Taking stock of supply chains

Neil HodgeThursday 22 February 2024

Geopolitical concerns – such as the conflict in the Red Sea – and issues such as energy price volatility suggest a need for companies to review their exposures and reduce the possibility of supply chain default. As In-House Perspective reports, it’s an area where in-house counsel can add enormous value.

Geopolitical tensions, price inflation, weather-related disasters and conflicts with an impact on major shipping lanes and key areas where goods and materials are sourced have elevated managing supply chain risk to a whole new level. An example is the conflict in the Red Sea, where Houthi rebels based in Yemen have attacked ships heading to Israel for attack or seizure, leading to a military response from the UK and the US. Given the area’s location, which is key to many ship routes, vessels are making diversions elsewhere, which causes delays and incurs significant cost.

This latest disruption follows not too long after the Covid-19 pandemic and the lengthy lockdowns it brought, which ground trade to a halt and had a severe effect on many organisations.

Given this, supply chain management has been thrust to the top of companies’ risk agendas. ‘The Covid-19 crisis highlighted several weaknesses within supply chains, and it showed that building resilience is crucial to mitigate the impacts of disruption’, says Carol Monteiro de Carvalho, Co-Chair of the IBA International Trade and Customs Law Committee and a partner in international trade, World Trade Organisation and customs law at Brazilian law firm Monteiro & Weiss Trade.

“The Covid-19 crisis highlighted several weaknesses within supply chains, and it showed that building resilience is crucial to mitigate the impacts of disruption

Carol Monteiro de Carvalho
Co-Chair, IBA International Trade and Customs Law Committee

‘For the past few years, and especially during the pandemic, rising inflation has been a significant problem along supply chains, and inflation rates do not seem to be decreasing any time soon’, she adds. ‘The high costs of raw materials, transportation and labour still have not returned to pre-pandemic levels, and they are keeping the pressure on costs to rise over all areas of the supply chain’. 

These issues, taken together with other concerns ranging from energy price volatility and interrupted supply to the increased risk of cyberattacks – which carry the danger of commercial partners’ data being exposed – strongly indicate a need for companies need to review their exposures and to try to reduce the possibility of supply chain default through a mix of better risk management, more comprehensive insurance cover and tightened contractual terms. It’s an area where in-house counsel can add enormous value.

Contractual building blocks

As a basic first step, lawyers say companies should check what force majeure protection their suppliers have under their contracts. Normally used to cover a situation where an unforeseen or unavoidable event prevents or delays a party from performing its contracted obligations, these clauses were commonly invoked during the pandemic as lockdowns were introduced. Suppliers will want force majeure provisions in place that relieve them from liability if they’re unable to deliver due to events beyond their control. Buyers, on the other hand, will want to trim down the scope of force majeure provisions and specify contractual consequences for their failure to deliver on time. 

A customer can try to delete or amend a force majeure clause to ensure that the supplier has a strict contractual duty to deliver goods/services on the agreed delivery date and/or at the specified price. The customer may also try to exclude certain factors from a force majeure event, such as the effect of another global pandemic or industrial action by the supplier’s own staff. However, many suppliers benefited from force majeure protection – or learned what they were missing – as pandemic-related lockdowns took effect. Suppliers who couldn’t lawfully perform their duties under the supply contract due to government restrictions were often able to prevent their customers from terminating their contracts and were therefore entitled to continue being paid – so long as they had favourable force majeure wording in place. As a result, suppliers are now more aware of the benefits of this protection and customers may struggle to secure deletions or meaningful concessions in negotiations.

Tammy Evans, a commercial litigation partner at Ignition Law in London, says that when it comes to businesses trying to reduce supply chain risk, a clear, unambiguous contract is the best form of basic protection available to any company. ‘It may sound obvious but that is the starting point and it’s often overlooked. Any ambiguity can leave vulnerabilities for reluctant suppliers to capitalise on when other issues are putting the squeeze on supply chains generally,’ she says.

“Any contractual ambiguity can leave vulnerabilities for reluctant suppliers to capitalise on when other issues are putting the squeeze on supply chains generally

Tammy Evans
Partner, Ignition Law

But Evans warns that force majeure clauses don’t always help. For example, they typically only apply to the events specified and the unprecedented shocks that have affected supply chains ‘have often not been catered for by these clauses’, she says. What can often prove more useful, she says, is strong negotiation and drafting on the surrounding clauses as the need for flexibility and scope for interruption needs to be built in at every level as much as possible.

