As COVID-19 recovery continues, manufacturers should use stress-tests, other measures to ensure supplier reliability.
By Ann Marie Uetz and Christopher Boll, Foley & Lardner
The global supply chain depends on parts being delivered on time and, as we’ve seen during this pandemic, one weak link can bring production to a screeching halt. Following a 3-month shutdown of the North American automotive industry, and shutdowns in parts of Europe, China and elsewhere, financial and operational distress is mounting for certain automotive suppliers of all makes and models. A direct result of weeks with no production and declining or little revenue, some suppliers will struggle as an opening economy necessitates a rapid increase in production with little supply or cash in the bank.
With the potential for a troubled supplier in your supply chain, even healthy manufacturers need to analyze their supply base for signs of financial or operational distress which can threaten the continued supply of goods. Supply chain stress tests – similar to financial stress tests which banks have been subjected to since the Great Recession – are a good place to start, as certain automotive suppliers struggle to deliver during the restart. This article outlines top considerations for dealing with financially distressed suppliers.
Identifying a Distressed Supplier
Distressed suppliers, also known as troubled suppliers, are suppliers that are financially and/or operationally unsound. Often suppliers enter distressed territory due to unexpected market shocks, such as black swan events like COVID-19, which have a tendency to catch management and customers off-guard. Without assistance from outside parties, distressed suppliers often struggle to meet agreed-upon production requirements or pay their sub-tiers for their own materials or supplies. As a result, the impact of a troubled supplier can have ripple effects on the entire supply chain, stalling downstream production and having compounding impacts on typically smaller, upstream sub-tier suppliers. This disruption can cause cascading effects, delaying the launch of new vehicles, stopping production of existing vehicles, and causing financial distress for smaller, upstream suppliers as well. There are a number of warning signs to look out for in identifying a distressed supplier:
- Shipments which are missed, late, frequently expedited, or short.
- Low quality shipment of finished goods.
- Unprofitable operations (signaled by frequent delays of new program launches).
- Failure to pay sub-tiers on time and/or in full and stretched payables.
- Frequent requests to change payment terms.
- A supplier is often a target of litigation involving claims against the supplier, including for non-payment of sub-tiers.
- Defaults under credit agreements.
- Extraordinary capital expenditures which appear to be behind schedule.
Business leaders within your organization should discuss the current situation and assess management’s understanding of each of these warning signs within their supply chain.
What to do in the Case of a Distressed Supplier
Companies should keep a close eye on their supply chain and frequently survey suppliers to identify potentially distressed or near-distressed suppliers. If your risk management team has identified a potentially troubled supplier on whom you depend for materials or component parts in order to supply to your end-customer, delay is your enemy. Management must quickly assemble a team to address the situation and establish a plan to work with and maneuver distressed supplier situations. This team should include members of your purchasing, engineering, operations, finance, and legal groups. Depending on the severity of the situation, you may also need to consult with outside financial or legal specialists who work regularly with distressed suppliers in the automotive supply chain. It is vital to assess the impact of the distressed supplier on your production, and your ability to meet the needs of your customers, as well as your ability to exit your supplier relationship or resource supply with alternative suppliers. Management should consider the following:
- The capabilities of alternative suppliers to meet the needs and expectations of you and your customers.
- Quality, up-time requirements, and costs associated with resourcing.
- Legal options and the ability to terminate contracts for breach or convenience.
- Potential requirements for approving tooling/PPAP.
In some cases, it makes sense to work with the troubled supplier and even provide some support for the continued flow of goods, while you take other steps to protect your long-term supply of goods. In other cases, it may be best to utilize your contract remedies for breach and move on to another supplier.
How to Guard Against Distress and Protect Your Supply
Sometimes the best offense is a good defense. Conducting an audit of new and existing suppliers’ business and financial health is a proactive approach to evaluating the risk in your own supply chain. This process helps you, as a customer, identify potential troubled spots before they cause a disruption to your business and those customers who depend on your reliability. Establishing financial and other criteria for new suppliers can help to build a strong supply chain for future supply. Consider the following:
- Financial position
- Review financial statements, credit applications, etc.
- Determine financial resources (i.e., lines of credit)
- Lender, customer, and supplier diligence
- Check UCC filings, tax liens, and judgment search
- Due diligence regarding past experiences
Establishing these processes can help guard you against distress and protect your position going forward.
Considerations if Forced to Stay – Accommodation Agreements with Distressed Suppliers
If you are unable to exit your current contract, you may need to enter into an “Accommodation Agreement” with the supplier and potentially one or more of its lenders. The Accommodation Agreement provides certain considerations by each party to prop up the supplier in order for it to continue production of those parts necessary for your business. Accommodation Agreements are based on a promise by the supplier to maintain the production and supply of parts to the customer without interruption, and a corresponding promise by the customer to provide certain financial and other accommodations to help support the supplier. Accommodation Agreements (i) provide additional liquidity to distressed suppliers when senior secured lenders lose the appetite to fund ongoing operations, (ii) reduce disruption to business, (iii) maintain supply to key customers, and (iv) increase likelihood of payout to senior secured lenders.
