Energy Suppliers in Crisis – The Legal Issues

The current energy crisis is well-publicised, with Suppliers of Last Resort (SoLR) being appointed in respect of six energy suppliers within the last 21 days, and Bulb Energy (supplier to over 1.7 million consumers) reported to be “racing to secure its future” and exploring new sources of funding.

Wholesale gas prices have risen to unprecedented levels in recent months and are now trading at approximately five times their level of two years ago. A perfect storm of global and socio-economic events – including shutdowns in the US, depleted domestic gas reserves, a reduced flow to the UK from Norway, Russia and Continental Europe, high demand from Asia, a significant fire at Britain’s main subsea electricity cable with France, the resumption of business after COVID-19, the aftermath of Brexit resulting in the UK being more exposed to higher prices than its European counterparts and a number of other national and international factors – has led to price increases. The UK seems to be particularly exposed in this regard.

While consumers are momentarily protected by the energy price cap, energy suppliers – particularly those without sufficiently robust hedging arrangements to protect against supply price fluctuations and smaller suppliers without resources to fall back on - are contending with their obligations to continue to supply at the low tariffs promised to customers whilst ultimately purchasing wholesale energy at significantly increased prices. All this further compounds the increased costs resulting from the impact of COVID-19 throughout the previous 18 months.

The current crisis poses a number of practical, commercial, legal and regulatory issues within the energy sector of which a variety of stakeholders need to be conscious. Below, we summarise the regulatory regime in place when energy suppliers face financial distress and consider the key issues for such stakeholders:

Supplier of Last Resort / Special Administration Regime

The insolvency of energy suppliers is highly regulated, with the intention of the key regulatory regimes being to protect the interests of consumers in order to ensure a continuity of supply, notwithstanding any supplier failure, whilst also attempting to promote competition in the energy supply market.

The “Supplier of Last Resort” (SoLR) regime can be invoked in the first instance by Ofgem as an alternative to the pursuit of a special administration order.

In prescribed circumstances, a failing supply company is under a statutory obligation to notify both the Secretary of State and the Gas and Electric Markets Authority that it is unable to pay its debts (i.e. that it is insolvent). Similarly a secured lender proposing to appoint administrators or enforce its security in respect of a supply company is obliged to notify both the Secretary of State and the Gas and Electric Markets Authority of this intention. Administrators cannot be appointed, nor can any chargeholder enforce its security, within a 14 day period following such notification. If a solvent, distressed sale of the supplier’s business is not capable of being achieved within this initial period, Ofgem may either:

1. appoint a Supplier of Last Resort; or
2. (if a Supplier of Last Resort cannot be appointed), apply to court for an Energy Supply Company Administration Order.

These two options are hierarchical – if a SoLR can be appointed, Ofgem will not pursue a special administration order. Instead, if a SoLR is appointed, the failing supplier’s licence will be revoked, such that it is no longer a regulated business and can instead be subject to an “ordinary” administration (or liquidation) process. Ofgem will generally apply to court for a declaration that the relevant supplier is insolvent and that its licence can therefore be revoked. This process was followed in relation to six UK energy companies which have recently collapsed into insolvency.

Ultimately, however, if a SoLR cannot be appointed, Ofgem has the power to seek the appointment of administrators pursuant to the special administration regime. In practice, the special administration regime has never been used and is likely only to be pursued in the case of a large energy supply company. News reports have suggested, however, that Ofgem sources have indicated that it may be necessary to use the special administration regime should a supplier the size of Bulb fail¹.

Supplier of Last Resort

Under the SoLR regime, Ofgem can direct any gas or electricity supply licensee to take over responsibility for a failed supplier's customers - i.e. to be a Supplier of Last Resort. Ofgem generally will consider the extent to which the proposed SoLR could supply the additional customers without prejudicing its ability to supply existing customers and will take into account those suppliers who, amongst other things, volunteer for the role, have sufficient credit cover, have arrangements in place to source the additional gas and electricity and have the capacity to operate the relevant change of supplier processes in order to minimise disruption to consumers.

Where possible, Ofgem will give potential SoLRs early warning that a SoLR situation may be imminent. Such warning notices may include the total number of domestic and non-domestic gas and/or electricity supply points and the likely energy volume commitments required.

