COVID-19 impact: managing insolvency risk and financial reporting

Increased insolvency risk

Profit warnings across a broad range of sectors have been increasing steadily since 2015. Unfortunately, we anticipate this trend to continue this year and beyond.

Uncertainty surrounding Brexit and mounting global trade and growth concerns were already causing consternation even before the COVID-19 outbreak. Businesses are now reviewing how to manage widespread disruption to supply chains, and how to continue trading for example in the face of lack of availability or delays to supplies. For many businesses, already under pressure, the impact of this further disruption may be more than they can bear.

The issue goes far beyond companies with obvious links to China. Companies in all sectors are beginning to report on the negative potential financial effects of COVID-19 on first quarter revenues. Airlines, hotels and others in the travel and leisure sector are coming under particular strain. Luminous Cruise and the Fujimiso Hotel in Japan were among the first reported to file for bankruptcy as a direct result of COVID-19, while airline Flybe has been forced to enter into administration.

Considerations for businesses and officeholders include:

Financial reporting

• The Financial Reporting Council (FRC) issued guidance for companies and auditors in February 2020 regarding COVID-19 risk disclosures. The FRC emphasised the need to provide up to date and meaningful disclosures when preparing year end reports.

• A particular consideration is whether to refer to the possible impact of COVID-19 in reporting on principal risks and uncertainties. Steps being taken to mitigate the risks should be included.

• Consideration should be given to whether additional impairment testing needs to be undertaken and whether leases have become onerous.

• The FRC noted that recent events would likely represent non-adjusting post balance sheet events for year end as at December 2019, but final year balances may be affected for those with other year end dates.

• Disclosing risks to the market can exacerbate liquidity problems and prompt creditors and shareholders to take action. Companies face a difficult challenge in meeting and satisfying their obligations to report and anticipating the potential effects. The terms of disclosures should be carefully considered.

UK regulated entities

• The FCA has released a statement on COVID-19. 

• All firms should have contingency plans in place to deal with major disruption events.  The FCA is actively reviewing the contingency plans of a wide range of firms, including in relation to operational risks and the steps firms are taking to serve and support their customers.

• Firms need to take steps to identify critical business services and functions and how they can continue to deliver those services if the business is significantly disrupted.

• Firms are expected to take all reasonable steps to meet their regulatory obligations, even in circumstances where alternative working arrangements might be in place and a large percentage of employees are off sick. This includes:

  • continuing to enter orders and transactions promptly into the relevant systems;

  • continuing to use recorded lines when required; and

  • ensuring staff continue to have access to the compliance support they need

• The FCA has no issue with alternative working arrangements if these minimum standards can be maintained.

Increased scrutiny of business decisions

• It is worth reminding directors of their duties at times of financial distress. For example:

  • they may need to take account of creditors' interests, as opposed to promoting the success of the company in the sole interests of its shareholders

  • they should take advice at an early stage to avoid entering into transactions (eg preferences and transactions at an undervalue) which could later be unwound by a liquidator if the company later enters into insolvency

• The moment at which directors should start to consider creditors' interests can be a very difficult thing to gauge in practice. In BTI LLC v. Sequana the Court of Appeal clarified  that the duty arises, "when the directors know or should know that the company is or is likely to become insolvent". It may be appropriate to increase the frequency of management accounts and internal financial reporting and to seek advice on solvency.

• Directors' duties can continue after the company has entered into an insolvency process, as confirmed by the decision in Hunt (as Liquidator of System Building Services Group Ltd) v Michie & Ors.  

• For directors, asset managers, employers, auditors and professional services providers there may be a heightened risk of claims as difficult decisions and judgment calls may need to be made.

• All entities should ensure that their contingency plans, and any steps taken in response to the economic impact of the virus, are documented, providing a clear trail so that firms can justify their actions in due course.

Protecting your business in the face of COVID-19

Key steps for businesses to minimise risk at times of distress include:

1) Risk of fraud

• At times of financial strain and business disruption, the risk of fraud can increase. Auditors will be acutely aware of the present climate and difficulties that businesses are facing as a result of COVID-19. For example, there may be an increased temptation for individuals to falsify revenues to meet targets or ratios.

• Businesses also need to be alert to opportunistic fraud by cyber-criminals using false communications about the unfolding situation.

2) Commercial and Business contracts

• Firms should review key contracts for applicable termination provisions, clauses regarding delay, notice provisions and "force majeure" clauses. See our article on "force majeure" clauses and the doctrine of frustration here.

3) Loan and credit agreements

• Firms should review any loan and credit agreements carefully, and well in advance of reporting deadlines. If terms may be breached a plan can then be formulated and advice taken. Engaging with lenders early can often lead to a better outcome than trying to ignore or deny obvious risks.

• In particular:

  • Covenants: Can loan covenants continue to be met? If there is likely to be a breach, lenders could demand a right to accelerated repayment. Whether the loan covenant has been breached may be open to interpretation, or the lender may have absolute discretion. Take advice on the likely interpretation of the clause. If there is a breach, consider whether the breach can be remedied or whether a waiver should be sought from your lender. Timing could be everything. If a waiver is not secured before year-end, accounts may need to reflect a change in the nature of the loan from a non-current to current liability.

  • Events of Default: Check the wording of events of default clauses, including whether COVID-19 could give rise to such an event that would allow a lender to call in a loan

  • Material Adverse Change: Check any Material Adverse Change clauses. MAC clauses can be found as isolated clauses or, for example, within representation, covenant or event of default clauses. Whether or not the MAC clause could be triggered by COVID-19 will be a matter of interpretation in each case.

  • Representations: Check any representations made and whether there is any requirement to update representations on a continuing or periodic basis, and whether any of these representations may no longer be true and accurate as a result of COVID-19.

4) Insurance

• Review policies carefully to check coverage.

• See our article here covering insurance considerations regarding business interruption cover, event and contingency cover, D&O, construction and professional liability.

5) Do you need to seek formal or informal protection from creditors?

• A company can seek to protect itself from creditors in a number of ways. Those include informal agreements, raising additional finance, restructurings and formal insolvency procedures (including some which provide for a moratorium on claims against the company's assets). A detailed account of these different options is outside the scope of this note but our highly experienced Restructuring and Special Situations team can assist.

6) Consider ongoing litigation

• If the company is involved in ongoing litigation, is there an increased risk that your opponent will soon become insolvent?

• If you are the Defendant, consider whether you should apply for security for costs. If you do make such an application for security, or already have security in place, check what effect the order for security would have in the event of insolvency - many orders for the payment of security will not rank ahead of other unsecured creditors meaning that you may still be left with little protection on costs.

• If you are the Claimant, consider carefully your enforcement strategy. Can other related parties, with a lesser risk of insolvency, be included as Defendants?

• Consider the terms of any after the event insurance policies and how they may be affected by the insolvency of one of the parties.

• Does the current climate create an opportunity for settlement? Consider carefully with advisers whether any payment made by way of settlement could be challenged as an unlawful antecedent transaction in the event of insolvency and what protections it might be possible to put in place in any settlement agreement.

7) Reputation management

• If you feel that stories are being published which are unfairly damaging your company, our reputation management experts can help with online and print media strategies including advice on potential defamation, malicious falsehood and/or harassment claims.