The COVID-19 situation is rapidly evolving. As countries around the world act to try and stem the contagion, businesses face serious disruption to their supply chains.
In recent years, supply chains have become increasingly global, frequently supporting just-in-time and similar manufacturing techniques, and are often complex with component parts crossing borders at various stages of the manufacturing process.
No sector’s supply chain is impervious to the disruption caused by the pandemic; however industries which source critical components from highly impacted regions, or which carry low level inventories and stocks, are likely to be particularly impacted.
Mitigating the impact
Supply chain professionals can take a number of short, medium and long-term steps to seek to mitigate the impact on supply chains. In the short-term, a crisis response team can be quickly established. The team’s key actions may include:
- Communications – a robust and evolving communication plan is needed, both internally (to include key stakeholders) and externally to the supplier base and beyond.
- Risk Mapping and Scenario Planning – this involves working to understand the risks associated with the supply chain (including shipping delays and supplier failure) and knock-on impacts to, for example, manufacturing, operations, sales and revenue, and mapping those risks across multiple scenarios.
- Pre-emptive Measures – this may include taking action to procure inventory and raw materials that are in short supply in impacted areas, and securing and transporting available inventory away from areas that are likely to go into lockdown.
- Key Supplier Program – where key suppliers are identified, it may be necessary to provide a program of support, such as flexing payment and other contractual terms, and providing working capital and debt finance.
- Alternative Sourcing Strategies – alternative sources of supply, as well as transportation and logistics, should be investigated and purchasing arrangements put in place where necessary.
- Key Customer Program – consider the risk that key customers become unable to take deliveries as ordered; alternatively that they have increased demand for certain products. Be ready to respond to customers seeking payment term extensions and consider taking out credit risk insurance to protect against customers becoming unable to pay their debts.
In the medium to longer term, we expect supply chain managers and their procurement teams to adopt a number of sourcing strategies and actions, which might include:
- Putting in place technology which provides better visibility across the value chain including key suppliers, and offers the ability to better monitor for stress points along the chain to include third party logistics and transportation providers;
- Testing the resilience of supply chain ecosystems;
- Adopting sourcing diversification strategies including micro-supply chains which enable manufacturing closer to the point of supply; and
- Further investing in the governance and management of key supplier relationships.
As a note of warning, however, competition and anti-trust laws may need to be considered as appropriate (e.g. close cooperation between an OEM (original equipment manufacturer) and its suppliers).
Supply chain contracts
Inevitably, COVID-19 will give rise to situations where suppliers (and their subcontractors and other third parties on whom they rely) are unable to perform to contractual terms, often with serious consequences for their customers and other counterparties. Scenarios include suppliers who are unable to deliver on time, or at all, and customers who no longer wish to purchase goods at the price agreed or at all.
In such event a number of legal and contractual considerations typically come into play, although they will vary from one contractual relationship to the next. Such considerations may include:
Force majeure. Force majeure may prove to be relevant where a party is unable to perform its contractual obligations for reasons related to the pandemic. Under English law (and other common law jurisdictions), force majeure is a contractual remedy-and whether or not the party will get relief will depend on the wording of the clause itself.
- Typically such remedies include having the right to suspend contractual obligations or terminate the contract, with potential exclusions from liability for associated delay and non-performance.
- A supplier may wish to rely on such a clause if it is facing difficulties with sourcing materials, whereas the customer may wish to narrow the interpretation of the force majeure clause to prevent the supplier from “wriggling out” of liability.
- You should look at whether the words “pandemic” and epidemic” are specifically mentioned in any force majeure clauses, as this may impact whether or not in can be relied upon in the current climate, although how the clauses is structured/drafted will also be pertinent.
- Sometimes, a force majeure clause will include consequential rights and obligations, such as requirement to implement a business continuity plan to attempt to mitigate the unforeseen event or a right to terminate if the event is still continuing after a certain period.
