Distressed Suppliers

In addition to price, a purchaser must consider whether the potential supplier can meet all of the purchaser's delivery requirements, including time and quality. Yet, that should only be the beginning of the analysis. The purchaser needs to dig deeper and consider the financial viability of the potential supplier. This might actually require reviewing the potential supplier's financial statements. Of course, financial statements only provide a historical perspective of the finances of the company. The purchaser should also look at the business plan and the forecasted sales of the company. After all of this analysis, the purchaser then will be in a much better position to determine which potential supplier will be the best in the long run.

Negotiate a Good Supply Contract

Once the purchaser has chosen the best supplier, it is critical that the purchaser negotiate an enforceable supply contract. Keep in mind that if the contract is unenforceable, and the supplier refuses to deliver, the purchaser will have no legal remedy and may be forced to pay a significantly high ransom amount to the supplier to get its products, even though the parties originally negotiated a much lower price. Under the Uniform Commercial Code (UCC) a contract for the sale of goods must be in writing and include a quantity term to be enforceable. UCC
§ 2-201. However, quantity does not have to be stated numerically. Rather, the UCC expressly recognizes requirements and output contracts. UCC § 2-306. Thus, a contract which states that the purchaser agrees to purchase all of the steel it requires from the seller will satisfy the quantity requirement imposed by the UCC.

The UCC sections in the chart below supply other relevant contract terms if not specified in the contract between the parties.

In addition to ensuring that the purchaser and supplier have an enforceable contract, the purchaser should negotiate beneficial terms in the contract such as:

• the purchaser's right to terminate for the seller's failure to supply or even a threat to supply;
• the purchaser's right to terminate for convenience;
• the purchaser's right to terminate for poor financial condition of the supplier;
• acceptable force majuere provisions;
• the requirement that the supplier provide routine financial information, including financial statements;
• the right of the purchaser and its designee to have access to not only the supplier's books and records, but also the supplier's operations and management; and
• memorialized rights of offset for any claims that may be owed including any professional fees that may have been incurred in enforcement of the contract by the purchaser (these offset rights should be expansive to include related parties as well).

However, having any of these rights means nothing, unless the purchaser is proactive in following up and reviewing the information available throughout the contractual relationship to make sure that the supplier continues to be viable.

Be Proactive

In a troubled financial situation where the supplier has multiple customers and may ultimately be going out of business, the last customer out will most likely pay the most. A customer that is proactive and well aware of a problem in advance of other customers or parties and takes that information to develop alternative plans, can save a tremendous amount of risk and cost. Early identification of problems, and responding to those early signs, gives a customer more time to create alternative plans. Typically, the more options available, the less expensive and less risky for the customer. Early warning signs of potential problems include:

• request for special or expedited payment terms;
• request for price increases especially where retro price adjustments are requested;
• turnover in the management team or key employees;
• rumors within industry regarding slow payment to trade vendors;
• knowledge of union unrest;
• failure to meet program dates for operations or design readiness;
• deterioration in quality performance levels;
• any significant change in the way a company does business; and
• delivery problems and/or expedited freight issues.

Being proactive means not only utilizing all information available from the supplier and watching for the warning signs, but also regularly reading trade and financial periodicals to assure that there is no negative financial information relating to, or information that may result in, a negative financial condition of the supplier in those periodicals. In addition to various media sources, services, such as Dunn & Bradstreet, monitor companies and should be considered valuable resources to glean information about a supplier. Further, in most industries, there is always talk about financial conditions of other parties in that industry. A customer should be cautious about believing or spreading the information, but should conduct additional due diligence to determine if there is any merit to the rumors. If so, the customer needs to prepare for alternative solutions.

Okay, We Have a Troubled Supplier, Now What?