‘If a contract specifies that time is of the essence for delivery then this leaves the supplier in a vulnerable position’, says Evans. ‘The supplier needs to ensure wherever possible that this is a qualified obligation, such as best or reasonable endeavours. Further, wherever possible, liability for failure to comply with deadlines should be limited. The contract should have the scope for review built in wherever possible and termination provisions considered with possible disruption in mind.’

Kamal Aggarwal, a partner in the dispute resolution team at the Thames Gateway Office of Thomson Snell & Passmore, agrees that in-house lawyers should re-visit contractual clauses in place with suppliers to ensure they cover current perceived risks, rather than rely solely on generic force majeure clauses. He says counsel should review and customise those clauses based on the specific risks that could affect their supply chain – such as war, sanctions, export controls and specific regional instabilities – and says it’s important to clearly define what constitutes a force majeure event and the obligations of both parties under such circumstances.

Another important move is to diversify and secure supply chains lawfully, says Aggarwal, so that contracts allow for the maximum possible flexibility in sourcing, as well as the ability to switch suppliers or logistics providers with minimal or no penalty. In-house lawyers should also ensure that contracts include clear termination and suspension rights that can be invoked in case of disruption. This should be coupled, he says, with detailed provisions on the consequences of termination or suspension, such as settlement of accounts and rights to existing stocks or work in progress.

Disputes and price variations

Aggarwal also suggests that in-house lawyers should ensure that contracts specify dispute resolution mechanisms that are pragmatic and efficient. These should include choice of law and jurisdiction clauses, specifics on whether arbitration or mediation should take place before any litigation and if so, include arbitration bodies and locations that are neutral and convenient. Other steps in-house lawyer should take, he says, include monitoring compliance and regulatory changes so that the legal function is abreast of changes to sanctions and/or export controls that could impact the organisation’s supply chains, while insurance policies should be reviewed and renegotiated to more effectively cover supply chain and geopolitical risks, ensuring that coverage is sufficiently comprehensive and tailored to the company’s specific exposure.

Ryan Mitchell, an associate solicitor at law firm Paris Smith, says companies can train their procurement teams to ask the right questions and to request evidence that backs up the supplier’s replies. ‘If responses don’t pass the sniff test then having a robust contingency plan in place, or simply going with another supplier, would be prudent’, he says.

He advises companies to check supply contracts to ensure that business-critical delivery dates are stated as strictly binding – rather than as estimates only – and to look out for price variation clauses. ‘It is common practice for supplier-friendly contracts to state that the date for delivery is an estimate only’, says Mitchell. ‘If delivery is late then the customer is at a disadvantage in trying to argue that it has a right to terminate and/or receive compensation. Even a minor delay can have a significant impact on just-in-time manufacturing, causing the customer a significant financial loss. If time of delivery is “of the essence” then the contract should say this,’ he says.

“Even a minor delay can have a significant impact on just-in-time manufacturing, causing the customer a significant financial loss. If time of delivery is “of the essence” then the contract should say this

Ryan Mitchell
Associate Solicitor, Paris Smith

Mitchell adds that sometimes a supplier’s standard terms will allow it to increase the price of the goods or services, even after the price has been agreed. A typical price variation clause is triggered by currency fluctuations or an increase in raw materials or labour that’s outside of the supplier’s control. ‘More favourable formulations may allow the supplier to pass on any increases in its cost of supply – including those the supplier would or should have anticipated when the original price was agreed’, explains Mitchell. ‘These clauses should be checked carefully as a price increase may be demanded shortly before planned delivery, leaving the customer with no reasonable alternative source of supply if it weren’t to pay the higher amount’.

Meanwhile, if contract terms need to be changed or quickly made more robust, companies could assess what they could offer to suppliers to maintain the relationship. Keeping an ongoing and open dialogue with suppliers would also keep them informed about how events are having an impact on operations and improve the chances of both parties making informed decisions.

Monteiro de Carvalho says legal counsel should aim to guarantee fair liability terms as part of the organisation’s measures to reduce the business’ exposure to risks in the supply chain. She says that ‘in-house lawyers hold an important role in contractual planning, making sure contracts cover worst-case scenario situations and contain clauses that could mitigate the impact of supply chain disruption’. These could include clauses relating to non-compliance with specific regulations, providing a legitimate reason for rightfully terminating the contract with the supplier; clauses that demand insurance cover for foreseeable risks; and those that relate to specific rules for subcontracting, or a pre-approved list of subcontractors.

