Automotive Insolvencies

Complicating the situation is the fact that even if tools could be moved to replacement suppliers, the parts produced by new
suppliers must pass a production parts approval process, or PPAP, before they can actually be used by OEMs in the production of vehicles. This can be time consuming and lengthy, especially in the case of safety parts such as airbag covers.

As OEMs have begun using suppliers as the sole source of a part, and OEMs stuck with insolvent suppliers have increased. Consequently, the OEMs have a vested interest in the continued smooth operation of an insolvent supplier that is unmatched in any other industry. [Note, in some cases, there are alternative suppliers with the capacity or ability to meet the debtor's commitments to the OEMs. In cases like these, the OEMs are typically willing to advance significant funds to the debtor in order to keep it operating. In other case the debtor has been able to force the OEMs in to giving it price increases rather that secured funding. (See Intermet Corporation, et al., Bankr. E.D. Mich. Case No. 04-67567).]

However, this supplier dependence and need for it to produce continuously does not mean that OEMs are powerless in the supplier's bankruptcy. In addition to their inherent veto power over the reorganization or sale of the debtor, the OEMs have the ability to reduce the value of the debtor's primary asset and its accounts receivable to literally zero overnight by setting off consequential damages under the terms of the standard OEM's Global Terms and Conditions and by refusing to make payments based on anticipated consequential damages.

Two Key Agreements

Accordingly, the classic 800-pound gorilla in typical mid-market insolvency, the secured creditor, must address the OEMs' concerns in an automotive supplier case to maintain its collateral position (In a typical mid-market case, the supplier has annual revenues of $500,000,000 or less. In larger cases, hedge funds present another major problem). Out of these unique dynamics, two key agreements have evolved, which are entered into early in a supplier's insolvency. Both of these can be entered into either in or out of bankruptcy, and essentially determine the road down which the case will go.

The Access Agreement

The first of these to evolve is the access agreement, which permits an OEM to take over a distressed supplier's factories and operate them if the supplier's financial condition is impairing production. A typical access agreement grants the OEM a junior lien on all of the debtor's assets as a condition to not resourcing work, and permits the OEM to operate the debtor's facilities upon the debtor's failure (or even the risk of failure) to supply the OEM or other specified defaults. It protects the secured lender by requiring the OEM, as a condition of access, to pay all obligations of the supplier, such as payroll, rent, insurance, utilities and to pay the secured creditor an access fee to compensate for the use of its collateral. Debtors have historically resisted entering these to the point of having their business resourced while they fended off entering an access agreement.

However, an OEM will not enter access agreements with some devious desire to take over a supplier's plant. In fact, OEMs have only exercised access in a handful of cases, often with bad results. In addition to not knowing the details of how to smoothly run a supplier's business, once the OEM has taken control of the assets, it has fiduciary duties to parties other than itself and can be liable if it operates the business for its own advantage to the detriment of other parties. Access to an OEM is an unpleasant risky alternative, and the only thing an OEM desires less than exercising access and operating a supplier, is shutting down production. [See, In re Del-Met Corp., 322 B.R. 781 (Bkrtcy.M.D.Tenn., 2005), where the debtor's customers were alleged to have exerted sufficient influence and control over the affairs of the debtor so as to constitute 'insiders' within the meaning of ' 101(31) of the Bankruptcy Code, and thereby owing fiduciary duties to the debtor. The court ultimately agreed that fiduciary duties might indeed be imposed upon the debtor's customers if such duties were found in the controlling state law.].

The Accommodation Agreement

What is more important in recent automotive insolvencies is the second key agreement, the accommodation agreement, which gets its name from the accommodations or credit en-hancements that OEMs provide to a debtor and its secured creditor. Even so, as is the case in all situations where both parties have leverage and risk, there is quite a bit of quid pro quo in a typical accommodation agreement.

The OEMs' accommodations typically include a covenant not to resource business for a specified period of time. This is usually a key element that a supplier looks for to allow time to either reorganize or find a buyer to preserve value and retain jobs. The no-resourcing covenant is usually tied to some benchmarks such as filing an acceptable plan by a given date or obtaining an acceptable buyer by a given date.

To maintain production, OEMs frequently agree to assist in funding the debtor's operations as part of the accommodations during this period. This is usually through subordinated participation in the secured creditor's debt so that the secured creditor's position cannot erode and so that it has, by definition, adequate protection. To further induce the secured creditor to continue funding, OEMs usually agree to accelerated payment terms so that the secured creditor's initial exposure reduces drastically when most of the existing receivables are paid.

