United States: Identifying and Dealing With Troubled Suppliers

A troubled supplier - generally smaller Tier 1 or any Tier 2 - in the automotive industry very often has relatively few customers and is at risk of losing its business if it cannot meet production schedules. A supplier's reliability is critical in a "just in time" delivery environment; the troubled supplier can have difficulty establishing credibility after a failure to deliver. Often the troubled supplier cannot pay its vendors and payroll without an acceleration of funding from its customers because its banks may have cut off additional available financing.

The customer, an Original Equipment Manufacturer (OEM) or its direct supplier (Tier 1), has significant production problems if a lower supplier does not meet delivery requirements. Customers rely on a limited number of suppliers or sole source suppliers due to the large cost associated with having more than one supplier for the same part. It is very expensive and time consuming for a customer to re-source parts in time to prevent losing production. A customer in the automotive supply business often has no choice but to financially support a troubled supplier because capacity may not be available at alternative suppliers, and tools used to produce parts may not work to make qualified parts by another supplier. In addition, the time and money to produce new tooling is prohibitive and would result in the shutdown of an assembly line because of the failure to have parts.

Various forms of support from a customer might include temporary price increases, the purchase of raw materials, accelerated payments, and hostage payments - including past indebtedness - to vendors who supply critical materials. A customer that closely monitors its supply base is able to move quickly before the supplier is completely unable to produce parts. In addition, if the customer is aware of the problems before the supplier's lender, they can act to protect their interests more effectively through set-offs against its accounts payable or an anticipatory repudiation claim.

The financial institution relying on the accounts receivable from the customer and the troubled supplier's inventory for its collateral faces a serious problem when its supplier/borrower becomes financially troubled. The customers take the position that they have a right of set-off against all accounts payable to the supplier. In addition, if the seller is eliminated as a vendor to the customer, the value of the inventory collateral will be substantially diminished.

As is typically the case with any financially troubled company, its trade creditors are the last in line for payment. Payment of unsecured creditors is dependent on the ability of the troubled supplier's business continuing because the liquidation value of a troubled supplier is often zero. Generally, a vendor will charge its troubled customer on a cash on delivery (COD) basis and creditors who supply unique items will refuse to ship unless and until they are paid on all of their old indebtedness - hostage payments.

An OEM or Tier 1 can take a number of steps to attempt to identify problem suppliers early. The due diligence suggested below will ensure that the supplier is meeting the quality and delivery requirements of the customer. In addition, early due diligence may permit the customer to identify potential areas of concern and communicate those issues to the supplier early enough so that the supplier can resolve such concerns. Periodic due diligence as outlined below can assist a customer in gaining comfort that its key suppliers are long-term players. Alternatively, the due diligence may identify issues early enough to either allow the supplier to correct the problems revealed by the due diligence or permit the customer to resource in an orderly way. Many suggestions are common sense ways of doing business but require a proactive approach to determine the financial strength and viability of suppliers.

Review your supplier's latest C.P.A.-certified, audited, reviewed, or compiled financial statements, including the income statements, balance sheets, and statements of cash flows for last two fiscal years, if prepared, or officer-verified financial statements if the supplier does not have C.P.A.-certified, audited, reviewed, or compiled financial statements. The lack of certified - or at least reviewed - statements may, itself, be a sign that the supplier does not have the accounting resources in place to make its financial statements accurate. Look at the following to determine if the supplier may have financial problems:

• What are the supplier's financial trends over the last two years? While financial information in isolation may not reveal issues, by looking at such information and trends over time, you may identify potential problems. Maintain a spreadsheet on each supplier that would allow an easy view of trends over time. By adding information from each new year to the spreadsheet, you could track information on a variety of matters such as earnings, cash flow projections, related party transactions, contingent liabilities, assets, and related party transactions. Changes over time should be carefully assessed.

• Look at the supplier's current assets as a ratio to its current liabilities to determine if the supplier has adequate working capital. Another measure of adequate working capital is the ratio by which the cash flow covers required payments of interest for borrowed money. Working with appropriate internal financial personnel, develop a set of ratios and minimum standards that, if not met, will trigger further investigation. Working capital shortages are often an indicator of trouble ahead.

• If the supplier has publicly held debt - such as bonds or stock - review materials filed by the supplier with the U.S. Securities and Exchange Commission (SEC), such as Form 10-K reports to elicit valuable information regarding the supplier, such as current financial statements and information regarding material litigation. These forms are available over the Internet.

• Look at the footnotes to the financial statements. Often these give critical information about the company that may not otherwise be apparent by looking at the financial statements.

• If the financial reports are certified, read the accountant's letter to see if the certification contains any qualifications, such as a going concern qualification. Also, see if the supplier's accounting firm has changed from prior reports. If so, find out why the change was made.

• Ask the supplier for an aged summary of its outstanding payables and the average number of days payables are unpaid. Again, on a year-by year basis, if there is a trend of greater and greater delinquencies in the supplier's accounts payable, this may indicate and predict working capital problems.