In-house counsel should then regularly review key clauses to ensure they remain robust and fit for purpose. They should also attempt to renegotiate contract terms if risks and business conditions have changed, Monteiro de Carvalho says. In-house lawyers can also take a more proactive role in supplier risk management by checking the financial status of suppliers; help create a contingency plan in case of an actual disruption; ensure clear communication and up-to-date training of team members so they maintain their awareness of supply chain risks and how to mitigate them; and secure storage of contractual documents and contact information, ensuring easy access in case an issue arises.

A key area for in-house lawyers to keep in mind concerns the measures the organisation uses to mitigate supply chain risks, as legal clauses and insurance cover may not provide the protection predicted. Martin Reynolds, a commercial property lawyer at law firm Parfitt Cresswell in the UK’s Thames Valley, says many businesses with extended supply lines and ‘just in time’ production practices often believe they’re covered against supply chain disruption – either through insurance or by contractual provision. However, this doesn’t necessarily mean they’ll receive compensation or insurance payments quickly, or in full.

Reynolds adds that cases such as Financial Conduct Authority v Arch Insurance and others in the UK – a test case in which the Court assessed if insurers were taking too narrow a view of whether key clauses determining business interruption events were applicable or not during Covid-19 lockdowns – ‘show quite how restrictive insurers can be in paying out on claims, and the concept of an overriding duty of good faith in business contracts remains unpopular in English law’.

Crispin Dick, a partner and Head of the Commercial Team at law firm Paris Smith in Southampton, in the UK, agrees that in-house lawyers must consider risk management options, as well as legal ones. For example, he advises in-house lawyers to check their companies have carried out due diligence on their supply chains to ensure that suppliers have sufficient stock to fulfil orders and if they don’t, they’re not reliant on sub-suppliers in regions likely to be affected by geopolitical disturbances. Contractual assurances around stock and supply chains can only be relied upon if things go wrong, and even then, cross-border contractual disputes are often challenging and expensive to resolve, he says.

Looking ‘more widely’

Some believe that in-house legal functions must also do more to keep abreast of wider risks and their impact on the organisation more generally rather than focusing on specific legal risks that typically relate to contracts. Fast-moving and ever-changing geopolitical and climate-related risks, for example, can present legal challenges for organisations and their supply chains that’ll require quick thinking and legal solutions from in-house counsel.

Javier Canosa, a former Co-Chair of the IBA International Commerce and Distribution Committee and a partner at Argentinian law firm Canosa Abogados, firmly believes in-house legal should ‘look more widely’. Something to keep an eye on, he says, are sanctions regimes and their impact – especially since regulatory monitoring and enforcement are growing stronger while companies still fail to do basic checks.

Another area is the impact of political regime change, he says. Canosa highlights that many major economies around the world have key elections this year and many countries have raised the issue of sourcing goods and services locally to bolster their own economies and improve resilience – most notably, the US. He predicts that if Donald Trump wins the US presidential election in November 2024, there could be a greater drive for US companies to source and develop goods at home, with ‘tax breaks and other incentives’. He says that ‘companies need to be proactive and look at what is happening politically in the countries they source from and consider how their supplies could be impacted if a government changes and becomes more protectionist. Arguing over contract terms is no good if your company is going to go bust because it can’t operate effectively and its market has moved.’

“Arguing over contract terms is no good if your company is going to go bust because it can’t operate effectively and its market has moved

Javier Canosa
Former Co-Chair, IBA International Commerce and Distribution Committee

Monteiro de Carvalho agrees that in-house lawyers must examine how emerging political, economic, climate and societal risks may have an impact on their companies’ operations and where legal solutions will be required to give greater protection. She highlights research indicating that ‘deglobalisation’, whereby companies engage in ‘reshoring’ – meaning that the production and manufacturing of goods is returned to the company’s country of origin – or ‘nearshoring’, whereby a company moves production closer to the final customer, is a growing trend among some organisations. The result is that supply chains are more integrated with local and regional economic systems.  

Meanwhile, ‘powershoring’, which refers to the attractiveness of using clean energy derived from renewable sources such as hydropower, wind, solar and biomass, is gaining traction, particularly in Latin America and the Caribbean. Such trends, she says, could have a significant impact on how supply chains function and develop in the region, particularly if companies stipulate they want suppliers to use ‘stable’ and low-cost energy suppliers as oil and gas prices continue to rise and some regions face energy shortages or crises.

There’s little doubt that supply chain risk will remain a considerable issue for companies globally, as geopolitical tensions in many regions of the world continue and the short-term economic outlook for many countries is mixed. Companies will be reliant on their in-house legal teams to provide much more protection in their contracts with suppliers and customers, while also expecting them to keep a keener eye on how organisations manage these risks operationally and financially, too.