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How to avoid supply chain disruptions

Dec. 8, 2005
In today's economy, the news is filled with stories of financial woes or bankruptcies of suppliers, with Tier One automotive supplier Delphi Group recently

In today's economy, the news is filled with stories of financial woes or bankruptcies of suppliers, with Tier One automotive supplier Delphi Group recently joining the ranks of high-profile failures. No matter what industry you're in, to prevent disruption to your business and to assure a source of supply for your production, it is critical that you monitor your suppliers' situations and be prepared if they start facing financial difficulties.

Any supplier to a company (the " customer") that provides critical products or services and faces financial difficulty could interfere with the customer's supply chain and production. This is particularly true when the supplier is the single source provider of the supply to the customer and the part or service is not readily available on the open market. Early detection is critical to providing the customer the most options for addressing production-threatening supplier situations.

Although options will vary based on the facts, there are a number of legal and internal processes which should be implemented by companies to reduce the likelihood of significant disruption by a financially troubled supplier.

Identifying troubled suppliers/ early warning signs
Include reporting obligations in the purchase orders or contract
In order to monitor the financial condition of suppliers, the customer can include financial and other similar reporting obligations in the purchase orders or contract. For example, the supplier can be required to supply copies of its financial reports, status of payables and organizational charts.

Conduct periodic plant tours
The right to conduct periodic plant tours can be included in the purchase order or contract. The customer should ask questions regarding the supplier's technological and accounting systems to determine whether they are being updated and whether they are appropriately utilizing technology available and commonly used in the industry.

Monitor delivery performance
Signs of trouble can also be found through the supplier's delivery and performance (or lack thereof). These signs can include late deliveries, increased use of expedited freight, requests for technical support, delay in response to production issues, requests by the supplier for price increases, accelerated payment terms, or changes in product quality.

The problem is that many companies do not notice these signs until it is too late because there is no coordination of reporting between different departments within the organization. For example, the request for price increases may be received by the customer's buyer while the customer's payables department may receive the shipping invoices for expedited freight. Without a mechanism to coordinate the reporting of these signs of trouble, they are often ignored and never considered, except on hindsight.

Give attention to press and other public reports
Often suppliers facing financial difficulty will be the subject of negative publicity or press. For example, there may be reports regarding downgrading of outstanding bonds, significant layoffs, the supplier's employment of various types of consultants or professionals, or a change in accounting firms. These reports should be monitored and the coordinator (discussed below) alerted.

Prepare for trouble before it happens
Identify a coordinator of troubled supplier situations
There should be a system in place for monitoring the suppliers, and one person centrally assigned and trained to work with troubled supplier situations when they arise. That person (the " coordinator") would be contacted upon identification of a potential troubled supplier situation. Large customer organizations would have a team that would report to the coordinator.

Draft strong purchase orders and contracts
When a troubled situation arises, rights under existing contracts are focused upon and can become the first line for action or defense. As a result, purchase orders can play a key role in the ability of a customer to protect its interests when dealing with a troubled supplier.

Purchase order forms and related contracts should be reviewed by legal counsel that has experience in dealing with supply chain issues. Otherwise, while the documents could be technically correct, they may not be designed to address real-world practical issues.

Establish and maintain tooling ownership
If specialized tooling is necessary, the customer should maintain ownership rights in the tooling so that in the event the supplier is unable or refuses to produce the parts, the tooling can be removed from the supplier's possession and transferred to an alternative supplier.

Pre-prepare court papers
The customer should consider preparing model complaints for tooling recovery and injunctive relief so that if it is necessary to litigate in any given case, the pleadings can be quickly modified to fit the facts in question.

What to do when facing a financially troubled supplier
Gather information regarding the supplier's financial situation
The customer should assess how significant and imminent the financial trouble is and whether the supplier has a good likelihood of a successful financial turnaround. The coordinator may need to consult with legal counsel and financial advisors to assess the viability of the supplier and to understand both the customer's and the supplier's options.

Consider the right to withhold payments of accounts payable
If there is an account payable owed, the customer should consider freezing the payable and asserting the right to set-off for damages caused by the supplier's anticipatory breach of contract. Before taking this action, the customer will want to consider the legal risks associated with such action as well as practical effects.

Determine ability to resource to an alternative supplier
This would include determining:

• whether the current tooling could be used, and if so the cost for transfer;

• whether the alternative supplier would need to obtain specialized or additional capital equipment;

• the time period before production could commence and product delivered;

• litigation risks associated with canceling the current supplier's contract;

• a comparison of the new contract price to the current supplier's contract.

Determine whether a parts bank can be established
Often there is a time delay before production can be commenced and product delivered by an alternative source. To avoid disruption during that time, additional product may be needed from the current supplier (commonly referred to as a "parts bank").

Negotiate a consensual solution if possible
If resourcing is not an immediately available or practical option, the customer should seek to enter into a settlement with the supplier. Typically the goal is to ensure current production and protect the customer in the event the supplier is no longer able to produce. The type of concessions from and obligations required of the supplier and the customer may include the following:

Price increases. Do not lightly concede a request by the supplier for a price increase to continue production. If a price increase is awarded, it should be done with appropriate protections to ensure use of the funds towards production of the customer's parts. Consider other options.

Supplying raw materials. If the supplier is having difficulty obtaining supplies or materials from its suppliers (the "sub-suppliers") for credit reasons or otherwise, the customer should investigate whether it can negotiate directly with the sub-suppliers for a better price and if necessary, become a direct buyer from the sub-supplier.

Parts bank and resourcing. As set forth above, often a parts bank is necessary to protect production in the event the supplier cannot work itself out of the situation and the production has to be moved to an alternative supplier. The agreement may contain a mechanism by which the supplier agrees to produce a parts bank to protect the customer in case of the supplier's shutdown and agreement by the supplier to cooperate in resourcing if necessary to maintain customer's on-time production.

Tooling acknowledgement and equipment purchase rights. As part of the protection to be able to resource without disruption in the event the supplier cannot meet its obligations, the customer should obtain an acknowledgement of the customer's ownership of the tooling and that it has been paid for so that it can move the tooling to the alternative supplier without disputes over ownership.

Access to plant if supplier cannot produce. If the ability to resource to an alternative supplier is simply not available and the failure to produce by the supplier would cause severe disruption to the customer and damages, the customer may want to obtain an agreement which allows the customer (or its designee) to access the supplier's facilities and use the supplier's facilities, machinery and personnel to produce the necessary parts.

Good preparation for addressing troubled supplier situations is the best defense for avoiding significant disruption to the supply chain. Having an experienced team to address troubled supplier issues is also important to success.

It should be noted that many of the above suggestions may be significantly impacted or will not be binding on the parties in the event of the filing of a bankruptcy or similar proceeding by or against the supplier.

Sheryl L. Toby, co-practice group leader of Dykema Gossett PLLC's (www.dykema.com) bankruptcy and reorganization department, provides solutions to creditors, debtors and lenders involved in troubled situations. She can be contacted at [email protected].

Learn more about supply chain management strategies at: www.logisticstoday.com/supplychainmgt