In the wake of widespread financial distress in the automotive industry, many original equipment manufacturers (“OEMs”) are proceeding with caution and making concerted efforts to minimize supply risk. Each OEM’s purchasing terms and conditions provide certain contractual obligations that must be met by suppliers in order to be awarded new business and retain existing business. Recently, in order to manage risk, certain OEMs have zeroed in on termination clauses, such as those relating to financial stability, cost competitiveness, and changes in ownership and control.1 The importance of this trend has registered below the radar of many suppliers and their stakeholders in the industry, as the headline news of OEM and supplier bankruptcies and re-emergence and the industry’s rebound have taken center stage.
Coupled with amplified focus, certain OEMs have recently even modified the terms and conditions of purchasing contracts, effectively allowing for more options to terminate a contract when the perceived supply risk escalates. The result is that many suppliers may now be doubly at risk: the financial risks they face now also present termination risk on contracts with their largest customers.
Financial Stability Clauses
OEM terms and conditions have long included clauses related to financial performance and stability. Recently however, in response to stress in the macro-economy and the automotive industry specifically, certain OEMs have broadened the scope of these clauses in order to provide protection from increased supply risk and to allow for the termination of the contract in the event the supplier becomes insolvent or financially unstable. In addition, the terms and conditions of many OEMs now require the supplier to provide quarterly and annual financial statements to the OEM so that they may assess the supplier’s “financially stability.”2 The financial stability clauses of several OEMs are presented below:
The terms of several other OEMs, including General Motors,5 BMW,6 and Volkswagen7 also provide that the OEM may cancel the supply contract in the event the supplier becomes insolvent or financially unstable.8 However, solvency, as identified in these clauses, can be defined and measured in a number of different ways. Traditionally, suppliers have not had complete visibility with respect to the analyses performed by OEMs to assess the financial condition of each of their suppliers. In certain cases, these analyses may not be robust enough to provide a complete or fully accurate picture of a supplier’s solvency or its financial ability to perform. Therefore, suppliers should take a proactive posture in defining and communicating their financial condition to OEMs to minimize the risk that they will be perceived as unstable from a financial perspective.
Common Uses of Financial Information by OEMs
Typically, OEMs employ standardized processes in evaluating suppliers across multiple quantitative and qualitative criteria. Such criteria may include percentage of defective parts, warranty rates for parts supplied, payment terms, and a variety of other metrics. Specific to the analysis of a supplier’s financial stability, an OEM may consider factors such as the supplier’s outstanding debt and its ability to make debt payments, its quarterly and annual net cash flows and profitability,9 measures for growth, as well as operating efficiency metrics. These factors may be summarized and compiled on a supplier scorecard that is maintained and updated regularly by the OEM. In many cases, these scorecards are used by the OEM to assess supplier risk and to make performance comparisons across its supply base.
While supplier scorecards are a common tool employed by OEMs, and will continue to be used to assess a supplier’s compliance with new and evolving financial stability clauses, these scorecards may not tell the whole story. Further, the actual metrics considered by OEMs are often unknown. In order to ensure OEM customers do not perceive them to be unstable, suppliers should make efforts to routinely evaluate their scorecards (if available to them) as well as their financial position and operating performance, and present OEMs with these findings, which should highlight their financial stability and ability to perform.
Potential Proactive Supplier Analyses
Given the “solvency” triggers in the financial stability clauses, suppliers may find it useful to employ robust analyses and procedures that monitor their financial position and provide support to OEMs that illustrates solvency and financial stability. Such analyses may include a variety of measures of solvency and financial stability in addition to those commonly considered by OEMs.
Commonly calculated measures of financial stability may include the supplier’s debt service coverage ratio, interest coverage ratio, and similar debt service ratios, which seek to analyze the supplier’s ability to meet its short- and long-term debt obligations. Further, a variety of profitability measures may be relevant to consider including gross margin, operating margin, earnings before interest and taxes (“EBIT”), earnings before interest, taxes, depreciation, and amortization (“EBITDA”), and net income. While OEMs may focus on net income profitability metrics, suppliers may consider operating margins or EBITDA to evaluate their profitability and cash flow before non-operating expenses or large non-cash charges such as depreciation and amortization. Depending on the supplier’s situation, these measures may better demonstrate financial stability, expected ongoing profitability, and cash flow generation. In general, suppliers would be best served to maintain a comprehensive system that analyzes and monitors their financial condition and develops the most timely and accurate financial story. Often, a review of the output from these types of analyses will allow the OEM to develop a more intimate understanding of the factors driving a particular supplier’s performance metrics and make the OEM more comfortable working with that supplier on a long-term basis.
Suppliers may also perform detailed analyses of the underlying data included within higher-level metrics. For example, the calculations of many debt service metrics consider the total interest and principal payments to be made for a full year. A calculation of debt service metrics for a full year may indicate a supplier has inadequate cash to meet its debt obligations in the long term. However, a supplier may, in fact, have adequate cash flow to service debt on a month-to-month basis, and may be managing its cash in order to do so. As such, it may be the case that an analysis of certain metrics on a monthly basis tells a much different story than an analysis on an annual basis.
The supplier may also be well served to provide analyses related to its various risk exposures. Such analyses may include a detailed breakdown of sales by customer to assess customer diversification, and summaries of backlog and future business prospects. Suppliers may also provide detailed assessments of risks related to industry trends, outstanding contingent liabilities, and other potential unsystematic risks, such as an assessment of the supplier’s supply chain. Suppliers may summarize and document the actions being taken to minimize the various risks to financial stability. For example, suppliers may describe hedging activities employed to protect from raw material pricing risk. A supplier’s demonstration that it has a strong understanding of its operating risks and is proactive in addressing and minimizing such risks will often give the OEM greater comfort in the supplier’s ongoing financial stability.
