“Scarcity” across the globe and industries

Shortages of steel in construction.  Shortages of wood for buildings.  Shortages of lithium for alternative power supplies.  Shortages of luxury goods.  Shortages of microchips in the mobility industry.  Shortages of packaging material across all industries.  Shortages of storage space and transport lines in logistics.  In short: global supply chain shortages.  All that contrasted by: increasingly high demand for affected goods in booming industries.  Whilst “demand” has often been the decisive market driver, there seems to be a shift to “supply” in situations of shortage.

The Corona pandemic has painfully demonstrated how vulnerable the complex modern business world has become.  Whilst the pandemic and its effects seemed to have diminished only a couple of weeks ago, it is strongly re-occurring in some regions of the world currently.  In addition, since the outbreak of the Corona pandemic, the global economy has encountered a growing number of (related and unrelated) shortages with manifold additional causes: the e-commerce boom, international trade disruptions and technical innovations in the mobility and tech industries, to name but a few.

The impact of these situations of shortages is massive.  We are not looking at singular events affecting a couple of parties in a supply chain or local regions.  Rather, the dimension is global.  We are looking at a cumulation of shortage events with an impact spanning continents if not the entire world.  Across the industries.

No one to blame, common interests

Often all stakeholders along a supply chain are affected.  Different actors globally are heavily impacted.  Often no specific party can be blamed.  Even if the parties were foreseeing the shortage event, and even if they were to use every reasonable effort – it is often not possible to avoid the impact on procurement, production, distribution, supply and logistics.  Often no alternative sources are available.  Supply chains are broken or interrupted.  Or prices are exploding.

At the same time, business is booming.  The parties do want to do business together.  They often have a strong desire to maintain the stream of commerce and overcome the situation together, instead of suspending or even terminating their relationship.  Their interests are aligned.

Principal legal considerations

Supply shortages and delays may trigger severe legal consequences.  Specific performance, which may even be enforced by means of injunctions or other interim relief in some jurisdictions.  Damages, liquidated damages, contractual penalties, indemnities, terminations.  This raises the questions as to how a legal system should react to these events of shortage, and what practices should be developed by legal practitioners.

The Corona pandemic has shown in a virtually unparalleled manner the resilience and weaknesses of traditional legal concepts and contractual agreements.  Similar questions of supply delays and shortages have arisen in virtually all jurisdictions around the globe.  Similar considerations apply in other recent situations of scarcity.

The discussion usually starts with the question whether the shortage event qualifies as force majeure.  There is no uniform answer to this question, and certainly no global answer.  Traditional force majeure clauses may help in some instances, in others they do not.  Taking the example of the Corona pandemic:  Is this really the poster child for a force majeure event?  Is it an event “outside the control of a party” in light of the concrete supply relationship?  After almost two years into the pandemic, is it still an unforeseeable event?  It also becomes apparent that the legal consequences of traditional force majeure clauses are rather rigid and inflexible.  They allow suspension and termination, but not adjustments of the contract.  Similarly, other contractual protection mechanisms such as material adverse effect clauses or hardship clauses are useful only in some circumstances.

Similarly, statutory law may afford only limited relief.  French and Spanish statutory laws know hardship and/or force majeure concepts.  German and Italian statutory laws implement concepts of impossibility and/or frustration of contract.  But all of these concepts have a narrow scope of application, require an analysis of the details of each particular case, and usually apply only in exceptional cases.  Common law practitioners would stick much more to the plain terms of a contract, without recourse to statutory law.

Extent of relief

Across the jurisdictions, there seems to be one fundamental similarity with respect to the legal justifications:  a company may rely on force majeure clauses, hardship, frustration of contract and similar concepts only to the extent it is actually affected by the shortage event.  If and to the extent the shortage event occurs and actually affects the supply chain, there may be a justification for a ramp-down of production capacities, supply shortages and supply delays.  Correspondingly, if and to the extent the shortage event eventually disappears, there no longer is a justification for cutting back production, limiting deliveries, or delaying supply.  At the same time, the legal systems do not allow any abuse of the legal justifications.  Such an event should not be used as an excuse beyond its actual impact on the supply chain.

In other words, any ramp-down, supply shortage and supply delay must principally be an adequate response to the event of shortage.

Good faith obligations

In many legal traditions, the principles governing the extent of relief are accompanied by varying obligations arising under the principle of good faith.  Often, these include obligations to promptly inform the other party about outages, delays and relevant developments including forecasts.  The affected party may also be required to explore and, to the extent possible, implement alternative sources of supply.

Above all, the principle of good faith acknowledges that the parties cannot be held responsible in an event of shortage.  This requires in turn, however, that they need to cooperate and work together in order to minimize the impact and damage for each of them and eventually overcome the situation.

Allocation of volumes

The principle of good faith also shapes the allocation of volumes.  When demand is high, capacities are low – and soon there are not sufficient capacities to satisfy the demand of all customers.  This triggers one of the key questions: whether the supplier may freely allocate its capacities, or whether the supplier is obligated to evenly distribute its capacities amongst all customers?  Or is there an obligation for preferential treatment of certain customers?

The answer to this question requires a case-by-case analysis.  Good faith principles will likely welcome the implementation of a fair share principle including an equal distribution of volumes amongst customers based on objective criteria, a preferred treatment of infrastructure critical customers or a preferred treatment of customers that would be particularly affected by a cut of supplies.  The supplier may have an interest to preferentially treat established or high-volume customers or customers with better prices.

