One of the best ways for a manufacturer to assess and reduce risk in its supply chain is to have in place strong legal terms with its suppliers.

Yet due to the speed of modern technology and growing complexity of supply chains, the reality of the manufacturing landscape is that legal terms aren’t always properly memorialized on paper as the manufacturer-supplier relationship develops.

That said, it remains important — perhaps more now than ever before — for a manufacturer to assess its relationship with a supplier at the beginning of the relationship, and execute any needed agreements to mitigate risk as the relationship unfolds.

The five tools discussed below will help guide a manufacturer in assessing and mitigating supply-chain risk.

Tool No. 1: Thoughtful use of master supply agreements vs. terms and conditions. When trouble arises in a relationship with a supplier, one of the first questions is “What does the contract say?” In a perfect world, the manufacturer and its supplier will have both executed a master supply agreement, or MSA (and corresponding statement of work) that sets forth comprehensive terms governing the sale of goods by the supplier to the manufacturer. In such a case, identifying the terms in place between the parties is as simple as reading the MSA.

While the MSA provides the most predictability in a supply relationship, and its use is the best practice from a legal perspective, it’s not always realistic from a business perspective. MSAs take time and money to negotiate, which may not be practical when contracting with a supplier for a one-time purchase of low-risk products.

Enter the terms and conditions (T&Cs) of purchase. Purchase T&Cs cover many of the same legal concepts as MSAs, albeit typically in an abbreviated form. Purchase T&Cs are seldom negotiated and are often located on the back of a manufacturer’s purchase order, or incorporated into the purchase order by reference to a website link. While this approach is common because of its ease and speed of use, using the purchase T&Cs in lieu of an executed MSA is not without cons. First, as mentioned, purchase T&Cs often don’t cover terms as comprehensively as MSAs. Even riskier than that, they’re subject to the “battle of the forms.”

Because purchase T&Cs aren’t usually signed by the supplier, whether they are enforceable is determined by a fact-based analysis that will turn largely on whether each party sent the other party its standard terms, whether they were properly drafted, and when they were sent. If the manufacturer sends its properly drafted purchase T&Cs and the supplier sends its properly drafted terms and conditions of sale, or sale T&Cs, what then occurs is a “battle of the forms” where the two parties’ forms “battle.” In the process, the terms that are inconsistent fall away, and those that are consistent, along with the gap-filler terms of the Uniform Commercial Code (UCC), govern. The contract is then formed based on the conduct of the parties, such as shipment and acceptance.

Therefore, a manufacturer that seeks to use a properly drafted purchase T&Cs must ensure that it’s armed for battle by sending it to the supplier before the goods are shipped. Otherwise, the manufacturer runs the risk that only the supplier’s sale T&Cs govern the transaction. Even if the manufacturer does timely send its purchase T&Cs, if they don’t contain language objecting to the sales T&Cs in line with UCC 2-207, the manufacturer still runs the risk that the sales T&Cs will govern.

Notwithstanding the manufacturer timely sending well-drafted purchase T&Cs, when trouble in supply-chain paradise arises, and the question of “What does the contract say?” is asked, identifying which terms governed the sale of goods by the supplier to the manufacturer without a signed agreement in place is a time-consuming process with muddy answers.

Tool No. 2: Thorough delivery-delay provisions. A delay in the shipment of important goods can stall production and endanger customer relationships. If the manufacturer has thorough delivery-delay provisions in place, such as those listed below, the blow of a delayed shipment can be lessened.

Notice of Delay

A valuable provision to include in the delivery-delay section of an agreement is to require the supplier to issue written notice of a delay, including written notice of any anticipated delay. This permits a manufacturer to begin its contingency planning early. The provision should expressly state that such notice does not relieve the supplier from responsibility for the delay.

Time Is of the Essence

A best practice for drafting actionable delivery contract terms is to ensure that delivery time is “of the essence” under purchase orders. “Time is of the essence” is a term of art in legal parlance, where the failure of a delivery to be made on the specified date results in an incurable material breach of the contract (although variations exist in case law interpretations of the phrase).

Non-Exclusivity

Where leverage permits, the manufacturer should seek to maintain non-exclusive relationships with its suppliers (that is, it can purchase the goods from that supplier or others, or manufacture the products itself). This permits a manufacturer to avoid a situation where it has a sole-source supplier with delivery delays, and no other quickly available option for procuring the needed goods. Having multiple suppliers of the same good, preferably in separate geographical regions, permits a manufacturer to be nimble when one supplier runs into troubles ( such as force majeure events, insolvency, and raw material shortages).

