Dorothee Schramm and David Roney, Partners at Sidley Austin, discuss their top 10 tips for managing legal risk from global supply chain disruption.
As the new coronavirus disease, COVID-19, spreads around the globe, the World Health Organization continues to upgrade its global risk assessment. In addition to the tragic health consequences of COVID-19, the virus is having a major negative effect on international business, disrupting numerous global supply chains.
Countless supply contracts are being disrupted by factory shutdowns in the areas most affected by COVID-19. In recent weeks, Chinese agencies and chambers of commerce have issued thousands of force majeure certificates to Chinese companies. However, COVID-19 will not give rise to a valid force majeure defense under every contract and in every circumstance, as different contracts and governing laws stipulate different requirements for different situations. Companies are therefore well advised to proactively manage the related legal risk and carefully assess which party must ultimately bear the financial losses caused by COVID-19.
The following seven tips will help to manage legal risk when confronted with immediate supply chain problems. Three additional tips will help to create a more robust supply framework for the future. All of these tips will be explained in more detail in an upcoming Sidley Webinar. In the interim, please reach out to your Sidley adviser for assistance with any urgent issues.
Facing Supply Disruptions Caused by COVID-19 – What Now?
COVID-19 may affect your company in different ways. Your own production may be affected by government shutdowns or dwindling numbers of employees coming to work. Alternatively, your suppliers may discontinue shipments, leaving you unable to produce your goods. Whatever the impact of COVID-19, the following tips will help you to manage the situation.
1. Identify the exact nature of the supply problems and document them. Up-to-date knowledge of the facts is crucial for proper management decisions and your ability to prove those facts may determine your success in any subsequent legal proceedings.
If your company is directly affected: Make certain you understand the reasons why you are unable to supply. Is it due to government-ordered factory shutdowns or quarantines, staff illness, staff staying home out of fear or other reasons? Identifying the exact nature of the problem is critically important and you should secure evidence proving the cause of your specific problem.
If your supplier cannot supply you: Do not accept an unspecific force majeure declaration, but ask for details about how exactly your supplier is affected. Do not take a position on the force majeure declaration before knowing the relevant facts.
2. Analyze the risk allocation under your contract and the governing law. Not every contract and governing law provides for a force majeure defense based on unforeseeable events outside the parties’ control. The scope and requirements of force majeure (and similar legal defenses) vary from contract to contract. A careful legal analysis of your specific situation is therefore indispensable and will depend on the exact nature of the supply problems, the specific terms of your contract, and the governing law. If you find yourself facing a force majeure defense by your supplier and, as a result, cannot supply your own customers, you need to assess the risk allocation under each contract separately to develop the best risk management strategy.
3. Say what needs to be said – but beware of the pitfalls. Specific contract terms or the governing law may require you to give prompt notice of a force majeure event, failing which this defense will be barred. If there is such a requirement, you may need to issue a force majeure declaration before you have had the opportunity to complete your assessment of the first two points above. If you receive a force majeure declaration from a supplier, carefully frame your response to protect your legal position and, if you must then issue a force majeure declaration to your own customers, avoid any language that could prejudice your position in a future dispute with your supplier.
4. Make efforts to overcome the supply problems. Many contracts and governing laws exclude a force majeure defense if you can overcome the consequences of the force majeure event. Often, you cannot rely on a force majeure defense to avoid significantly higher costs of supplying alternative goods, unless you are entitled to invoke hardship (which is rare under most governing laws). If you receive a force majeure declaration that you consider invalid, you are obligated to take steps to mitigate your damages. Document all your efforts to overcome the supply problems, particularly if they are unsuccessful.
5. Beware of how you allocate existing supplies. If your reduced production output allows you to supply only some of your customers, allocating the available supplies is tricky. Carefully check your contract and the governing law as to whether they contain any restrictions or guidance. Supplying your priority customers and declaring force majeure vis-à-vis all other customers may be problematic. If you receive a force majeure declaration, find out how your supplier allocates remaining stock.
6. Manage contract disputes proactively to resolve them efficiently. There will be many lawsuits over who must bear the losses caused by COVID-19-related supply chain problems. Managing contract disputes proactively will increase your chances of resolving them efficiently and successfully. Engage with your suppliers and customers in a cooperative and reasonable manner – this will go a long way toward avoiding or resolving disputes. At the same time, take all necessary steps to protect your legal and evidentiary position in the event a dispute escalates, and check your contract’s dispute resolution clause to identify what court or tribunal would decide a dispute and how that adjudicator would likely assess the situation. Sidley can assist with all of these steps through an early case assessment, which will help you decide whether to litigate or seek a settlement, as well as determine an appropriate settlement amount that properly reflects your chances of success in legal proceedings.
7. Putting an end to force majeure. Typically, force majeure serves as a temporary defense, which must be lifted as soon as it can be overcome and supplies can be resumed. Until that time, many contracts require that you provide regular updates. When necessary, you should assess whether your contract and the governing law only excuse temporary non-performance or also entitle you to modify the contract terms or terminate the contract altogether.
Make Your Company Virus-Fit for the Future
After SARS, MERS and the bird flu, it would be optimistic to assume that COVID-19 will be the last global health crisis of this kind. Now is a good opportunity to take measures to minimize global virus-related problems in the future. Here are the top three tips:
1. Have a Plan B (C and D). At present, companies that rely on one supplier in COVID-19-affected areas in China face the biggest challenges. Good supply chain practice mandates several suppliers in different countries and geographies. This practice will minimize the risk of disruptions that are likely to increase in the future, whether they are related to pandemics, climate change, or other global phenomena.
2. Update your force majeure clauses. You should update your template force majeure clause for future contracts or renegotiated contracts to make certain it covers common problems in the event of a global pandemic or similar disruptive phenomena.
3. Pay special attention to your dispute resolution clause. This contract clause will determine whether you can effectively enforce your rights. For example, if you receive an invalid force majeure declaration from a Chinese supplier, a Chinese court may not be the most favorable forum for pursuing a claim for damages. For important contracts where you are the supplier but rely on a sub-supplier, aim to agree in both contracts on compatible dispute resolution clauses that will enable you to resolve virus-related supply disputes under both contracts in a single legal proceeding. Sidley’s experienced international dispute resolution lawyers are well placed to assist you in identifying and negotiating such robust and well-calibrated dispute resolution clauses.
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