Key commercial considerations when dealing with a distressed company in a public sector contract

It is not uncommon for businesses that public sector entities are in contract with to face financial difficulties during the life of the contractual arrangements. Indeed, given the current political and economic landscape, this is unfortunately a problem we are seeing more and more public sector entities faced with. When such a scenario arises the public sector has to decide whether to provide financial assistance and/or some other type of relief to the distressed counterparty or let fate take its course.

If a contract is of strategic importance to the public sector or if the public sector simply takes the view that it wishes to help the distressed entity so as to try and mitigate any losses of its own that may arise in an insolvency situation then the public sector may be inclined to offer assistance. Such assistance may involve agreeing to waive any existing breaches of contract; agreeing to defer or increase or accelerate payments to be made to/by the public sector under the relevant contract or going so far as agreeing to loan to or invest money in the distressed entity.

Any offers of assistance must of course be carefully considered against the relevant circumstances but from our recent experience we would highlight some key commercial considerations for public sector entities when making such decisions:

• if payments to be made to the public sector under the contract are to be deferred what are the “new” payment terms being offered i.e. when will the deferred payments be made and what instrument will be used to deal with the deferred payment arrangements i.e. we have seen deferred payments being turned into loan notes as opposed to just simply being dealt with by a contract variation; will default interest still be applied or is it to be disregarded or will a new higher interest rate apply;
• if the contract price is to be increased or payment accelerated is this justified and what would be the risks of the same?;
• similarly, if a loan is to be made what will the terms of the loan be i.e. repayment terms; interest rates; any security package e.g. the taking of a floating charge or standard security or parent company guarantee etc; will it be convertible to equity?;
• ranking arrangements – if the distressed entity already has loans in place from a bank or other entity (including shareholders) ranking arrangements may need to be considered;
• what, if anything, is the public sector being offered as an incentive or “thank-you” for providing such assistance e.g. in some deals we are seeing warrants (entitlement to shares) being issued to the public sector and other incentives such as the ability to appoint an observer or director to the board of
• the distressed entity; and a prohibition on dividends being paid until certain conditions are met; and
• do any other contractual terms in the underlying contract need to be varied?

Clearly the above list is not exhaustive and any commercial decisions must also be assessed in accordance with any applicable procurement and state aid rules and relevant vires rules. For example, the variation of a contract would need to fall within the permitted modification scenarios set out in the procurement regulations otherwise there is a risk the modification contract could be deemed to constitute a direct award of a new contract (and which should be procured). State aid tests would also require to be applied to any proposed assistance.

Deciding what the best course of action is when dealing with a distressed entity can be complex and as such we would recommend early advice is taken when faced with the same so as to ensure the best possible outcome for the public sector and the public purse.