ON THE RIGHT TRACK

April 2013

sgh

AUTOMOTIVE REPORT:

Editor’s Comment PAGE 01

A Supply Issue PAGE 02

The Competition PAGE 03

Customer Credit Regulation Changes PAGE 04

Products and Services Segmentation PAGE 05

Biofuels Update PAGE 06

M&A Outlook PAGE 07

BRICS of the trade PAGE 08

Research and Development PAGE 10

Focus Formula One PAGE 11

Points Don’t Mean Prizes PAGE 12

CONTENTS

Despite the media’s superstitious approach to the 2013 plate, new registration figures are on the rise - positive news for an industry which has been going through some tough times.

There has been an overall fall in production since the recession arising from government austerity, increasing fuel prices and falling demand for major export markets. PSA, Opel and Ford have taken steps to reduce manufacturing whilst Daimler, VW and BMW have announced an intention to reduce costs.

Although the European economy will continue to be fragile, the outlook is much more positive with revenue growth forecast for 2014 as confidence improves and demand rises.

Manufacturers in the strongest position are those able to exploit global brands, develop new products such as hybrid and electric vehicles and enter new markets including India and other developing nations.

However, even with these opportunities the future of the industry is not guaranteed. Significant challenges ahead include meeting emission regulations and increasing competition from low-cost producing countries such as China.

Major Companies (market share 2012)

EDITOR’S COMMENT

Spring has finally sprung...

Ben ThornberPartner and Head of Automotive

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The global economy continues to have an impact on the number of units sold and produced throughout Europe and other markets. The impact is not just felt on the manufacturer, but on the entire supply chain. How can suppliers and OEMs protect their position?

Ensuring that contracts are commercially strong will help protect suppliers and OEMs alike when demand for parts decreases.

By adopting the following methods when negotiating contracts, suppliers and OEMs can improve their legal position during the negotiations:

• during the request for quotation (RFQ)-process for a new project, or during the annual price negotiations for existing projects, suppliers can make prices or productivity rebates subject to certain minimum purchase volumes

• where raw materials represent a significant share of the production costs of a specific part, an effective ‘raw material early termination’ agreement may provide protection if purchase volumes decrease and raw material prices go up

• termination rights for the supplier – particularly relating to the price arrangements - with reasonable notice periods allow suppliers to negotiate new prices that take into account decreased purchase volumes

Although this may appear supplier biased, OEMs need to take note and appreciate that in certain jurisdictions suppliers may be able to treat their business relationship as terminated if there is a fall in sales. This may give rise to compensation. It is important for both parties to pay particular attention to the legal implications of their commercial agreements and ensure that, where possible, appropriate volume provisions are built into the agreements they enter into.

Motor vehicle production

A SUPPLY ISSUE

*estimate

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THE COMPETITION

The US, Canada, Europe and more recently Japan have seen increasing numbers of dawn raids with Japan’s Fair Trade Commission recently conducting raids at various headlamp manufacturers. Although cartel investigations in the car parts industry used to be rare, the number of dawn raids in the sector has risen since 2010, with a number of global investigations conducted simultaneously with assistance from corresponding agencies across the world. Evidence obtained in one jurisdiction has led to further investigations by corresponding agencies – for example, evidence obtained in the US has led to prosecutions in Canada and Europe.

Most recent investigations in the US and Japan have seen the imposition of record fines in the industry. This includes Furukawa agreeing to pay $200m for its role in price-fixing, along with three executives each

receiving prison sentences within the US, while the Japanese Fair Trade Commission ordered Yazaki, Sumitomo and Fujikura to pay a fine of $168m (Yazaki: $125 m) for their mis-conduct in the wire harness sector.

Be competitive – not anti-competition

As the automotive market continues to come to terms with the current challenging trading conditions, there has been a strong incentive for companies engaged in the supply chain to enter into discussions with their competitors in an attempt to discover each other’s strategies for managing the decline in volumes. However, competitors should be aware of the significant risks involved in such discussions which could attract fines from regulators if they contravene strict competition rules.

