Protecting Your Supply Chain in the Face of Potential Auto Industry Challenges in 2018

As the economy has improved and unemployment has fallen in the nearly 10 years since the Great Recession, North American vehicle sales volumes have also steadily increased and the forecast remains strong for 2018. Bloomberg estimates that approximately 16.7 million vehicles will be sold in 2018, with the majority being light trucks and sport utility vehicle.

Due to the relatively high volumes of vehicle sales in the past few years, including the record-breaking 2015 year, the automotive industry has seen few high-profile bankruptcies in recent years. Notwithstanding the current robust and stable environment in the industry, however, individual suppliers may face particular problems that, if not identified and addressed, could force them into a bankruptcy filing or other workout situation and cause damage to the supply chain.

Certain trends appear to be driving instability in individual companies. First, there is the issue of increasing warranty and recall costs. In 2016, there were 50 million light vehicles recalled, according to a Stout Advisory report. Of those, 30 million were unrelated to the Takata air bag inflator recall. Experts suggest that the high volume of recalls is likely to continue because, as vehicles become increasingly complex and have electronic components supplied by many parties, failures and recalls become more likely. This is particularly true where several suppliers are providing components that are integrated into a single system during production. Recall liability can be costly for both OEMs and suppliers, and OEMs increasingly look to suppliers to bear a significant portion of the costs. A significant recall issue may negatively impact even a stable supplier, but for a supplier that is not in a strong financial position prior to a recall, the liability may push it into insolvency or bankruptcy.

Another trend that may negatively affect suppliers is consolidation in the supply base. As technology changes and innovations in vehicle technology become more expensive, the pace of consolidation activity is likely to increase.  Last year was a strong one for mergers and acquisitions, and this will continue as traditional suppliers purchase technology companies in order to obtain new products and market positions, according to a PricewaterhouseCoopers report on automotive trends. Consolidation will create winners and losers as the industry adapts, including through the growth of autonomous and connected vehicles. However, if a supplier is an unattractive target for consolidation, either because of its financial position or its products, it may find itself unable to compete with new, consolidated entities. Moreover, vertical integration is occurring, which has caused some suppliers to lose customers to competitors that have been purchased and integrated into larger suppliers’ businesses. These risks can exacerbate underlying problems and lead to distress and potential bankruptcies.

Identifying and Protecting Against Troubled Suppliers

The increased recall and warranty repair costs and industry consolidation may cause individual suppliers that are operating on thin margins to falter. A troubled supplier within a supply chain can cause significant harm to the upstream suppliers and ultimately the manufacturers. Customers should routinely evaluate the companies in their supply chain for warning signs of distress, including:

• Supplier requests for price increases, accelerated payment terms, customer financing support, or use of factoring
• Late deliveries or changes in product quality
• Requests for technical support
• Failure to update IT systems or to appropriately use existing technology in the industry
• Failure to effectuate cost reductions
• Deteriorating accounts receivable and accounts payable
• Employment of consultants and financial advisors
• Deteriorating market position
• Restatement or delays in issuing audited financial statements
• Changes in key management positions
• Renegotiated debt covenants, incurrence of new debt, fully drawn lines of credit and impending maturity dates

Where these signs exist, the exercise of common law and statutory remedies may allow a customer of a troubled supplier to achieve proactive changes to standard terms and conditions of new contracts (or negotiated changes to existing contracts). Through the use of these tactics, customers can address troubled supplier situations with greater advance awareness, leverage and options.

Customers also should routinely analyze their contracts to maximize their position in dealing with potentially troubled suppliers. A customer’s existing contracts with a given supplier have a substantial effect on the customer’s rights and remedies, both pre-bankruptcy and post-bankruptcy. For example, the terms of the contracts govern critical issues such as:

• Each party’s ability to terminate the contracts
• The supplier’s ability to stop shipment and impose “hostage” demands
• A customer’s ability to resource production to another, healthier supplier
• A customer’s ability to utilize certain contract remedies, including to demand adequate assurance of future performance pursuant to section 2-609 of the Uniform Commercial Code (UCC), or consider the contracts repudiated by the supplier
• Whether a contract is considered an “executory” contract in bankruptcy, whether it is integrated with other contracts, and the impact of this on the duty to perform in bankruptcy
• The troubled supplier’s ability to assume and assign, or reject, the contract in bankruptcy
• A customer’s ability to recover its tooling
• Lien rights
• Setoff rights

Through the imposition and application of statutory and common law contract rights, manufacturers can avoid troubled companies’ use of their own ordinarily broad bankruptcy rights to assume or reject contracts and to force contract counterparts to continue performing under the contract during bankruptcy. Where signs of financial distress are apparent, or a manufacturer otherwise has reasonable grounds to believe that a supplier’s future performance under a contract for the sale of goods is in doubt, a manufacturer may be able to demand adequate assurance of future performance from the supplier under  the UCC. If such assurance is not provided, a manufacturer may be able to consider the contract repudiated, enabling the manufacturer to resource or suspend shipment, or negotiate or impose more protective or otherwise better terms in order to “shore up” contract rights before a bankruptcy filing. These strategies can drastically alter the parties’ rights after a bankruptcy filing and provide greater leverage in negotiations and better outcomes.

To preserve supply, manufacturers also may participate in a pre-bankruptcy workout, intended to keep a troubled supplier on the verge of bankruptcy from ceasing production of necessary parts, by restructuring the supplier’s debt and capital structure. These transactions often include tripartite agreements among the troubled supplier, its significant customers, and its secured lenders to solidify the commitments of each party to keep the supplier operating while the workout (or bankruptcy) is progressing. These agreements commonly consist of access and accommodation agreements, and subordinated participation agreements. Through an accommodation agreement, the customers may provide (often as a group) accommodations that solidify the lenders’ collateral base through protections on inventory and receivables, commitments to continue sourcing of existing parts to the troubled supplier and limitations on setoffs while the lender agrees to provide working capital financing and not to foreclose. Furthermore, customer accommodations may include financing support, in which case the customer should obtain a participation agreement to obtain collateral for any financing it provides. An access agreement permits the customer, under certain circumstances threatening production and only as a last resort, to access the supplier’s plant to produce parts using the supplier’s own equipment and employees, pending transfer of the contract or facility to a healthier supplier.