One of the best ways for a manufacturer to assess and reduce risk in its supply chain is to have in place strong legal terms with its suppliers.
Yet due to the speed of modern technology and growing complexity of supply chains, the reality of the manufacturing landscape is that legal terms aren’t always properly memorialized on paper as the manufacturer-supplier relationship develops.
That said, it remains important — perhaps more now than ever before — for a manufacturer to assess its relationship with a supplier at the beginning of the relationship, and execute any needed agreements to mitigate risk as the relationship unfolds.
The five tools discussed below will help guide a manufacturer in assessing and mitigating supply-chain risk.
Tool No. 1: Thoughtful use of master supply agreements vs. terms and conditions. When trouble arises in a relationship with a supplier, one of the first questions is “What does the contract say?” In a perfect world, the manufacturer and its supplier will have both executed a master supply agreement, or MSA (and corresponding statement of work) that sets forth comprehensive terms governing the sale of goods by the supplier to the manufacturer. In such a case, identifying the terms in place between the parties is as simple as reading the MSA.
While the MSA provides the most predictability in a supply relationship, and its use is the best practice from a legal perspective, it’s not always realistic from a business perspective. MSAs take time and money to negotiate, which may not be practical when contracting with a supplier for a one-time purchase of low-risk products.
Enter the terms and conditions (T&Cs) of purchase. Purchase T&Cs cover many of the same legal concepts as MSAs, albeit typically in an abbreviated form. Purchase T&Cs are seldom negotiated and are often located on the back of a manufacturer’s purchase order, or incorporated into the purchase order by reference to a website link. While this approach is common because of its ease and speed of use, using the purchase T&Cs in lieu of an executed MSA is not without cons. First, as mentioned, purchase T&Cs often don’t cover terms as comprehensively as MSAs. Even riskier than that, they’re subject to the “battle of the forms.”
Because purchase T&Cs aren’t usually signed by the supplier, whether they are enforceable is determined by a fact-based analysis that will turn largely on whether each party sent the other party its standard terms, whether they were properly drafted, and when they were sent. If the manufacturer sends its properly drafted purchase T&Cs and the supplier sends its properly drafted terms and conditions of sale, or sale T&Cs, what then occurs is a “battle of the forms” where the two parties’ forms “battle.” In the process, the terms that are inconsistent fall away, and those that are consistent, along with the gap-filler terms of the Uniform Commercial Code (UCC), govern. The contract is then formed based on the conduct of the parties, such as shipment and acceptance.
Therefore, a manufacturer that seeks to use a properly drafted purchase T&Cs must ensure that it’s armed for battle by sending it to the supplier before the goods are shipped. Otherwise, the manufacturer runs the risk that only the supplier’s sale T&Cs govern the transaction. Even if the manufacturer does timely send its purchase T&Cs, if they don’t contain language objecting to the sales T&Cs in line with UCC 2-207, the manufacturer still runs the risk that the sales T&Cs will govern.
Notwithstanding the manufacturer timely sending well-drafted purchase T&Cs, when trouble in supply-chain paradise arises, and the question of “What does the contract say?” is asked, identifying which terms governed the sale of goods by the supplier to the manufacturer without a signed agreement in place is a time-consuming process with muddy answers.
Tool No. 2: Thorough delivery-delay provisions. A delay in the shipment of important goods can stall production and endanger customer relationships. If the manufacturer has thorough delivery-delay provisions in place, such as those listed below, the blow of a delayed shipment can be lessened.
Notice of Delay
A valuable provision to include in the delivery-delay section of an agreement is to require the supplier to issue written notice of a delay, including written notice of any anticipated delay. This permits a manufacturer to begin its contingency planning early. The provision should expressly state that such notice does not relieve the supplier from responsibility for the delay.
Time Is of the Essence
A best practice for drafting actionable delivery contract terms is to ensure that delivery time is “of the essence” under purchase orders. “Time is of the essence” is a term of art in legal parlance, where the failure of a delivery to be made on the specified date results in an incurable material breach of the contract (although variations exist in case law interpretations of the phrase).
Where leverage permits, the manufacturer should seek to maintain non-exclusive relationships with its suppliers (that is, it can purchase the goods from that supplier or others, or manufacture the products itself). This permits a manufacturer to avoid a situation where it has a sole-source supplier with delivery delays, and no other quickly available option for procuring the needed goods. Having multiple suppliers of the same good, preferably in separate geographical regions, permits a manufacturer to be nimble when one supplier runs into troubles ( such as force majeure events, insolvency, and raw material shortages).
Where the relationship is exclusive (that is, the manufacturer is only permitted to purchase the products from that supplier), then the supply agreement should set forth explicitly that the manufacturer has a right to purchase from alternative suppliers in the event that the supplier is unable or unwilling to meet the manufacturer’s order requirements (even as a result of a force majeure event).
While force majeure clauses are standard in supply agreements, a manufacturer should train a careful eye on these provisions. If drafted too broadly, they can excuse liability for a supplier’s delay in delivery in circumstances that shouldn’t rightly be covered by a force majeure provision. For example, equipment breakdown, raw material shortages and labor strikes are often among the listed events that excuse a supplier’s liability for delay. However, these are arguably not beyond a supplier’s control but can be managed, and mitigated against, with careful planning and foresight.
With current global events, a manufacturer might also consider conducting an audit of its major supplier contracts to see if pandemics, disease, quarantines and climate change are among the events that could be used as a basis to avoid liability for non-performance under the contract. A manufacturer might also seek to include a provision requiring allocation of short supply to the manufacturer.
