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Supply Chain Agreements: Selected Risk Allocation Provisions

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Supply Chain Agreements: Selected Risk Allocation Provisions

This one hour presentation will analyze the essential terms in supply chain agreements including, warranty provisions, consequential damages, indemnification, force majeure, and termination. We will discuss best practices for drafting. We will discuss best practices for attorneys when crafting such provisions.

Transcript

Hi everyone. My name is Jeff Soble and I'm a partner with Foley and Lardner in Chicago. And I'm here to talk about supply chain agreements, specifically selected risk allocation provisions. These are the provisions that allow parties to allocate who is going to have the risk in these agreements, buyers or sellers? These are the kind of provisions that, as a trial lawyer, I have dealt with both for buyers and for sellers in disputes all over the country. And I will tell you that if you listen to everything I say today and you follow all of the form language that I give you, you will absolutely reduce the number of disputes that you're in and reduce the risk that your company undertakes in these agreements and not have to pay for lawyers like myself, which is always a bonus. So we will roll in by starting with what is meant by a supply chain agreement. I think this slide should be relatively obvious, but also confusing because most people think of a supply chain agreement as that one big contract. But it's much more than that. It can be any of the the documents listed here, all of which are routinely used by companies in a variety of industries, whether they be letters of intent or the always confusing non-binding letter of intent or logistics agreements or amendments or acknowledgements or purchase orders or terms and conditions incorporated by reference to a web page that may or may not still exist from when they were originally done. It can be emails. It can be a combination of these agreements. I once represented a client against its customer on a large dispute, and the question of what made up the contract was dozens of documents and communications between the parties, and there was no real agreement among them during the dispute over what made it up. And these list of documents tell you why. So you need to manage your contracting documents and understand where it is. You've entered agreements so that you can understand where the following provisions may come in. And for those provisions, we're going to start by talking about warranties. We're going to talk about a variety of warranties, express warranties, implied warranties and then limited warranties specifically for certain defects and their disclaimers. And I think the important thing to understand here is we're going to be talking about uniform commercial code provisions that exist in at least 49 states. Louisiana with the Napoleonic Code is one exception. And so these provisions that we're going to look at are pretty consistent across the country. There are some unique state laws that impact certain aspects of these. But generally speaking, if you're doing business all over the country, you can rely on the UCC to be a good guide. However, it's important to remember that these are gap fillers. The UCC Article two sales provisions only apply if your contract documents do not address the issues. So if you don't have a provision on express implied or limited warranties. Then and you don't have any disclaimers, then these provisions are going to fill those gaps. And generally speaking, these provisions are buyer friendly. And this slide alone sort of demonstrates that because the express warranties and the implied warranties, the UCC adds those as gap fillers. The buyer doesn't need to do anything to obtain express and implied warranties from the seller. However, to limit the warranties or to have disclaimers, the seller must actually do some work. The seller must document it. The seller must use magic language. The seller must be proactive. So I've had clients oftentimes tell me we're okay with that documentation because we're just going to rely on the UCC, which we think is fair. And I always respond with, Are you going to be the buyer or the seller? Because if you are the seller, the UCC is going to be much more fair to the buyer than it is to you in the absence of documentation. So let's talk about some of these warranties and talk about how they allocate risk. The first is express warranties. This is your actual UCC provision. There's no reason to go outside of it. I am telling clients and associates I work with all the time. Don't reinvent the wheel. Use the actual code. You should be paraphrasing, if not just straight up plagiarizing a lot of this in your contract documents. But what is an express warranty? Well, they're obviously for the for the benefit of the buyer. This is the seller warranting something directly to the buyer. And how is it created? It can be any affirmation of factor promise that becomes part of the basis of the bargain. That is exceptionally broad. Those affirmations of factor promise can be in a contract document, but they can also be in a sample of the product. They can be in emails. They can be in sales materials. They can be in discussions between people. If it's not documented as to exactly what is being expressly warranted, it opens the door for the buyer to argue almost anything is expressly warranted. It can be through a simple description of the goods, often which is done by salespeople who are describing the goods in the rosiest language possible so that people will buy the goods. And if that is done and that is, quote, made part of the basis of the bargain, then the seller is suddenly warranting things about their products that they may not necessarily be meaning to. You can see the bottom here under section two, subsection two of two, dash 313. It's not necessary to use formal words. There's no magic language in express warranties. The second section reinforces part one A, that it's any affirmation of fact or promise. So you don't have to say this is a warranty or this is a guarantee. If you simply say, my product will do this, following my product can do