Risk Mitigation in Supply Chain Contracts: Protections for Failure to Perform
Date: May 11, 2020
Across the world, the business interruptions caused by COVID-19 and related shutdown orders have forced many companies to adapt and others to fold entirely. As some businesses struggle to stay afloat, contracts with those in their supply chains may hang in limbo. If your company has not been affected already, it will likely face similar issues as shutdowns continue and insolvencies begin to rise. Insolvency, other financial issues, and business slowdowns and changes could hinder your customers’ or suppliers’ abilities to perform under existing contracts, and it’s important to understand your rights and obligations in this situation.
One main purpose of any contract is to provide some assurance that the parties will perform as agreed. But as many businesses face economic hardships, you may wonder about your customers’ or suppliers’ abilities to fulfill their contractual obligations. Fortunately, in these uncertain times the Uniform Commercial Code (UCC) provides some protections for transactions involving sales of goods (not services) in the United States, and the United Nations Convention on Contracts for the International Sale of Goods provides parallel protections and remedies for global supply chains. Here are some questions to consider.
Did a customer or supplier “anticipatorily repudiate” the contract?
UCC § 2-610 addresses “anticipatory breaches” or “anticipatory repudiations,” situations in which a customer or supplier, either by words or actions, indicates that it cannot or will not comply with its contractual obligations before the time for performance is due. For example, a supplier may tell you that it will not deliver goods unless you are willing to pay a higher price. Or it may stop manufacturing certain products you agreed to purchase to focus on other products or projects, like hand sanitizer or face masks. Or a customer tells you it can’t meet the agreed payment terms. Whether any of these actions constitutes an anticipatory repudiation is highly fact-dependent and hinges on the circumstances and language that the customer or supplier uses when expressing its intent to not perform. For example, a delivery delay is usually not an anticipatory repudiation unless the contract contains a “time is of the essence” clause.
It is critical that anticipatory repudiation be based on more than mere uncertainty. An anticipatory repudiation exists when a reasonable person can conclude that its counterparty cannot or will not perform under the contract based on the counterparty’s overt acts or communications. For you to show that an anticipatory repudiation exists, the customer or supplier must have overtly acted or communicated in a way that substantially impairs the contract’s value and renders its performance reasonably impossible or that demonstrates its intent not to perform or continue performing when performance is due. A party’s general financial trouble is usually not sufficient, but some courts have found that issuing a notice of a plant closure was enough to constitute an anticipatory repudiation.
An anticipatory repudiation gives you rights even before a breach occurs. You may, in all cases, suspend your own performance. You can also either await the supplier’s or customer’s performance or cancel the contract and resort to the remedies available for a breach. However, because it is often unclear whether a party can or will perform under the contract, you can quickly become the breaching party if you wrongfully conclude that there has been an anticipatory repudiation. To avoid this risk, the UCC allows you to demand “adequate assurance” that the supplier or customer will perform as agreed.
Can you demand “adequate assurance” of performance?
If you believe that a customer or supplier has anticipatorily breached your contract or are otherwise concerned about whether it will fulfill its contractual obligations, under UCC § 2-609, you may have the right to demand adequate assurance of performance and, if commercially reasonable, suspend your own performance until it is provided.
Before you can demand adequate assurance, you must have “reasonable” grounds to be insecure about the other party’s performance, which requires a fact-specific analysis. For example, reasonable grounds for insecurity usually exist when a customer or supplier requests an accommodation or modification of the contract terms, such as changing time or place of delivery, substituting materials or ingredients used, or amending payment terms. In that sense, although certain conduct might not rise to the level of anticipatory repudiation, it could be a basis to request adequate assurance.
Your demand for adequate assurance must be made in writing. It should trace and cite the language from UCC § 2-609 and unequivocally state that it is a demand for adequate assurances – merely raising concerns about the other party’s ability or intention to perform is not enough. The demand should also state the specific basis for insecurity, indicate what assurances are being requested and provide a reasonable time to respond.
The supplier or customer can respond and potentially cure its anticipatory breach by, for example, indicating that it agrees to comply with the original contract terms and providing the documents requested (if any) that demonstrate its ability to perform. However, if the supplier or customer fails to give the assurances requested, you can provide written notice that the assurances are inadequate and you are treating the contract as cancelled.
You should also closely review your contract to determine if it specifically addresses what types of events can create insecurity, the time allowed to respond to a request for adequate assurance and the standards for determining whether assurances are adequate.
Can you refuse to deliver goods to or reclaim goods from a customer?
If a customer breaches its contract with you, the UCC also provides seller-specific remedies, including the right to refuse or stop delivery of the goods under UCC § 2-703(a). You can even refuse delivery if the buyer repudiates the contract.
A seller can also reclaim goods from an insolvent buyer after the goods have been delivered and accepted. However, under UCC § 2-702(2), the transaction must be for credit (where no cash is simultaneously exchanged) and the customer must be insolvent at the time it receives the goods. If those two conditions are met, you can send a written demand for reclamation within 10 days of the customer’s receipt of the goods – or longer if it has filed or files bankruptcy. However, your right to reclamation against an insolvent customer does not apply if the customer has already sold the goods in the ordinary course of business to a good-faith buyer. The right of reclamation is an exclusive remedy.
Once a customer files for bankruptcy, you lose your right to collect or attempt to collect on invoices and debts that pre-date the bankruptcy filing. You are also generally limited to recovery through the bankruptcy claims process along with all other creditors. In fact, certain payments a customer makes during the 90-day period before a bankruptcy filing may be challenged as preferential, and you may be required to return all or part of the money, depending on the circumstances. Fortunately, the UCC gives you some protections before a customer files bankruptcy and even during the 90-day preference period.
FOR MORE INFORMATION
For more information, please contact:
Kip T. Bollin
Stephen J. Butler
David S. Forsh
Sean A. Gordon
Laura Watson Schultz
Louis F. Solimine
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