Supply chains in the pandemic era | In Principle

Vehicle production is based on a supply chain system. During a pandemic, the risk increases that not all links in the chain will function properly. It is worth considering this risk in the context of restructuring and bankruptcy law.

In a well-organised system, parts arrive on the production line “just in time.” The just-in-time system requires excellent logistics and management of the organisation and close cooperation between its participants.

The introduction of lean manufacturing can increase economic efficiency, achieving a more competitive price for the final product (e.g. vehicle). It can also cut many costs (including storage) and losses resulting from downtime on the assembly line.

The key to this model is original equipment manufacturer (OEM) supplies, ideally executed by one or more certified parts suppliers. When production is organised this way, an obstacle encountered by one business in the supply chain has an adverse knock-on effect on subsequent recipients. Correct and timely fulfilment of contractual obligations by one business determines correct performance by other producers in the chain, and above all, the quality of the final product (and errors may even result in the need to recall batches of products). (For more on this topic, see Patrick Mears & Michał Barłowski, “Global Supply Chain,” Bloomberg BNA International Trade Reporter, vol. 32 no. 6, 2 May 2015.)

In a pandemic, an obvious obstacle is restrictions on freedom to operate, which can even lead to insolvency. This in turn brings certain consequences under bankruptcy law.

Legal consequences of insolvency

The restrictions on conducting business put in place to deal with the COVID-19 pandemic have resulted in reduction, or in some industries a total collapse, in demand, causing revenues to decline. Liquidity problems threatening insolvency give businesses the right to open restructuring proceedings. In case of a total loss of liquidity, insolvency requires the undertaking’s representatives to file a bankruptcy petition. In the automotive industry, a fall in demand for a manufacturer’s vehicles also has a negative impact on immediate suppliers and sub-suppliers involved in the production of components and parts for that manufacturer.

In Poland, the Restructuring Law and the recast Bankruptcy Law in force since 2016 meet the needs of businesses at risk of insolvency or insolvent, enabling them to open a restructuring procedure at an early stage as financial problems arise. The goal of the procedure is to reach an agreement with creditors and avoid bankruptcy. Timely opening of restructuring proceedings in the event of total insolvency will prevent the managers of the insolvent debtor’s business from being held personally liable. The Restructuring Law allows the debtor to file a petition for opening one of the four restructuring proceedings, i.e.:

• Proceedings for approval of an arrangement (postępowanie w sprawie zatwierdzenia układu)
• Accelerated arrangement proceedings (przyspieszone postępowanie układowe)
• Arrangement proceedings (postępowanie układowe)
• Reorganisation proceedings (postępowanie sanacyjne).

The first of these proceedings begins with the conclusion of an agreement with a restructuring adviser. The other three are opened by a court decision.

The key element in each of the proceedings is the conclusion of an arrangement, on the basis of which receivables arising prior to the opening of one of the restructuring proceedings (or the date of the arrangement in the proceedings for approval of an arrangement) are subject to modification, e.g. reduction, spreading out payment in instalments, or conversion into equity in the debtor.

Reorganisation proceedings have an additional benefit of staying enforcement proceedings against the debtor, and require that the debtor’s assets and liabilities be restructured before a vote on the arrangement can be taken. Without first restructuring the debtor’s business (restoring profitability), it would be irrational to propose an arrangement to the creditors. As a rule, reorganisation proceedings involve removal of the debtor from management of its own business. Then management is transferred to an administrator (restructuring adviser). In some cases, with the court’s approval, it is possible to partially maintain the debtor’s own management, if it would be beneficial to the restructuring of the debtor’s business.

When a state of insolvency arises, the Bankruptcy Law requires the debtor’s representative to file a bankruptcy petition within 30 days. There is a state of insolvency when there is a permanent inability to meet liabilities as they become due or when the amount of monetary liabilities exceeds the market value of the debtor’s assets and such state of affairs lasts longer than 24 months.

Revised rules during the pandemic

During the pandemic, the Restructuring Law and Bankruptcy Law were amended, most significantly by suspending the obligation to file for bankruptcy and by introducing a simplified restructuring procedure.

Suspension of the obligation to file for bankruptcy

From 13 April 2020, for the duration of the pandemic the obligation to file for bankruptcy has been suspended as long as the reason for the debtor’s insolvency is based on COVID-19 (Art. 15zzra of the Act on Special Support Instruments in Connection with the Spread of the SARS-CoV-2 Virus of 16 April 2020). To take advantage of this provision, the state of insolvency must arise during the period of either epidemic threat or a state of epidemic declared due to COVID-19. There is a presumption that if insolvency occurred during the pandemic, it is caused by it. However, in the event of a dispute, it will be up to the debtor to demonstrate that the insolvency did not arise from other causes. Therefore, it is worth collecting relevant evidence and connecting the lack of payment in a given period with restrictions imposed on the industry, the lack of payment of invoices by contractors affected by the lockdown, etc. The above does not mean that bankruptcy cannot be declared at the creditor’s request. Suspension of the filing obligation does not resolve the underlying problem of insolvency.

