Robert Russell, partner at DLA Piper – discusses Supply Chain Disruption: The Risk of Key Supplier Insolvency

In a globalised market place in which business supply chains are becoming increasingly complex, the risk of supply chain disruption can be substantial and have wide ranging effects on businesses operating across all sectors. The financial failure of key suppliers can trigger significant business interruption which may prejudice the timing and budget for project delivery, impact on customer service, cause loss of revenue and reputational damage and increase operating costs.

While there can be a number of causes for business interruption including natural disaster, adverse weather, product quality incidents and IT outages among others, "supplier financial failure" was cited as the most commonly occurring risk by a report commissioned by Zurich in 2012, and the insolvency or financial distress of key suppliers continues to be a significant risk for UK businesses.

Following the previous recessions of the 1980s and 1990s, corporate insolvency figures increased significantly once the economy returned to growth. While the traditional 'insolvency lag' has been less evident following the emergence from the most recent recession, businesses who have survived may now find themselves vulnerable to supply chain disruption caused by supplier financial failure as the market becomes more buoyant, potentially leading to a risk of overtrading by key suppliers. In addition, businesses which have focussed on cost cutting exercises - such as emphasising lean practices, outsourcing and increasing reliance on global supply chains in order to make short term savings throughout the recession - may now find that weaknesses in their supply chain structure begin to emerge as key suppliers are tested by improving market conditions.

Following a worldwide survey of over 500 risk managers and corporate insurance experts, a report published by Allianz in January 2015 ranked business interruption and supply chain risk as the top dangers currently faced by companies for the third year in a row, yet considers them to be the second most underestimated risk by companies themselves. In 2012, a report commissioned by Zurich found that while 70% of UK manufacturers ranked their supply chain as critical to their business; only 49% had reviewed and monitored supply chain risk at Board level.

The integrity of the supply chain is of critical importance to businesses operating in the manufacturing sector, but is equally relevant to businesses across a broad range of industries including construction, retail, telecoms and technology, hospitality and leisure and healthcare. Regardless of the nature of the business, underestimating the risk of business interruption caused by the insolvency of crucial suppliers can come at a substantial cost. Failing to deliver against contractual requirements or customer orders can trigger significant damages claims that can dwarf the overall value of the relevant supplier contract. For a principal contractor this can mean material financial and reputational loss and can lead to additional irrecoverable cost and management time being required in order to mitigate the situation.

As a major acquirer of services, a principal contractor can exert significant commercial leverage over key suppliers, thus securing clarity on the financial integrity of the supply chain, the attitude of secured lenders and the potential trading dynamic for that supply chain member over the course of a contract. Contingency planning may include consideration of termination options, third party retention of title issues, loss mitigation and potential counterclaims.

By recognising the importance of preserving supply chain integrity throughout the life of the contract, taking a proactive and robust approach to key suppliers from the outset and reacting quickly when supplier financial distress becomes evident, there is scope for businesses to significantly mitigate the risk and effect of a supplier insolvency and reduce overall business and insurance costs.