Ideally, a customer faced with a troubled supplier could acquire the goods from some other source without any interruption to its supply chain. However, in today's economic environment, particularly in single-source, just-in-time industries, alternative sources may be nonexistent and customers may be forced to deal with the financially troubled supplier. In those situations, more involvement by the customer is routinely required to assure continuity of supply. To assure continuity of supply, the customer may have to negotiate and provide accommodations to the supplier, which may include: 1) price increases; 2) gifts; 3) loans; 4) expedited payment terms; 5) bulletproofing supplier's working capital so lenders lend more on that working capital; and 6) providing guarantees to vendors who may be supplying your supplier. The level of involvement, accommodations, and cost can seem limitless at times to the customer.

During this time, it is critical that the customers develop various plans for future supply. The customer should then choose a strategy and plan with the least risk and the least cost. A customer should work with its attorney in order to understand the reason behind the process, and to structure a deal to best protect the purchaser at the least cost.

For example, in the automotive industry, lawyers providing assistance to customers in these circumstances, routinely negotiate and document what is referred to as “accommodation agreements.” These agreements will set forth, among other things, the accommodations being provided by the customers, the expectations of the supplier, and the expectations of the lender. Further, the customer may want to negotiate what is referred to as an “access and security agreement.” Under such a document, upon certain material defaults, the customer would have the right to step in and take over the supplier's production. Exercising rights under an access agreement is an insurance policy of last resort. As long as the supplier continues to produce and it is not being unreasonable, presumably, the supplier can produce at no more cost than it would take the customer. However, an access agreement gives the customer tremendous leverage.

Again, the ultimate goal is continuity of supply at the least cost and risk. The finality of the case could include several results: 1) reorganization; 2) a wind-down or resourcing; or 3) an asset sale to a more viable third party. Any and all of these could include the court system, depending on the situation. For example, any one of these options may be best facilitated through the bankruptcy process.

Setoff Rights

A proactive customer is doing more than just monitoring the quality, timing, delivery and financial condition of a supplier. A proactive customer will also be routinely determining whether it has any claims against the supplier, for: 1) material supplied; or 2) damage claims resulting from short shipments, misshipments, improper invoices, warranty claims, expedited payment charges, professional fees, and non-conforming parts. As these claims arise, they should be offset against any amounts owed to the supplier so that in a time of financial crisis, the customer does not find out that it is owed more money by the seller than it owes the seller. In any event, at the time of any financial crisis of the supplier, offset rights should be taken into consideration and can be significant leverage to negotiate with not only the supplier, but also the lender.

Conclusion

In today's economic environment it is likely that a purchaser of goods will have to deal with suppliers that might be financially distressed. In those circumstances, it is critical that you understand how best to maneuver through these troubled situations, maintain the ultimate goal of the circumstances, and minimize risk.

Hopefully, you have been proactive in monitoring the financial condition of the supplier, and at the first hint of any potential financial problems, you started developing alternative plans or sources of supply. However, in many circumstances, even if you have done everything correctly, there may be many cases in which you will still have to deal with a supplier that is financially distressed. In that circumstance, do what is best for business. In the short term it may be best to continue purchasing from the supplier while you look for alternative sources of supply for a long-term solution.

It is important to be conscious of these circumstances and construct the best possible deal including provisions that require routine updates on the financial information of the supplier. Before documenting the agreement, you should contact an attorney who specializes in these types of issues. With assistance from your attorney, you should be able to negotiate an appropriate arrangement to minimize risk, assure continuity of supply, and create “insurance policies” if something happens.

*****
James A. Plemmons is a member in Dickinson Wright's Detroit office and is practice department manager: Automotive, Bankruptcy & Insolvency and Product Liability Litigation for the firm. He represents OEMs and major automotive suppliers in distressed supplier cases. He can be reached at 313-223-3106 or [email protected].

Often, purchasers of goods are confronted with financially troubled suppliers and have to decide how best to deal with the supplier in question. There are many pitfalls that you need to avoid. With the complete arsenal of law and information, the customer should be in a position to maneuver through these situations while minimizing risk and cost. The following is information to assist purchasers when confronted with these issues.

