dbusiness.com - September 2022
With market volatility and supply chain constraints at record levels, manufacturers find themselves in unfamiliar territory with their supply base. As a consequence, manufacturers may need to protect production and reduce costs by finding an alternate source of supply during serial production. Changing suppliers mid-program often involves the termination of the supply contract, which can be fraught with legal pitfalls leading to costly litigation and delay. Knowing how to avoid these legal pitfalls can help smooth a manufacturer’s transition to a new supplier and minimize legal risk. The following four steps will help assure an orderly transition of supply.
First, understand your supply contract. The single most important roadmap for changing suppliers is the contract itself. The contract governs your rights and obligations with the supplier and may set forth a procedure for re-sourcing. In some cases, the contract may consist of a series of documents, such as quotations, purchase orders, and standard terms and conditions, that together constitute the supply contract. In other cases, there may be a discrete supply agreement negotiated between the buyer and seller and signed by both parties. The contract may provide a specific expiration date, after which no further obligations exist for either party. Often, the contract grants the buyer a right to terminate the contract with or without cause when changing suppliers before the expiration of the contract. Absent a specific provision allowing for early termination, other contractual terms, such as force majeure, may also give rise to termination rights. Understanding your contractual rights – and obligations – can go a long way toward developing a successful strategy to change suppliers.
Second, be prepared to give adequate notice. The less notice provided, the more damages a supplier is likely to claim. A “reasonable” notice period will depend on the products supplied. For example, less notice may be required for off-the-shelf products, while more notice may be required for custom-fabricated products or commodities with long lead times. Generally, the more notice the better. An exception to a long notice period may arise, though, if the notice itself may precipitate adverse action the supplier, such as withholding just-in-time supply and holding the products “hostage.”
Third, take advantage of the supplier’s missteps. A breach by the supplier, such as a significant failure to satisfy delivery or quality requirements, can form a legal basis for immediate termination without a significant lead time. A breach by the supplier may also excuse you from paying ordinary termination costs, which typically include payment for work-in-process and raw materials. In addition, threats by a supplier to stop shipping, or conditioning future shipments on extracontractual price increases – known as an anticipatory repudiation – may also provide sufficient legal grounds for contract termination. In those circumstances, a prompt legal demand for written assurance of supply may bolster your position.
Finally, prepare for legal action. Urgent situations created by hostile suppliers may require you to seek an emergency court injunction to prevent a sudden disruption in the supply chain. Courts are often sympathetic to the plight of manufacturers and are reluctant to allow one supplier to disrupt the entire supply chain. The negotiation of a legally binding “exit” agreement can also provide certainty, avoid legal disputes, and aid in the orderly transition of supply.
These four tenets provide a roadmap for manufacturers to change suppliers effectively and efficiently. Every situation is unique, though, so be sure to involve legal counsel early in the process to help plan and execute a successful strategy when you elect to change suppliers.
