How to mitigate the impact of inflation and supply chain disruptions on commercial contracts
03 February 2023
These are undoubtedly difficult times for businesses. Supply chain disruptions that emerged following the pandemic have contributed to a burst of global inflation which has led to record increases in costs such as energy, wages and transportation as well as higher interest rates.
These issues have, and will no doubt continue to have, a considerable impact on commercial contracts which may become unprofitable or difficult to perform. Tensions between contracting parties are also likely to increase as manufacturers and suppliers seek to increase prices to cover additional costs. Buyers, however, will want certainty and not to pay more than budgeted.
What can parties do?
As always, it is important to know your contract and be pro-active by reviewing and checking its terms. Read more in our article about “The importance of pro-active contract management in an economic downturn”.
Some contracts contain mechanisms which may assist in combatting economic pressures, such as permitting a supplier to unilaterally adjust the price via indexation or providing for some sort of price review in certain circumstances. It is important for suppliers looking to engage such provisions to fully justify any increases or reviews and comply strictly with the procedural requirements under the terms of the contract.
A buyer on the receiving end of an attempt to adjust the price should check the terms of the contract carefully to ensure that there is a right to do so and that it has been exercised properly by the supplier. Buyers can also look for other ways to mitigate any price increase. For example, the terms of the contract may allow flexibility to reduce order quantities, to reduce costs and/or seek a more cost-effective supplier elsewhere.
What can you do if the terms of the contract do not assist?
If the express terms of the contract do not assist with mitigating the impact of inflation or supply chain disruptions, it is unlikely that a term, such as a price increase, could be implied into the contract. In the case of Marks & Spencer plc v BNP Paribas Securities Services Trust Company (Jersey) Ltd, the Supreme Court adopted a restrictive view of the circumstances in which a term will be implied into a contract, emphasising that the court should only do so where the term is so obvious that it goes without saying or is necessary for business efficacy. The Supreme Court suggested a term can only be implied into a contract if, without the term, the contract would lack commercial or practical coherence. It is difficult to see how a term such as a price adjustment could meet this high threshold.
A commercial negotiation is, therefore, likely to be the most sensible option. Whilst there may not be a right under the terms of the contract to adjust the price or vary the terms of the contract, it will be in the parties’ best interests in most cases to try and maintain the commercial relationship and ensure that the contract remains viable going forwards by avoiding performance issues.
Suppliers seeking to negotiate a price increase should justify their request by providing supporting evidence and showing that they have considered other ways to mitigate the difficulties that they have been facing. It is also sensible to consider other potential ways to incentivise the other party to accept such changes. For example, would the other party be prepared to agree a price adjustment to extend the duration of the agreement or the quantity of the goods/level of services provided?
A buyer on the other side of such a request should satisfy themselves that the request is in fact related to the difficulties the other party is supposedly facing and not just an attempt to increase its bottom line. It is good practice to seek detailed calculations in support and require the party to demonstrate how much their costs have increased above expectations. A party contemplating agreeing to a price increase should also consider imposing conditions, such as providing for the price to revert back to the original if specified conditions are met or in certain circumstances.
Click here to read more about how to ensure that any variation to the contract is binding.
Can you terminate a contract for non-performance?
Despite best efforts to cooperate, preserve contracts and maintain business relationships, some parties will undoubtedly find themselves in a position where either they or their counterparty will be unable to perform their contractual obligations and will be in breach of contract. As a result, many businesses will want to know whether commercial contracts can be terminated as a result of such breaches.
Once again, it is important to check the terms of the contract carefully to ascertain the scope of termination rights. There may be a right to terminate for convenience, or by simply giving a period of notice to the other party without having to assert or prove a breach. Typically termination rights mid-term only arise if the other party is at fault. This commonly includes a right to terminate for “material”, “substantial” or, more rarely, “any” breach of contract. Absent a definition in the contract, it may only be possible to assess whether the particular breach would trigger a right to terminate by looking at previous decisions of the courts.
Any right to terminate for breach may only be exercisable after the defaulting party has been given a period of time to remedy their breach. If there is a ‘remedy’ or ‘cure’ provision, it will typically require the innocent party to serve written notice identifying the breach and requiring the party in breach to remedy the position within the time specified. If the breach is not remedied within that period, then the innocent party may be entitled to serve a further notice terminating the contract. ‘Remedy’ or ‘cure’ clauses should be complied with strictly, otherwise an innocent party may find that an attempt to terminate fails and they may be in repudiatory breach of contract.
In addition to any express provision for termination for breach, an innocent party should also assess whether the breach by the other party entitles them to terminate the contract under common law. Unless excluded by clear wording, a party will have a right to terminate a contract if the counterparty commits a ‘repudiatory breach’, namely a breach which is so serious that it deprives the innocent party of the substantial benefit to which it is entitled under the contract. A statement or conduct by one party which demonstrates its inability or unwillingness to perform its contractual obligations could amount to a repudiatory breach, entitling the innocent party to treat the contract as at an end and itself discharged from its own future obligations under the contract.
