Published on 10 December 2010 by Tony Groom

Many directors are afraid of terminating contracts and agreements when their companies are in financial difficulties normally out of a concern that termination will lead to a cancellation payment that the company cannot afford.

If a company is experiencing fewer orders or lower sales, for example, generally it will need fewer staff but the worry is that terminating contracts of employment will trigger costs that include payment to cover the notice period, redundancy payments and possibly payment of other contractual liabilities. Terminating contracts with senior staff is often very expensive due to the compensation for their loss of additional benefits often negotiated as part of their employment package.

Similarly, a reduction in orders may mean that the company only needs two of the five fork lift trucks it has where terminating a hire purchase, hire or lease arrangement ahead of the agreed contract period will trigger a termination settlement or a contract termination liability. Many of the standard hire contracts only discount the early settlement by 3% per year.

Equally it might now no longer be able to afford the 12-month advertising contract it agreed six months previously. Even terminating contracts with advisers can be expensive. One was the provision of human resources support by a national PLC that had a termination clause requiring 60 months notice.

A company in financial difficulties does not have the surplus cash to meet these obligations.  But while it puts off terminating arrangements that it no longer needs it continues to bear the costs, which is the reason many companies are in gradual decline as they slowly run out of money.

However, it is often better to cut the cash flow if this reduces costs that mean the business is viable: profitable with positive cash flow. There are remedies that can be used if necessary to deal with the crystallised liabilities when a company cannot afford them

It may be understandable that the business does not terminate the monthly hire or staff costs if it feels it does not have the money to pay the termination costs, but equally continuing to pay for the additional fork lift trucks might be at the expense of other creditors, for example HM Revenue and Customs (HMRC), unless orders return and sales increase to the point where those additional staff or trucks are needed again.

The issue is business viability and often this is a false hope. While the company is carrying the additional costs the business is not viable and too often directors are putting off dealing with onerous contracts and arrangements.

How can a company deal with this dilemma? Everyone may accept with hindsight that the early action would have avoided the problem building. However, it is with good reason that businesses often put off terminating such contracts especially when they believe they are about to get the order that justifies keeping the additional capacity.

Actually, the directors need to take steps to deal with this if they wish to avoid business collapse and running out of cash so that they can no longer trade.

Negotiating terms for informal arrangements with creditors is sensible. It may involve negotiating terms of payment, such as a Time to Pay (TTP) arrangement with HMRC for PAYE or VAT arrears, which have been very effective in helping companies out of insolvency. However, the problem is that the company will have to make payments out of future trading and if it has not looked at cutting other costs to help it return to profitability it won’t be able to afford to keep to its TTP arrangement with HMRC.

Many companies leave it far too late to reach informal arrangements that would have allowed them to terminate contracts before the company finally runs out of money.

There is a solution that allows companies to terminate contracts and not pay for them immediately on termination. A Company Voluntary Arrangement (CVA) avoids liquidation of the business and closing it down. It allows for paying the contract termination out of profits.

However, it can also be used to compromise the debt, for example by paying less than 100p in £1. An HMRC TTP is only allowed at 100p in the £1, whereas a CVA allows for less than that and can be stretched beyond the 12 months maximum the HMRC normally allows for a TTP where CVAs allowing for payments over five years are not uncommon.

Rescheduling payments through a CVA can mean paying as little as 30p, 40p or 50p in the £1, as long as the payments are realistic and affordable. CVAs provide a real opportunity for companies to terminate contracts, including hire agreements, employment contracts and office leases.

For a company in difficulty enlisting the help of a business turnaround and rescue adviser to establish whether it has a viable core, produce a plan for stabilising then rebuilding,  and help it to negotiate informal arrangements to pay creditors or formal ones via a CVA can make all the difference between a business surviving or going under.