How to Protect Yourself from Distress in Your Supply Chain

Step back and look at how any potential supply chain disruption may affect your own operations and financial results.

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The events surrounding the Coronavirus disease (COVID -19) has brought to the forefront a concern that was already brewing in some sectors of the global economy — supply chain disruption.

Although some manufacturers may have been in the process of putting in place early detection methods to spot the signs of potential distress in their key suppliers, or considering safeguards to prevent against this disruption, those efforts are now being accelerated. From a legal and commercial perspective, what should you be doing?

Support your supplier

The key question is whether you want to help your supplier resolve its short- or long-term problems or whether you want to look for alternative sources of supply. You may have to support your supplier at least for the short-term until you work through the alternatives, but understanding the source of the distress facing your supplier is critical to answering this question.

Some suppliers may be experiencing liquidity issues that affect their ability to deliver goods in accordance with the agreed terms of the supply contract. Understanding whether your supplier’s liquidity issues are a result of exogenous factors (e.g., the competitive landscape, regulatory issues and COVID -19) or endogenous factors (e.g., management issues, high leverage and limited or no access to credit) can help you decide whether you want to provide assistance to your supplier and what the obstacles are to providing that assistance.

Some of the options to consider are accelerating payments to the supplier (if only to provide time to re-source production to a new supplier), making a short-term loan to the supplier against, which future payments are offset (assuming that the supplier’s existing credit facilities do not prohibit that) and even acquiring a position in the supplier’s existing debt. These options are not mutually exclusive.

Situations exist in which suppliers have told companies that they cannot deliver products unless the company pays off all amounts owed to the supplier’s vendors. At the point at which you have to do this (and maybe even before), consider whether you simply should acquire the distressed supplier and develop a more vertically integrated manufacturing chain. Reviewing the reports from your supplier, tracking and evaluating the risk factors that could affect your supplier, monitoring your supplier’s operating performance and understanding your supplier’s business will help you decide the options that work best.

Can you re-source supply?

Well before any supply chain disruption occurs, you should have a solid grasp of what rights you have to use an alternative supply source, the steps you will need to take — both legally and commercially — to obtain an alternative supply source, and the amount of time it is likely to take to implement that strategy.

One of the key questions here is whether the supply contract contains an exclusivity provision or minimum purchase requirements that would render you in breach of the contract if you source the products from your supplier elsewhere. If your supply contract contains these or similar protections for the supplier, then you will need to determine what steps need to be taken to trigger the right to seek an alternative supply and how those steps can be taken in a way that does not threaten your existing supply of products until you make the switch. For example, if you need to declare a default under the supply agreement and terminate it before you can start placing orders with a new supplier, what defaults currently exist, does the supplier delay have a cure period and what happens if the supplier stops supplying at that point?

Re-source the manufacturing of the product

Once you are prepared to take the steps either to re-source the manufacturing of the product or even to manufacture the product yourself, you need to assess whether you possess the equipment, materials and technology, as well as the right to use (and perhaps sub-license) the supplier’s intellectual property.

For example, make sure you have the ability to reclaim any tooling in the possession of your supplier, so that you can easily transition the manufacturing of the product. In some cases, you may not readily obtain the cooperation of the supplier, especially if the supplier realizes that the return of tooling signals the end of the relationship and will have a devastating effect on its business.

Also examine what rights you have to use any of the supplier’s intellectual property needed for production. If the supplier has, for example, the patent on the components it is manufacturing or the manufacturing process uses your supplier’s trade secrets, do you have a present license to use such intellectual property to manufacture the product yourself? If so, do you have the right to sub-license that right to use the technology to a new, potentially unaffiliated supplier? Although we often think in terms of technology-driven products, copyrights also can be an issue, particularly in the consumer goods space.

Sometimes just having the right to use the intellectual property may not be enough. For example, consider what else is needed to manufacture the product. Putting aside the tooling issue, do you need access to testing data, source code, operating or product manuals or even key employees to take advantage of the intellectual property and re-source production effectively?

Understand the local insolvency issues that may affect the exercise of rights against your supplier

The backdrop to all of these considerations is the possibility that, while you are in the process of developing your strategy or exercising your rights, your supplier may commence, or be placed into, some kind of formal restructuring or insolvency proceeding. It is important to understand the possible jurisdictions in which that might occur, and for each such jurisdiction, how its restructuring process may affect the exercise of your rights.

The first question is whether a contract party has the right to terminate its contract after the commencement of a formal restructuring or insolvency proceeding because the contract either affords the non-debtor the unilateral right to do so or provides that the contract terminates automatically. The answer will depend upon the type of proceeding and the jurisdiction in which the proceeding occurs.

In the United States, for example, the “automatic stay” imposed after a filing under the U.S. Bankruptcy Code would prevent you from taking affirmative steps to terminate a contract after a bankruptcy filing. In addition, in most cases, a default triggered by the debtor’s bankruptcy filing is unenforceable if the debtor follows the appropriate procedures for retaining its rights under the contract. Even in the United States though, some increasingly popular alternatives to a formal bankruptcy case, such as an assignment for the benefit of creditors or even a receivership, do not offer the debtor the same level of protections against the termination of contracts. Moreover, if you provide notice of termination of a supply contract before a U.S. bankruptcy filing, whether the automatic stay prevents the termination will be a function of how the termination letter is worded and whether the supplier has a right to cure the default at the time of the bankruptcy filing.

For tooling or production materials held at the supplier, even if you have paid for the tooling, you may need to go to court to get it back. At that point, you risk that the court will block access to tooling or materials, the supplier may claim that it owns the materials (a particular risk for materials that are not separately identified and segregated), or that creditors may claim an interest in the tooling or materials. All of these risks have materialized in past cases under the U.S. Bankruptcy Code.

You may have a license to use the debtor’s intellectual property, but perhaps that license has not been triggered as of commencement of a restructuring or insolvency case. In the United States, you face the risk that, if the supplier stops performing or uses the bankruptcy process to “reject” the agreement that gave you these rights, you will not have any right to use that intellectual property. Moreover, even if you have a license, but do not have the right to obtain the “embodiments” of that license or those embodiments are not readily obtainable from a third-party source (such as an escrow), you may still face delays in using your license rights effectively.

The bottom line is that the commencement of a formal restructuring or insolvency proceeding is likely to add delay, but knowing how the law will work in each possible jurisdiction will help you develop an advance strategy for dealing with that situation.

Cash is king

Finally, step back and look at how any potential supply chain disruption may affect your own operations and financial results. When distress hits, remember that cash is king.

Do you have sufficient sources of your own liquidity to execute the strategies described above and to weather the effects of potential disruption on your own business? A close examination of your own credit facilities, understanding the conditions of making any draws and determining whether to build a cash reserve are part of the internal evaluations that you should consider making.