Can you escape a contract that is no longer economic to fulfil?
In the absence of any express rights to terminate under the contract or common law, a party is likely to find it difficult to escape a contract without facing consequences.
The contract may contain a force majeure clause which typically excuses a party from performance of a contractual obligation if any of a specified list of events outside a party's control prevents it from performing that obligation. If a force majeure clause is triggered, a party may be entitled to terminate the contract without incurring liability to the counterparty. Force majeure has no recognised meaning under English law and instead has the meaning given to it by the parties under the definition in the contract and so a party should check whether there is a force majeure clause and, if there is, the precise wording.
Whether a force majeure clause will assist a party looking for a way out of a contract will very much depend on the facts. It is unlikely, however, that rises in inflation, general market volatility or the mere fact that the contract is now loss making will be deemed a force majeure event. It is well established under English law that a change in economic or market circumstances, affecting the profitability of a contract or the ease with which the parties' obligations can be performed, is not regarded as being a force majeure event.
In rare circumstances the doctrine of frustration may apply. This will only be the case where the performance of the contract has become physically or commercially impossible as a result of an unforeseen event beyond the control of the parties, or where the contract has been rendered radically different to that envisaged by the parties at the time they entered into the contract. If the contract has been frustrated, then it is automatically terminated. As with force majeure, the doctrine of frustration is unlikely to apply just because a contract has become uneconomical because the doctrine is only triggered in the event performance is impossible. Also, whilst changes in economic conditions are unexpected, they are unlikely to be entirely unforeseen (Gold Group Properties Ltd v BDW Trading Ltd  EWHC 323 (TCC)).
The following practical tips represent good practice for parties who are facing supply chain disruption within the current economic climate:
- Check the terms of your existing contracts and consider if there are any provisions which may help combat economic pressures (read more in our articles about “The importance of pro-active contract management in an economic downturn” and “Contractual ways to improve cash flow”).
- Consider entering into commercial negotiations with your counterparty at an early stage in order to get the contract back on track (you can read about whether contract amendments made during an economic downturn are binding here).
- Where you are considering terminating a contract, check your rights to terminate, adhere to any remedy or cure provisions and ensure that any termination notification complies with any express terms of the contract.
We have created an initiative called “LS Unlock” to help businesses access legal advice during the uncertain times ahead. LS Unlock comprises a free initial assessment of significant commercial claims together with a menu of alternative fee arrangements which can reduce and, in certain cases, eliminate the upfront cost of pursuing a claim. This initiative has been designed specifically to assist clients in this uncertain economic climate.
Also in our economic downturn series…
Commercial dispute resolution: navigating the economic downturn06 February 2023
After-shocks of the COVID-19 pandemic, the war in Ukraine, sky-high inflation, “mini-budget” fiascos and the revolving door of number 10: as we settle into 2023, many of the political, humanitarian and economic events of 2022 and beyond continue to have a huge impact on businesses grappling with uncertainty and financial instability.
Post transaction disputes: bringing warranty claims – key considerations03 February 2023
The current economic climate may mean that recent purchasers of companies are looking to achieve an after-the-event price reduction, especially where the value of the company they have purchased may have fallen. One way of doing this may be to make a claim under the warranties in the share sale and purchase agreement (“SPA”).
Are contract amendments made in an economic downturn legally binding?03 February 2023
Performing obligations in commercial contracts in the current downturn is a serious challenge for some businesses. Sometimes that challenge will be so great that it is the catalyst for a breakdown of a business relationship. But where there is a common desire to get through these tough times, the focus may be on how contractual terms might be varied to ensure that both parties are able to survive.
How can I recover unpaid debts?03 February 2023
Even without a difficult economic landscape, establishing a strategy to recover a debt can make the difference between sitting comfortably and struggling through. It’s important to be aware of the different routes to recovery – and their limitations. Use this overview to understand your options and which option is best for your circumstances.
Dealing with a counterparty who is facing insolvency03 February 2023
There’s been widespread coverage of the impending economic downturn. The pressures of the war in Ukraine, the consequential energy crisis, high inflation and labour shortages have combined to create forceful economic headwinds.
Contractual ways to improve cash flow03 February 2023
It’s been a challenging couple of years for the UK economy. Businesses have had to grapple with Brexit uncertainty, the Covid-19 pandemic and the Russian invasion of Ukraine all affecting trade. These have in turn resulted in higher costs, compounded by inflationary pressures.
The importance of pro-active contract management in an economic downturn03 February 2023
Efficient contract management is an essential part of running any business. This is never more important than during times of economic uncertainty when businesses need to keep a close eye on contract performance, regularly review and monitor whether contracts still meet the business’ changing requirements and remain vigilant to the key indicators of potential failings or breaches.