Avoiding Trouble in the Supply Chain

Credit Professionals Possess the Skills to Mitigate Risk

One of the worst nightmares for any company is the shutdown or bankruptcy of a major supplier. Inability to obtain raw materials or parts may bring the purchaser to a halt and prevent it from getting its own product out the door. Causing a break in the supply chain may cause enormous consequential damages. Experience gained during the economic downturn in the automotive supply industry demonstrated both the inherent danger but also the resourcefulness of certain suppliers in dealing with the challenges of an unstable supplier. The lessons learned there are equally applicable to manufacturers who depend upon their suppliers just as their customers rely upon them. The need to identify supplier problems is heightened when the supplier is the sole source of a part or raw material and a replacement part or raw material is not available on the open market.

Generally, credit departments are charged with watching and collecting receivables. Good credit professionals with financial and risk management knowledge, however, possess the requisite skill and knowledge to help their companies analyze the risk of supplier trouble and create strategies for crisis management to minimize or prevent the nightmare of supplier problems. This article provides a checklist of strategies that companies should consider to provide protection. It focuses on both legal and non-legal strategies that can be utilized.

Identifying Troubled Suppliers

The first step is to understand that supplier "trouble" may be more than just financial unsoundness-it may also be caused by managerial weakness. To preserve and protect their own financial well-being, customers need to recognize the early warning signs of a troubled supplier and take effective steps to minimize loss and disruption to the supply chain. Early warning signs and the steps buyers may want to take to uncover supplier trouble include the following:

* Monitoring the financial health of the seller/ supplier. Customers should require financial reporting obligations in supply contracts. Monitoring the financial soundness of suppliers on a regular basis may reveal stress that might prohibit timely delivery or other issues capable of breaking or endangering the supply chain for the purchaser. If a supplier is having difficulty paying its creditors, it is likely to have trouble buying raw material and ultimately manufacturing its product.

* Conducting plant tours. In addition to inspecting the manufacturing facilities at the supplier's plant, the customer should also retain the right to test the integrity of the supplier's information and accounting systems and determine whether the supplier is using up-to-date technology. Failure to maintain up-to-date accounting or other systems may indicate that the supplier is financially troubled.

* Monitoring delivery and performance. Late deliveries, increased use of expedited freight, requests for technical support, lack of response to production issues, requests for price increases, altered or accelerated payment requests and changes in product quality are all signs that a supplier may be experiencing financial distress or management problems.

* Monitoring press and public reports. Watch for reports of downsizing, downgrading of outstanding bonds, significant layoffs, retention of various legal and turnaround consultants by the supplier and/or changes in accounting or auditing firms.

Preparing for a Crisis

Because trouble in the supply chain may arrive at some point, prudent companies will create plans to deal with, or hopefully avert, trouble if it appears on the horizon.

1. Develop a Crisis Team

Every company should have a permanent mechanism in place for monitoring troubled suppliers and one person or a team assigned to be the central contact when a potential troubledsupplier situation is identified. The crisis team should be charged with the important task of conducting internal training to assist purchasing agents, quality control, accounts payable and plant managers in recognizing the early warning signs of distress. The crisis team will need to assess how imminent the trouble is and whether there are steps that can be taken to avert the problem. The team will need to have access to senior management and possibly legal and financial advisors to assess the viability of the supplier and understand the customers options. In addition, the crisis team should know the employees at the supplier who will be crucial to possible resolution as well as the identity of alternative suppliers, if available.

2. Review Purchase Orders and Contracts

The terms and conditions of the relevant contracts that would apply in the event of a supplier breach should be reviewed. In some cases, these may be entered every time a purchase order is entered or an invoice is issued. In other cases, they will be incorporated in a long-term supply agreement. All purchase orders, invoices and contract forms should be reviewed by legal counsel experienced in dealing with supply-chain issues. What is the buyer's right to terminate? Is written notice required prior to termination? Is there a right to cure? Are liquidated damages allowed or prohibited? What warranties have been issued? Most importantly, if there are conflicting terms, which term applies?

