The age of supply chain disruption

Neil Hodge

Turbulent times – from the continuing Covid-19 pandemic to Russia’s invasion of Ukraine – have wreaked havoc on supply chains. Global Insight assesses the implications for businesses and their lawyers, from contracts to the need to diversify how goods and services are sourced.

The Covid-19 pandemic, and the emergence of variants of the virus, has caused significant difficulties for companies’ supply chains. These problems have persisted as outbreaks of the virus continue to appear around the world. Meanwhile, geopolitical events – chiefly Russia’s invasion of Ukraine – are further forcing companies to take stock of their supply chains.

While businesses in one market have been ready to steam ahead again, their suppliers in another market have found themselves locked down, hampered by staff shortages and held up by infrastructure and logistical problems as ports, airports and roads have been closed or blocked.

Some companies have struggled as the crisis in Ukraine and the subsequent sanctions on Russia have made it virtually impossible to import from those countries.

And while global economies may be recovering from the pandemic, business isn’t yet flowing freely. In mid-March, multinational companies including Toyota, Volkswagen and Apple supplier Foxconn, were forced to halt some operations as China widened its Covid lockdowns. The country’s latest curbs are among its biggest since the start of the pandemic. They effectively shut down the entire Jilin province and the technology hub Shenzhen, where a substantial proportion of automotive and tech manufacturing takes place.

Many companies are still faced with the same problems as they were when the first Covid-related lockdowns took place in March 2020. They also need to contend with the same lack of legal remedies if suppliers are hit with delays and customers cancel orders as a result.

A lack of remedies

Companies that have tried to enforce contract terms have had varying success. ‘Often, the test as to whether a legal provision in a contract provides a company with the protection it wants if the pandemic makes it too onerous or impossible to fulfil depends on the jurisdiction in which it is signed or applies’, says Javier Canosa, Co-Chair of the IBA International Commerce and Distribution Committee and a partner at Canosa Abogados in Buenos Aires.

For example, force majeure clauses – normally used to cover a situation where an unforeseen or unavoidable event prevents or delays a party from performing its contractual obligations – were commonly invoked when the pandemic emerged. However, they haven’t provided the level of assurance some organisations have wanted because they can be interpreted differently in different countries’ legal systems. Other clauses companies might have hoped to rely on, meanwhile, have given limited, if any, protection.

Hardship clauses – negotiated provisions intended to be applied when events occur that substantially alter the balance of the contract, either because of an increase in the cost of performance of one of the parties or because of a decrease in the value of the counter-performance – may have proved useful initially so long as they were included in contracts finalised pre-pandemic. For contracts written after the first Covid-related lockdowns, however, it is more difficult to invoke them in a dispute or even include them at all.

Meanwhile, material adverse change (MAC) and material adverse effect (MAE) clauses, which allow companies to terminate contracts if they can no longer deliver goods or services due to circumstances that prevent their operations or make them prohibitive, may not always apply because epidemics might not be among the events which the parties expressly intended to exclude or be classed as a ‘material’ event.

‘Some courts have favoured a restrictive interpretation of the materiality requirement, such that Covid-19 might not in and of itself be considered sufficient to constitute a MAC or MAE because its effects might not be of lasting nature and not exhaustible in a limited period of time,’ says Christopher Blake, Co-Chair of Hahn Loeser’s International Practice Group and Corporate Transactions Group, based in Cleveland, and a former Co-Chair of the IBA International Commerce and Distribution Committee.

As a result, he says, some contracts have opted to apply the Convention on the International Sale of Goods, which provides that a party is not liable for non-performance if it can prove the lack of supply/service is due to an unforeseeable – and unavoidable – impediment beyond its control.

Yet even these attempts to avoid liability may provide little protection to a business. In reality, the failure to fulfil orders means a loss of cashflow and perhaps permanently damaged business relationships in a climate where a company’s finances may already be in a perilous state.

Managing risk

For most companies – at least those without the ‘muscle’ of the world’s largest corporations – renegotiating contracts for the future is a good move.

Martin Hauser is Co-Chair of the IBA Mediation Committee and a commercial mediator at Martin Hauser Mediation in Munich. He says that, given no party is at fault due to changing circumstances, the best companies and suppliers can do is change their contracts to protect themselves in future. ‘They are aware that, if there is no agreement, a judge or arbitrator may review the case for them, a situation companies want to avoid because of the frustration a “win/lose” decision would cause’ as opposed to a jointly negotiated solution, he says.

Others, however, believe contracts are not a panacea and that the real salvation for companies is to accept higher levels of commercial risks but manage them better. Shane Freitag, Chair of the IBA Energy, Environment, Natural Resources and Infrastructure Law Section and a partner at Borden Ladner Gervais in Toronto, believes companies need to tackle supply chain disruption ‘as just another risk of doing business in a very volatile business environment’.

‘Contracts – even if written well – usually mean that you are going to get some compensation for a lack of supply but they don’t deal with the immediate problems that companies need to contend with in the meantime, which is replacing that supply at likely a higher cost along with potential delay’, he says.

‘Companies will have to accept a certain amount of risk even if they have a contract’, adds Freitag. ‘They will have to go beyond and look at their supply chains and check how they are managed and how resilient they are.’

Freitag says the checks companies should make include assessing whether the supplier’s supply chain is reliant on one or two key suppliers, and whether the company should have more critical or key inventory or alternate suppliers to tide it over if the supply chain falters. ‘Making these kinds of checks may take up a significant amount of time but it will provide more assurance in the longer term as contracts are only as good as the supply chain of the companies you are dealing with’, he says.

Blake agrees that companies have done better to improve their supply chain risk management processes than rely on contract terms. He points to the increased adoption of digital technologies to enable better real-time visibility in the supply chain, as well as companies agreeing to share key information – under a confidentiality arrangement – with other supply chain participants to allow parties to be nimble and solve problems more effectively.