Ask, annually, for a company-wide organization chart showing divisions and subsidiaries and naming key personnel. If the supplier's key personnel have changed or the structure of the supplier has changed, investigate why these changes took place.

Understand the management team's strengths and weaknesses. Ensure that the supplier's management is committed to the OEM's Global Purchasing Supplier Guidelines, including a commitment to the OEM's Supplier Manufacturing System (i.e., lean manufacturing).

Determine and identify the supplier's customer base by industry and concentration of customers within the industry. A broader customer base in diverse industries is beneficial. It is also helpful if the supplier operates and supplies customers outside of the United States.

Appropriate personnel should make periodic plant visits to observe, among other matters, whether the plant is clean and operating efficiently, whether the supplier adequately maintains its machinery, and whether the supplier has dedicated necessary machinery to the customer's jobs. During the visit, the supplier should make available appropriate manufacturing and executive personnel to answer questions. Prepare reports and note specific concerns about the supplier to form the basis for the next visit.

Order and review UCC financing statements. These will show who the supplier's lenders are and whether there has been a change over time. The financial statements should show whether the lender is in default. If the statements are not certified by a CPA, consider requesting an estoppel certificate from secured lenders to ensure that the customer is not in default of its secured lending agreements.

Assess e-commerce capabilities (i.e., business-to-business applications). Assess information technology systems and capacity generally.

Obtain available credit reports and utilize data sources within the automotive industry relative to suppliers. If the supplier has publicly traded debt, seek to determine its bond ratings and whether there have been changes. This information is readily available over the Internet.

Determine the key suppliers supporting your supplier.

If the supplier has a business plan, review and assess the quality of that plan. A plan that relies solely on increased sales or price increases should be viewed critically.

Any irregularities discovered in the due diligence suggested above or changes from your initial assessment of the supplier may be a warning signal. Again, a proactive approach is required to identify problems early before it affects production.

Various other indications of possible trouble include:

• Requests for price increases, early payment, accelerated payment terms, or direct financing.

• Requests for technical support.

• Late deliveries or changes in product quality.

• Failure to update IT systems or failure to appropriately utilize existing technology within the automotive industry.

• Failure to appropriately cut costs during economic downturns (determine if management and principals are making any sacrifices).

• Delinquent taxes.

• Poor judgment from management with respect to utilization of available cash.

• Deteriorating accounts receivable and payable. Employment of various types of consultants.

• Negative publicity or press.

• Negative variances from projections.

• Payments on insider debt.

• Excessive related party transactions.

• Deteriorating market position relative to competitors.

• Recent rapid growth in sales volume.

• Lack of focus by management or response to requests.

• Conduct proper due diligence on the front end.

• Periodically audit suppliers.

• Create a program to effectively select and manage the supply base. If decisions are made to reduce the number of suppliers, make sure termination of a supplier for certain parts does not result in a troubled supplier situation for others.

• Conduct internal training to assist purchasing agents, accounts payable, quality control, and plant managers in dealing with suppliers and recognizing potentially troubled suppliers. A process should be adopted to ensure that reports of potential trouble are provided immediately to a centrally assigned person.

• Identify troubled suppliers early and, if possible, re-source before supplier issues are critical. Create a bank of parts in the interim.

• At the first sign of trouble - if re-sourcing is not immediately practicable - conduct a legal analysis of available options in any given jurisdiction and related costs, including re-sourcing, bankruptcy, litigation to retrieve tooling, injunctive relief, orderly sale of business of the supplier, etc. Assess how long the supplier can continue to supply and how long it will take to re-source before determining the appropriate option. Maintain a file of law and outcomes in each jurisdiction to assist with strategy and planning.
• Be prepared to litigate to recover tooling or for injunctive relief to prevent supplier from refusing to manufacture or deliver parts. Maintain a database of jurisdictions where litigation has been initiated and maintain a database of the results of such litigation. Prepare and maintain a model complaint now for tooling recovery and injunctive relief so that if it is necessary to litigate in any given case, the pleadings can be quickly modified to fit the facts in question.

• An OEM and Tier 1 should maintain independence in troubled supplier situations. For example, Tier 1 suppliers should develop strategies to handle different situations depending upon the OEM that may be in any troubled supplier situation. When faced with requests for cost reductions from OEMs, assess the effect on the relationship with lower tier suppliers and work as a team to address all relevant issues.

• Review adequacy of purchase orders and other documents for, among other matters, ownership, indemnification, and rights in tooling, damages, and remedies; right of a lower tier supplier to subcontract; right to set-off; and strict procedures for changes in pricing. Assess whether a personal guaranty is appropriate. Consider whether to provide for an option agreement to acquire supplier's equipment needed to produce supplied parts.

• Document all variations from and amendments and modifications to purchase orders.

• In troubled supplier situations, assess the willingness of the supplier to act and negotiate in good faith and to provide additional information. Demand that open communications, mutual trust, and respect govern the relationship between the lower tier supplier and its customer. Develop a reputation that you will not negotiate with suppliers absent that consideration.

