Risk Mitigation in Supply Chain Contracts: Termination, Credit and Insurance Terms

As business shutdowns related to the COVID-19 crisis continue to wreak havoc on supply chains across the globe, companies responding to supply chain disruptions will find that their obligations, rights and remedies largely depend on specific language in their contracts. A carefully crafted (or renegotiated) contract and an appropriate, timely response when issues arise can help you avoid or mitigate insolvency issues within your supply chain. Here are some considerations.

What does the contract say about when and how you can terminate it?

Critical in responding to disruptions caused by a crisis is understanding the contract terms between you and your suppliers and customers. You must first identify key provisions that may be relevant during a crisis, particularly the termination rights governing who may terminate the contract, when and why.

Most contracts contain one of two types of termination rights: for cause or for convenience. Termination for convenience (without cause) gives you the ability to terminate a contract at will, effectively creating an option to end the contract for any or no reason. Termination for convenience clauses are rare because they create uncertainty and are more likely to be invalidated by a court if illusory or without consideration. Far more common are termination for cause provisions, in which termination is triggered by specifically identified events or circumstances that harm the terminating party or alter the transaction's nature. Termination for cause provisions usually apply equally to both parties.

Review contracts for clauses that create a right to terminate for COVID-19-related issues. A termination clause may provide you with the right to terminate if your customer fails to buy goods at an agreed quantity or if your supplier fails to timely deliver conforming raw materials. However, your right to terminate is not necessarily automatic. Depending on the contract, you may be required to provide the customer or supplier with notice and an opportunity to cure.

The contract may also specify which remedies and damages are available to you. For example, an exclusive supplier agreement may enable you to enter into a relationship with another supplier if the breaching supplier fails to satisfy minimum purchase/supply quantities.

Can you negotiate or adjust payment or credit terms?

If you have entered into long-term contracts, consider developing strategies to protect yourself against the risk that a customer or supplier may face financial difficulties and file for bankruptcy. You can build terms into contracts that will protect you if a customer or supplier faces pre-bankruptcy financial strain.

One to consider is tightening credit terms. You may require collateral, third-party guaranties and/or letters of credit. To be even more cautious, you may monitor the customer's or supplier's financial condition and even require periodic credit opinions.

You can also establish a cash-on-delivery (COD) payment arrangement, also known as "cash on demand" or "collect on delivery." In this arrangement, a customer agrees to pay for the goods at the time of delivery. The contract can specify that a COD arrangement is triggered if the customer fails to comply with the negotiated payment terms.

Another type of protection is requiring payment in advance of amounts due or payment of additional fees. Advance payment terms can be mandatory or optional, either requiring or permitting a party to pay some or all amounts due prior to the other party's performance or before their due date. Naturally, advance payment provisions can be an effective way to reduce the risk of nonpayment.

If you are concerned that a customer is experiencing financial difficulties, what can you do?

Once a customer files for bankruptcy, you lose your right to issue invoices for shipments and collect debts that pre-date the bankruptcy filing. Fortunately, the Uniform Commercial Code (UCC) provides some protections before a customer files for bankruptcy. For example, under UCC § 2-609 you may be able to demand adequate assurance in writing that a buyer can perform under the contract, such as a letter of credit or other document demonstrating the customer's ability to pay or perform. You may also be able to suspend your performance until you receive the assurance you request, which can allow you to review and amend your contract and potentially reconsider the credit line extended to the buyer. Review your contracts before a customer becomes insolvent or declares bankruptcy so you can determine how best to mitigate potential damages before they occur.

Does the contract require you, a supplier or a customer to maintain insurance or provide indemnification?

Review contracts with suppliers and customers for insurance requirements and indemnity clauses. Many customers and suppliers carry insurance policies that might apply to mitigate financial losses you suffer due to their COVID-19-related breaches or performance issues. In fact, the contract may require that they maintain insurance coverage. The types and levels of contractually required insurance coverage generally depend on the nature of the parties and the contract itself. While some insurance covenants are general and require only "sufficient insurance coverage," others might specify types and levels of coverage, such as commercial general liability, workers' compensation or an umbrella policy. Likewise, the contract might obligate a supplier or customer to indemnify you if their breach causes you to breach your obligations to third parties.

If you believe you may be entitled to insurance coverage or indemnification for crisis-related risks from supply chain partners, you should request and review copies of the relevant policies—not just certificates of insurance—and assess potential coverage. Of course, you must also ensure that carriers are on notice for claims under any even potentially applicable policies or agreements.

Similarly, evaluate your own potential contractual insurance-related obligations to provide insurance coverage or indemnification to supply chain partners for risks related to the COVID-19 crisis. Carefully identify and review insurance policies that may provide coverage for slowdowns and stoppages of your business or your suppliers' or customers' businesses or liability to third parties

As COVID-19 continues to negatively impact supply chains, parties should carefully review their contracts and consult with counsel about any uncertainties.

Reprinted with permission from Thompson Hine, a full-service business law firm.