this, my product can do that, this is what you're going to get when you buy it. You have made an express warranty as the seller to the buyer, and that is going to allocate some of the risk over the performance of that product to the seller. If that product does not behave or perform as expressly warranted through an affirmation of fact or promise. The risk of that happening is now allocated to the seller and not the buyer. Similarly, we have implied warranties, which are all for the benefit of the buyer. There's no benefit to the seller out of these implied warranties, and they are broad and ambiguous. The first one is the implied warranty of merchantability or usage of trade. And this applies to any good that is sold in the United States unless it is excluded or modified in writing. And we will talk about how to exclude or modify that in writing shortly. But if you do not exclude or modify it as a seller, you are impliedly warranting the merchantability of your product. What does that mean? Well, this Section two, dash 314, Subpart two does give a list of goods to be merchantable. Must be at least such as? And then it goes through the whole list. But what this list really does at the end of the day is mean that the goods have to work. Courts don't really put it that way, but the case law makes it clear that this puts the buyer in a position to say this good just doesn't work. It doesn't perform. I'm not getting what was merchantable because I can't do anything with it. It opens up sellers to claims. It opens up buyers and sellers to disputes because of the ambiguous nature of the definition. And it opens up everybody to spending less time buying and selling goods and more time working with lawyers like me to argue over what it means. It is so broad that under part two C, you can see that to be mergeable these goods must be at least such as C are fit for the ordinary purpose for which such goods are used. And that language is strikingly similar to the other implied warranty, which is fitness for particular purpose. So here where the seller at the time of contracting has reason to know any particular purpose for which the goods are required. So when read any particular purpose, I always think of uh, uh, a pharmacy, right? And off label use of medications. Well, you're good. May be used for any particular purpose for which the goods are required, not just any specific purpose, it's any particular purpose. It can be anything that the buyer is buying it for and that the seller knows. Buyer is relying on the seller's skill or judgment to select or furnish suitable goods. This is almost always easy for a buyer to prove because a buyer is selling and when you're selling. Most buyers and most excuse me, most sellers and most salespeople are promoting their skill or judgment. To help buyers select or furnish suitable goods. And again, it exists unless excluded or modified. And here are the helps you under the next section. And that's when we finally get to a section that starts to help sellers. But again, this one is proactive. It takes work. And here's where you can exclude or modify your warranties. You can exclude or modify the implied warranty of merchantability. You can also exclude or modify the implied warranty of fitness for a particular purpose. If you are a seller and you are not doing this, you are accepting the allocation of risk over these products, your products not working as you intend or hope. You are greatly expanding the scope of possible claims against you. And it's it's easy to avoid. You just need a document that says, as as is helpfully noted at the end of of the first paragraph, quote, There are no warranties which extend beyond the description on the face hereof. Um, you can go on to say under the next section that all implied warranties are excluded by expressions like as is with all faults. I am a big believer in this situation. That belt and suspenders. You should have a form exclusion or modification of the implied warranties that mentions them specifically. That also includes and here's where you just quote, You just plagiarize the statute. There are no warranties which extend beyond the description of the face hereof and says all implied warranties are excluded and these goods are sold as is and with all faults. There's no reason to create new language, to use different language, just use the language in the UCC. And this is the first way that sellers can start to allocate some of that risk back to the buyer. Because once you exclude or modify these implied warranties, the one of merchantability and fitness for a particular purpose, then your only warranty that which you expressly warranted and that is the first step you want to narrow as a seller, you want to narrow your potential liability to that which you expressly warranted. This is what I have expressly told you and promised my product will do and can do. And that is the only thing you can rely on. You don't have to worry about going beyond that if you're a seller. But because this requires actual written documentation, this is the first example where if there's no document to the between the parties on the sale of these goods, or if the document lacks any language about warranties, it's the advantage of the buyer. The second way that happens is through the limitation of remedies. So the limitation or the exclusion of warranties is what are we promising to do? And the limitation of remedies is if we break one of those promises as a seller, what are you the buyer, entitled to? If you do not limit remedies under section two, Dash 718 of the Uniform Commercial Code. You as a seller are opening yourself up to a limitless stream of potential damages. Should your product have a breach of express or implied warranty? That stream of damages is only prevented from going further by your imagination and the scope of your imagination, or the imagination of the plaintiff's lawyer who bring the claims against you. So you have to think of this limitation of remedies in addition to the exclusion or limitation of warranties. So you want to limit the remedies for breach in accordance with these provisions and use this language. First, under 2718, you want to consider a limitation that's just liquidated damages so that you can agree. If