Along these lines, the OEMs frequently agree to limit their set-off rights on the receivables to ordinary course set-offs, such as defective goods, short shipments and similar items, plus some amount for their ever-present financial advisers' and attorneys' fees. To further buttress the secured creditor's position, OEMs guaranty to purchase the inventory at favorable prices, such as raw materials, at cost, finished goods at purchase- order prices and work-in-process at a high percentage of pro-rated purchase-order prices. With the value of a debtor's accounts receivable and inventory back stopped, a secured lender is well collateralized for continuing to make in formula advances to the supplier and enable production to continue.

This 'bullet proofing' of the secured creditor's collateral is not without a price to the supplier. Under the accommodation agreement, in exchange for all of an OEMs' enhancements, the supplier is usually obligated to build a bank of parts so that the OEMs can resource as soon as the parts bank is built to a level where the OEM can pull its tools and move them without jeopardizing production. The milestones that a supplier must hit to maintain the no-resourcing covenant is usually linked to the time it takes a bank to be built and to get tools moved rendering the no-resourcing covenant for which the debtor bargained illusory. In fact, the OEM typically cannot resource early in the case due to the factors identified above. The no-resourcing covenant merely gives the supplier what the OEM's production methods already have given it.

Liens on Tools

While it is beyond the scope of this article, another significant issue in supplier insolvencies is the liens held on tools by toolmakers in many jurisdictions for tools that the OEM has already paid for, but for which the debtor has not in turn paid the toolmaker. An accommodation agreement in many cases will provide that all tooling paid for is 'customer-owned tooling' and provides for an escrow procedure for tooling that the OEM has not paid for so that the OEM can obtain title to and move the tools to the new supplier when it is ready.

Refusal to Ship

Another majort issue is the debtor's material vendors and tool makers holding it 'hostage' by refusing to ship unless portions of the debtor's past-due obligations are paid and/or the vendor is paid in advance. Because these key vendors know the risk a supplier poses to the OEM's, they frequently refuse to ship unless the OEM pays them directly and issues a 'comfort letter' obligating the OEM to step in and meet the debtor's obligations should it be unable to do so. In many cases, the accommodation agreement permits an OEM certain 'tooling set-offs' and 'material set-offs' in a manner that will not adversely impact the secured creditor. Usually, the OEM will only be able to set off against accounts arising two or more business days after it sends the debtor and the secured lender a direct payment notice that it is paying a vendor or toolmaker to ensure production.

This allows the secured creditor time to establish a reserve in the debtor's borrowing base so that it remains adequately collateralized. However, this essentially gives the OEM a carte blanche with the debtor's funds to pay vendors. And, the OEM has no incentive to assert the debtor's claims that it has been overcharged, the goods were defective or similar issues. Instead, even though the accommodation agreement usually gives a debtor the right to consent to maintain production before payment, the vendor is often quickly paid with the debtor's funds without its consent. In doing so, the secured creditor is covered, and the OEM maintains production. This leaves the debtor with claims against the OEM for wrongfully paying the vendor that the debtor lacks the time or resources to pursue.

Conclusion

In most current Chapter 11 proceedings, an accommodation agreement and access agreement are approved as part of the Interim Financing Order, so that they bear a judicial imprimatur and function as the rules of the game as a case progresses. While at first blush these agreements, especially the access agreement, seem harsh and unfair, they merely reflect the parties' rational response to the already present dynamics in the automotive supply chain when a supplier's insolvency threatens production.

When viewed in this light, it can be seen that like draconian finance orders, cash collateral orders and forbearance agreements that frequently exist where there is only one party with economic leverage, accommodation agreements and access agreements are the result of situations where two sets of interests both have significant power due to the business environment in which the debtor operates. The only constant is that in both the traditional case and the automotive case, with the exception of the nuclear option of shutting down, the debtor lacks the economic power to bargain for more and is forced to accept these agreements if its goal is to maximize values by operating and reorganizing, or achieve a going concern sale.

Steve Gross is managing partner of the Detroit office of business law firm McDonald Hopkins. For more than 20 years, he has been extensively involved in business restructuring matters, creditors' rights and corporate acquisitions and divestitures, especially in the automotive industry and other manufacturing businesses. He can be contacted at [email protected].

The unique environment of the automotive industry has resulted in the insolvencies of tier-one and tier-two suppliers developing distinct characteristics. Unlike many industries, automotive suppliers typically have only a handful of customers, without whom they have no business to reorganize or sell in an effort maximize values for creditors. This gives customers significant control in the options a debtor has when faced with severe financial distress. However, because of Original Equipment Manufacturers' (OEM) just-in-time methods of production ' unlike customers in many businesses that can simply decide not to do business with an insolvent entity ' OEMs and large tier-one suppliers cannot purchase automotive parts or assemblies elsewhere.

