How do you safeguard your interests if you find yourself dealing with a company that enters an insolvency process or is at risk of insolvency, whether as a contract counterparty or in a dispute? Conversely, if you find prospective contract counterparties raising concerns about your company's solvency, what protections might you be able to offer your counterparty in order to continue the relationship?
Although we address the general position applicable to all contract and dispute counterparties, we also look in particular at issues and options arising in relation to supply and distribution agreements, IP (including software) licences, and IP infringement disputes, and at the ways you can potentially leverage your IP rights to improve your position when a counterparty is at risk of insolvency. See here for a more in-depth look at the impact of insolvency on IP licences.
Contract counterparties
If a party to a contract you rely on for your business is at risk of insolvency or enters a formal insolvency process, this may have a material impact on your own operations. The insolvent counterparty may refuse or be unable to perform its obligations or may perform to a lesser standard. The business may be sold to a third party that you would not ordinarily choose to do business with. The contract may expressly provide for the insolvent party to be able to terminate. Even if it does not, a liquidator may be able to disclaim the contract as "onerous property" if it is considered to be an "unprofitable contract".
The insolvency of counterparties to IP licences raises specific additional risks. If your licensee enters an insolvency process, any uncontrolled use of your IP in relation to poor quality goods and services could diminish the value of your IP rights. If the licence is exclusive, your licensee's insolvency may result in no one exploiting and monetising your IP. If your business relies on licensed-in IP, your licensor's insolvency may affect your ongoing ability to use and sub-license material IP in your own business if a liquidator disclaims the licence.
Negotiating contracts with counterparties at risk of insolvency
If you are negotiating a contract with a party that is at risk of insolvency, you may wish to consider putting in place some of the following contractual safeguards. Once a counterparty to an existing contract enters an insolvency process, the steps available to you in respect of any money owed to you will be more limited. If you wish to recover particular assets, or to be able to take particular steps in order to realise the value of the contractual arrangement, you will need to provide for this expressly in your contract. Even then, as well as a liquidator's power to disclaim unprofitable contracts, liquidators and administrators may ignore certain contractual provisions and cause the insolvent company to be in breach, which may result in an unsecured claim against the insolvent company.
You should also bear in mind that liquidators and administrators have broad powers to challenge certain "reviewable transactions" such as "preferences" or "transactions at an undervalue" that alter the balance between unsecured creditors, and courts will set aside arrangements that frustrate the legitimate expectations of unsecured creditors upon a company's insolvency – ie that the claims of unsecured creditors rank equally with each other. Relevant considerations include:
- Security – If the contract creates material liabilities for your counterparty, it may be appropriate for you to take security over your counterparty's assets. In the event the counterparty enters an insolvency process, secured creditors will have claims which generally rank ahead of those of unsecured creditors, giving a greater prospect of recovering the debt and greater control and influence over the insolvency procedure. We address the taking of security over IP rights in particular here.
- Retention of title – If you are a supplier or distributor of physical products, incorporating effective retention of title (ROT) terms into your supply or distribution agreements can also help avoid losses due to a counterparty's insolvency. ROT terms, when effectively incorporated and enforced, will mean that you retain ownership of the products you have supplied and would be entitled to demand their return upon the counterparty entering into an insolvency process. In relation to copyright-protected products, ROT terms can also be helpful if you are the copyright owner to prevent 'exhaustion' of rights, which may provide an additional avenue for you to recover the products following your counterparty's insolvency (see Conditional licences below).
- Step-in rights – If you rely on your counterparty to carry out particular actions, you may wish to provide for a 'step-in' mechanism, so that you can carry out the relevant actions directly if your counterparty cannot do so for any reason. This can be a way of allowing a project to continue so that you can recover the financial returns you expected to receive. For example, if you supply technology, parts or products to a counterparty that finishes and brands the products and sells them on to end-customers, a 'step-in' mechanism could allow you to fulfil your counterparty's sales contracts with end-customers directly and receive the sales revenues upon your counterparty's insolvency. If you are a licensor of IP, you may wish to take over your insolvent licensee's sub-licences and receive the royalties payable under them. However, there are restrictions on what you may be able to do in certain circumstances, for example if there is a moratorium in respect of the counterparty (as discussed further below). There is also a risk that a liquidator or administrator may seek to unwind such transactions.
- Transaction structuring and provisions to acquire assets and IP – Any contractual provision that requires a party to transfer assets (including IP) to a counterparty on insolvency is likely to be open to challenge by a liquidator or administrator. An option to acquire assets or IP for fair market value, exercisable upon a particular trigger event that is not directly connected to insolvency, could be used as an alternative (but would not be free from the risk of challenge or potentially being ignored, even though this would cause the counterparty to be in breach of contract). If you are entering a highly material IP licence, consider structuring the transaction to reduce licensor insolvency risk, for example, by having the licensed IP assigned to a non-trading SPV and then taking security over the shares in the SPV (which may allow you to take possession of (or "appropriate") the shares on enforcing the security).