our product fails, you are entitled to a limited amount of money or other remedy. Right? Um. Anything that's unreasonably large, just giant numbers thrown out there. Courts routinely refuse. And you want to limit these remedies in the best situation to the repair or replacement of the product. And no consequential special other damages. And that's where we get into the next part of the 2719. Contractual modification or limitation of remedies. The UCC allows you to do it and then tells you how to do it. You may limit the buyer's remedies to return of the goods and repayment of the price or to repair and replacement of non-conforming goods or parts. So all that does is reverse the transaction. Either you give me my bad product back and I give you your money back, or I give you a brand new one. It can be the exclusive remedy. Which again allocates risk away from the seller to the buyer while still protecting the buyer from the basic operational function of the product. And you want there to be an available limited remedy, because if it's transparent, if it doesn't actually exist, if you can't replace the good, if you can't return the money for the good, then that remedy may fail of its essential purpose. And in that instance, it may open you up to all the other damages and remedies that you're trying to avoid through these contractual provisions, in particular, consequential damages. Consequential damages are probably the single biggest item that opens up companies to unanticipated damages and to damages that go well in excess of the scope of your contract. And what I mean by that is you may be a component parts supplier that sells widgets for a dollar a widget, and that widget goes into a product that your buyer and by the way, your profit margin may be 3% and that goes into a product that your customer sells for $10,000 a pop and their profit margins are 20%. But if you leave consequential damages as a possibility, you are opening yourself up to every lost sale they might have, every lost profit. They might have every loss of the business they might have. You are a $1 a pop widget manufacturer with a 3% profit margin, and your customer can easily rack up damages that they will relate to a breach that could put your actual business under threat. So what our consequential damages. They are tough to define. The definition itself is any loss resulting from general or particular requirements and needs of which the seller at the time of contracting had reason to know and which could not reasonably be prevented by cover or otherwise. It's any injury to person or property proximately resulting from a breach of warranty. And again, that opens up an entire world because it doesn't identify them specifically. So it's anything that someone can trace back to the breach of warranty or breach of contract. Here's some examples. Loss of anticipated profits, right? Not revenue. Revenue does not account for the cost basis for the goods. Loss of business. Costs of attempts to repair. Loss of goodwill. Which can be anything I can pay an expert to say it is losses resulting from the interruption of production. So if you deliver a widget, that widget for some reason malfunctions and causes your customer's line to go down and now they're not producing any goods for a day or a week or a month, they can sue you for that as consequential damages. Loss of reputation. Loss of contracts. They lose. You gave me a bad widget and now my customer. Right. Your customer's customer. They're refusing to enter a contract because of it. And your customer blames you. And then other. It can be anything. Anything. Someone can imagine, anything that a lawyer can equate and relate to the breach, anything that an expert can calculate. It's only limited by your imagination. You can exclude these so long as the exclusion is not unconscionable. And most of the time on presentations like this, I'm talking to businesses that are concerned about their business to business contracts. The supply chain agreements unconscionability between two businesses is very rare. It's even more rare in a negotiated contract. It just doesn't happen very much. There are exceptions. For example, there's this 1999 Third Circuit opinion that involved a dispute between two commercial entities. However, one of the commercial entities was a mom and pop gas station and one was Exxon. So not quite Fortune 100 company and Fortune 100 company. Sometimes bad facts do lead to bad law, but it still is useful to remember the issue because what it really means and what the court is getting here is if you're going to use these disclaimers of remedies, these disclaimers of damages and consequential damages, you want them to be clear and conspicuous. And here's one right. You can freeze the video right now, and here's your language for your clear and conspicuous consequential damages waiver. The only thing you could really add to this is if you had more examples of what you might use to limit your consequentials specific things you know that you want to make sure you're not liable for. You can add those and it's it's often good to list the ones that are most obvious to you, the ones you're most concerned about in a non limiting fashion. And this is the paragraph you add to do that, right? Without limiting the foregoing seller specifically disclaims and shall not be liable hereunder for any claims for loss of use or loss of profits, loss income or damage to reputation or whatever else your customer might lose. So it's good to know your customer's business so that you know what it is you want to disclaim. You want to be careful that you might be liable for when you put this together. Another way to allocate risk is to have an overall damages cap. Uh, and this means that no matter what happens, no matter how we, uh, what kind of claim comes up, what kind of dispute we have. I the seller will not be liable for more than. X dollars or some description of liability that you won't exceed, for example, where you are not liable for more than the full value of the contract. Right. And that's that goes back to similar we talked about before a part by part basis where you're limiting remedies to repair or replacement. You're also limiting as a seller, you're allocating the risk so that the