Regulatory investigations and the possibility of receiving fines for anti-competitive behaviour can have a serious impact on a company’s finances and reputation within the marketplace. It is therefore vital that suppliers and OEM’s educate their sales staff and ensure that potentially market sensitive information is not shared with competitors. Experience has shown that most employees have an insufficient understanding of the competition rules. Conversations around pricing, product margins, current ongoing or intended bid processes or volumes of orders could all be considered to contravene competition laws and may be the subject of anti-competitive investigation.

Parts suppliers, in order to remain competitive, should seek to identify new ways in which to reduce costs. This may involve

co-operating with competitors on product development, entering into joint production arrangements or creating joint ventures. Co-operation agreements should be structured to comply with competition law, a process which is greatly assisted if the parties involved do not hold strong market positions.

The European Commission has published so-called block-exemption regulations for joint R&D, joint production and specialisation agreements which will not be considered anti-competitive as long as they are entered into between competitors whose combined market share for the products which form the basis of the cooperation does not exceed 25% (for R&D agreements) or 20% (for joint production and specialisation agreements) and which do not contain any onerous restrictions on competition.

The last 24 months have seen increasing activity from competition authorities.

We would encourage oranisations to get involved in the consultation process in order to ensure that any concerns are properly considered.

The timetable is expected to take the following form:

• May 2013 - end of consultation period

• Summer 2013 - approval from Houses of Parliament

• Autumn 2013 - proposals for the implementation of the new regime are expected from the FCA

• April 2014 - responsibility for consumer credit regulation is expected to transfer to the

FCA by way of an interim regime

• 2016 - full regime expected to come into effect

The proposed changes are significant. For instance, the FCA is expected to have greater authority to impose (currently limited) fines for breaches of the Consumer Credit Act. This is expected to include the ability to impose retrospective fines. In addition it is expected than a more rigerous

authorisation progress, a more proactive regulatory process and possible criminal sanctions for breaches under the FSMA will also be introduced as part of the new regime.

Whilst businesses currently offering consumer credit products and services are expected to be given a two-year window in which to apply for FCA authorisation they nevertheless need to be aware of the impact and begin preperations.

CONSUMER CREDIT REGULATION CHANGESIn March 2013 the UK Government published a consultation document setting out its intention to transfer, under the Financial Services and Markets Act (FCA), responsibilty for consumer credit regulation to the Financial Conduct Authority (FCA).

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PRODUCTS & SERVICES VEHICLE MARKET SEGMENTATION

41% Petrol cars: 1.5 litres and above

17.3% Diesel cars: 1.5 to 2.5 litres

10.5% Engines: including rebuilding

7.7% Petrol cars: less than 1.5 litres

7.4% Commercial vehicles

6.5% Diesel cars: up to 1.5 litres

5.7% Diesel cars: 2.5 and above

3.9% Special purpose & all other vehicles

About 75% of cars manufactured domestically are exported to countries including the US where petrol remains the most popular type of fuel

The Fuel Quality Directive 2009 amended Directive 98/70/EC with regards to the

specification of petrol, diesel and gas-oil and introduced a mechanism to

monitor and reduce greenhouse gas emissions.

The 2007 Renewable Transport Fuel

Obligation ‘RTFO’ was amended in

2009 to close a loophole

on the

blending of biofuels and fossil fuels. It was amended again in December 2011 to impose a mandatory sustainability criteria from the Renewable Energy Directive and the Fuel Quality Directive 2011. The RTFO is divided into ‘obligation periods,’ which run from 15 April to 14 April the following year, and require suppliers of fossil fuels to supply a certain amount of biofuel within those periods. Each year the target increases until it reaches 5% of total road transport fuel supplied by volume for the period 2013-2014. The Department for Transport, as the regulator, issues renewable transport fuel certificates that show that the fuel supplied complies with the obligations of the RTFO, including the sustainability requirements. The 2011 amendment also introduced increased rewards for some fuel types, including those made from waste materials such as used cooking oil, and a requirement to have data on the carbon and sustainability performance of fuels to be independently verified before renewable transport fuel certificates are awarded. It is anticipated that legislation will come into force in April 2013 to expand the scope of the RTFO to include biofuels used in non-road mobile machinery.

