract by the customer which occurred before the commencement of the customer’s insolvency procedure, to the extent that such rights were not exercised by the supplier before that date.
• The legislation applies to supply contracts irrespective of when they were entered into (i.e. retrospectively to existing contracts) and the changes are relevant to all businesses, including those of financial good standing, with UK supply operations to customers. The prohibitions operate widely in respect of commercial supply contracts with only specific contract types excluded under the legislation.

Options to protect your goods/exposure customer risk

• Review supply terms for UK operations and consider revision if the current provisions (notably termination and related rights) may be rendered ineffective under the Corporate Insolvency and Governance Act 2020 upon the customer’s insolvency.
• Retain title to goods supplied until all payments due from the customer are made – robust contractual retention of title provisions properly incorporated in supply contracts can be very valuable for a fashion retail business which seeks to mitigate its exposure to the potential insolvency of its customers.
• Consider periodic ongoing monitoring of the following:
  • Have customer accounts been filed on time?
  • Have any CCJs/winding up proceedings been commenced?
  • Has there been an audit of stock segregation conditions at customer premises where the customer is holding goods supplied which are not yet paid?
  • Is credit insurance available?
• Review of financial position and payment terms.
• Monitor and review level of credit exposure.

Supplier Risk

• Is the supplier key to your supply/production operations?
• If the supplier ceased trading, what alternatives would be available, at what cost and within what timeframe?
• Monitor potential knock-on impact on your ability to deliver an onward supply contract.
• In the event of supplier distress, would that provide an opportunity to acquire assets/bring part of production required for your business in-house?

Early action to recover assets/obtain payment

• 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:
  • enhancement of protective provisions in your terms and conditions of trade (for example, retention of title clauses and early triggers where financial distress appears);
  • 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/guarantees from third parties for continued supply;
• the taking of security and guarantees to elevate and enhance creditor rights;
• securing provision of pertinent 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.

Proactive action and opportunity

As can be seen, while challenging trading conditions in this sector are likely to continue, retailers and businesses in the supply chain can enhance their resilience to supplier and customer distress by taking the proactive steps outlined. 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.