risks to you as a seller is no more than the value of your contract. And that really only happens when you have catastrophic failures. But that language is here, right? The total liability of seller, whether arising out of breach of contract warranty, tort, including negligence or strict liability or other theories, shall not exceed 100% of the amounts received by seller from buyer under this agreement for the products. I've seen that further narrowed to in in long term supply agreements that cover, say, three, five or even ten years. That is limited to 100% of the amounts received by seller in one calendar year or for a certain amount of product. You can define it however you want. It needs to be not de minimis. It needs to provide actual value to someone. Otherwise it could be considered to have failed of its essential purpose. And then it's going to open you back up to the full damages. But so you can see. Under warranties for the buyer to get warranties. They don't have to do anything. They just get them. They get express warranties by the negotiations and the paperwork back and forth and the sale of the product. They get implied warranties, literally implied under the law unless they're disclaimed. And everything else that we talked about are things that sellers need to put in their documentation to protect themselves from being open to an unlimited category of claims and an unlimited amount of claims. Another way that parties have to allocate risk amongst themselves in supply chain agreements is through indemnification, which is what is it? People throw this word around. But here's a straightforward old Black's law dictionary definition a duty to make good any loss, damage or liability incurred by another party. You're transferring the risk of loss from one party to another, often? Not always, but most of the time and we think about is related to third party claims. So. I sell this to you or I buy this from you. And if there are third party claims, we agree who's going to defend those? So this is used more often by a buyer than a seller because the buyer says, I'm going to buy your widgets. But if your widgets fail and my customer sues me or some unknown third party sues me, I want you, the seller to indemnify me for that failure. Because it's your product. It's not mine. So as a buyer, this is a provision that you want in writing, put into your agreements to protect you. Right. And what are some of these common indemnities we see for negligence and willful misconduct for breach, IP infringement, failure to comply with the law, and then for personal injury and property damage. These are the most common ones. You typically cannot be indemnified for your own negligence. You typically cannot be indemnified for what some jurisdictions call gross negligence, but for everyday product failures in the supply chain or even service failures, you can get indemnified. It's different from warranty. It offers a different risk allocation and protection. It is a second means of protecting oneself from unknown and open ended claims. It often includes a requirement of a defense. It often includes the recovery of attorney's fees and also expenses. The expenses in the defense can get very expensive, can can really rise expenses for experts and the like. And as we've already talked about, you can really limit the warranty remedies. So if you're a buyer and a seller has good warranty limitations and remedy limitations that you're unable to negotiate out, the indemnification is a way to get protection for some of those same things. But it takes more writing. It takes other considerations. You need to have procedures. You normally need to have notice. And you can imagine if I'm being asked to indemnify you, I want to get notice of that as soon as possible. I don't want you to call me up the day that you're about to start a jury trial and say we've had this claim pending for three years. You have to pay for it. There can be disputes over who controls the defense, who's going to be in charge. People often think, well, if I'm paying for it, I'm in charge. And there is some truth to that. But also it relates to the settlement authority, because if I'm paying for it and I'm in charge, I want to be able to settle. But as one of my clients found out, they had an indemnification related to some intellectual property and they were being defended and indemnified by the party that gave a license to. But that party had decided we don't want to use the intellectual property anymore. And so this lawsuit we're defending indemnifying will just enter a consent decree, consent judgment that. It did. There is an intellectual property violation and we'll agree not to use it anymore. And my client went, Whoa. That's our intellectual property. Your you're going to allow a court to enter an order that we have a problem, and now we're going to have all over the country and there was a vigorous dispute over, well, who's got to pay for that defense then? Who's got an authority on settlement and so on and so forth. The cooperation is also important because if you don't have cooperation from the party that you're indemnifying, you may not be able to defend. So, for example, again, if I'm the supplier and I've put this widget in a larger product that my my customer uses, I may need engineers or business people at the customer. I may need documents from the customer, I may may need all sorts of things that don't have access to. And so if you are going to agree to indemnify, you want to make sure the other party is going to cooperate with you. You're going to want to make sure that you consider these provisions all within the context of your other provisions, because we're allocating risk along all of these areas. So where where will we use that risk allocation and in what ways and how will they overlap? It's okay for them to overlap. You can also include in that requirements to obtain insurance, right? So often one party in a contract agrees that they will obtain liability insurance for the other party of the contract. And how does that liability insurance. Connect with, if at all, this indemnification provision. I was involved in a case where there were an indemnification provision and an insurance requirement, and the other side tried to argue