Bloomberg Law
Dec. 14, 2022, 9:00 AM

Chapter 11 Is the Best Route for Troubled Auto Part Suppliers

J. Eric Wise
J. Eric Wise
Alston & Bird

By 2025, electric vehicles will account for as much as 23% of all vehicle sales, with far fewer parts than a combustion engine vehicle.

Even as electric vehicles grow in popularity and production, the US automotive supply chain faces chronic financial and supply chain distress, and ongoing restructuring.

Fewer parts mean fewer contracts. This means less work for parts suppliers generally, more work for some suppliers with electric vehicle technology, and less work for suppliers unable to grow beyond combustion engine parts manufacturing and technology.

To reorganize debtors and continue operations via existing management—debtor-in-possession—Chapter 11 is the ideal route for restructuring troubled auto parts suppliers.

In the automotive industry, suppliers occupy three tiers—tier 1 supplies the original equipment manufacturers (OEMs), tier 2 supplies tier 1 suppliers, and so on.

OEMs are oligopsony buyers, with few purchasers and multiple sellers. Original equipment manufacturers prefer to have their suppliers semi-dedicated, increasing their control over supply chains.

Control is important because the absence of a single part will stop assembly, and immediate significant losses will follow. Continued operation of suppliers, even at a short-term loss, is critical to supply restructuring.

Generally, when a reduction in parts contracts caused by a shift from combustion engines to electric motors makes a supplier’s restructuring inevitable, the earlier a restructuring is undertaken the better.

Earlier restructuring means greater option value, and a chance for management to focus on making parts rather than cope with an overburden of debt and obligations. A distressed supplier, however, can continue producing parts so long as it has sufficient liquidity. When liquidity is depleted, the supplier must file for Chapter 11.

Using Chapter 11

When a Chapter 11 case commences, several things happen. First, the automatic stay of Section 362 of the Bankruptcy Code stops enforcement action. Second, debtor’s property becomes an estate known as “property of the estate.” Third, the supplier will need liquidity, which can come from two sources—existing cash or new financing.

If the source is existing cash that is collateral, the bankruptcy court must grant approval under Section 363 of the Bankruptcy Code. The party whose cash collateral is used is entitled to “adequate protection” under Section 361 for the diminution in value of the business resulting from the use of the cash.

If the source of liquidity is new financing, the bankruptcy court must approve the new financing under Section 364 of the Bankruptcy Code. Under Section 364, the new financing can “prime,” or come ahead of, other lienholders, and again with “adequate protection” for the diminution in value of the primed collateral.

The bankruptcy case will usually culminate with either a plan of reorganization, providing for a balance sheet restructuring and new working capital, or a sale under Section 363.

Shiloh Industries Inc., a recent Chapter 11 filer, provides a good example of use of cash collateral and financing and the accompanying “adequate protection.” Shiloh, a tier 1 supplier of materials used in noise and vibration reduction, and certain of its subsidiaries, filed for bankruptcy with a plan to sell their assets in a sale under Section 363.

Shiloh requested approval of post-petition financing of $123.5 million and for use of cash collateral.

When the Supplier Can’t Continue

What happens if the supplier is unable to continue production? It is important that the OEM be able to obtain supply elsewhere. Upon filing a petition in bankruptcy, the debtor splits into “property of the estate” and the debtor-in-possession.

When a supplier bids for a part, it provides the specifications. The prototype is electronic, and the supplier must produce the tools to make the actual parts—for example, a mold for a plastic part, or “tooling.”

Typically, the supplier makes the tooling investment, and then when completed, invoices the OEM, which purchases the tooling from the supplier. Now the OEM owns the tooling, and it is not intended to be “property of the estate” in the event of a bankruptcy.

In connection with the sale of the tooling, the OEM and the supplier are likely to have entered into a “use and access agreement” that sets forth terms and conditions—upon which the supplier may use the property of the OEM, and the terms (including indemnities) on which the OEM may enter the property of the supplier and reclaim its tooling property.

Having the terms laid out in the use and access agreement may make relief from the automatic stay to reclaim property easier and facilitate the transfer of production. But the answer is not that simple.

In Chrysler LLC v. Plastech Engineered Products, for example, the bankruptcy court held that the bargained-for possessory right of Plastech to the use of the tooling and the need for the tooling for the successful reorganization of Plastech was sufficient to deny relief from the automatic stay, preventing Chrysler from seizing the tooling.

The are many permutations of an automotive supplier bankruptcy, and the above is just an outline of a few basics. With the electrification dislocation on the horizon, professionals will need to deeply understand unique automotive supplier issues.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

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J. Eric Wise, partner in Alston & Bird’s Financial Restructuring & Reorganization Group, specializes in Chapter 11 matters, workouts, rights offerings, recapitalizations, restructuring, and post-petition and exit financing, as well as distressed debt purchases and sales.