Injunctions Assumptions and Supply Chains The Automotive Industry under Siege

Journal Issue

Feb 2006

Column Name

On the Edge

Citation

ABI Journal, Vol. XXV, No. 1, p. 20, February 2006

Topic Tags

Executory Contracts/Leases

Uniform Commercial Code/Article 9

Journal HTML Content

The American automobile industry is under
siege: Energy costs are on
the
rise, consumers are turning toward foreign vehicles, legacy costs
are mounting,
and foreign competition continues to squeeze
margins.1 General Motors’
shares hit their lowest price in more than 20 years, Ford Motor
Co.’s
shares continue to fall, and Delphi Corp., the world’s second
largest
parts manu-facturer, has declared
bankruptcy.2
 American automobile manufacturers have attempted to ease their
pain by passing
on costs to suppliers.3 As parties to the
automobile industry try to cope
with mounting economic pressures, they must understand the legal
issues that
they face—the nature of the industry and terms of their
contracts, the
avenues for relief and the possibility of insolvency. This article
examines
these issues.

Nature of the Industry: “Just-in-Time” Inventory and

Supply
Method
 The American automobile industry operates on a
“just-in-time”
inventory and supply method. Original equipment manufacturers (OEMs)

who manufacture
and assemble automobiles purchase their parts from “Tier
One”
suppliers who produce component parts. Tier One buyers purchase
parts from
“Tier Two” suppliers. Typically, OEMs and Tier One
buyers do not
maintain significant reserves. Rather, they maintain limited
inventories and
rely on frequent shipments.
 OEMs and Tier One buyers operate on a sole-source system where
only one
supplier provides a specific and necessary part. This sole-source
supply method
requires timely shipment of parts. If a supplier delays or ceases
shipment,
the delay can have significant consequences and could ultimately
shut down
an OEM’s entire assembly line. The damage flowing from the
shutdown
and the related employee layoffs would have severe impacts on the
OEMs. The
OEMs would seek to hold the supplier accountable.
Contracts between the Parties: Purchase Orders and Master
Agreements
 Automobile supply contracts are long-term contracts with fixed
prices. They
consist of general terms and conditions that define the contract and

include
purchase orders that set forth additional terms. When changes not
contemplated
at the time of execution of the contracts make it impracticable or
impossible
to perform under these contracts, suppliers may face the possibility

of insolvency
and buyers may face the possibility of disruption in their supply
chain. For
this reason, buyers and suppliers must understand their contracts,
the methodology
of relief available and the impact of bankruptcy proceedings.

Legal Avenues for Relief
 The master agreement and purchase orders govern the rights of the
buyers
and sellers and determine what relief, if any, is available. These
contracts
are interpreted under the Uniform Commercial Code (UCC) and the
common law
of the applicable jurisdiction. The terms of these contracts will
determine
the rights of the buyer and supplier when economic hardships arise.
Specifically,
a supply contract may be unenforceable because the contract either
lacks definite
and certain terms or because it contains a unilateral option to
terminate.
In addition, a supplier’s performance may be excused for
impracticality
or impossibility.
Definite and Certain Terms in Requirements Contracts
 Generally, OEMs and Tier One buyers contract with suppliers to
supply a
certain amount of parts required for a specific period, or the life
of the
product. The contract may not provide a set quantity term. The UCC
provides
that specific terms in a contract must be included and that these
terms must
be definite and certain.4 Among those
terms required is the quantity term.
Contracts that do not contain a definite and certain quantity term
may be
unenforceable.

However, a requirements or output contract, although indefinite
for lack
of a definite a quantity term, is
enforceable.5 A requirements contract is
a contract in which “a seller promises to supply all the goods

or services
that a buyer needs during a specific period and at a set price, and
in which
the buyer promises...to obtain those goods or services exclusively
from the
seller.”6 A requirements contract
provides that the supplier will provide
all of the buyer’s parts or some percentage of the
buyer’s parts;
these terms are definite and certain in quantity. Conversely, a
contract that
specifies that the supplier will provide “some” of the
buyer’s
parts is not enforceable. Suppliers should review their contracts
carefully
to see if they comply with the requirements of the UCC.
 In General Motors Corp. v. Paramount Metal Products Co.,
the court
held that purchase orders, although not “exclusive”
requirements
contracts, were enforceable requirements
contracts.7 Specifically, the court
noted that “[a] promise to buy of another person or company
all or some
of the commodity or service that the promissory may thereafter need
or require
in his business is not an illusory promise, and such a promise is a
sufficient
consideration for a return
promise.”8