Simplified restructuring procedure

In relation to the pandemic, a new restructuring procedure was introduced from 1 July 2020, to remain in force for one year: the simplified restructuring procedure (uproszczone postępowanie restrukturyzacyjne). It is based on the procedure for approval of an arrangement, and greatly simplifies what was already the simplest restructuring procedure. Judging by the number of open proceedings (and agreements concluded so far), the simplified restructuring procedure enjoys considerable popularity. Its major pluses for the debtor are:

• Ease of opening. The proceedings begin with an announcement of the opening in Monitor Sądowy i Gospodarczy, preceded by signing a civil contract with a restructuring adviser.
• Time for agreement with creditors. The debtor has 4 months from the announcement in MSiG (without the possibility of an extension) to agree with creditors, i.e. for acceptance of the arrangement by creditors; if that does not happen, the court will discontinue the proceedings ex officio.
• Stay of enforcement. As of the date of publication of the announcement in MSiG, all enforcement proceedings against the debtor are stayed, including, under certain conditions, those initiated by creditors whose receivables are secured in rem against the debtor’s assets (e.g. by mortgage, pledge, or transfer of title for security). This allows for restoration of cash flow and conduct of negotiations at a time when the assets are protected against execution.
• Protection against termination of key contracts. During the proceedings, there is a ban on termination of key contracts with the debtor covered by the simplified restructuring procedure, unless the supervisor of the arrangement consents to termination. This protects the debtor’s business from actions of counterparties that could adversely affect the operation of the business.

After the opening of simplified restructuring proceedings, as in the case of other restructuring proceedings, the debtor should perform on an ongoing basis the obligations arising after the opening of the proceedings. With the consent of the supervisor of the arrangement, it may raise new financing for this purpose.

EU legislation: Directive on Restructuring and Insolvency is on the way

A key piece of legislation affecting insolvency and restructuring proceedings is the Insolvency Regulation ((EU) 2015/848). Polish law replicates the notion of the “centre of main interests” (COMI), determining the local jurisdiction of the court to open restructuring or bankruptcy proceedings, and thus the law applicable to the debtor (the regulation applies throughout the EU, except for Denmark). The court declaring bankruptcy or opening the restructuring proceedings should confirm in a decision that the COMI for the given undertaking is in Poland.

For businesses operating within the supply chain, and in particular those operating within a single capital group, the notion of COMI may not be obvious or identical to the location of a vehicle dealer or components manufacturer. The opening of main proceedings where the COMI is located determines the possibility of opening secondary proceedings.

Meanwhile, the Directive on Restructuring and Insolvency ((EU) 2019/1023) obliges member states to introduce into their legal systems by 17 July 2021 (unless a country requests a one-year extension under Art. 34(2) of the directive) at least one restructuring procedure, which would include and be based on uniformly understood legal terms and concepts, so that the rescue of economically viable debtors can be carried out similarly in all member states.

It may be easier for Poland to bring at least one restructuring procedure into line with the requirements of the directive than for countries that have had neither existing restructuring proceedings nor a track record applying collective proceedings to prevent insolvency. The simplified restructuring procedure is intended to provide the basis for introducing the procedure required by the directive.

Restructuring or bankruptcy of suppliers

The situation for the end user of the product (the vehicle) is definitely worse when the supplier is declared bankrupt or reorganisation proceedings are opened (containing many legal institutions derived from the Bankruptcy Law).

• Right to terminate reciprocal contracts

The bankruptcy trustee or administrator in reorganisation proceedings has the right to terminate a contract if, on the date of declaration of bankruptcy or opening of reorganisation proceedings, obligations under the reciprocal contract have not been performed in whole or in part. (For specific rights and obligations, see Art. 98 of the Bankruptcy Law and Art. 298 of the Restructuring Law.) If maintaining such a contract is not in the debtor’s interest, it may be terminated by a unilateral declaration of withdrawal, e.g. when further deliveries would be uneconomic as a result of unfavourable contractual terms concluded prior to opening of the proceedings. If this were to happen in the case of bankruptcy and the contract was terminated by the trustee with effect from the opening of the proceedings, the final recipient is entitled to submit to the bankruptcy estate its claim corresponding to the amount due for the fulfilled part of the contract after the opening of the proceedings and the incurred losses for non-performance of the contract.