that the insurance requirement covered their indemnification obligation, but the contract didn't read that way. They were two independent and separate obligations. So when my company, my client's supplier. Had a couple million dollars of insurance, but it was a $10 million claim and we fought over whether the supplier had to make the difference up between 2 million and 10 million. And they wanted to limit their indemnification obligation to the amount of insurance they got. In fact, in construction settings in states like Texas, there are specific statutes that govern this, that govern how much someone can be liable for based on insurance requirements and indemnity obligations. And so depending on the kind of contract you're negotiating and the jurisdiction you're in, these indemnification provisions, these insurance provisions, you need to make sure that you're talking to each other and considering the law to understand just what you're agreeing to do and the extent to which you're agreeing to do it. The most popular recent risk allocation provision that was never popular before. Covid is the force majeure provision. I would say that in my career prior to Covid. Force majeure came up maybe once, maybe 2 or 3 times. And once Covid started, force majeure was everybody's topic de jure of risk allocation as parties fought over whether the Covid pandemic was a force majeure situation, and it resulted in a new focus on what had been the most boilerplate of boilerplate provisions, which is important because it's not a legal idea, it's a contract idea. This is not something that is typically found in statutes or laws beyond the laws that are talking about contracts. And so it is something that must be negotiated. And those negotiations depend on your interests. But but what does it do right? It excuses performance by one party or another or both in certain situations to a contract for defined contingencies, right. For those defined forces beyond the control of the contracting parties. Because it's a creature of contract. It can be anything. You can agree to anything as a force majeure. Everybody thinks of the typical ones, right? Act of God. Hurricanes, tornadoes, floods, etcetera. But it's still a creature of contract. So if you don't specifically say what you're talking about, you are not going to have it apply. And because it's a creature of contract and because it is an excuse of performance, it is going to be strictly construed in pretty much every court around the country. So you have to define it. You have to negotiate it. You can't slip it into contracts as much as you used to be able to because it has become a focus of a lot of legal departments around the world. And it is impacted globally, not just, of course, domestically because of the global nature of most supply chains for most major products these days. There are a lot of different things it can be, right? Here's just some examples. You've got your natural disasters, and those are all relatively understood. You've got your plant specific issues fires, explosions, floods, plant causing its own flood power outages, government related. That's where you could get into Covid. Acts of war. There can be real in this day and age. What is an act of war is a very hotly contested and litigated topic because you have governments sometimes allegedly working with non-government entities to attack business through cyber attacks and the like. And whether that's an act of war when there has been no declaration of war is often hotly contested. You have your new one's disease. I don't think I ever saw a disease in a force majeure clause before Covid, and now it is common to put in there. And then you have to think about. Right. An epidemic is a defined term. Typically, a pandemic is a defined term. A public health emergency is something that typically has to be declared. You have to be very careful with force majeure using language that has specific definitions like act of war, um, and understand what they mean. Tariffs again under the government related is a good one because particularly in the past ten years or so, tariffs have had some material impacts on the price of goods, and parties have tried to argue that the tariff is so onerous and the price of the good is so high that it's a force majeure. But if your force majeure clause does not address tariffs, it's not going to be a successful argument. And then you have your other whatever you want, um, strikes is and other labor issues I think are really good ones, particularly now as we see a couple of strikes going on in Hollywood and threat of another strike in the auto industry. Um, typically these have not been considered force majeure unless specifically mentioned because they have to do with a company managing their labor pool. And while these are shocks to the system, as far as managing that labor pool, it's still an issue of just managing your labor pool. What this really means is when you are entering a contract, you basically need to do what my manufacturing clients do when they start to develop a product, and that is to do a failure mode and effects analysis. What sort of grand failure modes could occur and what would be the effect of that failure on my business? Um, given the number of forest fires and extreme weather and other events, how are those going to impact the ability of your facility to operate? Power outages is an interesting one. We haven't had a lot of power outages this year, but of course, we've had them in Texas and Florida and other locations in the past few years. And the intense heat that has gripped a lot of the southern part of the country. That has led to some of my clients having to close down plants. And if you do not have a force majeure clause that specifically addresses plant closure due to weather of one kind or another, then you may find yourself on the hook for product that you can't produce because your plant is closed. At the end of the day, what it really means is you've got to do this failure mode and effects analysis for everything that could affect your business and try and get it into your force majeure clause. Because if you don't list it specifically, it's not going to count as force majeure. You have to consider when you're doing these claws and whether