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.

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Footnotes

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.