How It Works

The OEMs have shifted the cost of maintaining inventories to their suppliers over the past decade or so and now maintain only a few days' supply of parts. A supplier's failure to provide parts for as little as one or two days can shut down production lines at a cost of millions of dollars per day to the OEMs.

Complicating the situation is the fact that even if tools could be moved to replacement suppliers, the parts produced by new
suppliers must pass a production parts approval process, or PPAP, before they can actually be used by OEMs in the production of vehicles. This can be time consuming and lengthy, especially in the case of safety parts such as airbag covers.

As OEMs have begun using suppliers as the sole source of a part, and OEMs stuck with insolvent suppliers have increased. Consequently, the OEMs have a vested interest in the continued smooth operation of an insolvent supplier that is unmatched in any other industry. [Note, in some cases, there are alternative suppliers with the capacity or ability to meet the debtor's commitments to the OEMs. In cases like these, the OEMs are typically willing to advance significant funds to the debtor in order to keep it operating. In other case the debtor has been able to force the OEMs in to giving it price increases rather that secured funding. (See Intermet Corporation, et al., Bankr. E.D. Mich. Case No. 04-67567).]

However, this supplier dependence and need for it to produce continuously does not mean that OEMs are powerless in the supplier's bankruptcy. In addition to their inherent veto power over the reorganization or sale of the debtor, the OEMs have the ability to reduce the value of the debtor's primary asset and its accounts receivable to literally zero overnight by setting off consequential damages under the terms of the standard OEM's Global Terms and Conditions and by refusing to make payments based on anticipated consequential damages.

Two Key Agreements

Accordingly, the classic 800-pound gorilla in typical mid-market insolvency, the secured creditor, must address the OEMs' concerns in an automotive supplier case to maintain its collateral position (In a typical mid-market case, the supplier has annual revenues of $500,000,000 or less. In larger cases, hedge funds present another major problem). Out of these unique dynamics, two key agreements have evolved, which are entered into early in a supplier's insolvency. Both of these can be entered into either in or out of bankruptcy, and essentially determine the road down which the case will go.

The Access Agreement

The first of these to evolve is the access agreement, which permits an OEM to take over a distressed supplier's factories and operate them if the supplier's financial condition is impairing production. A typical access agreement grants the OEM a junior lien on all of the debtor's assets as a condition to not resourcing work, and permits the OEM to operate the debtor's facilities upon the debtor's failure (or even the risk of failure) to supply the OEM or other specified defaults. It protects the secured lender by requiring the OEM, as a condition of access, to pay all obligations of the supplier, such as payroll, rent, insurance, utilities and to pay the secured creditor an access fee to compensate for the use of its collateral. Debtors have historically resisted entering these to the point of having their business resourced while they fended off entering an access agreement.

However, an OEM will not enter access agreements with some devious desire to take over a supplier's plant. In fact, OEMs have only exercised access in a handful of cases, often with bad results. In addition to not knowing the details of how to smoothly run a supplier's business, once the OEM has taken control of the assets, it has fiduciary duties to parties other than itself and can be liable if it operates the business for its own advantage to the detriment of other parties. Access to an OEM is an unpleasant risky alternative, and the only thing an OEM desires less than exercising access and operating a supplier, is shutting down production. [See, In re Del-Met Corp., 322 B.R. 781 (Bkrtcy.M.D.Tenn., 2005), where the debtor's customers were alleged to have exerted sufficient influence and control over the affairs of the debtor so as to constitute 'insiders' within the meaning of ' 101(31) of the Bankruptcy Code, and thereby owing fiduciary duties to the debtor. The court ultimately agreed that fiduciary duties might indeed be imposed upon the debtor's customers if such duties were found in the controlling state law.].

The Accommodation Agreement

What is more important in recent automotive insolvencies is the second key agreement, the accommodation agreement, which gets its name from the accommodations or credit en-hancements that OEMs provide to a debtor and its secured creditor. Even so, as is the case in all situations where both parties have leverage and risk, there is quite a bit of quid pro quo in a typical accommodation agreement.

The OEMs' accommodations typically include a covenant not to resource business for a specified period of time. This is usually a key element that a supplier looks for to allow time to either reorganize or find a buyer to preserve value and retain jobs. The no-resourcing covenant is usually tied to some benchmarks such as filing an acceptable plan by a given date or obtaining an acceptable buyer by a given date.

