The development of new powertrain technology; challenges within established markets, such as diesel emissions issues; and falls in automotive production – production in the United Kingdom has fallen during the last 12 consecutive months – have all had a significant impact on the automotive and mobility industry. The rapid increases in demand for connected, electric, and hybrid vehicles – together with the associated infrastructure – means that effective cooperation among OEMs, suppliers, regulators, and other stakeholders is now more important than ever. The cost of this new technology, aligned with shocks to production, such as the ongoing uncertainties around Brexit and China trade tariffs, means that more than ever, fortune will favor the innovative and the well prepared innovator.
Hogan Lovells partners Joe Bannister (UK), Heiko Tschauner (Germany), and Chris Donoho (U.S.) are part of the firm’s Business Restructuring and Insolvency practice. Bannister and his colleagues have a wealth of experience acting for original equipment manufacturers (OEMs) and suppliers in some of the most complex and intractable automotive cases of the past decade. In this article they discuss the challenging issues that arise when an OEM is faced with a distressed supplier, and what can be done to mitigate the resultant risks.
The relationship between OEMs and their suppliers has always been highly symbiotic and capital intensive. What makes things different now?
Bannister: Profit margins for the sale of new motor vehicles are now tighter than ever. That has led OEMs to refine and manage relationships with key suppliers more robustly. This tighter management is illustrated in a number of ways. First, we have seen OEMs seeking to hold suppliers to fixed prices for key components for a number of years before insisting upon phased price reductions. That in turn has often reflected the technology underlying particular models becoming more established and less cutting edge. Additionally, OEMs have carried out regular supplier culls so that wherever possible, they hold fewer relationships with individual suppliers, but those relationships extend to a greater number and range of components.
The result is to leave the supply chain increasingly vulnerable to fluctuations in demand. Additionally, the highly integrated just-in-time nature of supplies means that production of particular vehicles will almost invariably be, at best, able to carry on for a few weeks and, at worst, for a few hours in the event of any disruption. The current uncertainty as to when, and if so on what terms, the United Kingdom will leave the European Union merely serves to exacerbate those issues.
What are the danger signs?
Tschauner: With the benefit of hindsight, what might appear at first sight to be an out-of-the-blue failure is usually anything but. Individual cases will vary, but expect first to see as danger signs some or all of requests for price increases, pleas for accelerated or increased payment terms, and late or short deliveries. Other danger signs are unexplained quality problems, loss of key personnel at the supplier, and restrictions or reductions in credit insurance. With listed supplier counterparties, look out for profit warnings, emergency – or under subscribed – rights issues, and rumors or announcements of requests for covenant waivers.
What should be done from an OEM perspective?
Donoho: Successful vehicle models will be in production for a decade or more, and therefore the relationship between an OEM and its suppliers will invariably be long term with no easy exit. Long-term relationships call for long-term management and financial oversight. Because of this high level of scrutiny, the performance of individual suppliers should be evaluated by an experienced and dedicated team within the OEM. That team should include within it individuals well-versed in the identification and management of distressed businesses. Where appropriate, those dedicated teams should also include external financial and legal advisors with relevant experience.
Bannister: Wherever possible, an OEM should work with the suppliers to build up or confirm the availability of surplus components to ensure that there is a “buffer” in place to give the OEM at least some protection against any interruptions in the supply chain. Where one is dealing with a vehicle that sells very well, building up a stock of surplus components may in fact be a difficult thing to do.
The OEM should also work out how long it would take to obtain a replacement supplier for particular components should there be a disruption for financial reasons or otherwise. If necessary, a replacement/financing program should be initiated in response to the financial distress of a particular supplier. An OEM should be on top of the reporting and information provisions in individual supplier contracts. It should ensure that these provisions are adhered to. If the OEM does allow a supplier additional time to comply with these provisions, or indeed waive any other breaches, the OEM should ensure that its rights are fully reserved.
What should be done from a supplier perspective?
Tschauner: The supplier’s position is really the mirror of the OEM. In our experience, early engagement is in the mutual interest of both parties, particularly where an OEM is one of a limited number of customers. To the extent possible, suppliers should proactively manage contractual performance. Ideally, to maintain trust they should notify OEMs of potential contractual breaches before those breaches occur. Wherever possible, the supplier should agree to a mutually acceptable alternative with its OEM customer. The supplier and its advisors should, wherever possible, make the most of any interdependency between the supplier and its OEM customer. In particular, suppliers should not underestimate the ability or willingness of an OEM to provide vendor financing, early payment, or other support where the alternative is delayed production and heavy losses.