3. Retain Ownership of Tooling

If a supplier is using specialized tooling to manufacture parts for the purchaser, the customer should retain ownership rights in the tooling. If title is retained and the supplier is unable to produce the parts, the tooling can be repossessed from the supplier by the customer and used for in-house manufacturing or transferred to an alternative supplier. Ownership of tooling is protected under state law and is state specific. Failure to perfect the customer's interest in the tooling may leave the customer at odds with the supplier's secured lender or the supplier itself. The time to determine the rightful ownership of tooling and to make sure that the interest is perfected is prior to a crisis or bankruptcy of the supplier.

4. Consider Freezing Accounts Payable

In the event that the financial or other distress of the supplier is evident, the customer should consider withholding payment from the supplier. A decision not to pay the supplier should not be made without close consultation with legal counsel, however. The customer may have the right to set off damages caused by the supplier's breach or imminent breach of the supply agreement against the accounts payable owed to the supplier. Obviously, such a decision will adversely impact future relationships with the supplier and, if wrongfully done, may expose the customer to damages. Setoff or recoupment of amounts owed to the supplier may be appropriate if the supplier owes money to the customer/purchaser.

5. Create a Parts Bank

If it appears that imminent financial distress of a supplier is likely to lead to disruption of the customers own ability to produce its product, the customer should consider creating a "parts bank" or inventory bank. The buildup of additional parts or raw materials will assist the buyer/customer during a period of transition to a new supplier, avoiding delay in production.

6. Accept Price Increases or Provide Other Financial Accommodations

Under certain circumstances the customer may really need to work with the troubled supplier. Problems for the supplier may only be temporary. For example, if a tornado or flood created an inability to produce parts or increased the cost of raw material for the supplier, the customer may want to agree to an increased price for the goods or accelerate payments to help ease the distress. This type of decision will, of course, create future goodwill and loyalty by the supplier to the customer who worked through the temporary problem. On the other hand, the customer may want to agree to increased prices or accelerated payments to insure delivery while it locates alternative suppliers. The customer may also want to consider purchasing raw material for the supplier if that is the only way to continue to receive the needed product. In that case, bailment of the purchased raw materials should be strongly considered.'

7. Find Alternative Suppliers

It is wise to identify additional suppliers and more important to explore the possibility of engaging them when it appears that the current supplier may not be able to continue to be viable. Building up a parts bank prior to moving to the new supplier will ease the transition stress and protect against disruption in manufacturing.

8. Enter into a Plant Access Agreement</p>

In the automotive parts industry, any break in the supply chain can prevent the original equipment manufacturer from assembling its automobiles. Because each auto part is essential, the industry utilizes access agreements. Access agreements could be considered in other manufacturing situations where the supplier is crucial to the customer's end product. The typical access and security agreement gives the customer the right to enter the supplier's plant and use the supplier's tooling, machinery, raw materials and sometimes even its employees to produce the parts themselves. Usually, the customer must pay for the employee expenses of the distressed supplier, maintain the assets of the supplier, pay use and occupancy fees to the supplier or its lender and in most cases, allow the distressed supplier to continue to produce products for other customers. Secured lenders of the troubled supplier would commonly be a party to the access agreement because its collateral would be used by the customer gaining access and it is likely to hold a lien on the customer's receivables.

Legal Rights under the Uniform Commercial Code

The discussion above includes practical strategies to be considered when dealing with a troubled supplier. Article 2 of the Uniform Commercial Code (UCC), adopted by all states and United States territories, offers legal remedies protecting buyers and sellers of goods. Although it is a "uniform" law, each state has adopted its own version and one must check with a specific state for its unique provisions. That being said, the following discussion concerns remedies available to buyers of goods and is generally applicable in all of the states.

1. Request for Adequate Assurance under UCC Section 2-609

Most credit professionals are familiar with Section 2-609 as it relates to the collection of receivables and the inability of customers to pay or otherwise perform. Section 2-609 is also available to a purchaser of goods who believes its supplier is unable to perform. Thus, upon reasonable grounds for insecurity, the buyer may demand adequate assurances of due performance that the supplier is able to supply in a timely fashion and according to the terms of the supply contract, including in quality and quantity. The demand under Section 2-609 should be (although not required) made in writing and should set forth the date by which the adequate assurance is to be provided. It is also wise to state what the adequate assurance should be. The demand should only be made in situations where the purchaser has good reason to believe that the supplier will not be able to perform. Any demand for adequate assurance must be answered within 30 days unless the written demand states otherwise.