Fuel quality has long been a focus of the European Commission...

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BIO-FUELUPDATE

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The M&A outlook in the global automotive industry is slowly improving since the low-point of 2009. There are now signs of recovery in certain markets. However, 2012 global M&A automotive results reveal that this progress has suffered a set-back. Transactions have decreased for four consecutive quarters. The 120 announced deals in the second quarter of 2012 have decreased 29% when compared to the 169 deals announced during the same period in 2011. The low volume of automotive transactions reflects the industry’s current trend of pursuing partnerships and alliances in an attempt to increase scale and enhance profitability, whilst consistently avoiding the costs and risks involved in full-scale mergers or acquisitions.

Much of this decline in M&A activity can be attributed to the ongoing debt crisis in Europe which has historically been the most active region in automotive M&A in terms

of both acquiring and target companies. Automobile production in the European marketplace is not expected to reach pre-recession levels until 2016. The current financial crisis and ensuing austerity measures have significantly impacted on the industry with new car registrations declining by 6.3% through the first half of 2012.

These challenges have rendered European assets, as well as automotive companies with significant exposure to Europe, more risky.

However, this is also likely to translate into more favourable valuations and an increase in inbound M&A activity geared towards acquiring technology and market access over the

next 12 to 18 months. Poor profitability is likely to lead to increased consolidation, with European suppliers as most likely targets.

In stark contrast to the situation in Europe, the North American automotive market is attracting investment due to the restructuring, which took place in 2008-2009. Similarly, the Asian market has increased in activity, though this was partly down to internal acquisitions and restructuring. The BRIC countries continue to make great strides. As automotive companies look to acquire assets that will support building higher quality and more technologically advanced vehicles for domestic and global consumption they are more

likely to increase technology focused acquisitions.

There are new signs pointing to an industry revival sparking interest and possible new investment. After peaking in 2009, bankruptcy filings have steadily declined and are at the lowest point in recent history. Recent restructuring has helped create a smaller, leaner contingent of automotive companies ready to participate in profitable growth. By 2017 global automotive production is expected to rise by 40% and automotive companies of all sizes are showing a willingness to embrace technology.

This has led to a trend in larger companies buying

up SMEs who specialize in advanced technology. This was perhaps best demonstrated by the recent $16.9 million acquisition by Green Automotive Co Inc of Liberty Electric Cars Limited, an Oxford based manufacturer, designer and developer of electric vehicles, which specialise in converting existing high-performance petrol powered vehicles into electric cars.

Overall the M&A market has made progress since the lows of 2009. Although the ongoing Euro crisis has halted recovery in this region the general picture for the global M&A automotive industry is one of increased activity and opportunity.

M&A OUTLOOK

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BRICS of the trade

However, with each of these countries having its own IP law, all four have been recognised as raising particular challenges for companies trying to protect and enforce their IP rights.

Companies should think seriously about developing an IP protection and commercialisation strategy before introducing technology into new markets. The best approach is to apply to register your trade mark before entering the global market – spending a few hundred pounds early on can save thousands later. Not only that, but dealing with IP as an afterthought can damage competitiveness and profitability.

Other recommendations include:

• undertakedetailedduediligenceonforeignpartners

• obtaineffectivenon-disclosureagreements

• asseswhatregisteredprotectionisavailable(e.g.patentsand designs)

• identify the merits of obtaining such protection compared to relying on trade secrets and laws of confidence

• seek specialist advice on IP law in each country

IP in focus: China

The main issue with brand protection in China is its ‘first to file’ trade mark regime. This means that the first party to file for a trade mark (without having to prove an intention to use the mark) will obtain registration, so preventing others from using it.