Funding suppliers: pre-insolvency?
Donoho: Wherever possible, the OEM should not allow just-in-time to production needs to prevent it from seeking or receiving an appropriate, commercial, quid pro quo for funding that is provided. One example is for the OEM first to obtain security for any funds that it may provide. Bear in mind, however, that obtaining security is likely to require the prior agreement of other lenders to the OEM. It may also be necessary for the OEM’s security to rank behind that of other lenders. That may or may not in fact protect the OEM depending on where value falls. At a minimum, however, the OEM should seek some control over the enforcement process. It should also seek the means to step in and manage the situation where the supplier has lost the ability to do so effectively.
Additionally, the OEM should insist upon tooling, finished, and unfinished goods being kept separate from products destined for other clients. In doing so, the OEM will maximize its chances of recovering components or finished goods in the event of the supplier entering a formal insolvency process. Additional valuable protections against a financially weak supplier can include enhanced rights of inspection and rights of entry into the supplier’s premises. Wherever possible, the OEM should seek nonexclusive licences to use or replicate any intellectual property or other design rights so as to maximize its ability of resourcing to a solvent counterparty.
Tschauner: The OEM should also be familiar with the particularities of the applicable insolvency regime. For example, the German insolvency code provides extensive voidability rights which can be reduced to some extent through contract management.
Suppose the supplier goes into bankruptcy or reorganization proceedings. What are the OEM’s options?
Bannister, Tschauner: The answer will depend upon the nature and effect of the particular bankruptcy or reorganization process. It will also depend upon the jurisdiction in which that process takes place. To some extent, these are matters that can be planned for if either or both of the OEM and the supplier has sufficient warning. For example, some procedures – such as a U.S. chapter 11 reorganization or an English administration – will have as their principal objective the rescue of the relevant debtor. Other procedures – such as an English liquidation – will be terminal processes, where the business in question ceases trading. The first step for the OEM and its advisors will be to determine which procedure is in play and what options it provides.
For example, there is case law in some jurisdictions that insolvent businesses are entitled – and may even be bound – to increase the prices of the components they supply to customers. This is because a financially distressed business must maximize the value of its assets to the benefit of its creditors. For the same reason, nevertheless, experience shows that it can still be possible to negotiate mutually acceptable, interim arrangements that protect the interests of both the OEM and the distressed supplier. Examples of such arrangements are the OEM providing what is in effect debtor-in-possession funding for ongoing production, with that funding being repaid in priority and as an expense of the relevant procedure. In such cases, we have successfully negotiated for OEM clients rights of inspection, options to purchase particular assets, and nonexclusive licences to particular intellectual property rights.
In other instances, we have assisted OEMs in the negotiation of pre-packaged purchases of the business and undertakings of stressed suppliers. As a result we have helped save many businesses and jobs through placing those businesses on a long-term, sustainable, financial footing.
What makes Hogan Lovells a stand out restructuring law firm in the OEM space?
Donoho: There are a number of reasons. First, the breadth of our client base sets us apart. We advise the entire range of stakeholders including debtors, management, creditor committees, suppliers, and restructuring practitioners. We have also acted for pension trustees and regulators across a whole range of industries, including the automotive sector. We possess deep practical and legal experience of the technical and commercial issues facing OEMs and their suppliers in these uncertain times. More importantly, we have that know-how in all the key automotive jurisdictions – the United States, United Kingdom, Continental Europe, and China.
In addition, Hogan Lovells has one of the legal profession’s largest and most experienced group of lawyers specializing in representing stakeholders in the automotive and mobility industry. More than 500 legal professionals collaborate globally in all relevant practice areas including M&A, antitrust, litigation, product liability, intellectual property, business restructuring, and insolvency. We provide one-stop legal advice to clients, including the world’s leading OEMs and distributors together with their suppliers, manufacturers, and regulators. Members of the Hogan Lovells automotive industry group include a number of our restructuring partners and their teams. We advise clients in all 50 U.S. states as well as in Europe, Asia, and the Middle East.