Always Research Supplier Before Entering into Supply Contract

In today's economic environment, many purchasers place significant weight on price when deciding from whom to buy products. Unfortunately, purchasers that place too much weight on price, rather than on financial stability and the viability of a supplier, may find that its goods cost much more in the long run. It is very risky for a purchaser to enter into a contract with a potential supplier who is not financially stable or who does not have competent management, even at a very low price, particularly if this is to be a single source supplier and it is difficult to quickly resource to a new supplier should trouble arise.

In addition to price, a purchaser must consider whether the potential supplier can meet all of the purchaser's delivery requirements, including time and quality. Yet, that should only be the beginning of the analysis. The purchaser needs to dig deeper and consider the financial viability of the potential supplier. This might actually require reviewing the potential supplier's financial statements. Of course, financial statements only provide a historical perspective of the finances of the company. The purchaser should also look at the business plan and the forecasted sales of the company. After all of this analysis, the purchaser then will be in a much better position to determine which potential supplier will be the best in the long run.

Negotiate a Good Supply Contract

Once the purchaser has chosen the best supplier, it is critical that the purchaser negotiate an enforceable supply contract. Keep in mind that if the contract is unenforceable, and the supplier refuses to deliver, the purchaser will have no legal remedy and may be forced to pay a significantly high ransom amount to the supplier to get its products, even though the parties originally negotiated a much lower price. Under the Uniform Commercial Code (UCC) a contract for the sale of goods must be in writing and include a quantity term to be enforceable. UCC
§ 2-201. However, quantity does not have to be stated numerically. Rather, the UCC expressly recognizes requirements and output contracts. UCC § 2-306. Thus, a contract which states that the purchaser agrees to purchase all of the steel it requires from the seller will satisfy the quantity requirement imposed by the UCC.

The UCC sections in the chart below supply other relevant contract terms if not specified in the contract between the parties.

In addition to ensuring that the purchaser and supplier have an enforceable contract, the purchaser should negotiate beneficial terms in the contract such as:

• the purchaser's right to terminate for the seller's failure to supply or even a threat to supply;
• the purchaser's right to terminate for convenience;
• the purchaser's right to terminate for poor financial condition of the supplier;
• acceptable force majuere provisions;
• the requirement that the supplier provide routine financial information, including financial statements;
• the right of the purchaser and its designee to have access to not only the supplier's books and records, but also the supplier's operations and management; and
• memorialized rights of offset for any claims that may be owed including any professional fees that may have been incurred in enforcement of the contract by the purchaser (these offset rights should be expansive to include related parties as well).

However, having any of these rights means nothing, unless the purchaser is proactive in following up and reviewing the information available throughout the contractual relationship to make sure that the supplier continues to be viable.

Be Proactive

In a troubled financial situation where the supplier has multiple customers and may ultimately be going out of business, the last customer out will most likely pay the most. A customer that is proactive and well aware of a problem in advance of other customers or parties and takes that information to develop alternative plans, can save a tremendous amount of risk and cost. Early identification of problems, and responding to those early signs, gives a customer more time to create alternative plans. Typically, the more options available, the less expensive and less risky for the customer. Early warning signs of potential problems include:

• request for special or expedited payment terms;
• request for price increases especially where retro price adjustments are requested;
• turnover in the management team or key employees;
• rumors within industry regarding slow payment to trade vendors;
• knowledge of union unrest;
• failure to meet program dates for operations or design readiness;
• deterioration in quality performance levels;
• any significant change in the way a company does business; and
• delivery problems and/or expedited freight issues.

Being proactive means not only utilizing all information available from the supplier and watching for the warning signs, but also regularly reading trade and financial periodicals to assure that there is no negative financial information relating to, or information that may result in, a negative financial condition of the supplier in those periodicals. In addition to various media sources, services, such as Dunn & Bradstreet, monitor companies and should be considered valuable resources to glean information about a supplier. Further, in most industries, there is always talk about financial conditions of other parties in that industry. A customer should be cautious about believing or spreading the information, but should conduct additional due diligence to determine if there is any merit to the rumors. If so, the customer needs to prepare for alternative solutions.