Whilst Ofgem will endeavour to appoint a SoLR that has consented to the role, ultimately its power to appoint a SoLR can be exercised without the replacement supplier’s consent – albeit there is likely to be reluctance to take such an approach for the obvious reason that, if there is no willing SoLR, this must be because the customer base to be transferred is wholly unprofitable and would cause loss to any SoLR who took it on.

Given the criteria of the SoLR procedure – particularly the preference that suppliers are able to operate the change of supplier processes efficiently and quickly, have adequate arrangements in place to deal with customer queries and have sufficient cover – it may be considered to prefer the “Big Six” suppliers. This is likely now to be the case even more given one particular sting in the tail of the SoLR regime – namely, that the SoLR must assume the credit position owed by the failed entity to a customer. Given that energy usage goes up in winter and down in summer, consumers that pay by direct debit (as a lot of suppliers require) will be in credit by September/October. It is therefore inevitable that the SoLR regime will prefer those suppliers whose balance sheet can absorb such credit balances.

A SoLR does have the ability to make, with Ofgem’s consent and only where the SoLR has not waived such right as part of the SoLR bidding process, a Last Resort Supply Payment claim², though even if such a claim were successfully made, the absorption of credit balances would still pose a significant cashflow issue for the SoLR in question in the interim, and any such claim would doubtless take considerable time to conclude³.

Special Administration Regime

Where Ofgem is unable to complete the SoLR procedure such that customers are transferred, Ofgem may then seek a special administration order. The regime amends the general administration process set out in the Insolvency Act so that the usual objectives (which, provided the company cannot be rescued as a going concern, prioritise the return of value to creditors) are disapplied to ensure continuity of supply to the consumer. This is achieved in particular by requiring that the administrator ensure that “energy supplies are continued at the lowest cost which it is reasonably practicable to incur” until the company is rescued, sold or its supply activities are transferred to another company. Similar regimes are in place to protect the supply of water and railways services.

Issues for Suppliers of Last Resort

Ofgem discretion to compel a SoLR

Historically, suppliers have been competitive about taking on the customers of failed suppliers and their concern has been that Ofgem’s decision will be to not appoint them as SoLR, meaning that they have lost an opportunity to quickly grow their customer book. In the current circumstances however, there may be no suppliers willing to be SoLR, given the requirement to take on any credit balances owed to customers (arising due to direct debit arrangements and the time of year) whilst continuing to supply at a pinchingly low fixed cap and with wholesale prices still high. It is therefore possible that a supplier will be ordered to take on a customer book and such a supplier might therefore seek to challenge Ofgem’s decision, potentially via an application for judicial review. This process is, however, subject to strict time limits.

Where judicial review is not considered viable, depending on each individual case, there may still be options to seek to recover any losses flowing from such a process from various entities or individuals, for example, industry participants or directors of the failed business. Issues concerning insolvency set-off, equitable set off and subrogation may also arise.

In light of the number of distressed suppliers, there will no doubt be a number of potential SoLRs who would be willing to accept a transfer of the customers. However, whilst the SoLR process will deal with the transfer of customers, due consideration will need to be given to the additional assets/infrastructure/data that will need to be acquired from the failed supplier in order to enable the new customer base to be efficiently subsumed. Typically such assets can be acquired out of the failed supplier's subsequent insolvency process, which will can commence once its licence has been revoked and the SoLR process is complete.

Data protection risks

Incoming suppliers should also be alert to future litigation risk: the large volume of data and reads that underpin industry flows and are vital in a SoLR process are ripe for challenge and, given the volume of customers and sums involved, minor discrepancies can lead to significant potential exposures. It is therefore important to ensure compliance with applicable data protection legislation in relation to consumer data. The following measures help to minimise data protection risks:

• Be clear, open and honest with consumers about how and why their personal data will be used. Provide clear and accessible privacy information, including informing the data subjects that their personal data is to be transferred to a new controller, information on what personal data is processed, what it will be used for, and who it will be shared with.
• Ensure personal data processed is kept secure and confidential.
• Carry out due diligence in relation to the transferred personal data to ensure that personal data processed is accurate and up-to-date.
• Limit the nature and volume of personal data processed to that which is absolutely necessary and proportionate.
• Only use the personal data for the purposes that is was originally collected.

