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After the crisis is before the crisis – checklist for strengthening the supply chain

December 2020

In the current coronavirus pandemic, many companies have realised that their purchasing structures have reached their limits. It has proven to be risky to rely only on one supplier. It is also evident that it can be challenging for suppliers to overcome large geographic distances (e.g., between Asia and Germany). Finally, “just in time” delivery has proven to be particularly vulnerable in crisis situations. Even though the crisis has not yet been completely overcome, the questions now are: What can we learn from it? How can we make sourcing more crisis-proof? How can we ensure the availability of necessary components for as long as possible in challenging times?

The following checklist provides an overview, from the legal perspective, of what to look out for when realigning sourcing.

I. Looking back and ahead – critical review of previous supplier relationships

Firstly, it is important to not just review new suppliers critically. Existing purchasing relationships can also result in obstacles that one must pay attention to. The realignment of purchasing offers the opportunity to initiate meaningful changes to previous purchasing contracts, if necessary.

Analysis of the problems encountered during the crisis and any unfavourable contractual clauses

As a first step, existing supplier relationships should be subject to a critical review. In which areas have problems occurred during the crisis? If delivery delays were mainly because of there only being one supplier (or only a few) of a component, then a second source supplier should be sought. Relying on several suppliers may however only help to a limited extent during a worldwide pandemic. In the case of local restrictions, as at the start of the crisis in China, a diversified supplier structure can contribute considerably towards minimising risk.

However, problems in supply are not always attributable to the number of suppliers. Existing supply contracts may also contain unfavourable provisions. Examples include:

  • No delivery obligations: Long-term framework contracts often do not include “hard” obligations that require individual orders to be accepted. In such cases, the supplier may be able to deliver, but is not willing to do so, because, for example, the shift in supply and demand resulted in more lucrative customer orders.
  • Cancellation of orders by the supplier: These clauses are often subject to strict requirements by the law on general terms and conditions. However, if they are effectively agreed upon, then contractually agreed deliveries quickly become worthless.
  • “Just in time”, i.e. provision of material deliveries only in direct connection with further processing: Such provisions can be found in all sectors, especially in the automotive supplier industry. The background is that many companies – also for reasons of liquidity and capital commitment – do not wish to maintain their own warehouse.

The result of a critical examination of existing contracts should be used to renegotiate with suppliers wherever possible. The additional points that are listed in this article and pertain to the signing of new contracts should also be taken into consideration. In this way, the crisis can become an opportunity.

Review of possible (change) restrictions

The review of existing contracts is not only important with regards to a possible new negotiation or a renegotiation. They can also result in obstacles to a change in suppliers or an amendment.

  • Can the contract be terminated at short notice?

It is common for supply contracts to be long-term or have long notice periods. If they also include exclusive contractual obligations (see below), changing or expanding the supplier base can be a lengthy process. Therefore, existing possibilities for termination should be checked. If there were delivery problems resulting from the coronavirus pandemic, the possibility of extraordinary termination or withdrawal from the contract may exist. However, it depends on the circumstances of the individual case and the specific structure of the contract. For example, it may be possible to withdraw from specific (individual) orders, but an existing framework contract is not subject to a right of withdrawal.

If there is no other possibility, the conclusion of a termination agreement should be considered. Depending on whether purchase obligations or exclusivity have been agreed to, consideration can also be given to simply letting the contract “dry out” (also see below on limitations based on good faith).

  • Are there exclusive purchase obligations or minimum purchase obligations?

Frequently, supply contracts contain provisions that products cannot be purchased from any other suppliers. Binding (minimum) purchase obligations have a similar effect. Occasionally, such obligations are also hidden, e.g., the obligation to purchase replacement parts for a longer period after contract termination. Often, such obligations are associated with contractual penalties.

  • Restrictions resulting from “good faith”

Even if the contract does not stipulate “hard” acceptance obligations, obligations can nevertheless exist based on good faith that the relationship does not end without a transition period. The greater the supplier’s dependence on a customer, the more this applies. Often individual customers account for most of the turnover of a supplier. If one of these customers completely withdraws orders that have been placed regularly over a long period of time, such suppliers quickly find themselves in a situation where their existence is threatened. This circumstance must also be considered when terminating a contract but can only be assessed if all aspects of the individual case are taken into account.

In respect to all these points, it is always recommended to carry out an in-depth legal review to determine to what extent the relevant clauses have been effectively agreed upon. This applies especially to provisions concerning duration, exclusivity, purchase obligations or contractual penalties, as such clauses are subject to strict effectiveness requirements by laws pertaining to cartels, competition and general terms and conditions. If the provisions are agreed upon as effective, violations can lead to claims for damages.

