Dealing With Suppliers In Crisis - Insolvency/Bankruptcy

In many industries, the supply chain can involve multiple suppliers and jurisdictions. In the current economic climate, it is not unusual for a supplier within the supply chain to encounter financial distress or even to enter into formal insolvency proceedings. This can have a significant impact on a company if its business depends on a distressed supplier and an alternative or additional supplier cannot be found (and production cannot be brought in house) or an alternative sourcing is not possible for other reasons, like part/raw material approval process, testing, customs etc.

If the company relying on deliveries cannot replace the distressed supplier with an alternative one that is able to supply the company in a timely manner with products of the same quality and quantity, this can cause an interruption of the company's ongoing production, as well as longer delivery lead times. This is more likely to be an issue when the relevant products are not commodities but rather customized products. By way of example, with respect to customized products in the automotive industry and based on our experiences, the transfer of production to a new supplier can oftentimes only be achieved within a period of at least 6-12 months because, among other things, it is necessary to carry out new quality tests and to produce test batches, etc., to ensure that the new supplier's products meet the applicable quality requirements and standards. Especially in just-in-time industries, such as the automotive industry, supply interruptions can dramatically affect business operations within a very short time. But also in other industries, financially distressed suppliers can significantly disrupt a company's business and cause massive damages. It is possible that damages may only appear time delayed due to higher safety stocks.

Short-term consequences of supply delays may lead to the triggering of (i) contractual penalties in the company's customer contracts, as well as (ii) significant damage claims against the company by its customers. A notable example of this is the disruption of an automobile manufacturers' production, which, based on our experiences, can cause losses of six-figure euro amounts within one day.

In addition, the need to re-source production from another supplier may lead to higher procurement costs, which it may not be possible to pass onto customers (thus reducing the often already-tight margin). The additional expenditures, which are associated with each change of supplier, such as costs of tendering and negotiating, certification and testing processes, adjustments in the supply chain and tooling costs, are also to be taken into account. Long-term risks may be both, loss of reputation and loss of customers. To the extent that the latter can be avoided, at the very least there is the looming threat of potentially tougher contractual clauses in future agreements with the customers.

In the following, we highlight various ways to address situations where a supplier encounters financial distress, in order to minimize the aforementioned risks.

Indications of an (Impending) Crisis of the Supplier

In principle, the financial crisis of a supplier can be divided into two stages: (1) pre-insolvency stage, and (2) preliminary insolvency and final insolvency proceedings. The following overview is limited to the pre-insolvency stage.

There are often many ways to detect early warning signs of a supplier's impending financial difficulties, even before a potential or actual insolvency filing. Although the indicators listed below as examples do not necessarily indicate financial difficulties, the occurrence of one or more of these events may mean that it is worth investigating the relevant supplier:

Supplier requests advance payments or any other kind of adjustment to the contractual terms;
Supplier requests payments to be made directly to its subcontractors;
Frequent changes in management;
Supplier is stalling or does not react upon the occurrence of difficulties;
Delayed deliveries;
Product quality issues;
Press or market rumors of financial distress;
New security/refinancing; or
Selling off parts of business/closing sites.

Maintaining an ongoing dialogue with suppliers is critical.

Risk Management Contingency planning

In any event, a company which is heavily dependent upon one or more suppliers should carry out a contingency planning exercise. This will include a detailed examination of each supplier and the associated financial and legal consequences for the company of any default. Early investigation and consideration of these issues is key.

As part of this legal and financial due diligence, in respect of each supplier, the company should include the following:

Identify the specific supplier company within the supplier group.
Does the company have the benefit of thirdparty support, such as a guarantee (e.g. from a parent company) or a performance bond?
Note the contractual commitments to the supplier (e.g. minimum purchase requirements).
Note the payment terms.
Note the termination rights (and ensure that those managing the contract retain evidence of any potential breaches by the supplier which might give rise to a right to terminate and that no breaches are waived).
When does title in the products pass from the supplier to the company?
Determine whether the Company has any claims arising from previous supplies which could be set off against current payments.
Who has title to product designs, data and certificates and does the company have copies of these (in essence, does the company have access to the information which it would need to continue to use the products which have already been delivered and, if necessary, to retain a replacement supplier)?
What are the company's contractual commitments to its customers (and any relevant penalties)?

