The failure of a business’ critical supplier can have ramifications beyond a stop in supply. In many cases, counterparty failure leads to an internal crisis mode as managers, legal counsel and directors attempt to navigate ‘what next’ amid speculation on how the situation snuck through the cracks.

A recent McGrathNicol review and investigation into the events surrounding the collapse of a strategic partner to a major Australian regulated entity has highlighted the importance of undertaking appropriate counterparty due diligence both during the sourcing and negotiation phase and the ongoing life cycle of the contract. This applies to all contracting including procurement, partnering (e.g. joint venturing), capital projects and mergers & acquisitions (M&A) transactions.

In this example, the counterparty provided a range of IT and other services critical for the operations of one of the regulated entity’s business units. The supplier was chosen from a competitive procurement process and the documented terms of the supply agreement saw monitoring in the form of Service Level Agreements (SLAs) and Key Performance Indicators (KPIs), reported on at least monthly.

However, despite what appeared to be well documented monitoring obligations, the sudden collapse of the counterparty some 12 months into the contract with little to no advance warning to the regulated entity had immense ramifications for:

• day-to-day operations including the business unit’s immediate continuity;
• financial performance (the loss was many millions);
• the entity’s reputation with its customers and other stakeholders; and
• legal and potentially regulatory action.

So how was the counterparty risk missed? Our subsequent review identified there was insufficient interrogation of information during the procurement phase, the counterparty became too familiar to the regulated entity, there was limited rigor around reviewing and testing both operational and financial reporting and early warning signs of financial distress (including failure to report regularly) were overlooked. In short, there was no due diligence conducted to control for counterparty risk.

Ideally, a strong counterparty risk management framework driven by thorough and appropriate financial and other due diligence will help drive prosperous contracting arrangements. At the very least, it will allow you to be ‘what next’ ready when contracts are not executed as planned.