Supplier Bankruptcy – A Real Risk during Recession
Recession is here. Slower demand, shrunk liquidity and increasing pressure on cost is here. Auto industry has suffered from severe decrease in the demand which has resulted into steep production cuts. Suppliers get paid 45 to 60 days after delivering parts, and this may cause a wave of failures in March and April, when the nearly total shutdown in U.S. auto production at the start of the year starts to hit their balance sheets hard. To other industries also, recession presents increased credit risk and a very real risk of supplier insolvency. In my opinion, supplier bankruptcy causes two different kind of risks.
The first and obvious risk due to supplier bankrupcy is Supply Chain Disruption. Based on the size and dependency on the supplier, this risk has a potential of minor disruption to complete shut down. Having identified alternative suppliers for key components is one of the best way to mitigate this risk. Yet, getting new suppliers in the supply chain is not an easy tasks. It may take few months.
Another option is to involve a bank/financer at a very early stage in the transaction. Companies can send the POs to the supplier simulataneously passing the information to the bank. Based on the account liquidity and supplier’s credit history, banks can qualify whether the supplier is fit enough to serve the future demand or not, thus, reducing the risk of disruption should the supplier go bankrupt. At the same time, information from the extended supply chain is leveraged by banks to offer trade finance to suppliers at various stages within the supply chain. This process mirrors the 'just-in-time' approach used by large corporates to optimize inventory holdings. The liquidity risk is substantially reduced given the visibility of information throughout the transaction. Regular reports from Banks / Credit Rating Agencies about your suppliers’ credit health are certainly worth during recession.
The second type of risk arises from supplier filing for Bankruptcy Protection. Under the US Bankruptcy Code, supplier may be allowed to delay the decision on the contract till the end of the case – which could last for weeks or months. It also prohibits company from terminating the contract and requires continuous receipt of goods/services and paying the supplier. Even if the Supplier Contract allows you to terminate it at anytime and without cause, or terminate it if supplier becomes insolvent, the clause is uneforceable under Bankruptcy Protection Code.
How to mitigate such severe financial and legal risk? Regularly obtaining financial information of the supplier certainly helps. Ensure that you retain ownership and control of software, equipment, data, deliverables and work in progress and supplier owned items that are critical to your business. Insulate yourself from any legal claims from supplier’s subcontractors. Ensure that the supplier is prohibited from delegating his responsibility without your approval.
Tough times calls for tough measures! Understanding interwoven relationship of financial supply chain & product supply chain and controlling the risk emerging out of it should be the priority of organizations during recession.