Safeguard of supply

Purchasers on the other hand wish to safeguard their supplies.  Put in place preferred customer concepts, without forcing suppliers to breach existing agreements with third parties.  Secure manufacturing material resources from down-tier suppliers, and their supply to first-tier suppliers.  Establish alternative supply sources and redundancy concepts.

Antitrust regulations

In addition to the civil law considerations, antitrust regulations prohibiting abusive or discriminatory conduct may be applicable, notably in the case of market dominant positions with respect to the relevant products on the relevant geographical market.  For example, a market dominant supplier may be obliged to evenly allocate its available products based on objective criteria and fair share principles under antitrust law.  On the procurement side, purchasers likewise must not abuse their market dominant positions as a means to achieve preferential treatment by their suppliers.

Force majeure clauses

Traditional force majeure clauses prove to be rather rigid in many of the recent situations of shortage.  Companies should consider reviewing the clauses they have in use and, where appropriate, adjust them:

• Include foreseeable, but unavoidable, and re-occurring events in the definition of force majeure.
• Extend “force majeure cases” beyond acts of god such as natural disasters.
• Include unilateral rights of amendment, corresponding to the situation of scarcity.
• Allow for suspension of supply and the monetary consideration, respectively.
• Allow for price adjustments, allocation of volumes and allocation of costs.
• Allow for more flexibility and include adjustment mechanisms with respect to volumes and prices.
• Include termination rights as last resort.

Flexibilization of contracts

Beyond the flexibilization of force majeure clauses, there also is a practical desire to allow more flexibility with respect to the performance of contracts:

• Allow for more flexibility with the handling of contracts and the legal consequences of force majeure events, allow the parties to cooperate to find solutions.  For example, add governance clauses for working together in good faith and the renegotiation of contract terms.
• Include ramp-down and ramp-up mechanisms, which lay down the rules applying in case a shortage event occurs or disappears.
• Extend the contract term for the same period of time as the duration of the shortage event.
• Add flexibility to framework agreements by allowing the conclusion of short-term statements of work, certificates of performance, or the like in order to allow performance in times of uncertainty.
• Conclude temporary interim agreements to account for the changed circumstances of the shortage event, which suspend long-term framework agreements and allow their resumption after the event has ended.

Transparency, communications, training, documentation

It is also advisable to be transparent with the contract partners and keep them informed about situations or scarcity, product availability and latest developments.  Companies should use a consistent line of communication on the basis of the foregoing considerations.  It is also important to provide training to procurement and sales people with respect to the foregoing principles and the line of communication.  Relevant facts including efforts of fair treatment of the contractual partners should be documented.

Rethink dispute resolution

Traditionally, supply contracts provide for the jurisdiction of state courts or, in international supply chains, for arbitral tribunals.  To reflect the interests of the parties and take the increased need for flexibility of contracts and additional remedies fully into account, however, there is a need for more specific dispute resolution mechanisms which provide on the one hand the parties with the necessary framework and support for an amicable solution of their disputes, and on the other hand a trier of fact which is able to take the required decisions in an efficient manner.

Such so-called escalation clauses might comprise a first phase of negotiation and/or mediation, where the parties attempt to negotiate final or interim solutions for their dispute.  The second phase will very likely require arbitration clauses, which provide for the authority of the arbitral tribunal to take the sort of decisions the parties require.  This might in particular include all sort of interim relief, for example on specific performance or the interim or short term adaption of the contractual framework affected by such external factors causing the scarcity of supply.  It might also provide for the explicit authority of the Arbitral Tribunal to decide about the long term adaption of their contract to a changed environment, or to fix an adequate price, or to allocate costs.

In particular cases, where problematic issues are likely to arise, the use of a standing dispute (avoidance) board might be an option.  Such dispute boards are increasingly used in international construction and infrastructure projects.  They have a double task:  first of all, during the lifetime of the project they assist the parties with resolving all issues which may come up, before they get to the level of a formal dispute.  Insofar, while being flexible, they often have the role of a mediator or advisor.  If requested by one of the parties, they can be sized with a request to formally decide on a specific question in an accelerated proceeding.  While such a decision is binding, each party has the possibility to bring the dispute before an arbitral tribunal which then issues a final and enforceable arbitral award.

All these mechanism have in common, that they are flexible and can be adapted to the parties’ needs. They require a certain level of sophistication by the parties and willingness to take responsibility for the solution of their problems and conflicts.

Résumé

During the Corona pandemic and other recent situations of scarcity, the number of parties affected often is not limited to two or even only a few.  Rather, a large number of of different industries and different actors across continents or even globally are heavily impacted.  The parties often have a strong desire to continue doing business and overcome the situation together, instead of suspending or even terminating their relationship.  Based on legal considerations such as the good faith principle and antitrust regulations, it is often advisable to implement the following steps to overcome the situation of shortage and keep the supply chain running: (1) implement a fair system of allocation of products following objective criteria; (2) on the sales as well as on the procurement side, avoid an abuse of market dominant positions within the meaning of antitrust law; (3) rework force majeure clauses and make contracts flexible; (4) act in a transparent manner and keep contract partners informed about shortages and relevant developments; (5) use a consistent line of communication; (6) train procurement and sales people with these principles; and (7) rethink dispute resolution mechanisms.

Authored by Florian Unseld and Karl Pörnbacher.