Unilateral Option to Terminate
 Automobile supply contracts typically provide the OEM or Tier One
buyer
with an unrestricted right to terminate the contract, with or
without cause.
Because the contracts are terminable at will, they may be challenged

because
they are not a commitment for a specific quantity, thereby making
the contract
illusory for lack of a specific term. That term is a quantity
commitment.
However, if it is determined that a buyer cannot unilaterally
terminate a
contract because the UCC imposes a duty of good faith, and fair
dealing and
termination of that contract would breach this duty, then the court
may determine
that the termination clause does not make the contract
unenforceable.9 The
court in General Motors Corp. addressed this unilateral
termination
issue and applied this good-faith
analysis.10
 Excuses by Impracticality and Impossibility

Recent increases in oil and energy prices have made many
suppliers’
performance under current fixed-price contracts impracticable.
Suppliers’
profit margins have shrunken, and in some cases, suppliers are
operating at
a loss. Generally, mere lack of profitability has not been a means
by which
to excuse contract compliance on the basis of impracticability and
impossibility.
However, significant unforeseen circumstances may provide relief
from the
contract terms.
 Performance under a contract may be excused under the doctrine of
impracticability
if “unanticipated circumstances beyond the contemplation of
the contracting
minds and beyond their immediate control make strict performance
impossible.”11
Essentially, if “a severe shortage of raw materials or of
supplies due
to a contingency such as war, embargo, local crop failure,
unforeseen shutdown
of major sources of supply or the like, which either causes a marked

increase
cost or altogether prevents the seller from securing supplies
necessary to
his performance [performance may be excuse for
impracticability].”12
 Performance under a contract may also be excused for impossibility

of performance.
“Generally, however, the excuse of impossibility of
performance is limited
to the destruction of the means of performance by an act of God,
vis major
or by law.”13 “The law is
well-established that economic liability
to perform contractual obligations, even to the extent of insolvency

or bankruptcy,
is simply not a valid basis for excusing
compliance....”14

The Last Resort: Forcing the Issue and Ceasing
Shipments
 After reviewing its contract, a supplier may determine that its
contract
is unenforceable because the contract lacks definite and certain
terms, contains
a unilateral option to terminate or the supplier’s performance

is excused
by impracticality or impossibility. As a result, the supplier may
decide to
cease shipment and impose price increases. This unilateral act,
however, will
put the supplier at considerable risk for damage and other claims. A

supplier’s
better option would be to seek modification and clarification of its

contract
and, if unsuccessful, continue to comply with the contract while
seeking declaratory
relief or arbitration (if required under the contract). In this way,

a supplier
can assert its rights while both protecting itself from damage
claims and
resolving uncertainty under its contracts.
 If a supplier threatens to cease shipments unless the OEM or Tier
One buyer
submits to price increases, what options are available to the buyer?

One option
is for the OEM or Tier One buyer to seek injunctive relief. However,

it is
unlikely that courts will allow for injunctive relief because there
is an
adequate remedy at law: Buyers may reserve their rights and sue for
monetary
damages.
 The court in Kelsey-Hayes Co. v. Galtaco Redlaw Castings
Corp. addressed
the consequences of a supplier’s threatened price increases
and its
buyer’s subsequent reaction.15 In
that case, the supplier executed a
three-year requirements contract for certain brake castings and also

supplied
additional castings under a later, 100 percent supply blanket
purchase order
of infinite duration. In order to avoid insolvency, the supplier
threatened
to cease shipments unless the buyer agreed to a 30 percent price
increase.
The buyer reserved its rights, paid the increases and then sued for
damages
for breach of contract and sought declaratory judgment that it was
not required
to pay the price increases. The court held that it could be
reasonably concluded
that the buyer’s agreement to pay the price increase was
executed under
duress, and therefore, the buyer may be able to receive damages from

the supplier.16

Accommodating Suppliers in Bankruptcy
 When buyers and sellers of automobile components face insolvency,
threats
to the supply chain become tangible. A debtor has the ability to
assume or
reject a contract. Parties who do business with debtors in
bankruptcy must
await their decisions. Further, parties who deal with debtors in
bankruptcy
must continue to perform under the contract until the debtors assume

or reject
the contract. The decision to assume or reject the contract may not
be made
until very late in the case.
 Automobile supply contracts are typically considered executory
contracts.
An executory contract is a contract in “which performance
remains due
to some extent on both sides.”17
Rejection or assumption of an executory
contract determines the status of the contracting creditor’s
claim.18
However, if the executory contract “expires by its own terms
during
the post-petition, pre-assumption/rejection period, the debtor has
nothing
to assume or reject.”19 Further,
“[a]n executory contract generally
remains in effect pending assumption or
rejection....”20 In short, the
contracting party must continue to perform under the contract prior
to assumption
or rejection, but the debtor is not bound by the provisions of the
executory
contract unless the debtor assumes the
contract.21

The U.S. Bankruptcy Court for the Northern District of Illinois
addressed
the repercussions of suppliers not assuming or rejecting their
contracts in
In re National Steel Corp.22 In
that case, a buyer and its supplier
executed a contract for the purchase of steel. Shortly before the
contract
term began, the supplier refused to ship steel to the buyer unless
it paid
for the steel in advance. After the term of the contract began, the
supplier
filed for bankruptcy. After filing for bankruptcy, the supplier
threatened
to cease steel shipments unless the buyer agreed to price increases.