- Frustration. This is a common law doctrine which might prove to be of assistance but is only likely to be considered if the contract either doesn’t contain a force majeure clause (which these days is quite rare) or the terms of the force majeure clause do not cover the event.
- The doctrine of frustration was developed by the courts to deal with situations which change fundamentally after the contract was entered into or which render performance impossible.
- The bar to establish frustration of the contract is very high. The courts will not be quick to overturn the bargain made between the parties to a contract; hence frustration is rarely available as a remedy.
- Undoubtedly, the bar might be reached in some situations arising from Covid-19, for example, where the contract requires performance in a region that is subject to a state-imposed lockdown but, in many other instances, the parties will need to refer to contractual force majeure clauses.
- Financial hardship alone generally will not usually be deemed sufficient by the courts to frustrate a contract.
- Material Adverse Change (MAC). Some contracts set out specific conditions which, if met, will entitle a party to relief or certain rights (e.g. price increase, termination of agreement). The problem with these provisions is that it is often difficult for the parties to predict the adverse changes accurately with the required level of detail. As a result MAC clauses are often ineffective, as the English Courts tend to interpret contracts strictly on the basis of the wording of the relevant provision(s).
- Change of law. In certain cases, a change of law might result in a party becoming unable to perform its contractual obligations because to do so would be against that new law. An example might be if the UK were to shut down all commercial activity, in which case suppliers may legitimately be unable to perform certain contractual obligations. This will depend on the specific facts and circumstances including relevant contractual provisions such as change management processes and change of law clauses. Force majeure or frustration may also be relevant.
- Relief Events. Outsourcing and other complex services contracts often include “relief event” clauses. These are sometimes quite prescriptive in terms of what can and cannot be claimed and the process which must be followed, hence these clauses, where identified, should be carefully reviewed in case unforeseen events such as pandemic permit additional time for delivery or incremental cost recovery.
- Incremental cost recovery. Pricing models and charging schedules may permit the recovery of incremental costs in some cases; in other cases a fixed price model may be in place.
- Duty to mitigate. Unless expressly excluded by contract, an affected party may still be under a common law duty to attempt to mitigate any damages or losses suffered. This duty to mitigate might also be imposed contractually. Each situation will depend on its own facts and circumstances; however attempts to mitigate should be recorded wherever possible with supporting documentation where available in case the matter ends up in a court or tribunal.
- Liquidated damages and delay payments. Contracts will often have a clause setting out a specific rate of damages which a party must pay if an agreed upon milestone is not met. However, contracts may also have a permitted delay or a relevant cause mechanism, under which either the delay is permitted (often because it is out of the control of one of the parties) or the rate of delay payments is reduced. The parties should review:
- Whether their circumstances would constitute a permitted delay under relevant terms; and
- Whether a delayed event has actually arisen or is merely anticipated. Where parties are working from a cost estimate, they may want to consider revising it to reflect any anticipated delay.
Liability and indemnities. The risk transfer under your contract should be assessed:
- The contract may specify when a party is liable for specific events, even if this would not be the case in the normal course of dealing.
- The parties may also have granted indemnities (where they have agreed to cover the losses of the other party) against specific events, for instance, it is common to see indemnities from a supplier to a customer for any losses arising from a delay in delivering specific goods.
- These liabilities can be capped, or even fettered (e.g. where any such loss must be a direct loss), and the parties should review their contractual risk exposure.
- Representations and warranties. Depending on what has been contractually agreed between the parties, there may be potential for claims in relation to contractual representations and warranties and other contractual promises.
- These representations and warranties are essentially contractual promises that a party will do something, or that a particular set of circumstances will be true throughout the contract (for instance a distributor may warrant that it will at all times hold a certain amount of stock ready for immediate supply).
- Again, there may be some limits placed on these representations and warranties. For instance, a party can limit such a warranty by stating it is only true as far as that party is aware at the time of contract. You should review any limitation on representations and warranties to check if the other party has escaped liability.
