Are You And Your Clients Ready To Deal With The Growing Threat Of Zombie Firms?

Gregor Kleinknecht and Anastassia Dimmek of Hunters Law LLP explain what zombie firms are, how to recognise them, and how to manage associated risks. 

Zombie firms (“ZFs”) are not a new phenomenon; they have haunted economies around the world for decades, most notably Japan in the 1990s. In the UK, their numbers have seen a significant increase since the Covid pandemic struck: government incentives intended to help companies to weather the effects of the pandemic have contributed to growing their numbers and artificially prolonging their life within the economy. 

What are ZFs?

ZFs are companies which are unable to cover debt servicing costs from current profits over an extended period of time and therefore cannot invest in future economic growth; they are artificially kept alive by Covid support schemes and low interest rates. On the surface, ZFs can continue to look like healthy companies and continue to attract business from customers, suppliers and partners. However, many observers anticipate that a wave of ZFs will enter insolvency and die once interest rates increase, inflation starts rising and government support schemes are phased out.  ZFs appear to be more prevalent in certain industries, such as the arts, entertainment and recreation sectors, which have been worst affected by the pandemic.  

The Coronavirus Business Interruption Loan Scheme, Coronavirus Larger Business Interruption Loan Scheme and Bounce Back Loan Scheme of 2020 offered government-backed loans to companies of varying sizes, saving many businesses from insolvency.  The Recovery Loan Scheme, which replaced them in April 2021 (likely to run until December of this year), was intended to help businesses recover during a post-pandemic transition period.  While these schemes may have fulfilled their purpose for many companies, they also provided the ideal breeding ground for ZFs. Insolvency statistics show a drop of 35% in overall company insolvencies in April 2021 compared to April 2019.  

Equally, the amendments made by the Corporate and Insolvency Governance Act 2020 to existing legislation, especially the Insolvency Act 1986 and Companies Act 2006, have the side effect of keeping ZFs afloat.  A new statutory moratorium process and restructuring plan procedure attempt to rescue companies as a going concern, while some provisions of the Act invalidate contractual termination clauses in certain circumstances. The Act’s temporary measures in relation to the wrongful trading liability of directors and the presentation of winding-up petitions lasted until June 2021.

Aside from stifling the economy’s vitality (which would normally see the redistribution of resources and capital to financially stronger and more flexible competitors), ZFs are a danger to unaware business partners, who may not only be faced with non-payment of invoices, but also a potential claw-back of historic payments once a ZF enters insolvency.  

How to recognise potential ZFs and manage the risk

Tools for recognising and managing the risk of dealing with potential ZFs range from publicly available information at Companies House, to a review of contractual clauses of existing commercial trading agreements. There are many red flags which a diligent business can identify in existing relationships with a potential ZF. By remaining in close contact with trading partners, it becomes easier to spot when things are not going well: deteriorating staff morale, low stock levels, erratic payments, requests for longer payment terms, falling profits or a change/resignation of directors and key personnel can all be early indicators of growing financial difficulties.  ZFs can also become more contentious and involved in disputes as they struggle for survival.  

A review of publicly available information and records filed at Companies House can reveal whether a charge or security over assets has been created, and a look into the submitted annual accounts can highlight increasingly tight margins and growing exposure to creditors.  However, this should be a first step only, considering that the information could be nine months old by the time it is filed at Companies House and may no longer reflect a company’s current financial situation.  

The best way for companies to protect their business now is to have a hard look at their contractual arrangements: do they already incorporate or can they be amended to include credit and payment terms for cash in advance or on delivery?  Is it commercially viable to shorten the period for payment or insert the right to suspend deliveries for non-payment?

It is important to assess the strength of existing retention of title clauses to ensure that the goods delivered will not form part of the insolvent estate once insolvency proceedings commence, and examine whether the contractual termination provisions stand up to scrutiny.  

While businesses may primarily fear a non-payment of invoices by ZFs, they also need to be mindful of the risk of potential claw-backs of previous payments made to the trading partner as either a debtor preference or a transaction at an undervalue during possible later insolvency proceedings.  It is crucial to collate a paper trail of evidence showing that any payments made to a creditor by a financially troubled company arose from genuine commercial pressure, rather than a preference over the company’s other creditors.

Enforcement after Brexit

For companies from the EU, which deal with potential English ZFs, and vice versa, the post – Brexit litigation regime has made it harder to enforce European judgements in the UK, and UK judgements in Europe. The Brussels Regulation (Recast) is no longer applicable, and tools such as the European Order for Payment are also no longer available. The effect of the Brussels Regulation (Recast) was to provide clarity and greater speed by governing which court had jurisdiction in civil and commercial disputes and ensuring the recognition and enforcement of foreign judgements. 

While the UK still recognises exclusive jurisdiction clauses under the Hague Convention in B2B contracts, the scope of the Convention is much more restricted than that of the Brussels Regulation (Recast).  For instance, interim measures such as injunctions and freezing orders do not benefit from reciprocal recognition in the EU anymore.  

Furthermore, foreign insolvency regimes work differently and often grant other forms of protection than businesses are accustomed to in the UK. The practical difficulties posed by the new litigation environment make it all the more important to assess existing business relationships realistically and recognise warning signs early – as well as having a thorough review of contractual relations now.

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