force majeure applies. Is the obligation that's been interrupted. Covered, Right. We just talked about that at length. Does the event that's causing it fall within those described it's similar. Did it actually prevent performance? Does it prevent performance or does it just make the performance more expensive? Right. And that's really the biggest hurdle. You have to show that it makes it. You cannot perform. There's no alternative means. And this happened. We've got two examples in the past ten years. The first was the big West Coast labor dispute that shut down all the ports and all these people shipping product into the United States said, well, it's force majeure. We we are prevented from performing. And the court said, no, you're not. You can air freight. Yes, that is much more expensive, but you are not prevented from performing. You're really just arguing that your performance is now much more expensive. Same thing with the steel tariffs. We talked about tariffs a little bit before. The steel tariffs. Led a lot of raw material to become much more expensive than was contemplated by the contracts. And absent having that specifically spelled out in your force majeure, you are not going to get relief for it. When you have a dispute and you start to have product that you're selling for more money than you're being excuse me for less money than it's costing you to produce. And of course, Covid, same thing. There were very few successful force majeure claims throughout Covid. I think the only thing that really helped people was that since every almost every industry was impacted in almost every way. Companies were forced to work together the best they could, but negotiating leverage for those in lesser positions was thin at best, because force majeure claims were really just not very successful. And we saw this with a lot of suppliers. We all experienced supply chain problems of one kind or another for almost anything and everything we could imagine during Covid. And very few of those were very few of the parties in those supply chains were protected by force majeure provisions, which is why, as we've talked about this, you have different strategies if you're the buyer or the seller. If you're the buyer, you do not want the seller's performance to be excused. You want a narrow set of very specific events. You don't want labor, right? Seller You have labor strikes. Pay your labor force more. Just deliver my product. You want to have prompt notice requirements and you want to define it to a specific duration. This is one of the real challenges with force majeure is, okay, you have a force majeure event, how long does it last? How long are you impacted? How long is it that you cannot perform as opposed to your performance is just going to cost you more than it was supposed to? You want to keep the time to resume performance as short as possible. And you want to be able to terminate if it goes beyond that. Right. It's the. Okay, we're going to excuse your performance supplier of mine, but if this goes on too long, the impact on my business is such that I have to terminate this contract and find a new supplier. So you want to keep that escape hatch provision for yourself and try and keep this entire provision as narrow as possible and keep its duration as narrow as possible. Not surprisingly, if you were the seller, you have the opposite strategy. You want the list to be as broad as possible. You want to just keep adding things to that list and you want to have a catchall that you can argue covers something that happens that you didn't think of. You want to make sure that your performance can be suspended indefinitely until the force majeure event is over. Right. Now, think of that in terms of Covid. If there was a force majeure event that allowed for pandemics. When would that pandemic event be over? Thereby no longer excusing the seller's performance. That can be a difficult thing to define without any specific attention to the detail of it in your contract. It could be very ambiguous. It could leave a buyer open. It could give a seller a lot of leverage. Um, that as a buyer you want to keep. So you really need to be thinking about these not as boilerplate provisions anymore because there are very different strategies as a seller and a buyer. And in fact, if you are a company that is in the middle of a supply chain, so you have both suppliers and customers, to the extent that you use form agreements, you actually want to make sure that you have a form on your buy side and a form on your sell side and you want to reconcile them, right? This buyer seller conundrum, when you do both, you can't have one set of contracts for everything. One of the ways that I see this play out the most is is again related to the warranty provisions we discussed earlier in that as a buyer, you get a two year warranty from your supplier, but then as a seller, you give a four year warranty to your customers. So that warranty is at least in part based on what you're selling, what your suppliers sell to you. And now you have a gap you have committed to four years. You've only received two years during that, during year three and year four, you have an unprotected warranty obligation for which you're not getting the same from your customers. Me From your suppliers. So what if it all goes wrong? What if we get the termination? I think most people do not think of termination as a risk allocation provision. But it is. I have a client right now going through the termination of an agreement, and that termination has put a whole lot of things about their business at risk because it was not thought of in the contract negotiation. And the process has been difficult because terminations are always difficult. Terminations are like divorces, and rarely does a termination end with both sides happy about it. Even if a contract just comes to its defined end, if you have a five year agreement and it just ends. No one renews it, no one terminates it. It just ends. Someone inevitably is not happy about that. Someone is upset that the business is over. Maybe it's the buyer who wishes they were still getting product at the price that they were before. Maybe it's the seller who's lost a key customer of theirs to impact their balance sheet and