- Representations and warranties are often made against the most crucial aspects of performance of the contract, and therefore can be a useful tool to achieve contractual damages if one party fails to perform the contract.
- Suspension and termination. If termination does take place, then you should look at:
- Whether the contract determines the consequences of such termination, including what happens with ownership and payment for goods which have shipped but have not been delivered.
- Whether there are any break fees or compensatory payments which fall due if a contract is terminated by one party.
- What happens where deliverables are subject to a test and acceptance process which has not yet been completed.
- Dispute resolution. Often contracts contain an escalation clause that initially requires the persons responsible for managing the contract to engage and try to solve the problem and/or to refer this internally in the organization to the management of the company in order to seek an early resolution and to avoid a dispute. However there may also be obligations to mediate or engage in ADR before escalating matters further, and you should check whether such clauses are binding on you.
- Governing law and jurisdiction. In this note we consider the application of English law. However, global supply chains often cross multiple jurisdictions and it may be that other laws and jurisdictions are relevant to construction and interpretation of contracts and to any disputes that arise between the parties. For instance, in some jurisdictions force majeure-type provisions operate to override the contract, whether silent on the topic or not.
- Notification. In the event that a party decides to serve notice of breach on the counterparty or to take other formal steps in relation to an alleged breach or other dispute, then the relevant notice and dispute resolution provisions should be reviewed, and advice taken where appropriate.
- Time limits. All legal claims must be commenced within a certain time frame, otherwise they are considered to be time-barred and the counterparty will have a complete defence to any claim brought in respect of that contract.
- Generally, the statutory limitation period is 6 years for a contractual claim (or 12 years if the document was completed as a deed).
- However in some cases contractual limitations may also apply to claims. Any such limit will often carve out claims for a specific event and try and limit the time period to bring any claim for that event (often to a year or two).
- Note that while statutory limitation periods generally run from the date on which the cause of action accrued (i.e. the date of breach of contract), contractual limits may apply for a set time period irrespective of whether the action accrues during this period.
- Liability limitation. The parties to supply chain contracts often seek to limit their liability:
- The usual liability limitation clause will include overall liability caps for each party (i.e. the maximum that can be claimed from a counterparty) as well as setting out any specific types of loss which are outside the cap (i.e. uncapped) as well as excluded types of loss such as indirect losses, loss of profit, loss of business, loss of goodwill/reputation, and loss of opportunity.
- We recommend that you check your supply contract for overall liability caps to assess the overall risk profile as part of supply chain scenario planning.
- This is possible if you have your counterparty’s cooperation, but should be carefully considered. We suggest dealing with things in stages-tackling urgent issues first. In particular, make sure any renegotiated position is carefully thought through and is realistically achievable; otherwise you could end up simply delaying the problem.
- Relationship management. Last but by no means least, at times like these, suppliers and their customers will need to work closely together. Regular calls between contract / relationship managers (and wider governance tele/video-meetings) should be established (if not already happening) and affected staff should be kept in the loop.
For organizations with complex supply chains, needing to review hundreds or thousands of contracts, to determine the position under force majeure and related liability and indemnity risk, AI analytics tools can be used to extract and analyse relevant clauses in the first instance. As can be seen, a very wide range of issues can be impacted, hence the desirability of undertaking a contract review exercise to parse and sort high volumes of contracts and agreements and identify and retrieve relevant clauses for review.
Looking forward, we expect to see Covid-19 specific clauses being introduced into some supply chain contracts (in the same way that “Brexit clauses” have been appearing in recent years), and that force majeure clauses – at least for a time – will bear more scrutiny in negotiations than is typical. Similarly, clauses dealing with business continuity, exclusivity of supply, price adjustments, renegotiation triggers and thresholds, temporary suspension and termination rights, and supply chain transparency, will also fall to be considered.
Please get in touch with any of the authors of this article, or your usual Fladgate contact, if it would be helpful to discuss these themes or others in the context of any issues that you might be facing.