Supply chains are crumbling. Manufacturers struggle to catch up with demand as the global economy recovers from the pandemic impacts on production across all industries. Prices for industrial raw materials are skyrocketing. Shipping container rates are up 400%. Ports are congested, trucks are without drivers, and warehouses are empty.
Suppliers and buyers are facing off over the allocation of risks, including rising production costs and delivery shortfalls. Commercial terms that were boilerplate – like force majeure or commercial impracticability — are now important.
As power outages rage across China, manufacturers worldwide are bracing for widespread, indefinite raw material shortages. In this environment, rapid risk assessment and mitigation is mission critical.
Raw materials are increasingly scarce. The capacity to fill orders is declining. What to do?
Review and triage existing contracts. Many commercial contracts contain flexibilities that allow delayed or minimized production.
Keep customers informed. Informed customers are better positioned to take action to mitigate their downside risk and, in turn, less likely to take action against you.
Know your rights and obligations if you cannot deliver. Force majeure provisions and the Uniform Commercial Code (UCC) can guide your decisions with an eye toward maintaining customer relationships and avoiding litigation.
Even if your contracts have price and volume commitments, there may be options to mitigate your risk. See whether they have price escalation provisions allowing for periodic equitable increases or adjustments when triggered by a defined event, like when a price index indicates a certain percentage increase. Your contracts may have provisions that provide for:
Delayed deliveries. Does the contract say schedule or lead times will be determined at the time of the order, or, if specified in the contract, are subject to change based on then-available capacity?
Limitation of quantities. Does the contract say order acceptance or production quantities are subject to available capacity at the time of the order?
Lesser shipments. Does the contract say all orders are subject to a shipping tolerance of +/- a certain percentage?
Options under those contract provisions may require exercising commercially reasonable efforts to allocate production capacity among similarly situated customers in a fair and reasonable manner. This is where knowing your rights and obligations will prove useful.
Commercial Impracticability
Commercial impracticability is a defense to nonperformance where an unexpected event makes contract performance commercially impracticable. Mostly, market shifts and increased cost do not support the defense. Some courts have allowed it where the price increase was considered severe. Material shortages more frequently support an impracticability defense.
A manufacturer contemplating nonperformance based on commercial impracticability should be mindful of its obligation under the UCC to fairly and reasonably allocate production among its customers. Unless the contracts expressly permit allocation within the seller’s sole discretion or based on something other than equitable treatment of similarly situated customers, an allocation plan should take its requirements into account
In addition, manufacturers should be careful not to allocate production to high-paying customers to the detriment of others without supporting contract language. A manufacturer employing this UCC rule should provide timely notice to customers.
Force Majeure
A force majeure clause excuses performance in the face of events contemplated by the parties in the contract. Courts typically interpret force majeure provisions narrowly based on a plain reading of the language. Market shifts and increased costs are not usually force majeure events. Materials shortages could be a triggering event if included in the force majeure clause.
A manufacturer’s declaration of a force majeure event does not terminate a contract. It excuses performance until the earlier of (a) resolution of the force majeure event, or (b) expiration or termination of the contract. Manufacturers considering declaring a force majeure event as to one customer should be careful of their treatment of similarly situated customers, including avoiding situations where preferential treatment of one customer might lead to a material shortage for another. Remember, a force majeure event must be one outside of a party’s control.
Going Forward
Consider whether your contracts sufficiently protect against future supply chain disruptions:
Force majeure provisions should include pandemics and communicable disease outbreaks, as well as cyber-related disruptions like ransomware and other cyber attacks.
Do you reserve the right to adjust delivery time and production volume based on your capacity at the time the order is placed?
Is the right to allocate capacity left to your sole discretion?
Do your contracts have price escalation provisions triggered by defined market shifts?