10 Ways to Improve Your Supply Contract
Brexit, COVID-19, and the Suez Canal congestion brought Force Majeure clauses in supply chain contracts into sharp focus. Force Majeure clauses seek to limit the liability of a party whose performance is affected by an unforeseen event beyond that party’s control.
Force Majeure clauses commonly provide for a limited range of remedies, namely extra time for performance, suspension of performance, or termination. But they do not satisfactorily allocate the risks and costs caused by delay.
Parties to a supply contract should therefore consider regulating the following 10 additional points:
1. Contractual indemnities. Including specific indemnities in a contract can be a useful tool to protect buyers against potential losses associated with delayed or non-delivery. While buyers may not themselves suffer loss, their customers might; for example, construction is halted due to unavailability of delayed goods. Customers will then seek compensation for their loss from the buyer.
Under standard terms of sale for goods, the supplier’s liability for such "third-party claims" will commonly be excluded and cannot be recovered. An indemnity that covers the buyer against such loss is advisable.
2. Liquidated damages. It is often difficult and time-consuming for a buyer to establish actual loss caused by delay. Including a liquidated damages clause in a contract can provide a suitable solution.
These clauses provide that if a certain type of breach occurs—a delayed delivery, for example—a fixed sum is paid, such as a fixed rate for each day of the delay. The claimant does not have to prove its loss when making the claim, nor will the claim depend on the interpretation of clauses capping liability or excluding certain liability such as lost profits.
As the level of compensation is an agreed remedy, adding such clauses to a contract can help preserve the commercial relationship despite poor performance.
3. Compensation for shortfall. Long-term supply contracts usually determine minimum supply/purchase quantities. Specific remedies to deal with shortfalls on either side should be incorporated in the contract.
These remedies can include compensation for any increased prices that the buyer has to pay a third party to obtain similar goods elsewhere. The supplier, on the other hand, will insist on an express right to get paid for the shortfall in quantities purchased or to reflect the shortfall in a price adjustment.
4. Right to seek alternative suppliers. Hand in hand with compensation for shortfall, the buyer in an exclusive supply agreement must ensure that it has the right to seek alternative suppliers while its contract supplier is unable to perform the contract. Any such supplies from third parties should be counted against the buyer’s minimum purchase obligations under the agreement.
Once the supplier is able to resume supplies, the buyer must be granted time to terminate and run-off any alternate supply arrangements with third parties before it can commit to receive goods from the supplier again.
5. "Step in" rights. Often problematic are rights for the buyer to "step in" the supplier’s existing arrangements with its sub-suppliers. The supplier will often be reluctant or unable to grant such rights and to provide the customer with access to its sub-suppliers. Also, sub-suppliers may be reluctant to accept the customer as a third or new party to their existing arrangements with the supplier.
In order for step-in rights to "work", the customer must ensure that the supplier is obliged to facilitate access to its sub-suppliers and assist the customer in agreeing to terms with the sub-suppliers. Step-in rights provide an effective remedy only in very limited supply scenarios.
6. Material adverse change. Material adverse change clauses provide for a right to adjust/adapt the contract or to terminate it if market conditions change adversely. If the adverse conditions and the adjustment can be anticipated clearly (e.g. raw material prices increase above a certain threshold, or currency exchange fluctuates), then such clauses can be a useful tool to adjust prices or even to provide for a clear right to terminate a contract if it is no longer commercially viable.
The issue is that it is often difficult for the parties to accurately predict and describe the adverse conditions and the adjustment to the contract that needs to flow from them. If the conditions or remedies are expressed on merely general terms—for example, the parties shall "negotiate and agree" adjustments to the contract—then there is a risk that the provisions are not enforceable.
7. Forecasting. Often overlooked is the importance of adequate forecasting provisions. Regular and frequent forecasts provide an early warning system if a party’s ability to supply or receive goods is impaired by an unexpected event. This often enables the parties to enter into a dialogue to resolve the problems or to adjust the contract by agreement.
8. Termination. Terminating the agreement for breach ends the commercial relationship and is therefore only a remedy of last resort. As only "material" breaches commonly entitle the aggrieved party to terminate, disputes can arise over whether a mere delayed delivery is sufficiently "material" for this purpose.
If delivery timing is important, then the contract should expressly state time of delivery to be "of the essence" of the agreement. If time is "of the essence" then late delivery should entitle the buyer to terminate the agreement and claim for damages.
9. Business continuity. Ensure that the supplier has in place a business continuity and recovery plan that will be implemented should delays occur. Other remedies could include obligations to maintain insurance and performance guarantees from the parties’ group companies.
10. Dispute resolution. Irrespective of contractual remedies, delays in the supply chain have the potential to trigger disputes. It is therefore vital for any supply contracts to have clear provisions that enable, but also oblige, the parties to seek to resolve any grievances amicably.
The contract should include a dispute resolution protocol that escalates a dispute that cannot be immediately resolved by the parties to their respective senior management. If the senior management is unable to resolve the issue, the matter can move to the next level, often mediation and arbitration.
Ultimately, a long-term commercial relationship is more likely to survive a crisis if the contract clearly allocates and regulates the risks and costs of the venture.