In addition to financial stability clauses, several OEMs include general competitiveness clauses in their purchasing contracts. These terms and conditions may be put in place to ensure that the OEM is receiving the best possible price, quality, delivery, and general performance from each of its suppliers. Certain of the OEMs competitiveness clauses are as follows:
As demonstrated above, many OEMs’ terms and conditions state that if the supplier is unable to remain competitive across the identified criteria, the OEM may terminate the contract for cause. Therefore, similar to financial stability clauses, suppliers should make efforts to enact systems that assess and monitor their own pricing, quality, and performance in relation to that of similarly situated suppliers. Suppliers may wish to fully document the underlying pricing models utilized in the bidding of programs and in deriving ongoing price changes. Further, suppliers may maintain complete records of quality and performance measures such as delivery metrics, manufacturing error rates, warranty rates, and other measures. In the event negative quality and performance issues arise, suppliers should swiftly address those issues and immediately communicate the actions taken to OEM customers. Suppliers may wish to fully document standard procedures for evaluating quality issues and identify internal personnel specifically responsible for the identification and resolution of any problems that arise. Proactive measures such as these may go a long way to demonstrate to OEMs that the supplier is working to remain competitive and that the OEM will not be exposed to significant risks in this regard.
Change in Control Clauses
A third class of termination terms and conditions that OEMs utilize to minimize supply risk (and one that has been recently updated by certain OEMs) are change in control clauses. Such clauses allow the OEM to terminate the contract in the event the supplier sells a significant portion of its assets through an asset sale, merger, or similar transaction. Certain change in control clauses are outlined below:
Change in control clauses are another source of termination risk for suppliers. Given the challenging industry environment in recent years as a result of the global recession and credit crisis, the structure and ownership of many companies has changed by necessity. Consolidations and recapitalizations are likely to continue to occur on the industry’s path to recovery as it deals with issues such as rising raw material costs and lingering excess capacity. For example, two middle-market suppliers may see benefit to merging in order to best align cost structures, complement manufacturing capabilities, and reduce risk exposures. However, it is critically important to consider change in control clauses, such as those detailed above, prior to any such strategic actions given the potential far-reaching implications on valuation, synergies, and key customer retention and growth.
Suppliers should evaluate the relevant contract terms and conditions with each of its key customers in order to develop an understanding of the risks of ownership changes. Suppliers should communicate plans for changes in ownership prior to implementing such changes and provide the OEM with confirmation of its ability to continue to meet contractual obligations after the changes occur. In the event the OEM is unwilling to work with the supplier, the costs and benefits of the proposed change in ownership should be assessed in order to determine whether the costs of the ownership changes (e.g., a lost OEM customer contract) outweigh the anticipated benefits.
Given the termination risks inherent in the standard terms and conditions of OEM purchasing contracts, suppliers should be proactive in measuring and presenting their case for financial stability and general competitiveness. Performing and presenting routine, independent assessments is a key best practice that suppliers can employ to ensure OEMs that they are both financially stable and operationally competitive. Further, suppliers should remain cognizant of all contract terms, especially those that pose termination risk such as solvency, competitiveness, and change in control clauses. While such actions and attentiveness may not eliminate all termination risk, they may go a long way in managing and minimizing it.
Jacob M. Reed
1 It is important to note, as stated in the “2010 OESA North American OEM Production P.O. Terms and Conditions Comparative Analysis” published by the Original Equipment Suppliers Association (“2010 OESA Comparative Analysis”), that in addition to these types of termination clauses, the standard terms and conditions of every OEM, except BMW, allow for termination without cause (for convenience). However, this article focuses on clauses allowing for termination for cause.
2 See for example Chrysler Group LLC’s (“New Chrysler” or “Chrysler”) Terms and Conditions, Section 20(b).
3 Chrysler Production and MOPAR Purchasing General Terms and Conditions, Section 21(a)(3).
4 Ford Motor Company Production Purchasing Global Terms and Conditions, Section 26.04.
5 General Motors Company General Terms and Conditions, Section 11.
6 BMW Group International Terms and Conditions for the Purchase of Production Materials and Automotive Components, Section 2.7.
7 Volkswagen Group of America, Inc. Terms and Conditions of Purchase, Section 17.
8 It is important to note that Section 365(e)(1) of the U.S. Bankruptcy Code invalidates and overrides any provision in a contract that purports to allow termination due solely to a bankruptcy filing or insolvency. However, the Bankruptcy Code only applies to a U.S. bankruptcy filing, and does not apply to a finding of insolvency outside of the U.S. bankruptcy context (2010 OESA Comparative Analysis).
9 “Profitability” may be measured in a variety of ways, such as at the net income level or the operating income level. It may be beneficial for a supplier to utilize several methods to assess profitability to ensure that OEMs are considering profitability in the most appropriate way for the supplier’s business operations.
10 Chrysler Production and MOPAR Purchasing General Terms and Conditions, Section 32.
11 Volkswagen Group of America, Inc. Terms and Conditions of Purchase, Section 18: “Termination for Breach or Nonperformance.”
12 Hyundai Motor Manufacturing Alabama, LLC Parts Development General Terms and Conditions, Section 28(a)(iv).
13 General Motors General Terms and Conditions, Section 12.