Where the relationship is exclusive (that is, the manufacturer is only permitted to purchase the products from that supplier), then the supply agreement should set forth explicitly that the manufacturer has a right to purchase from alternative suppliers in the event that the supplier is unable or unwilling to meet the manufacturer’s order requirements (even as a result of a force majeure event).

Force Majeure

While force majeure clauses are standard in supply agreements, a manufacturer should train a careful eye on these provisions. If drafted too broadly, they can excuse liability for a supplier’s delay in delivery in circumstances that shouldn’t rightly be covered by a force majeure provision. For example, equipment breakdown, raw material shortages and labor strikes are often among the listed events that excuse a supplier’s liability for delay. However, these are arguably not beyond a supplier’s control but can be managed, and mitigated against, with careful planning and foresight. 

With current global events, a manufacturer might also consider conducting an audit of its major supplier contracts to see if pandemics, disease, quarantines and climate change are among the events that could be used as a basis to avoid liability for non-performance under the contract. A manufacturer might also seek to include a provision requiring allocation of short supply to the manufacturer.

In addition to these concerns, manufacturers should consider modifying force majeure clauses to capture the imposition of economic sanctions, export controls, or other restrictive trade measures that prohibit the performance of the contract within the definition of “embargo” or “governmental action.” Taking this step demonstrates that the manufacturer and its counter-party considered such risks and freely agreed to them. This can provide a freedom of contract defense against breach of contract claims, and reduces the likelihood that foreign courts will reject force majeure arguments on “public policy” grounds. We discuss these restrictive trade measures in greater detail below.

Liquidated Damages

A particularly aggressive approach often taken by manufacturers with leverage is to impose liquidated damages in the event of a delivery delay. Liquidated damages can take the form of a flat fee per day or per week in which the delay continues. Another common approach is to tie the damages to a percentage of the price of the delayed goods. Be careful here; there are a number of ways that a liquidated damages provision can be rendered unenforceable by a court, so if a manufacturer intends to rely on this provision, it should be drafted by counsel that has familiarity with these types of provisions.

Tool No. 3: Strong defective product provisions. Say that the goods arrived, but are defective. What’s a manufacturer to do? If it has strong defective-product provisions in place, the damage to the manufacturer in connection with the defective goods will be mitigated. Some key terms are outlined below.

Rejection of Product

From the manufacturer’s perspective, rejection provisions should state that the goods will not be accepted until inspection, evaluation, and testing by the manufacturer or its agents at the manufacturer’s facility. Manufacturers should avoid deadlines for having to accept or reject the good, but if one must be imposed, the deadline should align with the time the manufacturer requires to evaluate a good for defects in its projected busiest times. Manufacturers should include contract provisions which state that acceptance prior to discovering a latent defect does not cause a manufacturer to waive its rights with regard to any remedies related to such latent defects. A manufacturer would also be wise to point out that payment does not, by itself, constitute acceptance of the goods.

Warranties

If a defect or non-conformance in the good arises after the goods have been accepted, the manufacturer will look to its warranty rights if the goods are still within the warranty period provided by the contract. Some of the most common warranties are that the goods will:

• Conform with product specifications and samples;
• Be free and clear from all liens and encumbrances with good and merchantable title;
• Be free from defects in design, material and workmanship (latent or otherwise) and of good and merchantable quality;
• Comply with, and have been produced, processed, packaged, labeled, imported and/or exported (if applicable), delivered and sold, and be capable of operating in conformity with all applicable laws;
• Be new, not used, refurbished, or reconstituted;
• Be fit for the use intended by manufacturer; and
• Be manufactured by adequately trained, properly supervised personnel, in a good, timely, professional, and workmanlike manner, and in accordance with the best practices in the supplier’s industry.

Remedies

A manufacturer-friendly remedies section will allow a manufacturer to choose as a remedy for defective and non-conforming goods either repair, replacement or refund, at the manufacturer’s option, in addition to all other remedies that such manufacturer is entitled to under the agreement, applicable law, or otherwise. It would also permit the recovery of consequential damages (such as customer fines, and lost profits) that result from such defective or non-conforming product.

