Benjamin Franklin famously said, “By failing to prepare, you are preparing to fail.” In these uncertain times, with contractual relationships coming under strain, spending time understanding your key dependencies and possible weaknesses in your trading and supply contracts can be a worthwhile exercise.
Based on our recent experience of conducting contract reviews for clients, here are a few questions to ask when analysing your key contracts with a view to ensuring a degree of protection against the risks of a COVID-19 loss of supply or market demand.
1. Where is your delivery location?
Where your delivery location is can affect your attitude to risk. For instance, if the delivery location is in or near a liquid market, this might mean that a replacement product can be easily obtained if your supplier fails to deliver to you. On the flip side, if your delivery location is less liquid and more constrained, this might suggest adopting a more cautious approach in your contract negotiations.
2. Are there any other delivery or storage options in the area?
To guard against the risk that your delivery location may close or become constrained in some way (e.g. because storage at the port is at full capacity), you should consider what alternative delivery and storage options exist in the vicinity so that you can receive your product.
3. Who is your counterparty?
How critical is your counterparty to your operations? For instance, is the product a specific chemical or commodity which is not readily available from others in the market, or does your counterparty have rights on a certain storage facility pipeline or throughput rights which are vital to your supply arrangements? If your counterparty is critical to your supply arrangements, you are likely to want to temper your approach accordingly in any contract negotiation.
4. What are your quantity and duration commitments?
How large is your contract both in terms of volume and duration? Obviously, the loss of a large contract could have a large adverse impact on your financial situation, particularly if the cost of any replacement contract is sizeably greater than the lost one.
Does your contract contain minimum monthly or annual quantities? Is there a right to reduce volumes for any reason? The existence of such clauses will likely have an effect on your bargaining power in any contractual renegotiation.
Absent any clauses allowing you to vary contractual performance, it may well be that, as a buyer, you will be required to take a minimum contractual quantity, failing which payment for under lifted volumes must be made.
It is also worth noting that some counterparties are now incorporating COVID-19-related price and volume renegotiation clauses into their new contracts.
5. What exposures do you face?
You should consider the extent to which a counterparty failure and the loss of a physical position can be mitigated by a suitable financial hedging strategy.
6. What are your suspension and termination rights?
What are your contractual rights to suspend or terminate if your counterparty fails to perform? For instance, some contracts allow for immediate suspension, whilst others merely offer a termination right which can only kick in after a grace period has expired.
7. What rights do you have to claim force majeure?
Does your contract have a force majeure clause? In the absence of a force majeure clause, are you nevertheless able to rely on force majeure-like principles? In Spain and France, for example, the concept of force majeure is enshrined in law under their respective civil codes.
Under English law, adverse economic conditions and falls in market demand are not typically force majeure events. To amount to force majeure, an event generally has to be something which prevents a party from performing its contractual obligations. So in the context of a supply contract, this typically means a physical impediment preventing delivery or acceptance of the product.
8. Are there any other clauses in your contract that might assist?
Are there any other clauses that you might rely upon? For instance, some contracts provide that the parties may renegotiate if a change in law or economic circumstances mean that a party is financially disadvantaged.
Also consider whether the law of the contract offers any assistance. In Spain, for example, if contractual performance becomes excessively onerous as a result of an unforeseen event, the affected party may request a renegotiation. If, subsequently, renegotiations fail, this can lead to termination by agreement or intervention of courts in some cases.
The above represent just a few considerations to bear in mind when embarking on a COVID-19 health check of your key contractual relationships. When considering contract renegotiations, it is likely you will want to adopt a variety of strategies depending on the exact nature of your contracts, your supply needs and your counterparties.