2. Anticipatory Repudiation

If the supplier does not provide acceptable adequate assurances that it can perform, the customer may consider the contract repudiated or terminated. Anticipatory repudiation is a remedy provided for in Section 2-610 of the UCC. It is a much more serious remedy than a request for adequate assurance, as it terminates the contract. If anticipatory repudiation is exercised, the buyer of the goods may attempt to recover the portion of the contract price, which may have already been paid to the seller and attempt to cover the needed goods with another vendor or recover the damages for non-delivery as calculated under Section 2-713 of the UCC. The "cover" of the goods must be in "good faith and without unreasonable delay." Where a buyer elects not to cover, it may be denied recovery for damages if the "cover" would have mitigated its damages. If the customer/buyer elects to cover, it will be entitled to damages for increased costs of the comparable goods and increased costs of transportation. The alternative goods must be regarded as commercially reasonable alternatives to the originally ordered goods from the breaching supplier.

3. Actions for Specific Performance

What happens when an alternative supplier is not available and the part or raw materials are crucial to the operation of the buyer's business? The buyer may want to consider filing suit for specific performance and request a preliminary injunction requiring the seller to continue performance under the contract. Specific performance is allowed where the goods are "unique" or where "other proper circumstances" require this outcome. The order for specific performance may include such terms and conditions as the payment of the price, damages and other relief that the court concludes is appropriate. Buyers should note that the specific performance remedy is not for money damages, but to obtain the goods that are required. The goods or raw materials that are the subject of the specific performance must be really unique and unavailable elsewhere.

4. Special Property Interests in Goods

The buyer who has paid an insolvent seller part of the purchase price may hold what is identified by the UCC as a "special property" interest in the subject goods, even though delivery has not occurred. If the seller becomes insolvent within 10 days of the receipt of the first payment for the goods, the buyer will obtain a special property interest in the goods under Section 2-502. If these particular goods are identified in the contract and are conforming, the buyer may recover the goods from the seller. The buyer, however, may have a problem if the seller files a bankruptcy after the payment, but before delivery. If the contract between the buyer and seller is assumed in the bankruptcy, the buyer will have continued rights to the goods under the terms of the assumed contract. If the contract is rejected, the buyer will merely hold an unsecured claim for the damages.

5. Liquidated Damages Provisions

If liquidated damages have been agreed to in the contract, they may be recovered if they are reasonable. Reasonableness will be determined by (i) the anticipated or actual harm caused by the breach; (ii) the difficulties of proof of loss; and (iii) the inconvenience or unfeasibility of otherwise obtaining an adequate remedy. A contractual term that assesses unreasonably large damages will not be enforced if it is regarded as a penalty.

Conclusion

Credit professionals can easily increase their value within their company by utilizing the appropriate practical and legal strategies provided in this article. Although none of the strategies are discussed at length, it is hoped that this list will be the beginning of an understanding of the options available. Avoiding undue stress in the supply chain or knowing what to do when it appears is crucial and can save purchasers delay in producing their own products as well as avoiding consequential damages to others in the chain.

Good credit professionals with financial and risk management knowledge, however, possess the requisite skill and knowledge to help their companies analyze the risk of supplier trouble and create strategies for crisis management to minimize or prevent the nightmare of supplier problems.

If it appears that imminent financial distress of a supplier is likely to lead to disruption of the customer's own ability to produce its product, the customer should consider creating a "parts bank" or inventory bank.

1. A bailment agreement recognizes that the customer who purchased the raw materials owns those materials even though they are in the possession of the supplier. The customer should file a UCC financing statement providing notice to all, including the lender of the supplier, that the raw materials belong to the customer and are not subject to the lien of the supplier's lender.

DEBORAH THORNE, ESQ.

Deborah L. Thorne, Esq. is a partner in the Finance Insolvency and Restructuring Department of Barnes & Thornburg LLP. She is a fellow of the American College of Bankruptcy and is a vice president of the American Bankruptcy Institute. She is a co-author of Interrupted! Understanding Bankruptcy's Effects on Manufacturing Supply Chains, published by ABI in 2012, which discusses many of the concepts described in this article in more detail. Deborah can be reached at [email protected] or at 312-214-8307.