This has caused issues for many companies who enter the Chinese market only to discover that a third party has already registered their trade mark and is now seeking to enforce this against them. Trying to claw back trade marks in these circumstances can be very costly and time consuming. The amount of patents being filed in China has hugely increased in the last couple of years and competitors will be quick to snap up patents for parts/goods that are not sufficiently protected.

The rapid growth of BRIC countries Brazil, Russia, India and China has opened up potential markets for automotive manufacturers implementing their global strategy.

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The Chinese patent system is broken down into three different types of patents:

• An Invention Patent – this can protect new products, processes and improvements

• A Utility Model – a ‘mini patent’ that can protect products but not methods

• A Design Patent – akin to a UK registered design

An Invention Patent usually takes three to five years to be granted as it is the only type of patent that undergoes a substantive examination. Current reports suggest only a small number of the Invention Patents filed in China are successfully registered.

Utility Model patents are extremely popular with Chinese companies as there is no substantive examination and they are usually granted within several months rather than years. They are a quicker way of gaining protection and can be valuable in fencing off key technologies and gaining a competitive

advantage. The current figures suggest, however, that foreign companies are taking full advantage of Utility Model patents to protect their products. When considering IP strategy in China, UK automotive companies should consider applying for a combination of the different types of patents to sufficiently protect their parts/goods.

It is also a good idea to keep detailed records of your design/invention processes with dates on all documents. This is particularly important if you ever need to enforce your IP rights in China as there is a high threshold for what will pass as court-admissible evidence. Therefore, it is always good to plan ahead.

The increase in manufacturing costs in China (largely due to increased labour costs) may also lead companies to look elsewhere (e.g. Vietnam) for cheap manufacturing. While China poses its challenges in relation to IP, the law has developed and improved rapidly over the years and corresponds substantially to IP laws in Europe. Therefore, companies will need to bear in mind that moving their manufacturing to other countries, where IP law is likely to be even less developed, will raise a whole new spectrum of challenges.

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It is a common misconception that a tough economic climate reduces capacity for research and development. However, cost reduction itself usually requires innovative thinking, as companies seek to ride out the longest global recession in living memory.

WHAT’S NEW?

The UK Government continues to buck the cost cutting trend when it comes to incentivising R&D by improving rather than reducing its R&D tax incentives. From 1 April 2013, many companies will be able to claim a cash credit of up to 10% of their R&D expenditure. This does away with previous restrictions that meant many loss making companies could not benefit immediately. The new credit should also be more visible to internal and external stakeholders, which is a deliberate attempt to encourage companies to use the money they obtain to reinvest in R&D.

This major change to the tax treatment of R&D expenditure sends a clear message that the UK Government sees innovation as absolutely essential to the UK and a key way to support and grow our manufacturing industries. It is important to note that the tax incentives for R&D are not just for brand new inventions, but are designed to support commercial development activities and therefore their scope is very often underestimated by companies. In many cases, companies unnecessarily disregard activities they see as essential to their survival, such as cost reduction, process improvement and regulatory projects, and therefore fail to maximise the relief they could be claiming.

MANUFACTURING AND SUPPLY CHAIN COMPANIES

Despite disappointing headlines, such as the loss of nearly 1,000 jobs at Honda’s Swindon plant, we are still hearing about developments in electric cars, hybrids and even robotic cars, showing that innovation remains absolutely key to the industry.

The automotive industry cannot afford to stand still as it comes under pressure from both customers and regulatory bodies to adapt. In the shorter term, the industry has little choice but to invest in developing technology to reduce carbon emissions, as petrol and diesel engines will be subject to ever more stringent regulation. Many companies do not realise that regulatory projects can qualify for R&D relief; the driver for the project is regulation, but it is the technological solution developed that matters.

Many companies are considering collaborative R&D in order to manage this future transition, but they should still ensure that they are claiming what they are eligible for in terms of relief for their input.