Issues for Directors of Distressed Energy Suppliers

Directors of the energy suppliers most impacted by the recent price increases may find themselves in an invidious position and should be mindful of their duties to the shareholders and, where financially distressed, the creditors of the company (in addition to the company’s statutory obligations as a regulated entity, including to notify the relevant authorities in the event that it becomes unable to pay its debts, as referenced above).

Directors will need to carefully consider the ability of the supplier to continue to trade if losses are being incurred and are projected to continue, in light of the costs of supply compared to the fixed or capped level of income achievable from sales. As many companies are continuing to face significant, and increasing, cash flow pressure, directors should carefully consider their actions in the context of the legal framework.

Much of the UK regime revolves around directors acting “reasonably”. What may or may not be considered “reasonable” will in any case be considered by reference to the prevailing circumstances.

Directors should carefully consider the implications of taking on additional credit (and deferring settlement of existing liabilities). They should rationalise whether adding additional burden to the balance sheet of the company will ultimately benefit its stakeholders. This is often a difficult decision to make, but is likely to be particularly challenging during this period of uncertainty around future price of supply. Directors will need to act responsibly and reasonably, to protect value and minimise potential losses to creditors.

Directors are subject to statutory duties which will apply to them whether or not the company is, or is likely to become, insolvent. Directors should continue to comply with these duties and seek professional advice as to how they should do so in circumstances of uncertain insolvency, as the approach they should take may be different to the approach they would take when the company is solvent.

Wrongful trading

Directors will not be held personally liable for wrongful trading simply because the company was trading whilst insolvent. The main strand of the test is whether the directors know, or ought to have concluded, that there was no reasonable prospect of avoiding insolvent administration or liquidation. Directors should therefore seek to implement a strategy which has a reasonable prospect of avoiding the company entering an insolvency process. The difficult future decisions regarding the prospect and level of any revised price cap and liquidity/cash reserves are likely to be key. Whilst we recommend that at all times directors should protect value and minimise losses, legislation states that once there is no reasonable prospect of avoiding formal insolvency, they should take every step with a view to minimising potential losses to creditors.

In such circumstances directors should consider carefully whether to continue trading and, if they do trade on, the decision to do so must be justifiable and would require very careful navigation with the aid of expert advice from both their lawyers and an insolvency practitioner. In any case, the strategy and the reasons for it should be regularly monitored and properly minuted at board meetings.

As a result of the COVID-19 pandemic, wrongful trading liability was temporarily suspended under the Corporate Insolvency and Governance Act 2020 which states that, when considering the contribution a director is required to make to company assets, the court is to assume that a director is not responsible for any worsening of the financial position of the company or its creditors during the period 1 March 2020 to 30 September 2020 and during the period 26 November 2020 and 30 June 2021.

Following the expiry of these periods directors can be held personally liable for wrongful trading and should take this into account in their decision making.

Fraudulent trading

Directors who are knowingly involved in the carrying on of a business with intent to defraud creditors can be held personally liable if the company becomes insolvent. Directors should therefore remain vigilant of their intentions when making and implementing financial and other business decisions.

Disqualification

Liquidators and administrators are obliged to report on the conduct of all persons who have been directors of an insolvent company within the previous three years. Such directors can be disqualified from acting as directors or being involved in being a director of or managing or setting up companies if it is found that their conduct makes them unfit to do so. Directors can also be found personally liable and made to financially account for the consequences of their unfit conduct.

Antecedent Transactions

Directors should also beware of breaching their duties by entering into transactions at an undervalue or preferences. These can be set aside if entered into within relevant periods prior to the company entering insolvent administration or liquidation.

Issues for Suppliers to Distressed Energy Suppliers

The risk of unforeseen counterparty customer financial distress and failure amidst the on-going challenges for business from the current crisis means that pre-emptive legal and operational protections against the risk of heavy financial loss or business disruption from customer failure are more valuable than ever for those operating within or supplying into the sector.

