The spread of the coronavirus in 2020 caused lockdowns of businesses and schools and shutdowns of industries worldwide. Throw worker shortages, dwindling supplies of raw materials, surging prices, and other complications into the mix, and it’s no surprise that some U.S. manufacturers are hurting.
And the forecasts aren’t optimistic. Tim Uy of Moody’s Analytics has stated that supply chain problems “will get worse before they get better.”
The effects can be particularly painful for manufacturers that rely on sole-source suppliers. In response, many manufacturers are trying to diversify their supply chains. But that’s a long-term solution to a problem that will persist over the near term.
So, manufacturers who count on a sole-source supplier will be forced to ride out the storm. And the storm may get even more destructive to the extent that more suppliers begin to experience financial distress on top of operational challenges.
What is a manufacturer to do? One option is to adopt an approach used by automotive suppliers and manufacturers for decades.
The Accommodation Agreement
The automotive industry has a tiered structure of suppliers that produce and supply goods that ultimately make their way to original equipment manufacturers, such as Ford Motor and General Motors. Historically, the industry has operated under a “just in time” supply chain model (pioneered by Toyota), with many single-source suppliers. One supplier will often provide several OEMs with an essential (and not easily replaceable) pars. Therefore, a financially or operationally distressed supplier unable or unwilling to ship goods can significantly disrupt industry-wide production.
Because threats posed by distressed suppliers in the automotive industry can be costly, are not easily remedied, and occur fairly frequently, the industry has developed legal tools for resolving disputes and keeping the supply of goods flowing.
One such tool is an “accommodation agreement.” In this agreement between a customer (or group of customers) and a supplier, the supplier assents to continue producing and supplying goods without interruption. The customer promises to provide financial and other accommodations to keep the supplier afloat. In some cases, the customer’s accommodations allow the supplier to restructure and remain a going concern. In others, they buy time for the customer to move parts production to another supplier.
Accommodation agreements require negotiation and cooperation between a troubled supplier’s key customers and lenders. Some of the key components of accommodation agreements are the following:
Forbearance: Customer agrees not to move parts production currently with the supplier to another supplier for a defined period.
Setoffs: Customer agrees to limit its setoff rights against suppliers. (Setoff rights allow entities to apply their mutual debts against each other.)
Financial support: Expedited payments by customers, particularly when the lender restricts funding.
Inventory purchase: Agreement by the customer to purchase raw materials, work-in-process, and components from the supplier to the extent the customer moves parts production to a new supplier after the period of forbearance; this monetizes materials, parts, and equipment that would otherwise be of less value to the supplier once a customer moves its business elsewhere.
Inventory bank builds: Supplier agrees to produce (and customer agrees to pay for) a bank of parts for the customer.
Access: In conjunction with the execution of an accommodation agreement, the parties will often enter into an access agreement. Such an agreement allows a customer access to the supplier’s facilities to produce its parts itself, if necessary.
These and other provisions can ensure that manufacturers get the goods they need while protecting the supplier and its lenders. Over decades, the automotive industry has refined these agreements to the point where customers, the troubled supplier, and its lenders can get in a conference room (these days, a Zoom room) and hammer out a deal quickly — even in a single day.
In my experience as a restructuring lawyer in Detroit, I’ve been involved in numerous situations where this contractual framework has prevented supplier bankruptcies, resolved litigation, and, most importantly, kept assembly lines running. And there’s no reason that this framework — at least the key components of it — can’t be modeled to resolve supply chain issues in other industries that frequently use sole-source suppliers. What’s required is some creative thinking, cooperation, and compromise among parties who all have a lot to lose if a key supplier goes down.
David G. Dragich, founder of The Dragich Law Firm, represents businesses in all aspects of complex corporate reorganizations, bankruptcy, insolvency, and distressed asset acquisitions and dispositions.