Okay, We Have a Troubled Supplier, Now What?

Ideally, a customer faced with a troubled supplier could acquire the goods from some other source without any interruption to its supply chain. However, in today's economic environment, particularly in single-source, just-in-time industries, alternative sources may be nonexistent and customers may be forced to deal with the financially troubled supplier. In those situations, more involvement by the customer is routinely required to assure continuity of supply. To assure continuity of supply, the customer may have to negotiate and provide accommodations to the supplier, which may include: 1) price increases; 2) gifts; 3) loans; 4) expedited payment terms; 5) bulletproofing supplier's working capital so lenders lend more on that working capital; and 6) providing guarantees to vendors who may be supplying your supplier. The level of involvement, accommodations, and cost can seem limitless at times to the customer.

During this time, it is critical that the customers develop various plans for future supply. The customer should then choose a strategy and plan with the least risk and the least cost. A customer should work with its attorney in order to understand the reason behind the process, and to structure a deal to best protect the purchaser at the least cost.

For example, in the automotive industry, lawyers providing assistance to customers in these circumstances, routinely negotiate and document what is referred to as “accommodation agreements.” These agreements will set forth, among other things, the accommodations being provided by the customers, the expectations of the supplier, and the expectations of the lender. Further, the customer may want to negotiate what is referred to as an “access and security agreement.” Under such a document, upon certain material defaults, the customer would have the right to step in and take over the supplier's production. Exercising rights under an access agreement is an insurance policy of last resort. As long as the supplier continues to produce and it is not being unreasonable, presumably, the supplier can produce at no more cost than it would take the customer. However, an access agreement gives the customer tremendous leverage.

Again, the ultimate goal is continuity of supply at the least cost and risk. The finality of the case could include several results: 1) reorganization; 2) a wind-down or resourcing; or 3) an asset sale to a more viable third party. Any and all of these could include the court system, depending on the situation. For example, any one of these options may be best facilitated through the bankruptcy process.

Setoff Rights

A proactive customer is doing more than just monitoring the quality, timing, delivery and financial condition of a supplier. A proactive customer will also be routinely determining whether it has any claims against the supplier, for: 1) material supplied; or 2) damage claims resulting from short shipments, misshipments, improper invoices, warranty claims, expedited payment charges, professional fees, and non-conforming parts. As these claims arise, they should be offset against any amounts owed to the supplier so that in a time of financial crisis, the customer does not find out that it is owed more money by the seller than it owes the seller. In any event, at the time of any financial crisis of the supplier, offset rights should be taken into consideration and can be significant leverage to negotiate with not only the supplier, but also the lender.

Conclusion

In today's economic environment it is likely that a purchaser of goods will have to deal with suppliers that might be financially distressed. In those circumstances, it is critical that you understand how best to maneuver through these troubled situations, maintain the ultimate goal of the circumstances, and minimize risk.

Hopefully, you have been proactive in monitoring the financial condition of the supplier, and at the first hint of any potential financial problems, you started developing alternative plans or sources of supply. However, in many circumstances, even if you have done everything correctly, there may be many cases in which you will still have to deal with a supplier that is financially distressed. In that circumstance, do what is best for business. In the short term it may be best to continue purchasing from the supplier while you look for alternative sources of supply for a long-term solution.

It is important to be conscious of these circumstances and construct the best possible deal including provisions that require routine updates on the financial information of the supplier. Before documenting the agreement, you should contact an attorney who specializes in these types of issues. With assistance from your attorney, you should be able to negotiate an appropriate arrangement to minimize risk, assure continuity of supply, and create “insurance policies” if something happens.

*****
James A. Plemmons is a member in Dickinson Wright's Detroit office and is practice department manager: Automotive, Bankruptcy & Insolvency and Product Liability Litigation for the firm. He represents OEMs and major automotive suppliers in distressed supplier cases. He can be reached at 313-223-3106 or [email protected].