Considerations for Supply Contracts During Trade Tensions
Shifts in supply chains are becoming more common as the tit-for-tat tariffs imposed between the US and China continue on without an end in sight. And China and the US are not the only countries imposing increased tariffs as well as non-tariff barriers to trade. Other countries that have a history of higher tariffs and non-tariff barriers to trade, may also be looking to make trade policy adjustments in order to adapt to the changing trade landscape.
How Should Suppliers Respond?
Both China and the US and other governments have relatively quick processes in place for imposing new tariffs , however, most product suppliers need time to assess their options and re-plan their manufacturing processes and supply chains in order to respond to these measures and avoid the higher duty rates. Similarly, governments can also nimbly remove the higher tariffs, but product suppliers often have supply chains that cannot be changed as quickly and they need to determine the risk associated with creating new supply chain routes. It is not just product suppliers who are impacted. New tariffs disrupt many businesses in the supply chain and impact decisions made on product sourcing, routes to market and manufacturing.
The mere threat of new measures can also be severely disrupting. Product suppliers have to consider the likelihood of whether the trade tensions will end sooner or later and whether they should take no action or adjust vulnerable supply chains. All these factors can make it difficult for product suppliers to plan for and deal with the risk of higher production costs due to increases tariffs.
Businesses need to determine how to respond to the higher tariffs. Some businesses might consider a tariff classification review or a review of the location of supply chain activities including manufacturing and assembly process. We focus here on the careful drafting of sourcing contracts, which can create flexibility and adaptability but also add additional costs.
A Closer Look at Supply Chain Contracts: Flexibility and the Associated Costs
In order to ensure a supply chain is adaptable and flexible, supply chain contracts should include language that allows for the ability to restructure manufacturing processes and other parts of the supply chain on short notice. More flexible terms may allow a product supplier to restructure quickly, however, this may come with higher costs. Businesses must balance the benefits with the costs of more flexible terms. We list below some of the supply contract terms that will be critical to flexibility, together with the concessions that may need to be given in order to gain flexibility.
- Multi-layered contract. Where the arrangement with a manufacturer/ transporter/ distributor is long-term, consider having a foundational contract that frames the general conditions for the relationship while specific terms, such as the price, time and amount of each transaction, may be fixed by additional individual contracts. Such arrangement allows for a change in the price, quantity, timing, etc. with each transaction. The trade off is that this arrangement may require renegotiation for each subsequent contract, which could be costly and time consuming.
- Force majeure clauses. Force majeure clauses contemplate events beyond the parties’ control, which allow one party to unilaterally suspend a contract for a period of time or, if the situation does not improve, terminate the contract. Many contracts adopt boilerplate force majeure clauses. The contract should clearly define a “force majeure” event. Typically, significant increases in tariffs are not force majeure events. However, it is a point of consideration for contracts moving forward.
- Hardship clauses. Hardship clauses generally require the parties to implement and enforce the contract fairly and without detriment to any party’s interest. If a substantial hardship does arise, the parties will work together to rectify or remove the hardship and remedy any detriments suffered by either party. Businesses should consider expanding the scope of a hardship clause to allow for higher tariffs.
- Cancellation/re-issuing rights. In some circumstances, tariffs may significantly increase the costs of goods to the point where it no longer makes sense for product suppliers to receive the ordered products. Consider seeking rights to cancel and re-issue purchase orders and invoices at short notice to accommodate a sudden change in cost from higher tariffs. There is a trade off. Broader cancellation rights result in higher costs borne by the manufacturer/ transporter / distributor in order to account for the risk of cancellation. Such costs would be reflected in the terms of the agreement.
- Minimum volume. Many supply contracts include minimum volume and other sourcing commitments that require a product supplier to purchase a minimum amount from the manufacturer during a specified period of time to secure a certain price. Similarly, transport and distribution contracts may also require a minimum volume for transport/distribution services. Businesses should consider negotiating hardship exceptions to cover minimum volume requirements and such hardship exceptions would cover significantly higher duty rates.
- Provisions binding the supplier to a manufacture. Significantly higher tariffs may push product suppliers to consider moving manufacturing to another country. This can be a difficult and expensive process. It takes time and money to set up a manufacturing process and conduct due diligence on a new manufacturer. Among other things, product suppliers must ensure that they have all the legal mechanisms in place allowing them to switch manufacturers. Product supplier should ensure that there is no contractual restriction on switching a manufacturer and that the product supplier holds all of the intellectual property rights and technical data to the products so that they may give manufacturing instructions to another manufacturer on short notice.
- Flexible language. Most contracting parties put in great effort and resources in order to clearly spell out the contractual terms. Depending on the nature of the transaction, consider using terms that can be tailored to different events and circumstances. For example, consider employing terms such as “reasonable,” “good faith,” and “commercially reasonable in light of the circumstance” instead of more specified, rigid terms that are less malleable. Of course, these flexible terms are sometimes a double-edge sword because they also could result in different interpretations of what is “reasonable” or “good faith” and thus creates higher uncertainty, especially when dealing with a new partner.
Similarly, a cooperative relationship may promote further flexibility when dealing with the uncertainties of higher tariffs. Highlighted below are some contractual terms for fostering collaboration between a product supplier and its manufacturer, transporter and distributor.
- Emphasis of cooperation. Requiring the parties to cooperate may be critical to finding an amicable solution. Hardship and force majeure clauses can require the parties, upon the occurrence of certain events, to renegotiate in good faith or using their best effort.
- Clear process to handle disputes and contingencies. Disputes and contingencies cannot be entirely avoided in business transactions. Having a clear process to deal with such events is crucial and fundamental. The parties must decide beforehand what processes the parties will take to resolve a dispute. Would the parties try to amicably resolve the issues or utilize another means, such as arbitration or judicial proceedings? If the cost of products is significantly increased, how will that burden be shared between the parties? Should an expert valuer for example be engaged to determine cost impact? The supply contract should clearly lay out the processes for handling disputes and contingencies.
While the contractual terms above provide product suppliers with more flexibility in the face of higher tariffs and other unexpected events, such flexibility does not come without costs. The challenge for product suppliers then is to balance the costs and benefits of flexible terms to determine whether such terms make sense for their business, both short-term and long-term.
Big Picture Considerations
The trade tensions do not appear to be going away anytime soon and so it is critical for businesses to adapt their supply chain to manage for the higher tariffs. The issues raised here are also part of broader considerations for modern supply chain planning. For example, cross-border suppliers might want to consider building in redundancy by having multiple manufacturers in different jurisdictions. That way, when it becomes too costly to purchase from one manufacturer, the supplier could increase the quantity of purchase from a manufacturer in a different country. To this end, suppliers should also ensure that they have the ability to ramp up supply with a manufacturer at short notice or they could consider potentially paying a fee to have a new manufacturer on standby.
Given the uncertainties around existing and potential future tariffs, businesses must have plans to identify solutions for managing supply chains in order to reduce the burdensome costs and associated with the increased tariffs and consider all the opportunities and risks associated with changes.
Supply chain contract considerations are just one of many tools to consider in responding to increases in tariffs. Businesses should also consider revisiting classification of its products and utilisation of existing and the expected new free trade agreements.