COVID-19 Information – Contract Issues

April 3, 2020

Many businesses, including manufacturers and other suppliers within industry supply chains, are closing temporarily because of the COVID-19 emergency, sometimes because of state “stay at home” requirements and sometimes because their customers are shutting down or stopping all orders. Even if companies remain open, counterparties with whom they have a supply agreement – as buyer or as seller – may not be functioning.

Current conditions will raise significant issues throughout supply chains for both buyers and sellers of goods. Some likely questions will include –

  • Is my performance under the supply agreement excused by the pandemic?
  • If I am open and need parts, but my supplier is closed, will I breach the supply agreement if I buy from another supplier?
  • How do I obtain assurance from my supplier or customer that they will honor their future obligations under the supply contract?
  • What do I do if a critical supplier tells me it can continue to supply my needs only if I significantly increase the prices I am paying?

Excusing Performance – Most supply agreements contain a prevision excusing a party’s performance under certain extreme circumstances. These are often referred to as force majeure clauses. Here is a typical provision – this one is in the terms and conditions of a supply contract between a Tier 1 parts supplier in the automotive industry and one of its Tier 2 suppliers:

Neither party will be liable to the other party for any delay in delivery or failure to perform caused by natural disasters, wars, acts of God, actions by governmental authorities, embargoes, acts of terrorism, or court injunctions or orders, if such is without such party’s fault or negligence (an "Excusable Delay"). For the avoidance of doubt, an Excusable Delay does not include (i) acts or omissions of Supplier's subcontractors or suppliers (including price increases or the inability of Supplier to obtain necessary manufacturing inputs from its normal or customary sources), (ii) labor disputes of Supplier, its subcontractors or its suppliers, including lockouts, strikes or slowdowns, or (iii) failure to comply with applicable Law. If an Excusable Delay occurs, the affected party will promptly notify the other party of the nature and anticipated duration of the delay or failure. XYZ will be entitled to terminate the Purchase Order if the Excusable Delay event persists or, in XYZ's reasonable opinion, is likely to persist long enough to jeopardize XYZ or any of XYZ's production. If XYZ determines that it must procure the Products from an alternative source during an Excusable Delay, the parties will discuss in good faith an equitable sharing of any excess cost incurred by XYZ in procuring the Products (or products similar thereto) from such alternative source.

The threshold question is whether this clause applies to the present situation. COVID-19 is not a “natural disaster, war, act of God, … embargo, act of terrorism, or court injunction or order.”  An order by the state government in which the company is located may, however, be an “action by governmental authorities.” Because the federal government has not taken any generally applicable action requiring businesses to close, each state is reacting to the pandemic in a different way. For example, in Ohio the Director of the Department of Health has issued an extensive “Stay At Home Order” that specifies which industries are deemed essential, in which case they are permitted to remain open. Companies that are in the supply chains of essential industries are also allowed to remain open to continue supplying goods to the essential companies.1

Accordingly, manufacturers and suppliers in Ohio that determine that they are either considered an essential industry or in the supply chain of an essential industry have not been ordered to shut down. Consequently, under the force majeure clause quoted above, such companies have not been ordered by a governmental authority to close (unless their local jurisdiction have issued such an order apart from the State of Ohio), and the pandemic will not excuse their performance under that supply contract.

Since contracts differ across industries and companies, it will be critical for buyers and sellers who are parties to supply agreements to carefully review the force majeure clause in their supply contract, and to contact counsel for assistance if there is any question.

Obtaining or Selling Goods Elsewhere – If only one of the parties to a supply agreement is closed, and the other needs to continue to buy or sell goods, the party that remains open for business will have to decide if it can obtain needed goods from another supplier or sell goods to another customer. If the supply agreement is exclusive, or if the buyer has agreed to purchase 100% of its requirements from the supplier, unless performance is excused by the present circumstances purchasing from a different seller or selling to a different buyer will be a breach of the contract. Thus, the question of whether a breach is occurring will depend on the answer to whether the force majeure provision in the supply agreement excuses the performance of one or both parties. Exercising a force majeure provision to excuse performance will be a two-step process – determine first if the clause applies to the pandemic and the situation in your state or locality, then find out if your supplier or buyer intends to continue to honor their obligations under the supply agreement. The answer to these two questions will determine your next step.

Assurance of Future Performance – The Uniform Commercial Code, which is the basic law governing the sale of goods and is applicable in all states, provides a mechanism for obtaining assurance from a counterparty to a supply agreement that the party will continue to perform. If one party to a contract is reasonably concerned about the other party’s performance, the concerned party can write to the other party and demand assurance of future performance. A lawyer in our Business Practice Group can assist you in preparing that letter.

Supplier or Buyer Demands for Accommodations  -- In some cases, the counterparty to a supply contract will use the emergency to refuse to buy or sell unless critical issues like price or delivery terms are adjusted. This can occur under at least two scenarios. One, the performance of other party may be excused under the applicable force majeure clause. In that case, the counterparty is essentially saying “I am not required to supply (or buy) but I will for a premium price (or a price reduction).” In this scenario, the other party will have to decide if its business need to buy or sell the goods is such that it would make economic sense to agree to accommodate the demands. For example, a seller may decide that its margins are sufficient that it will still make money (or at least not lose money and be able to stay in production) with the adjusted price. If it would not make economic sense to agree to the accommodation, the demand can be refused because it would be a breach of the supply agreement, and the counterparty will then have to decide if it wishes to invoke the force majeure clause.

A second scenario could be that the force majeure provision does not apply. In this situation, the counterparty seeking an adjustment may be saying that it cannot continue to operate and produce goods (or buy goods) because of economic conditions generally – for example, if other customers or suppliers have disrupted its supply chain. In this case, since the force majeure provision does not apply the party demanding accommodation is on weaker ground. The other party should agree to waive the breach of the contract only if it makes clear economic sense. For example, that party may need the supply of the party requesting accommodation to meet its obligations to its customers, a common occurrence for Tier 1 suppliers in the automotive industry, who are often caught in the middle.

Attorneys in our Business Practice Group have experience with all of these thorny issues. For example, we have negotiated and prepared dozens of accommodation agreements during previous trying times to ensure the continued functioning of the supply chain. Please let us know if we can assist you.


1 This description of the Order is general and does substitute for a careful review of the Order and consultation with counsel for questions about its coverage and meaning. The Order is available for download at https://governor.ohio.gov/wps/portal/gov/governor/media/news-and-media/ohio-issues-stay-at-home-order-and-new-restrictions-placed-on-day-cares-for-children.

 

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