Accommodation Agreements often require negotiating among the distressed supplier’s customer base and lender group. In these situations, self-preservation will typically bring these groups together, but not always. It is important to understand each party’s leverage in order to protect your own position as a customer or supplier. Increasingly, Accommodation Agreements are being used to facilitate out-of-court sales and/or wind downs of operations of distressed suppliers. Accommodation Agreements are popular among lenders and customers, as they reduce time and expense associated with a bankruptcy filing, and maintain some control with lenders and customers alike.
The following are typical key terms that are negotiated with respect to Accommodation Agreements among automotive customers, their suppliers, and the suppliers’ lenders who are often parties to or beneficiaries of the Accommodation Agreement.
1. Forbearance from Resourcing Existing Business
Customer agrees to not resource business currently with supplier to an alternative supplier for a defined period. In exchange, the supplier often agrees to certain conditions, some of which might include the following:
- No material default on any purchase order (current or future for the term of the Accommodation Agreement).
- There exists no “Event of Default”, as defined in the Accommodation Agreement, during the term of the Accommodation Agreement.
- No material default on financing arrangements, during the term of the Accommodation Agreement.
- Creation of parts inventory bank.
2. Limitation of Setoffs or Recoupment
Customer agrees to retain its rights and claims against supplier, but agrees to not exercise its right of setoff or recoupment against accounts payable to supplier for damages arising from supplier’s failure to perform its obligations. This arrangement seeks to provide the lender with assurance that cash flows from production will continue and be predictable. Nonetheless, the supplier often retains the right and may exercise the right of setoff and recoupment, even while an Accommodation Agreement is in force, for the following circumstances:
- Short shipments
- Defective or non-conforming products
- Improper invoicing
- Warranty claims (some exceptions)
- Direct payment to vendors for raw materials
3. Change of Payment Terms
Customer may agree to change (i.e., accelerate) payment terms on shipments made during fixed period. Often this might include changing payment terms from Net 60 to Net 30, or quicker. In line with topic #2 immediately above, this continues to provide the lender with assurance that cash flows from production will continue and be predictable.
4. Purchase of Inventory
In a case where a lender is involved, and there is a default under either the applicable loan documents or the Accommodation Agreement, the customer agrees to purchase all raw materials, work in process, and finished goods inventory which are merchantable, usable, and related to parts provided to the customer by supplier. Prices are fixed at certain percentages of the supplier’s actual cost or purchase order price and the customer will make payments directly to the lender.
5. Customer Financing
In some cases, customers might directly finance production of supply by their suppliers. In these scenarios, typically customers agree to provide a specific amount of financing to the distressed supplier to cover the supplier’s cash shortfalls and in return will receive production from the supplier. Customers often provide financing through:
- Subordinated participation in the lender’s line of credit to supplier; or
- Price relief for customer’s production.
6. Inventory Bank Financing
The customer agrees that it is solely responsible for financing its inventory bank requirements. Where a lender is involved, any financing arrangement it enters into is subject to the lender’s approval, and no part of the lender’s line of credit may be used to finance the inventory bank.
7. Acceleration of Payables
The customer agrees to pay all existing payables within __ (e.g., three) business days of execution of the Accommodation Agreement.
8. Payment of Operations Costs
The customer agrees to reimburse supplier, on a daily basis, its pro rata share of the total costs incurred in the production of its parts.
Individual accommodations are scenario specific and depend on a multitude of factors, including the relationship with the supplier and the presence of a supplier’s lender. The above terms will vary based on the customer’s dependency on the distressed supplier, and the lender’s security position (e.g., whether it is over- or under-secured). The more dependent, the better the terms for the supplier and the longer the wind-down process will take, and the less dependent, the less support a customer will provide for the distressed supplier. It is vital that customers and suppliers identify their points of power and leverage in working through a distressed supplier issue, and negotiate support according to that leverage.
The risk of financial and operational distress within the supply chain is increasing, but proactive manufacturers are best positioned to mitigate these risks. As the industry continues its restart, manufacturers should monitor and analyze their suppliers, identify troubled and at-risk suppliers, and establish processes for working through potential disruption events. These and the other steps we have discussed in this article are important steps to mitigating future and existing risks to business in the COVID-19 environment.
About the authors:
Ann Marie Uetz is a Partner at Foley & Lardner who counsels manufacturers – chiefly in the automotive and defense/aerospace industries – on all aspects of the supply chain, including bankruptcy.
Christopher Boll is an Associate at Foley & Lardner who advises clients on business transactions, including acquisitions and workouts that arise within the supply chain.