Symmetry With Customer Obligations

A manufacturer should seek to ensure that the obligations it is undertaking in its agreements with customers are backed up by the rights it is receiving in its agreements with suppliers. For example, if a manufacturer is warranting to its customer that products do X, Y and Z, then the manufacturer should ensure that the suppliers of its products are doing the same. As another example, if a manufacturer’s sole and exclusive remedy for a defective product from its supplier is replacement of the product or a refund of the purchase price, then the manufacturer should ensure that its agreements with customers correspondingly limit the manufacturer’s responsibility.

Tool No. 4: Comprehensive product recall provisions. Another legal tool to house in a manufacturer’s toolbox is a set of comprehensive product-recall provisions. First, in order to assess the risk of recall, it’s imperative that the manufacturer require the supplier to provide written notification if the supplier becomes aware of circumstances that a stop sale or product recall may be necessary under applicable laws or otherwise. Under product-recall provisions, the manufacturer should have the sole right to determine whether to institute a recall.

One more important decision to make is to determine how the cost of the recall should be allocated. A manufacturer with leverage will require a supplier to shoulder the entire burden of the recall cost if the recall arises from the supplier’s breach of the agreement, negligence, or intentional misconduct. A less straightforward approach would be to require the supplier to negotiate with the manufacturer as to an equitable division of the costs.

Product-recall provisions should not be considered in a vacuum, though. They are heavily supported by the following terms:

• Audit. Manufacturers can sometimes get ahead of a recall by exercising their rights under the audit provisions that they have in place with the supplier.
• Indemnity. Manufacturers should require that a supplier indemnify the manufacturer at least to the extent that the recall was caused by the supplier.
• Consequential damages disclaimer. Manufacturers should ensure that recall costs for which the supplier is responsible are carved out of any mutual consequential damages disclaimer that the parties have agreed to.
• Insurance. Manufacturers should ensure that suppliers have adequate insurance to cover any recalls that the supplier causes. Product-recall insurance should be given extra thought in terms of coverage limits.

Tool No. 5: Use of strategies to mitigate international exposure. Finally, manufacturers engaged in international sales and shipments should take steps to ensure that these transactions comply with U.S. and other restrictive trade measures. Notable examples of trade measures include the various economic sanctions programs administered by the U.S. Department of State and U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”), as well as the military and commercial export control laws enforced by the Department of State’s Directorate of Defense Trade Controls (“DDTC”) and the Department of Commerce’s Bureau of Industry & Security (“BIS”). Many of these laws operate on a strict liability basis, with U.S. government enforcement agencies conducting broad-ranging investigations and imposing substantial penalties for unintentional infractions. So even though violations tend to be rare, the legal, financial, and reputational consequences can be severe.

There are several important areas of risk implicated by trade measures. Broadly, those areas are as follows:

• Economic sanctions. The risk of economic sanctions are compounded by the broad scope of U.S. jurisdiction. As a general rule, OFAC sanctions apply to any manufacturer that is incorporated or physically present in the U.S., including its employees. These restrictions “flow down” to foreign-incorporated subsidiaries. Foreign-incorporated manufacturers that have no presence in the U.S. can also trigger OFAC’s jurisdiction by using the U.S. financial system, engaging in U.S. dollar-denominated transactions, or by asking U.S. citizen employees located outside the U.S. to participate in transactions prohibited under U.S. law. So-called “secondary sanctions” are even broader, allowing the U.S. government to target foreign-incorporated manufacturers that conduct business with certain Iranian and Russian entities, even if the transaction doesn’t otherwise implicate U.S. jurisdiction.
• Export controls. Another area of risk is posed by inadequate compliance with U.S. export control laws, which cover any item made in the U.S., shipped from the U.S., or that contain de minimis amounts of U.S.-origin content. These rules apply equally to products, software, technology, and technical data. The broad scope of U.S. export control laws can lead to unexpected surprises when manufacturers collaborate with colleagues and customers in foreign countries — especially when manufacturers work on high-tech or defense-related activities. Sales through international distribution channels also present potential concerns. With U.S. jurisdiction following products in addition to parties, third-party sales to prohibited countries or parties can trigger enforcement actions even if a manufacturer has no ties to the ultimate customer.
• Anti-boycott requirements. Manufacturers must be wary of penalties that stem from violations of anti-boycott requirements. For instance, U.S. manufacturers that sell and ship products into the Greater Middle East must also contend with a third challenge: the Arab League Boycott of Israel. This little-known area of U.S. law prohibits U.S. manufacturers and their foreign-incorporated subsidiaries from engaging in discriminatory practices against Israel or Israeli parties, or from agreeing to do so in contracts, correspondence, or similar documents. Such provisions typically arise in wire payment instructions or letters of credit, and can be difficult to identify. Further, while the Greater Middle East is the greatest source of boycott-related risks, manufacturers should also be attentive to the fact that business partners in East Africa, South Asia, and Central Asia may use boycott-related terms and conditions in their own transactional documents.

