Long Term Supply Contracts In Auto Supplier Bankruptcies

Long Term Supply Contracts In Auto Supplier Bankruptcies

The author wishes to thank his colleague, John T. Gregg, for his assistance in preparing this piece.

In this LexisNexis Emerging Issues Analysis, author Patrick Mears examines long term supply contracts in auto supplier bankruptcies, posing the question: may the nondebtor seller change payment terms for postpetition sales to the chapter 11 debtor?


In virtually all Chapter 11 cases of auto suppliers, particularly higher-tiered suppliers such as Delphi Corporation and Lear Corporation, and original equipment manufacturers like Chrysler Corporation and General Motors Corporation, a clash of interests will occur between the Chapter 11 debtor-supplier, on the one hand, and the nondebtor, lower-tiered supplier, on the other hand.  The Chapter 11 debtor will attempt to move mountains in order to keep its operations functioning at prebankruptcy levels so as to stabilize, maintain and increase its cash flow.  One strategy employed by Chapter 11 debtors to achieve this goal involves insisting that the debtor’s suppliers continue to supply goods under the terms of their prepetition supply contracts.  These contracts normally contain extended payment terms.  The nonbankruptcy seller, however, is often reluctant to bet on the debtor’s survival and may push for abbreviated payment terms including, in many cases, cash on delivery or cash in advance.  How these competing interests are accommodated in Chapter 11 cases may make the difference between the debtor’s successful reorganization or its uncontrolled liquidation.

A.         The Economic Matrix:  Long Term Supply Contracts and the Auto Industry

            The prevalent type of supplier contract in the American automotive industry is the long term requirements contract.  Under these contracts, manufacturers of discrete parts and assemblies agree in writing to sell those goods to higher-tiered suppliers or to OEMs normally on unsecured credit terms.  Often, these contracts are “requirements” contracts where Tier II Supplier sells to Tier I Supplier all of its requirements of certain goods for an extended time period which in most cases will be the anticipated life-span of the particular vehicle model assembled by an OEM.  The normal term of these contracts is therefore 5 or 6 years.  Many, if not most, of these sellers are “sole source suppliers,” meaning that the buyer of the components will contract only with one seller.  The universe of suppliers to OEMs for the production of a particular model is but a fraction of their number 60 t0 80 years ago in the heady days of Alfred P. Sloan, Henry Ford and Walter Chrysler. 

            The combination of sole source suppliers for automotive parts with “just in time” inventory systems creates an unstable brew in normal economic times.  However, in a recessionary economic environment such as we have today, this admixture becomes explosive.  The “resourcing” of parts manufacturing from a financially troubled, sole source supplier to an economically healthy one cannot be achieved overnight.  Rather, this process may take six months or more because the parts to be fabricated by the replacement supplier must be approved by the purchaser through a procedure known as the “Production Part Approval Process” or “PPAP.”  In order for a part made by a new supplier to be “PPAPed,” the parts must satisfy all of the specifications and tolerances demanded by the ultimate customer, the OEM. In circumstances where production of a part is being resourced to a new supplier but where PPAP of the part has not occurred, there will be the constant threat of a line shutdown if (i) the financially troubled supplier is unable or unwilling to continue production pending resourcing; and (ii) an inadequate supply of parts, referred to as an “inventory bank,” is not available to supply the OEM’s production needs during the process of resourcing.  A line shutdown is likely to cause the OEM to incur consequential damages of millions of dollars per day, the liability for which losses the OEM will attempt to assign to other members of the supply chain. [footnotes omitted]

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