their bottom line, but somebody is unhappy when that termination happens. So what do you do about it? Well, you pay a little more attention, your termination provisions. You start with making sure that you draft them with an eye towards a smooth transition and with defining a specifically as possible. Why you might terminate. The most common is for breach of the agreement. But you have to understand what what constitutes a material breach. Things go wrong with agreements all the time. Right? We have lengthy relationships that last years that relate to millions of individual products, if not more. Um, and there's lots of things that go along the way and people make mistakes. Shipments get missed, one bad product goes out, there's warranty rates, so on and so forth. What is a material breach? What materially impacts the contract? You've got to think about what sort of notice is required that you want to require, how much notice. I see in a lot of these agreements things like 30 days notice. But then in practice, when the issue comes up, 30 days is not nearly long enough to work through the various things that need to occur after that notice takes place. Um, I've seen provisions that had a 30 day notice and cure period that also required the parties to participate during the notice period in executive discussions and mediation. And getting all of that done in 30 days is almost impossible, given schedules, people, schedules of lawyers, schedules of mediators, schedules of executives. You have to think about how these things will practically play out. And typically, if there's an opportunity to cure the material breach, you got to give somebody the opportunity to cure it. There may be a material breach. Your supplier might say, Yep, absolutely. Got a material breach, but I can fix that and here's how I'm going to fix it. And then everybody shakes hands and they're happy. Or you get a buyer who gets behind on payments. And it's enough that the number of payments is a material breach, but there's an influx of cash and they can cure it within a reasonable period of time that everyone agrees to. And then you move on and everybody's happy. So you have to think about these in your clauses, right? You want to have something like this sample where in the event of a material breach by the other party, either party may terminate this agreement by written notice specifying the material breach. That's important. You want to make sure that when someone is going to terminate, they have to tell you this is specifically the material breach that you had in my practice. What I like to do is I like to reference the precise provision or provisions of the contract that have been materially breached and. What about them were materially breached? For example. The contract requires you to pay within 30 days. Right. You have the last six payment and that's. Excuse me. Section nine and the last six payments have all come in 50 days. 50 days when it should be 36 months in a row. That is a material breach of the contract. And then the other side's got the right to cure it if it's curable. Now, the example I gave, one side may argue that's not curable unless they can do something to ensure that the the they have new procedures in place that will prevent it from happening in the future. But it needs to be cured. And then in the event that such cure is not made within the period. And upon expiration of the cure period. This agreement will terminate. Now, I think a lot of companies treat this period. As a negotiation period. And I understand that. And for business, that's often very much the best way to go. But you should definitely dual track your use of this period, not just to negotiate and work with your business partner, but also to make sure that you are simultaneously trying to honor the provisions of the termination in the agreement. Because if you don't if you don't think of this from a dispute standpoint until after you're outside of this cure period. You who have failed to cure. Whether you are the buyer or the seller, you will lose almost all of your leverage in those ongoing negotiations. If you think of this 30 day period, if you think, well, this doesn't really become a dispute until I get to day 31. Well, on day 31, not only are you at a dispute, but you've lost your negotiating leverage. So you need to use that leverage before the cure period is over. And you need to cure documenting not just what provision you've cured, but how you've cured it and how the material breach no longer exists. The more detail you can provide, the better. Um, it's better to do that than just send a check. If someone says it's payment is owed, particularly if there's a dispute over how much payment because you want to set yourself up later to argue that you cured. And it's much easier to do that if you document it at the time with specificity. You can also, of course, terminate for convenience, but terminating for convenience. Which is the ability to terminate for no reason. This is a unilateral right and it's going to impact the value of the contracts you enter if you're the one getting paid. Right. If you're the supplier and you enter a ten year agreement and you count on your business to have that ten year agreement, but the buyer has a termination for convenience, right? Your contract is unlikely to be worth ten years of sales. You definitely want a longer notice period if you have a termination for convenience as opposed to breach and you want to have protections for excess and obsolete inventory for capital investments you've made. Um, I've seen plenty of situations where supplier enters, uh, a 5 or 10 or even longer year contract. They, of course make millions of dollars in capital investments to service that contract, but they allow the other side to terminate accordingly. Similarly, even on a shorter contract, two years, there could be a big capital investment, in part because the supplier is counting on the ability to renew that contract. Um, and it's important that you have provisions in your agreement that address that so that the, the supplier can't later come back and say, no, no, no, no. We we spent millions or tens of millions preparing to do this and we need you to pass that money back because we're not getting the value