Although restrictive trade measures can be complex, most U.S.-based manufacturers (and their foreign subsidiaries) can mitigate the associated risks by building layered defenses into their global supply-chain and distribution systems. Manufacturers can also employ risk-based approaches that adopt fewer defenses in lower-risk jurisdictions, while deploying more defenses in higher-risk jurisdictions. Some of the basic elements in an effective, risk-based system include the following:

• Restricted party screening. Manufacturers conducting business internationally should screen their business partners and other transaction parties against the various restricted-party lists (“RPLs”) maintained by OFAC, BIS, the DDTC, and other agencies. This screening is essential because many economic sanctions and export control programs target specific parties in addition to problematic countries. The same is true for the sanctions and export control laws enforced by Australia, Canada, the European Union, the United Kingdom, and other foreign jurisdictions where manufacturers may conduct business.
• Compliance terms and conditions. Manufacturers should also adopt terms and conditions that require their business partners to comply with U.S. and other applicable economic sanctions and export control laws. These provisions should give manufacturers the ability to terminate agreements in the event of a violation, and obtain indemnification for damages and legal fees where possible. These protections are necessary (but not sufficient) in any international sales agreement — especially when selling to (or through) third-party distribution channels. 
• Non-diversion statements. Manufacturers shipping products subject to U.S. jurisdiction should include statements on their commercial invoices, bills of lading, or other shipping documents. These statements should state that the products are subject to U.S. law, and warn that diversion to restricted countries, restricted parties, or for restricted end-uses is prohibited. Like the compliance terms and conditions discussed above, these non-diversion statements are necessary but alone are not sufficient to protect a manufacturer. When combined with other defensive measures, however, the statements help demonstrate that the manufacturer made a good faith effort to comply.
• Annual compliance certifications. Manufacturers shipping to customers or business partners in higher-risk regions should consider obtaining an annual international trade-compliance certification from these parties. The purpose of these certifications is to show that the manufacturer requested — and ultimately received — a written promise to comply. Although such certifications will echo previously agreed terms and conditions, they can also lay the foundation for a detrimental-reliance defense in the event that third-party conduct exposures a manufacturer to government enforcement actions.
• End-use/end-user certifications. These certifications are similar to annual compliance certifications, but end-use/end-user certifications operate on a transactional basis rather than a generalized one. Obtaining these certifications can be particularly helpful when business partners are located (or selling into) countries and regions that have a higher number of restricted parties, or are known for diverting projects to restricted countries. Notable examples include China, India, the Greater Middle East, and the former Soviet Union.
• Audit rights and cooperation provisions. Adding audit rights provisions to commercial agreements with foreign business partners can be helpful in the event that a manufacturer requires information from its customers, suppliers, distributors, or other parties in order to investigate possible violations, or verify compliance with applicable trade restrictions. However, as a general rule, manufacturers should avoid seeking audit rights unless they intend to exercise them on a proactive basis, and have the resources necessary to do so. Otherwise, manufacturers risk over-promising on paper and under-delivering in actual practice. A wiser, more targeted approach for a manufacturer seeking to avoid a strong commitment to audits would be to adopt language requiring foreign business partners to assist with (and provide records related to) any internal investigations or government enforcement actions that may arise from time to time.

The five legal tools discussed above are not exhaustive, nor are they indented to address every risk that manufacturers might encounter when working with international supply-chain and distribution networks. However, they are definitely tools that merit considering, sharpening, and using when circumstances require. By adopting a more proactive approach to these issues, manufacturers can mitigate the legal and commercial supply-chain risks while laying the foundation for stronger business relationships.

Kate Wegrzyn and Christopher Swift are partners, and Jenny Wang is special counsel, at Foley & Lardner LLP.