Contracting for Turbulent Times

Introduction

It's fair to say that recent years have been challenging for business. Numerous disruptive events have put pressure on global supply chains. And the nature of these events has been unpredictable and varied. The COVID-19 pandemic, natural disasters and armed conflict, through to the disruption or failure of IT systems and vital transport links.

More recently we’ve seen nations taking a different stance on globalisation and foreign policy – a shift that many commentators believe is here to stay.

In January the World Economic Forum published the 20th edition of its Global Risks Report. It highlights declining optimism and a range of risks across geopolitical, environmental, societal, economic and technological domains. State-based armed conflict was identified as the top risk in the current global risk landscape, with climate and environmental issues being ranked as the most severe risks over a longer-term (ten-year) horizon.

The question then is – how can businesses strengthen their contracts and supply chain arrangements to compete effectively in turbulent times?

Achieving supply chain resilience

The good old days of relative stability throughout the 1990s and early noughties are behind us. We’re seeing a marked shift away from just-in-time inspired business strategies (which focus mainly on efficiency) to more of a “just-in-case” approach with greater emphasis on business security and supply chain resilience.

Various factors contribute to an organisation's overall level of supply chain resilience. But how a business contracts with, and manages, its suppliers and sub-tier suppliers is a key piece of the jigsaw.

Pre-contractual considerations

Before committing pen to paper, it's important to sense-check that a prospective supplier not only meets your requirements in terms of quality, price and other commercial considerations, but that the appointment of the supplier supports the resilience of your overall supply chain.

While this article focuses primarily on achieving resilience through robust contracting, key considerations at the pre-contract stage include:

• Does appointing the supplier align with the wider supply chain strategy? Strategic considerations in response to earlier disruptive events have included:
  • stockpiling
  • diversification of suppliers (multi-sourcing)
  • diversification of supplier geographies
  • proximity of the supply base (nearshoring)
  • vertical integration (insourcing)
  • tech-enablement and the use of connected supply chain processes

• Supplier due diligence – Most businesses undertake due diligence on key suppliers as part of their supplier onboarding process. This will typically involve assessing a prospective supplier's financial standing and legal compliance (this might involve undertaking audits, and requiring the supplier's commitment to comply with a supplier code of conduct and other policies). But one element that warrants more detailed interrogation is security of supply – can you rely on the supplier to deliver the goods? It will be important consider this issue both in terms of the supplier organisation itself but also considering the supplier's subcontractors and sub-tier suppliers.

Contracting for resilience

When contracting with key suppliers, there are range of mechanisms that can be introduced to a contract to improve security of supply. These range from absolute obligations requiring the supplier to deliver all customer orders, through to provisions designed to incentivise a supplier to deliver on time and in full. These provisions can be particularly relevant during challenging times and can provide helpful leverage to ensure that a supplier is appropriately motivated to meet your requirements over those of a competitor.

Relevant considerations include:

• Exclusive supply obligations. These are contractual provisions that require a supplier to supply goods exclusively to the customer. Provisions of this nature require careful consideration from a competition law / anti-trust perspective to ensure they're lawful and enforceable but, subject to those requirements being met, there's almost no better way of ensuring that a supplier prioritises your custom. For obvious reasons, provisions of this nature can be hard to negotiate in practice and often come at a price.

• An obligation to accept all customer orders. Another form of protection would involve placing a binding obligation on the supplier to accept and fulfil all customer orders. This contrasts with the more usual position whereby a binding obligation to supply only arises once a supplier accepts a customer order, with the supplier typically having discretion as to whether it accepts or rejects each order. A compromise might involve the supplier having a binding commitment to accept all customer orders up to certain level – either a pre-determined amount, or an amount determined by reference to the customer's forecasted requirements (see below).

• Forecasting. Forecasting is helpful because it encourages both parties to plan ahead. As noted above, forecasting can be used in conjunction with a firm obligation on the supplier to meet customer demand. This might involve, for example, the supplier having an absolute obligation to meet the customer's forecasted requirements in any given month, perhaps with a softer, “endeavours” obligation to meet demand in excess of the forecasted quantity. One point to consider, however, is that suppliers will typically want to see a firm purchase obligation from a customer in return – effectively making the forecasts binding, or at least partially-binding.

• Consignment stock. Consignment stock refers to a situation where a customer takes physical possession of the goods before it purchases them. In this scenario, the goods will remain the property of the supplier but will be stored by the customer at the customer's risk. The customer has no obligation to buy or pay for the goods until it “calls off” stock from consignment. This sort of arrangement can be helpful where stockpiling forms part of the customer's overall strategy for resilience.

• Safety stock. The rationale for safety stock arrangements is similar to that for consignment stock (discussed above), the difference being that under this model the supplier (rather than the customer) stores the goods. This is effectively just a contractual obligation on the supplier to maintain an agreed stockpile of finished goods, raw materials or component parts for the purposes of satisfying the customer's demand.

• Service levels and service credits. By imposing robust service levels on a supplier, with appropriate remedies (for example the payment of service credits for non-compliance), these measures can incentivise a supplier to prioritise a customer over other third parties by making it financially detrimental to miss deliveries. Service levels can take various forms, for example a service level obliging the supplier to deliver a certain percentage of customer orders “on-time-in-full” (OTIF), or to meet the customer's forecasted demand over a given period.