Reacting to supplier financial distress

In addition to the above steps aimed at detecting the early warning signs of potential supplier financial distress, maintaining an ongoing dialogue with the supplier and carrying out a financial and legal review, the company will need to consider alternatives to its existing supply arrangements, such as:

Adjustment of the contractual terms;
Termination of the supply agreement; or
Support of the supplier.

These options are explained below in greater detail.

In each case, as a matter of English and German law, consideration needs to be given to the grounds upon which any step may be susceptible to challenge by any insolvency officeholder which is subsequently appointed in respect of the supplier.

Adjustment of Contractual Terms

First and foremost, the payment terms of the supply agreement can be adjusted. Thus, it might be conceivable, for example, to convert a 60-day payment term to a 14-day payment term or in some exceptional cases even to a 0-day payment term. This would provide the supplier with earlier liquidity and could generally transform the exchange of services into a so-called “cash transaction”. As a matter of German law, such a cash transaction is more difficult to be challenged by the insolvency administrator in case of a subsequent insolvency of the supplier. Nonetheless, it should be noted that when deliveries of a supplier are made under a framework agreement, an adjustment of delivery and payment terms may still be challenged by a future insolvency administrator. (For further details on challenge rights, see German Insolvency Law)

If the parties mutually agree to shorten the payment term, there is a possibility to request (additional) security from the supplier in return. As a matter of English and German law, it should also be noted here that such additional security may be challenged by the insolvency officeholder in case of a subsequent insolvency.

As a matter of German law, the same applies, perhaps not generally but under certain conditions, in the case of payments or collateral granted by a preliminary insolvency administrator. Therefore, even during the stage of preliminary insolvency proceedings over the assets of the supplier, the contractual relationship should only be continued with caution.

As a matter of German law, if a company indicates its willingness to pay the supplier in advance, it has the right to refuse performance (the so-called uncertainty defense) in accordance with Sec. 321 German Civil Code (Bürgerliches Gesetzbuch “BGB”) if it becomes apparent after the conclusion of the contract that the claim for consideration is at risk due to the inability to perform on the part of the supplier. This right to refuse payment is, however, not applicable where the consideration is effected or a security granted. The uncertainty defence is usually a plea which is made by the supplier being obliged to perform in advance vis-à-vis its debtor. In individual cases, it can nevertheless be beneficial for the debtor in the supplier situation.

Termination of the Supply Agreement

As regards termination rights, these depend on the specific context of the agreement. Subject to the terms agreed upon, an early termination may entitle the supplier to claim damages against the company, especially in cases where the contract provides for a minimum quantity or a minimum term.

Usually, agreements provide for exceptional termination rights or events of default giving rise to a right to terminate. Such terms should be drafted and exercised with care.

As a matter of German law, according to the case law of the German Federal Court of Justice (Bundesgerichtshof), contractual clauses that provide for an exceptional right to terminate the contract in the event of the filing of an insolvency petition, or the commencement of insolvency proceedings, are void. Thus, termination rights should not be related to an insolvency scenario. Instead, the termination should be linked to other causes, such as delayed performance, deterioration in the assets of the supplier or the violation of other material contractual obligations, or the initiation of enforcement measures against a supplier.

Under English law, there is no equivalent prohibition, as the prohibition relates only to termination by a supplier and not by a customer.

Supporting the Supplier

The company may also wish to consider different forms of financial and/or operational support for the supplier. Whilst the structuring of such support is fact specific, the following are often used:

Financial Support

Financial support may be:

Off-take assurances or short-term stock replenishments;
Modifying payment terms, providing, for instance, for temporary price increases, advance payments or full instead of partial payments. Similarly, as noted above, reducing the payment terms may also be considered. In such cases, it may be possible for the company to obtain protection through the provision by the supplier of security, third-party guarantees, transfer of ownership or other collateral, prepayment or performance bonds or warranty guarantees or, in an English law context, the holding of any advances on trust (to the extent that they are not required by the supplier as part of its day-to-day cash flow). In many cases, however, the supplier is unable to provide protection and, to the extent that it is able to do so, it may be susceptible to challenge by an insolvency officeholder;
Providing production materials or direct purchasing of raw materials for the supplier. For instance, this could take place by providing the supplier with the company's own tools or machinery or direct purchasing (and paying for) of production materials that are necessary for the supplier's production. In such cases, it should be ensured that the materials so provided (and tools and machinery made available) are stored separately and clearly labelled as the property of the supporting company. Additionally, appropriate written agreements, including storage plans and inventories, should be in place and the agreements should include relevant processing clauses;
Assumption of supplier's liabilities, for example, by paying supplier's subcontractors directly. This approach of paying the supplier's subcontractor in fulfilment of one's own obligations vis-à-vis the supplier may be attractive (particularly if title to the materials passes to the company at least until such time as they are required by the supplier as part of the production process). However, as a matter of German law, it is usually subject to avoidance rights. In this context, the German Federal Court of Justice (Bundesgerichtshof) has, in an important decision, set out possible exceptions to the usual insolvency avoidance rights if the direct payment is documented through a tripartite agreement between the customer, the supplier and the supplier's subcontractor. This tripartite agreement must be concluded prior to the exchange of services and even prior to the due date and enforceability of the respective claims;
Granting of loans or conclusion of standstill agreements with respect to existing claims against the supplier. In this regard, loans should, where possible, be secured by guarantees, transfer of ownership or other collateral, even if these are possibly subject to avoidance rights of an insolvency administrator;
Granting of a waiver of the right to set off against its own existing claims, such as claims based on discounts and rebates; and/or
Payment to the supplier for continuation of the business and partial assumption of the supplier's losses

Operational Support

In terms of operational support, this could mainly consist of assisting and supporting the supplier's business activities. More specifically:

Supporting the supplier in negotiations with other creditors and/or end customers (whilst being clear that the company does not represent or control the supplier, as this may lead to liability based on de facto management);
Assisting in the search for investors;
Concluding agreements on corporate governance (e.g., management agreements); or
Acquisition of shares in the company

Limits to Supporting the Supplier

When considering whether to provide financial or operational support to the supplier, it is important to have regard to the following points:

Firstly, the supporting company must be aware that, by providing respective support to the supplier, it becomes a creditor of the supplier and that such claims may be largely lost in the event of insolvency proceedings if there is no collateral or if the support is challenged by the insolvency administrator;
Furthermore, as a matter of German law, it must be ensured that the acts of support do not exceed the limit of aiding and abetting insolvency or inciting the favoring of creditors, or that the assumption of activities for the supplier does not result in a de facto management of the supplier. Otherwise, the acting individuals may be held personally liable under civil and criminal law;
As a matter of English law, any involvement in the management of the supplier may lead to potential liability as a shadow director;
As a matter of English and German law, in the event of subsequent insolvency proceedings of the supplier, the insolvency administrator may be entitled to challenge declarations, legal actions and asset transfers to the extent they are considered detrimental to the insolvency estate. In particular, the subsequent provision of collateral is usually subject to insolvency avoidance rights
As a matter of German law, with respect to financial support provided to the supplier, the risk that such support can be characterized as a self-interested restructuring loan must be avoided. This would be the case where a supplier with significant financial difficulties is provided a loan in return for the granting of collateral, thereby misleading third parties about the financial abilities of the supplier;
As a matter of English law, transactions at an undervalue and preferences may be susceptible to challenge if the supplier enters into formal insolvency proceedings; and
Finally, in case the company assumes or supports parts of the production activities of the supplier, the risk that employees of the supplier are entitled to demand to be considered employees of the company must be avoided.

All of the above risks can be prevented to a great extent if the approach taken is properly tailored in advance.

Checklist

Implement supplier monitoring and carry out legal and financial due diligence;
Maintain a regular dialogue with the supplier; and
Anticipatory contract drafting:
- Taking of security;
- Grounds for termination in case of crisis scenarios without being directly tied to insolvency itself;
- Exemptions from confidentiality in case of crisis scenarios;
- Use of trust arrangements; for instance, in case of the deposit of software/source code;
- Exclusion of an (implied) agreement even in case of multiple orders; and
- Pay attention to the case law of the Federal Court of Justice, e.g. in case of direct payment in the supply chain.
In the crisis:
- Diligent analysis and appropriate structuring, e.g. embedded in a restructuring concept with the involvement of all customers; and
- Meet certain rules of conduct:
  - No external representation of the company in crisis; and
  - Claim uncertainty defense.

Originally published 6 July 2023

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