of our out of our contract. If you're a buyer, you want a real simple paragraph. Write Buyer may terminate this agreement for convenience by providing x days, months, weeks, advance written notice supplier. If you're the supplier. That means you may have just entered a long term agreement, but you cannot count on an existing longer than that termination provision because the buyer can always choose to leave for convenience. It is a huge amount of risk to put on the supplier. It can exist the other way. The supplier can do that. The buyer and a lot of the same issues arise. If you're the buyer, then you want to make sure that you have provisions that help you in finding a new supplier so that you are not finding yourself without products that you need to incorporate into whatever you're making to sell it to end users or to other companies. You need to make sure that there's a transition. Right? And and that's where this whole divorce comes in. The the the notice of termination is sort of the or notice of breach is really the I'm filing for divorce. And then everything that follows is negotiating your divorce agreement. And the more that you think about this up front, the more you will be protected later. You have to think about these termination provisions as kind of your prenuptial agreement. Um, the more that they address these issues, the less you have to address them later because you you want to consider what provisions will still exist following the termination. Right? You may have confidentiality provisions. You may have intellectual property at issue. You may have all sorts of things that you want to make sure you're protected, either as the seller or the buyer. Right? If you're the buyer, you may have to share confidential information about how your products work with the seller so that they can sell their products to you and you don't want them sharing that confidential information with anyone after there's a termination. If you the seller, you may have the same situation, right? You may. You've got confidential information about, say, the costs. You don't necessarily want your cost to be public knowledge. And so you want to make sure that your confidential information is preserved and protected on an ongoing basis. And there's a slew of provisions that this normally applies to inform agreements. But you want to look at your entire contract and you want to look at your entire business relationship and think about, okay, after we're not doing business together and there's almost always an after, we are not doing business together. Very few companies do business from day one in perpetuity. So it shouldn't be contentious to talk about. All right, someday we may not do this together. Some day you may have a new customer. I may have a new supplier. What are we going to do? You need to know the rights and obligations that are triggered by the termination. What do I have to do post termination so that I'm not in breach creating new claims? What do they have to do? What's going to happen with the supply chain? How is it going to transition? How am I going to transition the product I have? What can I do with it? Oftentimes, we have exclusivity provisions in agreements, and if the buyer suddenly terminates and I have inventory as the seller and there's an exclusivity provision, either the buyer should have to buy that product post termination or I should have the right to sell it to someone else if I can. But I certainly don't want to be left with it as a supplier on highly manufactured products that require specialized tooling. Who owns it? Who owns the tooling? Oftentimes I hear people say, Well, I paid for it, so I own it. But not everybody always agrees with that, particularly when the tooling can be held hostage at one at either the buyer or the seller. So what happens to the tooling? Who has the right to it? Who should get it? Where is it? How is access obtained? If it's being financed, who has the obligation to pay for the rest of the financing? These are all provisions that the parties have to consider so that they can smoothly terminate their business relationship, shake hands and wish each other the best without interrupting either of their businesses. It's that. As friendly as possible. Divorce that you want to get. Here. We've talked about how each of these provisions allocate risk amongst amongst the buyer and the seller. But here we're really talking about allocating risk for the benefit of both. Right here, the allocation of the risk is to eliminate it, eliminate the risk of interruptions in supply and eliminate the risk and interruptions of sale, eliminate the risk for each other as much as possible. And think when companies come at it from a mature perspective and they recognize that someday they will probably not be doing business together. They can have open and honest discussions about the best way to resolve things when they go wrong for both their benefit, in fact. Most people listening to this, you've probably negotiated a new contract in the past couple of years because you were moving from one supplier to another. So the idea that in doing that with your new supplier, you're never going to terminate your relationship is just not realistic. Um, so with that, I've reached the end. Um, it's a little bit information about me, but thank you for the time and the effort listening to this. Again, these are provisions that should help you to allocate risks fairly based on who's getting the benefits and who has the burdens under your supply chain contracts. So that when do you think when things do go wrong and I promise you they go wrong? I've been doing this since 1996, and I couldn't do it for this long and probably do it from now until I retire if things didn't routinely go wrong. When those things go wrong. The more you've thought about them in advance, the more you've documented them, the less uncertainty you will have, the less money it will cost you when they go wrong, and the less you will have to spend time locked in conference rooms with litigators like me, trying to figure out the best, most efficient way to get out of it. Thank you very much for your time.

Presenter(s)

JS
Jeffrey Soble
Partner
Foley & Lardner LLP

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