One of the bigger supply chain legal stories of 2014 came out of the apocalyptic demise of the supplier relationship between Apple and GT Advanced Technologies (GTAT), a New Hampshire based company that Apple chose to supply sapphire for use in the new iPhone 6 screens.
Before Apple met GTAT, iPhone screens were made of glass, which allowed Apple’s touch-screen technology to be much more sensitive and precise than earlier stylus-controlled screens. But which also (as anyone with a four year old or anger management problems knows) has a tendency to scratch and break. What GTAT was supposed to bring to the party was sapphire. Sapphire is one of the strongest materials on the planet, and can be industrially made. Uncontaminated sapphire also happens to be transparent.
On October 31, 2013, Apple and GTAT finalized their supply agreement – a legal opus composed of at least seven separate contract documents. It was the biggest agreement of GTAT’s corporate existence, and sent its stock value soaring. The governor of Arizona touted the deal as an economic miracle, since it promised the opening of a new facility in Mesa and more than a thousand jobs.
Less than a year later saw GTAT filing for bankruptcy, most of the Mesa employees being laid off, and the Mesa facility being “repurposed,” though for what no one yet knows. And iPhone screens are… still made of glass.
What went wrong?
The story GTAT spun in its bankruptcy filings was of its woeful role as an ill-fated underdog dominated by Apple the Bossy Behemoth. According to GTAT, Apple had its way with GTAT by saying hurtsome things to it like, “Put on your big boy pants.” The result was a one-sided agreement that heavily favored Apple and put all of the business risks on GTAT.
For the sake of learning from others’ misfortune, however, our takeaway is different.
We think that there were two big legal issues with the Apple-GTAT agreement. The first, which we will discuss in this post, has to do with the problematic nature of development contracts, and of negotiating development and production contracts simultaneously.
In the supply chain context, a “development contract” is a contract to develop a new product, or to develop an existing product using new technology. The potential problems are legion. The product might not work, or might not work at the expected cost structure or time schedule. Even if it does work, the market might not accept the new product. Or the new product might be beaten out in the market by somebody else’s new product. None of this can be predicted at the outset.
Therefore, tying a full-scale, production-level supply chain agreement to the success of a development project –which is what Apple and GTAT did – can be hazardous. The Apple/GTAT supply agreement not only presumed that Apple and GTAT would successfully develop a new product at their anticipated cost structure and by a certain date, but they also bet over $500M in production-level orders on it.
Of course, some bets make sense. We’re comfortable betting that the sun will come up tomorrow. We’re not comfortable betting that two suns are coming up tomorrow, one in the shape of Chuck Norris’s beard and one looking like Grover from Sesame Street. So how big was the Apple/GTAT bet?
Here are some fun facts:
- GTAT never made sapphire in commercial quantities before. Its involvement in the sapphire market was as a manufacturer of sapphire furnaces. Apple knew this, and originally, the deal between the parties was for Apple to buy furnaces from GTAT, not the sapphire itself. Somehow, the terms morphed.
- Sapphire “boules” of the size contemplated by the Apple/GTAT agreement (262 kg) have never been made before by anybody in commercial quantities. A sapphire “boule,” by the way, is the unit that manufactured sapphire comes in. It looks something like a sapphire log.
- GTAT was supposed to make the new product in a facility that had not been tested, with new and inexperienced employees.
For a development contract to work, risks and rewards must be carefully examined. Optimally, production terms and conditions should not be finalized until both parties know the technical parameters of the product, what it costs to make, and what the market is likely to be. If parties insist on negotiating production terms before development is complete, the production contract should reserve the right to renegotiate price, timing, and warranty and indemnification terms. Development contracts are like a first date: At this point in the relationship, no sane person would negotiate marriage terms.