Some have gone further and entered into strategic partnerships with suppliers and original equipment manufacturers – companies that manufacture and sell products/parts of a product that their buyer uses or resells under its own branding – to stand a better chance of ensuring uninterrupted supplies. Those companies lucky enough to have large financial resources, such as microchip-maker Intel, have been able to build their own manufacturing plants to produce the components they need.

Recurring lockdowns, coupled with the financial collapse of suppliers or suppliers’ failure to source goods and services to meet customer demand, is forcing businesses around the world to reassess how and where they source goods and services from. Many companies are trying to rationalise their supply chains by sourcing closer to home and reducing their exposure to critical suppliers.

But there are still practical problems around carrying out appropriate due diligence when onboarding new suppliers directly and checking whether current suppliers are making similar checks when they engage new companies to satisfy their clients’ demands. These problems are exacerbated by the travel restrictions still in place in some countries, which can prevent companies from carrying out site visits to verify a supplier’s credentials and working practices.

Dalton Albrecht, Senior Vice-Chair of the IBA International Commerce and Distribution Committee and Senior Counsel at EY Law in Toronto, says that while there is ‘no substitute’ for conducting site visits and physical audits, companies and in-house counsel can still gain necessary assurance through other means if ‘on the ground checks’ are not possible or practical.

For example, he says, a lot of the necessary information should be easily accessible. Using only email, one can ask for ownership details, the names/CVs of the management team, how many suppliers the company may be reliant on to fulfil orders, its code of conduct and any history of regulatory and/or criminal fines or sanctions, among other details.

‘There is absolutely no reason why you should not be able to obtain this kind of information on an ongoing basis if you have or are negotiating a long-term supply contract – nor is there any reason why a supplier can’t provide it’, he adds.

Albrecht recommends that businesses should re-evaluate their supply chains, as well as their contract terms, with in-house counsel taking a lead role. ‘Companies need to look at their contracts with suppliers and see what information they are entitled to have access to. If the contracts only allow for limited exchanges of information, they should be changed at the earliest opportunity. If a supplier is reluctant to provide more information, or refuses to do so, this should be red-flagged and risk-assessed’, he says.

Rogue suppliers

Albrecht warns there’s no ‘cast iron’ defence available for any company that has engaged a supplier that is complicit in slavery, child labour or abuses of workers’ safety or rights –hence the need for checks.

‘A contract that only indemnifies the purchasing company for the failings or criminal behaviour of a supplier is unlikely to limit or defuse blame or keep a corporate reputation intact’, says Albrecht. Even if such a contract can be enforced in a foreign jurisdiction with a possibly very different legal system, he adds, it may be difficult to obtain a damage award –and doing so would probably happen years after the fact.

A company’s ‘corporate reputation, especially in these ESG-focused times, is more important than damage awards for lost revenues’, says Albrecht.

However, a company may be able to limit any damage suffered as a result of its relationship with that supplier if it can show that there might be exceptional circumstances as to why it was not aware of the behaviour or conduct and that it acted diligently.

‘If a company can show that it would normally conduct a site visit prior to formally engaging any new supplier, and that it would usually conduct annual or regular checks thereafter, it may be able to mitigate some of the damage as this could demonstrate that the company has robust vetting processes in place and takes supply chain monitoring seriously’, says Albrecht.

If the company simply carries out a site visit at the beginning when it’s about to engage the company as a supplier and there’s no subsequent follow-up or monitoring, however, that’s unlikely to prove much of a defence, says Albrecht.

In common with many other commentators, Albrecht believes better risk management and more thorough due diligence will likely prove its worth compared to a reliance on tighter contracts – though contracts are still necessary and important. He believes it’s now a harsh reality that many companies are no longer as financially resilient as they once were due to supply chain and cashflow challenges, which means there’s a greater risk of suppliers going bust quickly.

‘Lockdowns have exposed just how fragile many supply chains are, especially for those companies that are over-reliant on one or two key suppliers’, says Albrecht. ‘Companies need to learn the lessons from the pandemic and ensure that they conduct checks not just to assess the legitimacy of the suppliers they are dealing with, but also whether they are financially strong enough to withstand another lockdown or another kind of crisis.’

He also believes that companies should, if they haven’t already, make it part of their terms and conditions to ask for regular financial statements from key or large suppliers so they know whether they’re at risk of going bust or defaulting on their contractual terms.

For Albrecht, there are two key reasons for this. First, the pandemic has shown that too many suppliers are operating with heavy debt burdens that put them at risk if production is slowed down or interrupted completely. Second, an over-reliance on one or two suppliers could prove fatal if, for example, the country/countries they are based in suddenly prohibit exports.

Albrecht says the lessons and procedures being conducted to ensure supply chain resilience during the pandemic should also serve companies well for other disruptive events, namely geopolitical crises. The Russian invasion of Ukraine highlights the need for companies to regularly evaluate geopolitical risks and consider whether supply chains should be further diversified. This could even make near-shoring the most appropriate option if critical parts and/or services are currently sourced from politically volatile or militarily unstable countries or regions.

‘One cannot rely on just one supplier, especially in a faraway location with a different legal system or one that is not legally or geopolitically stable, even if that would otherwise reduce costs through economies of scale’, says Albrecht.

‘Look at the sanctions against Russia: it’s virtually impossible to import from Russia or Ukraine now, and if that was your only source of supply, your business is crippled. In hindsight, this has become painfully obvious to many auto parts companies or companies relying on Ukrainian agriculture and mineral resources’, he says.

Neil Hodge is a freelance journalist and can be contacted at neil@neilhodge.co.uk