Coronavirus Outbreak Prompts Supply Chain Disruptions

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Now in its third month, the coronavirus outbreak that began in Wuhan, China, has claimed over 2,000 lives and brought one of the world’s most dynamic economies to a near standstill. While China is grappling with a public health crisis, the new outbreak has demonstrated how far China has come as a crucial player in the global economy since the 2003 epidemic featuring a related virus that caused Severe Acute Respiratory Syndrome, or SARS (the 2019-20 iteration was named “SARS-CoV-2” by the World Health Organization last week). 

The China of 2020 has evolved into a multifaceted economic partner to the world, and the efforts that China has taken to control the spread of the virus have begun to present multifaceted consequences across the globe. For United States manufacturers, the interruption of raw materials, parts, intermediates, and finished products from China has continued long enough to present a variety of supply chain impacts. These events, coming on the heels of a protracted trade war between China and the U.S., provide an opportunity for manufacturers in the U.S. to reevaluate—and possibly restructure—their contractual relationships with Chinese partners and consider the legal consequences that can flow from the type of supply chain disruptions that are now underway.

Upstream/Downstream

With many Chinese factories and mines idled, many U.S. manufacturers have found themselves without the raw materials, parts, or products they contracted to buy from their Chinese partners. These contracts take a number of forms, from “requirements contracts” (seller agrees to provide everything that the buyer needs) to “output contracts” (buyer agrees to buy all that seller produces) to contracts for fixed quantities or prices.

Companies also enter into toll manufacturing or contract manufacturing arrangements in which one company sells as its own products the goods that are manufactured by another.

When a supplier is unable to fulfill its contractual obligations, a number of legal issues arise. Can the buyer purchase from another source? What if the goods cost more? Must the buyer resume purchases from the seller when the seller is able to fulfill the orders, and at what quantity or price?  What happens when the purchaser is unable to use all of the product it contracted to buy, and rejects a delivery?  These questions and others should be addressed in the parties’ contract. The answer may be determined by a provision known as a “force majeure clause,” which is routinely included in supply agreements and excuses a party from its obligations when it is prevented from complying due to some—but not necessarily all—circumstances outside its control.  Mandatory government intervention is often deemed “force majeure,” but voluntary action, such as closing a factory, may not be, even when intended to control an epidemic. The first step in assessing the impact is determining the circumstances covered by the force majeure provision. In some circumstances, the provision may be specific enough to apply directly to diseases or outbreaks. 

China has issued over 1,600 certificates to Chinese companies intended to support claims of force majeure.  The certificates reportedly state: “on January 30, 2020, the companies within the administrative area of Hebei Province are forbidden to recover production before 24:00 February 9, 2020. The matter is true.”  The legal effect of such declarations is dubious, and in any case a declaration would not alter the terms of any private contract. At most, the Chinese declarations show that certain facilities in Hebei were prohibited from producing for a period of eleven days, from January 30 through February 9. Hebei is just one of many industrial centers in China. The binding constraints imposed by the Chinese government were limited both in time and in place and do not seem to rise to the level of a typical force majeure event.

Manufacturers in the U.S. also have another problem: keeping faith with their own downstream customers.  If a critical raw material or part is not available, or costs substantially more, the U.S. manufacturer will have difficulty meeting its own delivery obligations and may be limited in its ability to pass on the cost increases (some raw material prices have increased as much as 25 percent during the crisis).  The manufacturer could potentially invoke its own force majeure clause and might be able to seek damages from its upstream supplier, but such contractual remedies will not necessarily replace income lost when the ultimate consumer buys another product—a car, a television, a cell phone—instead. 

Third-Party Obligations

If a manufacturer experiences sufficiently severe disruptions in its supply chain, it could run afoul of its obligations under financial agreements or other transactional contracts. In many cases, such agreements will include financial and credit covenants that could trigger a default or other consequences when circumstances arise that have a “material adverse effect” on the financial health of the party involved. While such agreements generally allow parties an opportunity to cure any financial deficiency, such a cure is not always within the party’s power. And while the hope is that the current crisis in China will be resolved soon, there is currently no time limit on the disruption the crisis has caused.

Lessons

In an era of just-in-time inventory planning and a true global market, manufacturers need to assess their own supply chain vulnerabilities and identify those trading partners that pose the greatest risk. Manufacturers need to work through their contractual relationships with those suppliers to preserve their rights and to establish actionable remedies in case of interruption. Manufacturers also need to evaluate their customer relationships to ensure that they are not held responsible for failing to deliver product when they have been left in a lurch by suppliers. Finally, manufacturers and suppliers need to assess the covenants they have undertaken and restructure those, where possible, to limit their exposure to unanticipated supply chain risks.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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