When Contracts Go Bad

April 30, 2007
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GRAND RAPIDS — In the conclusion of his recent presentation at the 9th Annual Automotive Suppliers Symposium at Van Andel Global Trade Center downtown, Daniel Sharkey, litigation chair for Detroit-based law firm Butzel Long’s global automotive team, invoked local District Court Judge Gordon Quist:

“The allocation of risk in cases like this involving so-called ‘just-in-time’ inventory management will probably continue to be the subject of continuing negotiation and litigation.”

Quist referred to a 2005 case in the U.S. District Court of Western Michigan in which he ruled against a West Michigan manufacturer that had abruptly shut down a California manufacturing facility, leaving months worth of unused steel in the supply chain.

While the case dealt with the home appliance supply chain, Sharkey said the situation aptly describes the increased litigation today he has seen among his automotive clients, as well as many sectors of U.S. manufacturing. The widespread adoption of just-in-time manufacturing has created “tense” procurement channels vulnerable to raw material and component problems.

But while the risk of a work stoppage increases on the OEM’s end of the supply chain, the risk of rising production costs is often assumed by suppliers.

“You generally try to allocate risk in a way that is mutually acceptable to both parties and in a way that balances those risks so that the burden doesn’t fall unfairly to one side or another,” said Peter Gustafson, an attorney with Warner Norcross & Judd in Grand Rapids and the mediator for the aforementioned district court case.

“But these things tend to crop up when the wording is ambiguous toward raw material increases. It’s not a just-in-time problem. When you’re dealing in a period of price volatility, you can spike that ripple through manufacturing and potentially create a severe hardship.”

This became apparent for the automotive sector in early 2004, when the price of steel jumped 100 percent in a mere 55 days. Under constant competitive pressure, automotive OEMs could not agree on price increases, and many suppliers with long-term purchase orders were faced with absorbing the higher costs at a loss. In the years since, Sharkey said, assigning the risk of raw material costs has become a primary concern among his automotive clients.

“Typically, the courts will hold you to the contracts you negotiate,” said Bill Rohn, an attorney with Varnum Riddering Schmidt & Howlett and chairman of the firm’s trial practice group. “That the economy has tightened and you’re losing your shirt is typically not a good legal argument.”

Gustafson agreed: “One might think that our law is such that if you enter into a bad contract and don’t clarify the rights and responsibility of the parties, you can still get out of it on equitable grounds, but that’s not accurate.”

There is legal doctrine that could provide relief from unfavorable contracts, Rohn said, but these situations generally occur only when material is practically impossible to acquire or, as Sharkey noted, in force majeure (“greater force”) scenarios such as hurricanes Katrina and Rita in 2005, the 2004 tsunami and, in some instances, strikes.

Still, depending on the situation, the law is subject to larger business concerns, according to Sharkey: “You look to the contracts first, but the buyer can’t shut down the customer. … With that said, write this down: Lawsuits are bad customer relations. If you go down that road, they won’t forget. Maybe not right away, but you’re done.”

At this point, a just-in-time model offers some keen leverage to the supplier — any litigation could force a temporary but costly stoppage in its supply chain.

“This may sound like extortion, because it is,” Sharkey said. “But for the supplier, it might be that or bleeding to death.”

Ultimately, the supplier could choose to quit making the part, especially if the purchase order has no end-date or none in the foreseeable future, Sharkey said, adding, “What is really frightening is when a supplier says, ‘I’m not making money. I’m just closing up shop and retiring. Go ahead and sue me, I’m out.’”

For most companies, the only sensible way to negate the effects of rising raw material costs is to build risk mechanisms into the contract terms. However, in the current state of some industries, specifically automotive, that is not always practical.

“We all know that in today’s automotive industry, the buyer has eight bids sitting on his desk,” Sharkey said. “If you don’t accept their terms, your bid goes into the wastebasket, and they look at one of the other seven.”   

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