To maintain production, OEMs frequently agree to assist in funding the debtor's operations as part of the accommodations during this period. This is usually through subordinated participation in the secured creditor's debt so that the secured creditor's position cannot erode and so that it has, by definition, adequate protection. To further induce the secured creditor to continue funding, OEMs usually agree to accelerated payment terms so that the secured creditor's initial exposure reduces drastically when most of the existing receivables are paid.

Along these lines, the OEMs frequently agree to limit their set-off rights on the receivables to ordinary course set-offs, such as defective goods, short shipments and similar items, plus some amount for their ever-present financial advisers' and attorneys' fees. To further buttress the secured creditor's position, OEMs guaranty to purchase the inventory at favorable prices, such as raw materials, at cost, finished goods at purchase- order prices and work-in-process at a high percentage of pro-rated purchase-order prices. With the value of a debtor's accounts receivable and inventory back stopped, a secured lender is well collateralized for continuing to make in formula advances to the supplier and enable production to continue.

This 'bullet proofing' of the secured creditor's collateral is not without a price to the supplier. Under the accommodation agreement, in exchange for all of an OEMs' enhancements, the supplier is usually obligated to build a bank of parts so that the OEMs can resource as soon as the parts bank is built to a level where the OEM can pull its tools and move them without jeopardizing production. The milestones that a supplier must hit to maintain the no-resourcing covenant is usually linked to the time it takes a bank to be built and to get tools moved rendering the no-resourcing covenant for which the debtor bargained illusory. In fact, the OEM typically cannot resource early in the case due to the factors identified above. The no-resourcing covenant merely gives the supplier what the OEM's production methods already have given it.

Liens on Tools

While it is beyond the scope of this article, another significant issue in supplier insolvencies is the liens held on tools by toolmakers in many jurisdictions for tools that the OEM has already paid for, but for which the debtor has not in turn paid the toolmaker. An accommodation agreement in many cases will provide that all tooling paid for is 'customer-owned tooling' and provides for an escrow procedure for tooling that the OEM has not paid for so that the OEM can obtain title to and move the tools to the new supplier when it is ready.

Refusal to Ship

Another majort issue is the debtor's material vendors and tool makers holding it 'hostage' by refusing to ship unless portions of the debtor's past-due obligations are paid and/or the vendor is paid in advance. Because these key vendors know the risk a supplier poses to the OEM's, they frequently refuse to ship unless the OEM pays them directly and issues a 'comfort letter' obligating the OEM to step in and meet the debtor's obligations should it be unable to do so. In many cases, the accommodation agreement permits an OEM certain 'tooling set-offs' and 'material set-offs' in a manner that will not adversely impact the secured creditor. Usually, the OEM will only be able to set off against accounts arising two or more business days after it sends the debtor and the secured lender a direct payment notice that it is paying a vendor or toolmaker to ensure production.

This allows the secured creditor time to establish a reserve in the debtor's borrowing base so that it remains adequately collateralized. However, this essentially gives the OEM a carte blanche with the debtor's funds to pay vendors. And, the OEM has no incentive to assert the debtor's claims that it has been overcharged, the goods were defective or similar issues. Instead, even though the accommodation agreement usually gives a debtor the right to consent to maintain production before payment, the vendor is often quickly paid with the debtor's funds without its consent. In doing so, the secured creditor is covered, and the OEM maintains production. This leaves the debtor with claims against the OEM for wrongfully paying the vendor that the debtor lacks the time or resources to pursue.

Conclusion

In most current Chapter 11 proceedings, an accommodation agreement and access agreement are approved as part of the Interim Financing Order, so that they bear a judicial imprimatur and function as the rules of the game as a case progresses. While at first blush these agreements, especially the access agreement, seem harsh and unfair, they merely reflect the parties' rational response to the already present dynamics in the automotive supply chain when a supplier's insolvency threatens production.

When viewed in this light, it can be seen that like draconian finance orders, cash collateral orders and forbearance agreements that frequently exist where there is only one party with economic leverage, accommodation agreements and access agreements are the result of situations where two sets of interests both have significant power due to the business environment in which the debtor operates. The only constant is that in both the traditional case and the automotive case, with the exception of the nuclear option of shutting down, the debtor lacks the economic power to bargain for more and is forced to accept these agreements if its goal is to maximize values by operating and reorganizing, or achieve a going concern sale.

Steve Gross is managing partner of the Detroit office of business law firm McDonald Hopkins. For more than 20 years, he has been extensively involved in business restructuring matters, creditors' rights and corporate acquisitions and divestitures, especially in the automotive industry and other manufacturing businesses. He can be contacted at [email protected].