RESEARCH & DEVELOPMENT:TAX RELIEF

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With eight out of eleven F1 teams based in the UK, Britain really is the home of F1 racing. The F1 season continues to attract huge audiences globally, despite tough times in the global economy. Crucially, the F1 ruling body, the FIA, has demonstrated a clear desire in recent years to increase competition between the teams and to place more emphasis on driver ability. It has done this by limiting development budgets, testing time and standardising some elements of the vehicle technology.

Rather than reducing R&D in the sector, this restriction on development has forced the teams to be ever more innovative in the technology they develop and the way that they deploy it. R&D is absolutely central to the premise of F1 and it is well known that the technology developed for the track filters down to the consumer car market, and it therefore has a much wider impact than F1 alone. In fact, the impact of F1 R&D is not restricted to the automotive industry, with companies such as McLaren Applied Technologies looking at the wider application of the technology developed for the track. A case in point is the McLaren TT cycling helmet, which draws on extensive expertise in aerodynamics and computational fluid dynamics.

Given how R&D intensive the F1 sector is, it may be tempting to assume that taking advantage of the R&D tax incentives available would be a no-brainer. However, with the FIA changing regulations each season, F1 teams constantly need to reconsider the boundary between R&D activities and racing activities, as this is the key distinction which determines the amount of relief they can claim. The line between racing and testing blurs with every reduction in testing kilometres, meaning the race weekend itself starts to become a test session for new parts and vehicle set ups.

FOCUS FORMULA 1

With the FIA changing regulations each season, F1 teams constantly need to reconsider the boundary between R&D activities and racing activities

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In 2009 Jean Todt reduced the number and type of people

who could be eligible to be stewards at various races.

Technology has been introduced in an attempt

to assist stewards in reaching a decision

together with improving

consistency in the decision

making

process. During the 2012 season a total of 60 penalties were awarded against 22 of the 25 drivers competing.

However, consistency is questionable, with different penalties being awarded against different drivers for what appear to be similar racing incidents.

A further comparison of similar incidents between Romain Grosjean and Mark Webber, Bruno Senna and Nico Rosberg, Kimi

Raikkonen and Fernando Alonso reveals all three incidents had similar outcomes. Yet differing penalties were handed down or, in the case of Raikkonen, no penalty at all.

Fans, teams and members of the racing community have offered different opinions as to how the inconsistencies could be tackled. One option that has been proposed is to reduce the number of stewards at each race. This could

In considering ways to improve driving standards, it appears that the world of Formula 1 is to receive a points based penalty system. The introduction is being

heralded as an improvement. However, irrespective of the penalty imposed, the consistency of their application needs to be considered alongside the

manner in which they are imposed.

POINTS DON’T MEAN PRIZES

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A comparison of incidents notes the inconsistency that arises from race to race and season to season.

During the 2011 Hungary GP, Lewis Hamilton received a drive through penalty when his car span in front of Paul di Resta.

In Singapore, Adrian Sutil received a ‘slap on the wrist’ for a similar incident and at a following race a $20,000 penalty for spinning into Nick Heidfield.

During qualifying in Japan, Vergne received a three place penalty for impeding Kovalainen under Article 31.7, whereas Vettel received a reprimand for impeding Alonso in a similar manner but his penalty was imposed under Article 16.1.

work where there is only one steward per race or, in the extreme, one steward per season.

The stewards’ room is designed to operate like a court; there are claimants, defendants, witnesses and judges.

If the stewards have a greater regard to precedents established from similar racing incidents, their ability to impose a more consistent and ‘fair’ penalty could be improved.

Introducing a points system will improve credability. However, when acting in a judicial capacity the stewards should adhere to precedents.

Until then the inconsistencies will continue and any penelty points system introduced may not work.

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Disclaimer:

The content of this report is a guide only. For legal information on any of the subjects mentioned, please contact Ben Thornber on 0800 763 1662, ben.thornber@sghmartineau.com or Gareth Brewerton on 0800 763 1393, gareth.brewerton@sghmartineau.com

For further advice or information on R&D tax relief please contact Jennifer Tragner on 07944 227 298, jtragner@almacg.com or Gavin Gardner on 07984 773130, ggardner@almacg.com