In addition, new legislation introduced in the UK in June 2020 prohibits the operation of a range of termination and other contractual rights on which a supplier is likely to expect to rely in circumstances where its supply contract counterparty enters one of several UK restructuring or insolvency processes.

Now is the time for businesses to assess critically their potential exposures, review whether legal protections in supply contracts may be ineffective in light of recent new legislation and enhance their protection strategies. Specific legal and operational planning and on-going monitoring processes will significantly mitigate the risk and effect of customer insolvency, increase optionality from an early stage and thereby enable resulting business costs to be minimised. For a detailed exploration of the various steps available to a supplier with concerns about the financial stability of a counterparty (albeit in the context of Retail businesses), please see our previous article here.

Certain warning signs may be a breach of an energy supplier’s licence condition, or regulatory action being taken against a licenced energy provider by Ofgem. This could include an order that the provider rectify missed payments concerning renewable energy obligations. Ofgem publishes any such notices on its website, here.

Emergency Finance?

There will be an influx of energy suppliers, in varying stages of distress, seeking emergency finance in the current market. How appealing such opportunities to fund are (and the related pricing and terms offered) will of course be determined by the overall financial strength of the individual energy supplier in light of its customer book, supply terms, forecast, brand strength and balance sheet.

While the uncertainty around wholesale energy prices continues to rage, the longevity and quantum of suppliers’ hedging arrangements will also be a key factor in any decision making process for boards and lenders alike. Forecasting as prudently as possible is a must but there is no escaping from the fact that it is not possible to accurately predict how prices will fluctuate going forward. Indeed some companies who aren’t yet distressed may nevertheless need to consider whether to close their businesses and close out their hedging while it is still ‘in the money’ and they are still able to make a return to shareholders, rather than gamble on energy prices dropping and bringing their trading model back into profit before their current hedging arrangements expire.

Conclusion

The SoLR and special administration processes are both intended to ensure continuity of supply in the midst of supplier financial distress and collapse. Time will tell whether such measures will prove adequate to achieve this objective in light of the significant and widespread distress that now appears to be facing the sector.

It also remains to be seen whether the measures taken to promote greater competition, and therefore better consumer pricing, by enabling a number of smaller firms to enter the market, will be re-evaluated in light of the risk that, as these smaller suppliers fail, we may see a return to a market dominated by the traditional “Big Six”.

We are available to advise in relation to all issues arising out of the current difficulties resulting from energy prices, whether for energy suppliers, business customers, wholesalers, service providers, creditors and current and prospective lenders. At DLA Piper we have market leading Energy and Restructuring teams with credentials across the whole spectrum of Energy sub-sectors. These include advising:

• a “Big Six” energy supplier concerning issues arising following their appointment as SoLR over a large failed energy provider;
• a “Big Six” energy supplier in potential judicial review proceedings and claims for wrongful trading, following the trade sale of an energy provider to another provider, which was approved by OFGEM;
• a “Big Six” energy supplier in relation to the potential judicial review of Ofgem’s decision to appoint another provider as SoLR;
• multiple energy suppliers appointed as SoLRs on the appointment, and the acquisition of assets from the failed supplier;
• a “Big Six” energy supplier in relation to a substantial contractual dispute with another joint venture energy supplier, recovering a significant portion of disputed sums payable by the business partner;
• an energy company in multi-million pound claims of fraud and breach of contract concerning a core business partner;
• a “Big Six” energy supplier in relation to the continued provision of essential supplies to Toys “R” Us and Thomas Cook; and
• a leading provider of smart meters and associated equipment in relation to the amendment and restatement of its master services agreement with a significant UK supplier and the impact of new England and Wales insolvency procedures upon the same.

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¹See here
²Broadly, this is a levy which enables any shortfall suffered by the SoLR (being the delta between the total amounts recovered by the SoLR from transferred customers and its costs of supply (including debts assumed in relation to pre-existing credit balances) plus a reasonable profit) to be claimed from network operators and thereafter passed on by those operators to their end customers.
³ By way of example, when EDF submitted a Last Resort Supply Payment claim to Ofgem in May 2020, Ofgem launched a 4 week consultation process before subsequently consenting to part of the claim on 26 November 2020.