The buyer
went ahead and paid the higher prices. However, the supplier never
assumed
or rejected the contract, nor did the buyer seek relief to compel
the supplier
to assume or reject the contract. The issue of the increased prices
arose
in the buyer’s motion for allowance and payment of an
administrative
expense. In that motion, the buyer claimed that it had an
administrative expense
for any amount it paid for the steel over the contract price, plus
costs,
interest and attorneys’ fees. The buyer further alleged that
the supplier
breached its contract by demanding that the buyer pay for the steel
in advance
and at a higher price than required under the pre-petition
contract.
 The court held that the buyer did not have an administrative
expense for
the increased costs and that the supplier did not breach terms of
the executory
pre-petition steel supply contract. In addition, the court held that

the price
increase did not constitute a violation of the automatic stay and
held that
because the contract had not been assumed and therefore was
unenforceable,
the price increase “did not constitute an act to obtain
possession of
property of the creditor’s bankruptcy estate or to exercise
control
over property of its estate in violation of
§362(a)(3).”23
 Conclusion

As the automotive industry continues to face economic stress,
buyers and
sellers of automotive parts must carefully evaluate their
contractual relations
and the options available to them inside and outside bankruptcy
proceedings.
The industry will succeed if parties to these contracts recognize
their legal
rights and work to negotiate modifications to their contracts that
spread
the economic pain to all the contributors to the supply chain.

<hr>
<h3>Footnotes </h3>

1 See, e.g., “Why Are U.S. Carmakers in
Difficulties?” (April
20, 2005), at news.bbc.co.uk/1/hi/business/4466175.stm; “Auto
Industry
Seeks 2006 Rebound” (Dec. 21, 2005), at
www.cbsnews.com/stories/2005/
12/18/business/main1134746.shtml. 
2 See “GM Shares Sink Below 20-Year Low” (Dec. 29,

2005),
at news.yahoo.com/s/nm/20051229/bs_nm/autos_gm_stocks_shares_dc.

3 See, e.g., Banham, Russ, “Caught in the Middle”
(May 1,
2001), at www.cfo.com/article.cfm/2994486/c_2984412/?f=archives. 
4 UCC §2-201(1). 
5 UCC §2-306(1); see Lorenz Supply Co. v. AM STD
Inc., 419
Mich. 610, 358 N.W.2d 845 (1984). 
6 Black’s Legal Dictionary Pocket Part at 141 (2nd
ed. 2001).

7 See, e.g., General Motors Corp. v. Paramount Metal
Products Co., 90
F. Supp. 2d 861 (E.D. Mich. 2000).

8 Id. at 873 (citing Corbin, 1A Corbin on Contracts §156
(1963);
Precision Rubber Products Corp. v. George McCarthy
Inc., 872 F.2d
187, 188 (6th Cir. 1989)). 
9 See Merritt-Campbell Inc. v. RxP Products Inc., 164
F.3d 957
(5th Cir. 1999). 
10 See General Motors Co., 90 F. Supp. 2d at 874.

11 Bissell v. L.W. Edison Co., 9 Mich. App. 276, 287, 156

N.W.2d
623 (Ct. App. 1967). 
12 UCC 2-615, note 4. 
13 General Motors Corp., 90 F. Supp. 2d at 872 (citing
Stasyszyn
v. Sutton East Associates, 161 A.D.2d 269, 555 N.Y.S.2d 296,
299 (1990)).

14 Id.

15 See Kelsey-Hayes Co. v. Galtaco Redlaw Castings
Corp., 749
F. Supp. 794, 796 (E.D. Mich. 1990). 
16 See Id.
 17 In re Superior Toy & Mfg. Co., 78 F.3d 1169, 1172 (7th

Cir.
1996) (quoting 2 L. King, Collier on
Bankruptcy ¶365.02,
at 365-21 (15th ed. 1995)).

18 11 U.S.C. §365. 
19 In re National Steel Corp., 316 B.R. 287, 304 (N.D.
Ill. 2004).

20 Id. at 305. 
21 See Id. at 304. 
22 See Id.

23 Id. at 310.

Journal Authors

Anne F.B. Weissmueller

Randall D. Crocker

Journal Date

Wednesday, February 1, 2006 - 12:00