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Bloomberg Law Analysis

ANALYSIS: Of Supply Chains, Contracts & Businesses That Pivot

May 18, 2020, 8:56 AM

Today’s pandemic economy reflects an abrupt drop in worldwide demand, as individuals move less, work less, and purchase less. In the United States, a fractured supply chain struggles to provide goods and services to immobilized regional markets. What do businesses need to come out safely on the other side? And what contract terms will provide the flexibility they need to see it through?

Where Are We Now?

David Simchi-Levi, professor of engineering systems at Massachusetts Institute of Technology, posits three recovery scenarios.

Pessimistic: No vaccine or cure for Covid-19 for a long time, causing continued requirements for social distancing and suppression of demand.

Optimistic: North America and the European Union develop capacity to test for illness. They come back to life at the end of the second quarter of 2020.

More Likely: Recurring phases of illness cause peaks and valleys in both demand and supply over an extended period. Supply chains need to re-position operations and logistics to areas where employees are well enough to work and not quarantined.

The critical business metric in these scenarios is time: the time it takes to get back to business after a disruption, or time to recovery (TTR).

Professor Simchi-Levi acknowledges, however, that the pandemic adds complexity to normal risk-mitigation plans. Recurring shutdowns will cause recurring regional demand failures—for example, the sort that Chinese companies are experiencing now that they are gearing back up and demand is faltering in the U.S. and elsewhere.

How Should Contracts Pivot?

It’s likely that contracts will need to change to reflect the new reality. Here are some deal terms and potential changes in deal arrangements we are watching.

—Contract parties will need to communicate more often and more effectively. They may need to refer to their trade associations or improve their crowdsourced market information to review forecasts and learn about supply chain opportunities, as well as upstream and downstream failures. Contracts may need to refer to external sources of information for the benchmark data they need to understand supply availability, pricing, profit margins, and the like. In fact, rules about cartels may need to be adjusted (beyond the business review letters DOJ is already accelerating, such as with PPE) so that companies can share more information, while price-gouging rules may need to be enforced more systematically.

—Payment and delivery terms will need to be more flexible to deal with supply failures, demand failures, and demand spikes. In some cases, midstream parties may hold off on payment until goods are sold, meaning that more sellers may ask to take a security interest in downstream goods or payment streams until they receive payment. Amending contracts will need to be easier, or parties will need to have more flexibility under a master agreement or in a purchase order. Overall, we expect to see more conversations about which party can better bear risk of nonpayment or delay—and we may see third parties, such as banks, play a role in taking on some of the supply chain risk.

—It may be more efficient to more broadly share or license intellectual property needed for manufacturing and production, so that additional supply chain partners can jump in where needed.

—Components or materials substitutions clauses may need to be changed to make identification of “approved” suppliers and vendors easier.

—Parties may need to build longer lead times into their contracts, reflecting a move away from just-in-time delivery and possibly a return to inventorying and warehousing (which may be easier where there are recession-related real estate price declines). Supply chains may need to have backups to their backups, in terms of materials and personnel.

—Manufacturers may over-produce during times when employees are productive and well, meaning that they may need to secure advance sales (forward contracts) on goods, even if those purchases don’t reflect current needs. Will we see more seasonality of employment as a consequence? Will employment agencies and local outsourcing (such as for logistics and truck drivers) help fill in gaps?

—Parties may need to train agents and employees to take over colleagues’ work, in case of illness.

Modifying or removing restrictions on sales may be needed, so that parties can switch between wholesale and retail—or sell outside of their traditional “territory.”

—It may be necessary to alter definitions of default in performance and payment to reflect greater uncertainty.

Businesses That Have Pivoted

While some contractual pivots will allow businesses to bridge the gap so that they can return to normal, others are making more significant changes in their operations. Here are a few recent pivots:

Kossan Rubber Industries Bhd. began as a manufacturer of parts for fishing boats, but pivoted to produce rubber gloves during the HIV/AIDS crisis in the late 1980s. The Malaysia-based company now has expanded to send supplies of gloves to China, the U.S., and the EU.

Canadian apparel giant Gildan Activewear Inc. shifted to making face masks and gowns in its Honduras factory.

Having trouble getting your food from Kroger or via FreshDirect? Startups and small, local farm-to-table operations have identified that pain point. Farm to People has grown by 400% since March 1, using a pool of off-duty Uber drivers who use Farm to People’s routing software.

See some of the good stories from the 500,000 independently-operated restaurants in the U.S. that employ about 11 million people. And take a look at Greenmarket, which creates a community of agricultural producers, and see how they are focusing on retail sales now.

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