But claiming full damages is not easy, and Polish law as a rule does not recognise the notion of indirect damages or consequential loss. The burden of proving damages lies with the claimant, and from an economic point of view, the solution adopted for the recipient of the end product is unsatisfactory. Not only could vehicle production suffer, but getting actual financial compensation is highly questionable. At the same time, as an unsecured claim, the claim under the supply contract is settled after secured claims are satisfied (under the right of segregation). This occurs after a significant lapse of time, at the end of the bankruptcy proceedings.

In the case of reorganisation proceedings, the claim is not included in the arrangement and therefore is not subject to reduction. However, claims exceeding the amount of the benefit and the loss suffered after the opening of the proceedings, e.g. claiming a contractual penalty for withdrawal from the agreement which is grossly excessive, may not be considered or may be mitigated (possible analogy with bankruptcy proceedings).

It is comforting to know that trustees (with the approval of the judge-commissioner) rarely exercise such far-reaching powers. Our experience shows that in the automotive supply chain system, trustees tend not to exercise the right to terminate a contract. From the trustee’s perspective, the debtor’s entire production is often based on supplying one or more major customers. The trustee is obliged to liquidate the debtor’s assets by selling first of all the whole enterprise (within the meaning of Art. 55¹ of the Civil Code and Art. 316 of the Bankruptcy Law), i.e. including rights under contracts, thus obtaining the highest price (to this end, among other things, provisions were introduced for a prepared liquidation, erroneously equated with the “pre-packaged sale” in Anglo-Saxon jurisdictions). In this light, ceasing production and laying off staff overnight may be an action that reduces the value of the company (the trustee has the right to run the debtor’s enterprise without the consent of the council of creditors or if a judge-commissioner has not been appointed, for 3 months). However, it is expected that the terms of further deliveries will be renegotiated (payment in advance for a given batch), enabling the trustee to continue production.

• Invalid termination of a contract due to bankruptcy/restructuring proceedings

Caution should be exercised against inserting in supply contracts clauses enabling unilateral termination of the contract with immediate effect in the event of filing for bankruptcy or opening of restructuring proceedings (this does not apply to proceedings for approval of an arrangement or simplified restructuring proceedings) or approval of an arrangement by a counterparty to such a contract. Clauses giving this right to one of the parties in the event of a declaration of bankruptcy, opening of restructuring proceedings, or filing for bankruptcy or opening of restructuring proceedings, are quite common in agreements with foreign counterparties. They are invalid under Polish law.

• Return of forms and templates to the end user

One of the practical problems arising from the termination of a contract is the need to change the supplier and transfer the production to another manufacturer, including the recovery of forms and templates transferred for the duration of the contract.

Retransfer of possession of forms and templates from the debtor to the end user who owns them (or has an exclusive licence to use them) is often problematic. Licences, as well as tangible elements, are lent under a contract for the production of specific parts of a vehicle (constituting machinery within the meaning of the civil law, Civil Code Art. 51), with forms and templates remaining the property of the end user or another entity. According to the provisions, a third-party property right does not constitute part of the bankruptcy estate, and things and rights should be excluded from the bankruptcy estate on the owner’s application.

From a practical point of view, attention should be drawn to the necessity of fulfilling the formal requirements of the application, as the legal title to forms and templates must be demonstrated in the application, and it may be difficult to complete the relevant documents (due to the lapse of time and the need to find the originals and not copies of documentation). The party should act immediately after the opening of the proceedings, as the trustee may sell the forms and templates (e.g. altogether with the machines and production equipment), in which case the end user will be left with only a claim for repayment of the price received by the trustee.

The impossibility of recovering the forms and templates can be painful for the end user, and given the wear and tear and low economic value of these items (often scrap value), the compensation granted does not constitute any real compensation. Instead, it may generate a risk of breach of the licence and introduction onto the market of parts produced by an unauthorised person who acquired the machines together with the forms and templates from the trustee.

Finding forms and templates on the debtor’s side may also pose a problem. Even if the trustee intends to transfer their possession to the end user, it can be difficult to locate them, especially if production was transferred from one factory to another over the course of long-term cooperation. Therefore, at the stage of concluding a contract, it is recommended not only to permanently mark the owner’s details on the forms and templates, but also to require the counterparty to maintain appropriate documentation, including the right to examine the condition and use of the forms and templates during the course of performance of the contract.

Conclusions

Like other sectors, the automotive industry has suffered from the constraints caused by the COVID-19 pandemic. In this situation, production based on a supply chain system may involve additional risks. The threat of insolvency of one of the undertakings in the supply chain has negative economic effects going beyond the typical breach of bilateral contractual relations, given the commonality of economic interests of the participants in the chain.

Therefore, it is worthwhile for businesses participating in a supply chain during the pandemic to recognise the risk and try to reduce it at the stage of establishing the terms of cooperation, taking into account the provisions of the Restructuring Law and the Bankruptcy Law.

Michał Barłowski, attorney-at-law, Restructuring & Bankruptcy practice, Wardyński & Partners