- Conditional licences – If you are a licensor of IP, consider making the grant of licensed rights subject to and conditional on timely payment of royalties. If your counterparty fails to pay on time in accordance with the agreement, but continues to exercise its licensed rights, you may be able to assert IP infringement as well as breach of contract (depending in part on the type of IP right licensed). For example, if the licence allows the manufacture of products, any products manufactured after the counterparty's failure to pay may be considered infringing products. If the licence allows the sale of physical products protected by copyright, which you supply subject to a retention of title until onward sale to an end-customer, any sale of stock after the counterparty's failure to pay may be considered an infringing activity. If you are able to make out an IP infringement claim, this could provide additional mechanisms to recover products incorporating your IP (see Dispute Counterparties – Leverage your IP rights below).
- Escrow arrangements in software licences – If your business depends on licensed-in software, enter an escrow agreement with the software vendor. The agreement will require the vendor to deposit the software source code with an escrow agent, to be released to you upon the vendor's insolvency or another agreed trigger event. Make sure that the events that trigger release from escrow are sufficiently broad, and that you are granted all of the rights to use the source code that you may need to maintain and update the software in the future. Some escrow agents also offer a validation service to ensure the deposited source code is usable.
- Termination – Expressly provide for a termination right in the event of your counterparty's insolvency (the exact trigger events for which can be subject to negotiation). Consider whether any specific consequences of termination should apply. For example, if you are a licensor of IP, you may wish to require your licensee to deliver to you any unsold stock that incorporates your IP following termination of the licence. However, one of the measures in the recently enacted Corporate Insolvency and Governance Act (CIGA) is to restrict the enforceability of such clauses where the termination is solely as a result of the counterparty entering into an insolvency process, so in future this kind of termination right may be of limited use (see our article for more).
- No assignment – Expressly provide that the benefit of the contract cannot be assigned by your counterparty without your consent, to prevent the contract being sold to a third party following the original counterparty entering an insolvency process – while a sale agreement may still purport to include an assignment of your contract, the assignment will not ordinarily be effective unless and until you provide your consent. If you are a licensee of IP, you may also seek to restrict your licensor's ability to transfer the IP to a third party (although your rights in relation to the third party will depend largely on whether the third party has notice of your rights).
- Put third parties on notice of your rights – If you license-in registered IP, record your licence on the IP register in order to put third party acquirers of the IP on notice of your rights. Security granted over registered IP rights can also be recorded on the relevant IP register, as well as at Companies House for a UK-incorporated counterparty.
- Performance guarantees – Consider seeking a performance or payment guarantee from a member of your counterparty's corporate group or key individual associated with your counterparty.
- Remuneration structure – If one of your counterparty's key obligations is to pay money, consider structuring payment obligations so that a greater proportion of the remuneration is paid up-front, for example a lump sum payment rather than running royalties.
What to do when a counterparty to an existing contract becomes insolvent
If you have an existing contract and your counterparty is at risk of insolvency or enters an insolvency process, you should consider first and foremost whether you have any specific contractual (including security) rights you wish to rely on, eg termination (subject to the CIGA reforms mentioned above), step-in rights, proprietary rights, or security rights. If not, the options available to you may be limited to claiming as an unsecured creditor in the counterparty's insolvency process.
- If you are an unsecured creditor, and before your insolvent counterparty is subject to any formal insolvency process, you could take steps to present a winding up petition or apply for an administration order in respect of your insolvent counterparty. However, your claim would still only rank equally with those of other unsecured creditors, and the resource required to take these steps may not justify the return.
- If you are an unsecured creditor and you do receive notice that your counterparty has or is intending to enter into an insolvency process, you should ensure that you register your claim by submitting a proof of debt so that you receive information, your views are taken into account, and that you exercise your right to vote.
- If you are a secured creditor, you may wish to enforce your security. Depending on the type of security, you may be able to appoint an administrator to the counterparty, or receiver to the charged assets to realise those assets and distribute the proceeds. Once the counterparty enters into an insolvency process, your rights to enforce your security will be more limited, but your claim as a secured creditor will largely rank ahead of those of unsecured creditors.
- If you continue to provide goods or services after your counterparty enters liquidation or administration, the liquidator or administrator may agree to pay for these as an expense of the liquidation or administration – ie you will receive priority payment. If so, you should ensure that you only provide goods and services against an appropriately authorised purchase order or undertaking to pay.
- If you believe you have a retention of title claim to goods held by your counterparty, you should promptly register your claim with the liquidator or administrator and arrange to attend the premises as soon as possible in order to identify your goods.