II. Caution when concluding new contracts

If the decision has been made to conclude contracts with second source suppliers, the problems identified in the analysis should be avoided and additional important points should be considered. The following list is not exhaustive but provides some ideas on points that should be considered in future supplier relationships. In general, the conclusion of framework contracts is recommended. Compared with a business relationship based on individual orders, these have the advantage that central points can be managed uniformly for the entire supply relationship.

Selection criteria for suppliers / Know Your Customer

Prior to the conclusion of a new contract, a comprehensive review of the future contractual partner should take place. Apart from any internal compliance requirements, the following aspects can be important:

  • Where is the delivery from? If the delivery is from outside the EEA area, you will quickly become the importer of the goods – with all the resulting legal obligations (e.g., insurance, CE conformity). In addition, regional sources of supply offer the possibility, if necessary, of using alternative delivery routes in the event of transport problems.
  • Are your own desired or required quality requirements ensured? Proven and established processes are often not transferable at the start, so that frictional losses can occur especially at the beginning of a new supply relationship.
  • Does the supplier have the necessary financial resources? It can be risky to rely on a new supplier who is still recovering from the last crisis.
  • Can the supplier be reached? In the current coronavirus crisis, many companies were faced with the problem that they could not reach their suppliers at all.

Agreement on delivery obligations

Binding delivery obligations (e.g., within the framework of a specific forecast) should be agreed with the new suppliers. Cancellation options by the supplier should be avoided. The agreement of a priority delivery is common, but legally risky.

Consideration of special logistics concepts

As already stated, a lack of stock can quickly lead to replenishment problems. The frequently applied “just in time” delivery concept exposed the vulnerability of supply chains. Large geographic distances between suppliers and customers also increase the risk of problems in intermediate stages in the supply chain – be it through export restrictions in the supplier country, failure of logistics companies, closures of ports, cancellations of flight connections or similar incidents.

A solution to these problems is the extensive stockpiling of goods at the production site. For companies that cannot or do not want to have this capital commitment, logistics concepts such as Kanban systems or consignment storage systems can be a solution. In this case, the supplier sets up a warehouse on site for the customer, from which the necessary goods can be supplied. Goods in the warehouse generally remain the property of the supplier. The conclusion of the purchase and transfer of title take place only when the goods are removed from the warehouse. Even if the supply from such warehouses is not endless, it can help bridge short and medium-term supply bottlenecks.

Weighing up contract terms: Safety vs. flexibility

The duration of the contract and the possibility to terminate the contract – if necessary, also at short notice – are important aspects when concluding new contracts. On the one hand, a longer duration serves to ensure planning security (if it is secured by the delivery obligations, see above). On the other hand, short-notice termination options provide flexibility.

Include coronavirus clauses

Since German law does not recognise the “force majeure” concept for supply contracts, a detailed force majeure clause should be included in new contracts. The current coronavirus pandemic should be taken into account separately because a prerequisite for invoking force majeure is that the event was not foreseeable when the contract was concluded. This is no longer the case for contracts that are concluded after the significant extent of the coronavirus pandemic became known. It should therefore be made clear that impairments due to the coronavirus should not give rise to liability. When drafting relevant clauses, the law on general terms and conditions must be observed.

Avoid exclusivity

With regards to the question of the extent to which an exclusive purchase obligation is to be agreed, care must be taken not to bind oneself too closely to one supplier (see above). Such provisions should therefore be avoided wherever possible, especially when setting up second source structures.

Pay attention to the choice of law and jurisdiction

Even if checking contracts precisely to see which law and which jurisdiction apply is a general recommendation, these questions have become even more relevant in view of the coronavirus crisis. In the event of a supply disruption, it can be particularly important to obtain legal protection quickly (e.g., through an interim injunction). The choice of a foreign law or jurisdiction can prevent this.

Conclusion: Strengthening purchasing is an important component of resilience in crisis times

The coronavirus pandemic has clearly shown how quickly supply chains can come under stress. The risk increases, the fewer suppliers there are, the further away these are from the customer and the more “just in time” delivery is used. The diversification of sourcing is therefore an important step towards effective risk diversification. When concluding new or additional supply contracts, special attention must be paid to both existing contracts and new contracts. Investing here increases the resilience of purchasing for the next crisis.

Authors

Ulrich Becker
Dr. Ulrich Becker
Partner
Frankfurt