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ANALYSIS: Need for Supply Contract Changes Triggered by Covid-19

Nov. 16, 2020, 10:21 AM

As 2020 comes to a close, supply chain management has become a topic of keen interest in boardrooms and the C-suite. Concerns about the fragility of the supply chain are giving way to new approaches, including new technology, exploration of local markets, and diversified reliance on foreign sources. As a consequence, lawyers have been strategizing to reshape key contractual relationships.

For decades, physical supply chain management has been based on low-cost supply and minimal inventory, a strategy that has benefited both the consuming public and global manufacturers. But in response to the disruptions occasioned by Covid-19, climate change, and new trade relationships, companies are reevaluating, rethinking and redesigning their supply chain strategies to increase optionality and minimize fallout from future interruptions.

Conventional Supply Chain Characteristics

In search of ever-reducing cost components and raw material supply, companies extended their supply chains across the globe in recent times and linked them together by complex logistics and multiple intermediaries. Modern supply chain management, epitomized by “just-in-time” inventory principles, is premised upon every link in the chain performing efficiently and flawlessly. Lawyers drafted supply contracts with precise product and delivery schedules and penalties for nonperformance in support of clients’ commercial objectives of reliability and low cost. These complex chains worked well when supply and demand were predictable and relatively even. While just-in-time manufacturing made supply chains extremely cost-efficient, it also increased dependencies.

When the recession and pandemic hit in early 2020, the fragility of global supply chains became apparent. As the supply side of the chain collapsed, buyers were forced to accept force majeure declarations and scramble to find alternative sources when their contracted suppliers and transportation resources shut down. The pandemic was a wake-up call.

Building Resiliency

Since the initial shock of the pandemic, companies have been adapting to the new environment by building increased resiliency and responsiveness into their supply chain structures. Corporate counsel are being called upon to assist in this effort with revised contractual language and risk-mitigation approaches.

One of the perceived vulnerabilities of global supply networks is the lack of end-to-end visibility. Customers know their contracted (or “first-tier”) suppliers, but it is not always so obvious who is supplying the suppliers. Consequently, an important step now being taken by supply chain participants is to map their extended supply network, so that they can identify risks by finding pain points and isolating concentrations and weaknesses. Visibility down to second-, third-, and fourth-tier suppliers helps companies plan for contingencies.

Ensuring Supplier Viability

To address visibility concerns, corporate counsel may assist commercial clients by engaging in additional pre-contractual due diligence of critical suppliers to ascertain important relationships among lower-tier suppliers and the commercial, political, geographic, and competitive risks they entail.

These questions also may be addressed by adding new representations and warranties to the supply contract. For instance, a buyer may require suppliers in its network to disclose information about production capacities, commitments, dependencies on critical raw material or transportation resources, and contingency and continuity plans in the event of supply disruptions. The buyer may also request information about cash, working capital, and financing.

Breach of one or more representations, which may only come to light during a disruption in the chain, will give rise to a claim for damages or termination of the supply agreement. The strength and adequacy of these representations and warranties will differentiate individual suppliers from their competitors and potentially enhance the reputations of the buyer and its supply network.

The Demise of Force Majeure?

Force majeure clauses excusing performance may change the most. These clauses shift the risk and consequences of “uncontrollable” events from the party affected by the event to the other. As a general principle, a supplier whose performance is delayed, prevented, or made impossible due to an agreed-upon force majeure event is excused and has no liability to the counterparty while the effects of the event persist.

In the wake of the pandemic, some buyers, particularly those with sufficient commercial bargaining power, are refusing to accept these no-longer-theoretical consequences, and they are declining to include a force majeure clause in the contract. Suppliers, as a result, will not be relieved of contractual liability when disasters occur. Whether suppliers that are forced to accept this condition will be able to exact a price for this increased risk remains to be seen.

Alternatively, if buyers agree to permit force majeure excuses, the typical lengthy list of triggering events may be severely curtailed, resulting in the supplier bearing the financial consequences of most supply disruptions.

Another possibility is for the force majeure clause to include a liquidated damages provision that requires the affected party to pay an agreed damage amount as the price for declaring its inability to perform and transferring the consequences of nonperformance to the other party.

Additional Contractual Flexibility

Buyers may increasingly insist on contractual language that affords additional optionality in the event that a supplier is unable to perform in accordance with the agreement. This would include the ability to shift production seamlessly to other suppliers, more hospitable locations, or closer consuming markets. Sole sourcing will likely give way to diversification, both geographic and numerical, in supply origin. In some instances, suppliers (not buyers) may be required to find alternate sources for supply that they are unable to produce.

Other alternatives may develop to give greater certainty to the process and capture efficiencies. These may include stand-by or back-up arrangements with geographically diverse partners and additional insurance protections.

Supply Chain Technologies

Moreover, supply contracts will address the benefits and efficiencies of technological improvements in supply chain logistics, such as automation, artificial intelligence, cloud computing, 3D printing (customized manufacturing), and lower overall energy expenditures. While reliability and resilience are the main objectives of these developments, more environmentally friendly and energy-efficient supply networks are likely to result, which benefits manufacturers’ reputations and their ESG (environment, social, governance), sustainability, and climate change objectives.

Access additional analyses from our Bloomberg Law 2021 series here, including pieces covering trends in Litigation, Transactions & Markets, the Future of the Legal Industry, and ESG.

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