Signs of Distress: Key Legal and Operational Issues for Auto Suppliers During the COVID-19 Economic Downturn
In late March, most automotive suppliers, in Michigan, across the country, and around the world, halted operations as automotive manufacturers closed plants in response to the COVID-19 pandemic. Auto suppliers are now determining when and how to resume operations.
The New York Times recently reported that major U.S. auto suppliers communicated to Michigan Governor Gretchen Whitmer that they are ready to resume production and requested that she provide clarity about when they will be permitted to do so in light of the ongoing state of emergency in Michigan. According to the Times, the Motor & Equipment Manufacturers Association and Original Equipment Suppliers Association told Whitmer that "delays in re-opening facilities would increase liquidity risk for suppliers and jeopardize long-term capital investment and employment for Michigan.” Subject to certain safety protocols being implemented, Governor Whitmer, through Executive Order 2020-77 permitted manufacturing, including auto suppliers, to resume operations on May 11. The automakers have targeted May 18 as the date by which they hope to get operations back on-line.
Regardless of how soon the automotive industry restarts, it will be a tough road ahead for many suppliers. Automakers such as Ford and Fiat Chrysler recently announced billions in losses during the first quarter of 2020, and have predicted even more challenging times ahead. The financial struggles of those at the top will ripple down the supply chain.
In light of these circumstances, it is incumbent on auto suppliers to be aware of signs of financial distress—their own, and that of their suppliers and customers up and down the supply chain. The days ahead will require extreme vigilance and quick, strategic action. Here are some issues that suppliers should be considering, and circumstances they should be on the lookout for, to protect their businesses.
Protect Supply Chains
Plan for certain of your suppliers of parts and services to fail, or at a minimum experience disruptions, moving forward. Assess and identify critical parts and services, particularly those that come from a single-source supplier, and make contingency plans to ensure continuity of your supply chain. Some suppliers may request price increases, accelerated payment terms, or other forms of financial accommodation. In the event such requests are made, be ready to re-source supply, negotiate new terms, and/or take swift legal action to enforce the terms of the existing contract.
Review the Financial Health of Customers
In every economic downturn, one of the ways that companies try to conserve cash is by delaying payments beyond contract terms. Audit the financial health of your customers. Be diligent about enforcing payment terms. In some cases, amend payment terms to cash on delivery. To the extent your business is experiencing liquidity issues, consider approaching certain of your customers to determine whether they will pay you more quickly.
Demands for Adequate Assurance of Performance
Under UCC Section 2-609, a party to a contract has the right to demand adequate assurance of performance from a distressed counterparty. This demand usually comes in the form of a “demand for adequate assurance” letter. UCC Section 2-609 provides: “When reasonable grounds for insecurity arise with respect to the performance of either party, the other may in writing demand adequate assurance of due performance and, until he receives such assurance, may, if commercially reasonable, suspend any performance for which he has not already received the agreed return.”
Demands for adequate assurance tend to be made more frequently during times of economic distress. To the extent that you suspect that any of your suppliers or customers may be, or may become, unable to perform under a contract, but are not yet in breach, you may want to consider demanding adequate assurance. If a contract counterparty fails to provide adequate assurance, you may be able to repudiate the contract.
If you receive a demand for adequate assurance, it’s important to thoroughly and timely respond to it. Under the UCC, a party has to respond “within a reasonable time not exceeding 30 days.”
If your business is experiencing financial distress, and has a line of credit or other form of loan agreement with a lender, expect increased scrutiny. Lenders will be closely monitoring whether their borrowers are abiding by the various covenants found in loan agreements, such as maintaining specified debt-to-asset ratios. When a covenant is violated, it gives the lender the right to take a number of actions, including demanding penalty payments, increasing the amount of secured collateral, or terminating the debt agreement, any which can push a company into bankruptcy.
However, in many cases a lender would prefer that a borrower stay out of bankruptcy, and would be willing to negotiate an interim measure, such as a forbearance agreement, that allows the borrower breathing space to move forward. In a typical forbearance agreement, the borrower acknowledges that it has defaulted on its obligations, and the lender agrees that it will refrain from exercising its remedies for such defaults as long as the borrower performs or observes the new conditions set out in the forbearance agreement, and, by a certain date, cures the defaults.
Access and Accommodation Agreements
Because of the interconnectedness of automotive supply chains, in which a single supplier often produces a key part for a number of customers, the failure of such a supplier can wreak havoc on the just-in-time manufacturing model of the automotive industry. Accordingly, when a supplier is experiencing financial difficulties, those likely to be impacted often band together to implement a solution.
A common solution used to address the risk of a disruption in supply from a troubled supplier is for the supplier, key customers, and the supplier’s lender to enter into access and accommodation agreements. Through an accommodation agreement, customers provide certain accommodations (e.g., price increases and/or acceleration of payments), and, in return for additional collateral protection, the lender continues to lend and agrees not to foreclose as long as the other aspects of the accommodation agreement are adhered to. An access agreement typically permits, to the extent necessary, customers to gain access to the supplier’s plant to run operations in order to maintain the supply of parts until another solution can be implemented.
Take Action Now to Protect Your Business
While the automotive industry is gearing up to reopen plants and resume production, the economic downturn is almost certain to cause distress and disruption moving forward. Now is the time to plan for different contingencies and take steps to ensure that you have sufficient liquidity to operate, you understand your rights and obligations under purchase and supply contracts, and your supply chains are protected. If you have any questions about how to protect your rights and shore up your business as the automotive industry prepares to come back on-line, please contact David Dragich at 313.886.4550 or firstname.lastname@example.org.