In addition to these concerns, manufacturers should consider modifying force majeure clauses to capture the imposition of economic sanctions, export controls, or other restrictive trade measures that prohibit the performance of the contract within the definition of “embargo” or “governmental action.” Taking this step demonstrates that the manufacturer and its counter-party considered such risks and freely agreed to them. This can provide a freedom of contract defense against breach of contract claims, and reduces the likelihood that foreign courts will reject force majeure arguments on “public policy” grounds. We discuss these restrictive trade measures in greater detail below.
A particularly aggressive approach often taken by manufacturers with leverage is to impose liquidated damages in the event of a delivery delay. Liquidated damages can take the form of a flat fee per day or per week in which the delay continues. Another common approach is to tie the damages to a percentage of the price of the delayed goods. Be careful here; there are a number of ways that a liquidated damages provision can be rendered unenforceable by a court, so if a manufacturer intends to rely on this provision, it should be drafted by counsel that has familiarity with these types of provisions.
Tool No. 3: Strong defective product provisions. Say that the goods arrived, but are defective. What’s a manufacturer to do? If it has strong defective-product provisions in place, the damage to the manufacturer in connection with the defective goods will be mitigated. Some key terms are outlined below.
Rejection of Product
From the manufacturer’s perspective, rejection provisions should state that the goods will not be accepted until inspection, evaluation, and testing by the manufacturer or its agents at the manufacturer’s facility. Manufacturers should avoid deadlines for having to accept or reject the good, but if one must be imposed, the deadline should align with the time the manufacturer requires to evaluate a good for defects in its projected busiest times. Manufacturers should include contract provisions which state that acceptance prior to discovering a latent defect does not cause a manufacturer to waive its rights with regard to any remedies related to such latent defects. A manufacturer would also be wise to point out that payment does not, by itself, constitute acceptance of the goods.
If a defect or non-conformance in the good arises after the goods have been accepted, the manufacturer will look to its warranty rights if the goods are still within the warranty period provided by the contract. Some of the most common warranties are that the goods will:
A manufacturer-friendly remedies section will allow a manufacturer to choose as a remedy for defective and non-conforming goods either repair, replacement or refund, at the manufacturer’s option, in addition to all other remedies that such manufacturer is entitled to under the agreement, applicable law, or otherwise. It would also permit the recovery of consequential damages (such as customer fines, and lost profits) that result from such defective or non-conforming product.
Symmetry With Customer Obligations
A manufacturer should seek to ensure that the obligations it is undertaking in its agreements with customers are backed up by the rights it is receiving in its agreements with suppliers. For example, if a manufacturer is warranting to its customer that products do X, Y and Z, then the manufacturer should ensure that the suppliers of its products are doing the same. As another example, if a manufacturer’s sole and exclusive remedy for a defective product from its supplier is replacement of the product or a refund of the purchase price, then the manufacturer should ensure that its agreements with customers correspondingly limit the manufacturer’s responsibility.
Tool No. 4: Comprehensive product recall provisions. Another legal tool to house in a manufacturer’s toolbox is a set of comprehensive product-recall provisions. First, in order to assess the risk of recall, it’s imperative that the manufacturer require the supplier to provide written notification if the supplier becomes aware of circumstances that a stop sale or product recall may be necessary under applicable laws or otherwise. Under product-recall provisions, the manufacturer should have the sole right to determine whether to institute a recall.
One more important decision to make is to determine how the cost of the recall should be allocated. A manufacturer with leverage will require a supplier to shoulder the entire burden of the recall cost if the recall arises from the supplier’s breach of the agreement, negligence, or intentional misconduct. A less straightforward approach would be to require the supplier to negotiate with the manufacturer as to an equitable division of the costs.
Product-recall provisions should not be considered in a vacuum, though. They are heavily supported by the following terms:
Tool No. 5: Use of strategies to mitigate international exposure. Finally, manufacturers engaged in international sales and shipments should take steps to ensure that these transactions comply with U.S. and other restrictive trade measures. Notable examples of trade measures include the various economic sanctions programs administered by the U.S. Department of State and U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”), as well as the military and commercial export control laws enforced by the Department of State’s Directorate of Defense Trade Controls (“DDTC”) and the Department of Commerce’s Bureau of Industry & Security (“BIS”). Many of these laws operate on a strict liability basis, with U.S. government enforcement agencies conducting broad-ranging investigations and imposing substantial penalties for unintentional infractions. So even though violations tend to be rare, the legal, financial, and reputational consequences can be severe.
There are several important areas of risk implicated by trade measures. Broadly, those areas are as follows:
Although restrictive trade measures can be complex, most U.S.-based manufacturers (and their foreign subsidiaries) can mitigate the associated risks by building layered defenses into their global supply-chain and distribution systems. Manufacturers can also employ risk-based approaches that adopt fewer defenses in lower-risk jurisdictions, while deploying more defenses in higher-risk jurisdictions. Some of the basic elements in an effective, risk-based system include the following:
The five legal tools discussed above are not exhaustive, nor are they indented to address every risk that manufacturers might encounter when working with international supply-chain and distribution networks. However, they are definitely tools that merit considering, sharpening, and using when circumstances require. By adopting a more proactive approach to these issues, manufacturers can mitigate the legal and commercial supply-chain risks while laying the foundation for stronger business relationships.
Kate Wegrzyn and Christopher Swift are partners, and Jenny Wang is special counsel, at Foley & Lardner LLP.
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