• Before troubled supplier situations develop, OEMs and Tier 1 suppliers should work as a team with Tier 2 suppliers and subsuppliers on things such as lean manufacturing, performance standards, organizational structure, e-tool implementation, and management issues.

• If re-sourcing is not feasible, work with legal counsel and a financial advisor to assess the viability of the company, determine a plan of action, and negotiate a consensual solution if possible.

• Do not concede lightly to a price increase. This should be a course of last resort after other options are assessed. Understand why the supplier believes it needs the price increase and make sure that the supplier uses the additional monies to produce your parts. Do not agree to a price increase if the monies will be used to pay a secured lender or other creditors.

• If the supplier is having difficulty obtaining supplies or materials from its suppliers for credit reasons or otherwise, investigate whether it can negotiate directly with such suppliers for a better price.

• Before providing financial assistance, require that the troubled supplier prepare for evaluation cash flow projections that clearly outline its needs going forward.

A series of agreements is typically negotiated that provides some protection for all parties. The agreements provide continued financial support to the troubled supplier from its lender or - in some cases the customer - for a period of time. The customer gets a continued supply of goods and the lender gets legal assurances that the value of its collateral is protected. Unsecured creditors can get payment for new supplies on a COD basis. There are generally a series of agreements: a forbearance agreement, a financial accommodation agreement, and an access agreement.

A forbearance agreement sets forth conditions pursuant to which the lender will forbear from exercising rights after a default by the supplier borrower.

Forbearance agreements typically provide provisions as follows:
acknowledgment of the amount of debt, with no offsets; acknowledgment of default; definition of the forbearance period; financial terms of forbearance (e.g., interest rate, fees, and payment obligations); full releases by the borrower, equity holders, and guarantors to the bank; reaffirmation of guarantees; and additional default terms. In an automotive case, a condition to the effectiveness of the forbearance agreement may be the execution of the access agreement and financial accommodation agreements by the appropriate parties. Because resolution of the supplier's troubles is critical to continued contract for goods, the agreement may also set deadlines for the restructure of debt.

An access agreement grants rights, upon the occurrence of certain events, to the customer to operate the supplier's plant to assure a continuing supply of parts.

An "access event" triggers the right of customer access to the supplier's part production, which includes the following:

• The supplier files a voluntary bankruptcy petition or has a petition filed against it that is not dismissed within period of time. However, such provisions may not be enforceable by a bankruptcy court.

• The supplier fails to satisfy the customer's requirements pursuant to purchase orders that would cause an imminent interruption of the customer's operations, as determined by the customer's reasonable judgment.

• The lender commences foreclosure proceedings.

• The supplier fails to restructure its debts by a certain date.

Access agreements also provide that the obligations of the supplier to the customer to grant access is secured by a blanket lien on the supplier's assets, subordinate only to the security interests of the lender. The OEM may also participate in loans by buying a subordinated participation agreement. However, an access agreement also will provide that the lender's senior security interest is subject to the customer's right to access for some period of time. The lender can accelerate and foreclose, but may not liquidate the plant and equipment in a way that interferes with the customer's right to operate the assets under its right of access.

The lender and the troubled supplier may make agreements as to what each may or may not do in the event of a bankruptcy, such as the right of the lender to seek a lifting of the automatic stay so long as the lender does not impair the right of access of the customer.

The obligations of the customer during any period during which the customer exercises its access rights, include (i) the customer's obligations to indemnify the lender and the troubled supplier for damages or liabilities caused by the troubled supplier, (ii) maintenance of the assets, (iii) insurance obligations, (iv) a use and occupancy fee, and (v) provisions for allowing the troubled supplier, under certain circumstances, to allow production for other customers.

Provisions are included to require the troubled supplier to continue to employ its employees during the access period at the customer's expense.

The customer agrees to purchase all of supplier's "usable" and "merchantable" inventory (e.g., raw materials, work-in-process, and finished goods) related to the parts purchased by the customer, either upon an event of default under the forbearance agreement, foreclosure, or after access at prices defined in the agreement.

A financial accommodation agreement is customized for the specific situation but deals with granting protection to the lender and its accounts receivable, and other collateral.

The customer, for the benefit of the lender only, agrees not to set-off claims against the accounts payable owed to the supplier. Once the lender is fully paid, the customer will assert a right of set-off against further payables, to the detriment of administrative creditors in a Chapter 11 proceeding and unsecured creditors.

The agreement may provide terms pursuant to which the lender will supply debtor-in-possession (DIP) financing of the supplier in a Chapter 11 bankruptcy proceeding.

The customer may agree to supply certain raw materials to the supplier with the right to set-off against accounts payable for the value of the raw materials supplied by the customer.

The customer generally insists that its ownership rights in tooling is acknowledged by the lender and customer. In addition, if certain production equipment is important because it is necessary to produce parts, the financial accommodation agreement will contain an option for the customer to purchase the equipment.

The supplier also releases all claims against the lender and customer.

As a condition of any cash collateral order in a Chapter 11 bankruptcy proceeding, the lender and/or the customer will insist upon having the bankruptcy court approve the financial accommodation agreement and the access agreement.