Dispute counterparties
If you are in a dispute with a company that enters an insolvency process, your counterparty's insolvency could significantly limit your options and your ability to obtain relief. In this scenario, leveraging your IP rights could improve your position by at least allowing you to recover products that infringe your IP, and to have counterfeit products delivered up to you or destroyed. If you are in a dispute with a company that is at high risk of insolvency, you may wish to take steps to resolve the claim and obtain some amount of compensation quickly.
Disputes against insolvent companies
If you are in litigation or are contemplating bringing a claim against a company that enters an insolvency process, first consider the following questions.
Is it cost-effective to pursue the claim?
Unless you have a proprietary right or security interest in respect of the company's assets, your claim is likely to rank equally with those of other unsecured creditors, meaning you may only recover a small amount of the claim. Having a court judgment against the company won't automatically mean that you can recover the debt ahead of other unsecured creditors. However, there may be circumstances where it is necessary to commence or continue a claim, for example, if you are seeking delivery up or destruction of counterfeit or infringing goods or an order for specific performance.
What restrictions may affect your ability to bring or continue legal proceedings, or receive settlement payments?
Broadly speaking, an automatic moratorium or stay will apply in the event of compulsory liquidation or administration, such that no legal process can continue or be brought against the company or its property without the court's permission or consent of the administrator.
Additionally, there is a new standalone moratorium proposed by the CIGA which will be available to companies which are or are at risk of becoming insolvent. In the event of a voluntary liquidation, there is no automatic moratorium but the company or its creditors can apply for a stay of any proceedings.
In the event of receivership or a company voluntary arrangement (CVA), no automatic moratorium applies. However, the terms of a CVA will usually seek to compromise unsecured debts owed by the company. If you have settled a claim but the counterparty is subject to a winding up petition, a settlement payment made by the counterparty after the petition is presented will be void against a subsequently appointed liquidator unless a validation order is obtained.
What are your options if a moratorium or stay applies?
- Engage with the insolvency practitioner – You should engage early with the insolvency practitioner, particularly if you are asserting any proprietary, security, or contractual rights. For example: if you wish to prevent sales of or recover goods which are counterfeit or infringe your IP rights and seek disclosure of records; if you are seeking to recover goods which are subject to an ROT claim to allow you to inspect and identify them; if the insolvency practitioner is intending to sell the business (which may include an assignment of contracts to which you are party); or if it is necessary or desirable for you to commence or continue proceedings against the insolvent company. If your claim is simply as an unsecured creditor, you should still notify the insolvency practitioner of your claim and submit a proof of debt. The insolvency practitioner may adjudicate on claims if they intend to make a distribution to unsecured creditors. If you are not happy with the decision, you can appeal to court.
- Leverage your IP rights – If your claim relates to the insolvent company's use of infringing or counterfeit goods, the insolvency practitioner may be more willing to deliver up the goods (and underlying records) once you have informed them that the goods are infringing and cannot be sold. Remember that goods do not need to be counterfeit in order to be infringing. For example, if you have granted the insolvent company a licence to sell products incorporating your IP conditional on timely payment of royalties, the company will no longer benefit from the licence if it fails to pay on time or if you terminate, and will no longer be able to lawfully sell stocks of the products. To the extent the administrator refuses to engage, you may want to consider the potential personal liability position of the administrator in respect of ongoing infringements.
- Consider whether there are other potential defendants – If you are claiming IP infringement there may be joint tortfeasors (for example, company directors) against whom you can bring your claim, or who can make the settlement payment, instead of the insolvent counterparty.
Disputes against companies at risk of insolvency
If you are in a dispute against a company that is at risk of insolvency, be mindful of the potential consequences of insolvency (as set out above). One of the first things to do when pursuing a company is to check it has the financial resources to pay the amounts you believe are owed. You should continue to check the financial health of the company on an ongoing basis. Take proactive steps to ensure you are notified of any changes by setting up an alert on Companies House to follow the company (free of charge) and monitor the Central Registry of Winding-up Petitions and London Gazette.
If you are already in a dispute with a company at risk of insolvency, and the company is, as a result, not engaging fully in the litigation process, there may be steps you can take to quickly resolve the claim. Consider whether any 'unless orders' can be applied for, on the basis of non-compliance with court orders or the Civil Procedure Rules. If proceedings are in the early stages and statements of case are being filed, note the implications of the other side's failure to file an acknowledgment of service or defence. It may be possible to apply for default judgment (make sure a certificate of service has been filed for the claim form first).
There may also be grounds for a summary judgment application, which would result in an enforceable costs order. Note that where a moratorium applies, this will also apply to the enforcement of judgments. To capitalise on any costs awarded, be sure to complete the relevant enforcement process before the counterparty enters into an insolvency process (or has a winding up petition presented against it).