• Liquidated damages for late delivery. As above, the payment of liquidated damages (being a pre-determined payment) for late delivery can motivate a supplier to deliver on time.

• Indemnities. An indemnity which requires the supplier to compensate the customer for losses suffered for a failure to supply, or delay in supplying, the goods would provide a powerful remedy. An uncapped indemnity would likely be viewed as an onerous remedy, and therefore may be challenging to negotiate in practice, but as an opening position it would provide a platform for negotiating other remedies to address the issues, such as service credits or liquidated damages.

• Longer payment terms and rights of set-off. In combination with service credits, liquidated damages or indemnities, a right of set-off can entitle a customer to withhold, or make deductions from, earlier invoices if a problem arises in respect of late delivery. This is more likely to provide a remedy if longer payment terms are agreed.

• Parent company performance guarantees. A performance guarantee is a form of ancillary contract that involves the supplier's parent company guaranteeing its subsidiary's performance of the contract. Guarantees of this nature can be used to require a parent company to step-in and perform the contract or, at the very least, to apply helpful pressure if the subsidiary is uncooperative. A performance guarantee differs from a financial or payment guarantee, which only guarantees the subsidiary's obligation to make payment.

Spotting problems early

It has been said that risk is what remains when you’ve considered everything else. In other words, supply chain disruptive events are almost always unexpected.

While it's not possible to predict the future, contractual provisions can at least provide an early warning mechanism in making a customer aware of potential vulnerabilities before a serious problem arises.

By inserting provisions into the contract that require suppliers to share important information, a customer can spot potential issues early and plan its purchasing activity accordingly.

Provisions to consider include:

• Reporting obligations. For example, requiring a supplier to share important information concerning:
  • its own supply chain (including the identity and location of subcontractors and sub-tier suppliers);
  • its production capacity and manufacturing lead times;
  • its stocks of finished products, raw materials and component parts.

• Governance. In addition to reporting obligations, it can be helpful to tailor the agenda for regular meetings to include the consideration of key factors which have a bearing on supply chain resilience. This might include considering the information that’s been shared pursuant to the supplier's reporting obligations, but it also provides an opportunity to assess and discuss the supplier's performance against key service levels and performance metrics.

• Audit. Audit rights can be helpful in providing the customer with an opportunity to “stress test” a supplier's resilience, by using the audit to undertake renewed due diligence on a supplier's subcontractors and sub-tier suppliers, and by testing a supplier's business continuity and disaster recovery (BCDR) plans.

Reacting to disruptive events

As Robert Burns once said, “the best-laid plans of mice and men oft' go awry.”

Although the measures outlined above support a more robust relationship with key suppliers, it’s impossible to plan for every eventuality. In a worst-case scenario, what else might be relevant from contractual perspective?

Other, more reactive, contractual considerations include:

• Force majeure. Does the supply chain disruptive event trigger the force majeure provisions of the contract and, if so, what are the implications? It’s important to remember that, even if an event falls within the contractual definition of force majeure (often defined by reference to an event being beyond a party's control), that doesn't necessarily mean that it relieves the affected party from its obligations under the contract. It will be important to consider whether the threshold for claiming relief has been satisfied (often this requires the force majeure event to have prevented or hindered the affected party's performance), and whether the contract requires the party claiming relief to take any positive steps to benefit from the clause.

• Business continuity and disaster recover (BCDR). If the contract includes BCDR provisions, these will often be triggered by a disruptive event. A supplier's ability to claim relief under the force majeure clause will often be conditional upon carrying out its BCDR obligations. From the customer's perspective it will be important to consider the force majeure and BCDR provisions to ensure that the customer appropriately “polices” the contract to ensure the supplier complies with its obligations to mitigate the impact of the disruptive event.

• Step-in rights. Step-in clauses are contractual provisions that enable a customer to step into a supplier's shoes to perform or manage the contract in the supplier's place, and to recover its costs incurred in doing so. If a disruptive event occurs, a customer will need to consider the merits of exercising this right (if available). Step-in rights can be helpful, but usually only in limited circumstances where the customer is well-placed to deliver all or part of the services.

• Termination rights. Finally, if a supplier simply cannot fulfil the contract, the customer may wish to consider terminating the agreement to appoint another supplier. It will be important to consider which termination rights are most readily exercisable as some termination rights (for example a right to terminate for material breach), when exercised, are often not entirely risk free, exposing the terminating party to the risk of a claim for wrongful termination. Termination will give rise to other considerations such as:
  • the steps to be taken to ensure an orderly transition to a new supplier;
  • whether termination gives rise to any undesirable consequences (such as a transfer of employees by law);
  • payment obligations; and
  • the status of any rights or claims arising before termination.

Concluding thoughts

Robust supply chain arrangements will allow you to respond quickly to external factors, enabling your business to be successful even in the face of disruption. But effectively managing your supply chain means knowing where the risks sit and taking steps to mitigate those risks where possible.

While supply chain resilience will inevitably involve balancing risk and cost, a properly considered supply chain strategy that's underpinned by robust contracts should empower a business to outperform its competition regardless of market conditions.

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