4 Key Supply Conditions That You Should Include In Every Agreement Or Purchase Order
According to a 2018 McKinsey article, poor supplier performance can result in significant (10-20%) indirect costs. Proper planning and making sure you have the right terms and conditions in your supply agreement will reduce your company’s financial exposure and protect it from litigation.
What type of conditions should you include in your supply agreements to protect your company in case of the need to change or cancel a legally binding agreement? In this first of two articles, we discuss 4 key conditions that you need to include in your next supply agreement or purchase order.
If there is one thing the last two years have taught us, even the best laid plans can go awry. That’s why it pays to be prepared in case you need to modify, suspend or cancel a legally binding purchase order (PO).
Your ability to cancel a PO after its execution depends on the terms and conditions you’ve included in the supply agreement or related purchase order.
Because a PO is legally enforceable when incorporated into the supply agreement, it is important that you cover for all possible contingencies when you draft its terms and conditions, including a specific right to modify, suspend or cancel the PO. Otherwise, when conditions force you to cancel or modify a binding PO, the company could face claims if the agreed terms are violated.
You can protect your company and minimize any financial or legal headaches, by including a right to cancel, suspend or modify the purchase order should any of the following four conditions arise.
1. Detection of errors or defects during inspection prior to delivery.
Typically, a supply agreement contains provisions on the right to inspect goods either before or at delivery to determine whether they meet the agreed terms and specifications. This is not just a contractual right but also a legal right. For example, the Uniform Commercial Code (UCC)1 in the United States gives the buyer a right to inspect the goods.
A supply agreement should specify the buyer’s inspection rights, including when and where the inspection may take place and by whom. A typical condition is for the buyer to give the supplier prior written notice of the inspection which is typically conducted once during a contract year. Less commonly, a ‘surprise inspection’ is conducted without giving the supplier prior notice. The provision should give inspection rights to the buyer as well as authorized personnel, entitling them to perform the inspection at the supplier’s and any of its subcontractor’s premises, if necessary, to ensure delivery of the goods in accordance with the agreement. The supplier should be expected to provide any assistance necessary and cooperate with the inspection process.
Timeframe to Fix Errors/Defects
It’s also important to specify the timeframe to notify the supplier and fix any errors or defects found during an inspection. This is normally a period prior to the delivery date. If the supplier fails to correct the issue within the timeframe and will not be able to deliver the correct goods or fulfil its obligations under the agreement or PO, the buyer should have the right to cancel or suspend the PO by giving notice.
Obvious Delivery Issues
You can also cancel, suspend or modify a binding PO for obvious delivery issues, such as wrong or short deliveries or if there are frequent, consistent and minor errors and defects that breach the agreement (e.g., outside of agreed specification or key performance indicators). In such cases, the buyer does not have to accept the goods, can reject the whole delivery, or can accept a partial delivery. It is important to specify these rights in the supply agreement in order to exercise it.
2. A Force Majeure event
“Force Majeure” refers to an event beyond a party’s control that delays, interrupts or prevents the impacted party from performing its obligations under the supply agreement. Strikes, work stoppages or labour difficulties, fires, floods, pandemics, acts of war, civil unrest or other acts of God are common examples of Force Majeure events. Your supply agreement should specify the steps that must be followed in case of such an event.
The supplier is often the party most affected by a Force Majeure event, as they have the burden of performance under the PO. Make sure to include clear requirements for the supplier to give prompt notice of a Force Majeure event. The supplier should inform the buyer within a reasonable time and on the foreseeable extent of the non-performance, such as inability to deliver goods on time. The requirement to promptly notify the buyer under these circumstances must be taken seriously by the supplier, any delay in such notice may cost the supplier late delivery fees or the loss of certain reliefs.
If a Force Majeure event blocks the supplier’s ability to perform, the supplier can suspend outstanding deliveries, without further liabilities until the event has lifted. For Common Law countries (like the US, the UK, Australia, Canada and New Zealand), this right to suspend must be specified in the contract. In Civil Law countries the right to suspend performance may be provided under applicable statute law. Once reported, the supplier also has the duty to exercise due diligence to eliminate or remedy the Force Majeure event and mitigate any losses. If despite this, the event continues beyond the agreed period, the buyer is well within its rights to terminate the PO. Although neither party is at fault, because the buyer’s business is severely dependent on the supplier’s performance the buyer can act in his own interest and procure these goods from an alternate supplier. In such situations the buyer is not entitled to claim any costs from the supplier for securing the goods from an alternative source but only to the rights and liabilities that were accrued under the supply agreement prior to the Force Majeure event.
If a Force Majeure clause is included in the supply agreement, the parties should ensure it permits the unaffected party to terminate the agreement or PO in order for the buyer (or supplier) to exercise these rights in whole or in part. The buyer should also have the right to suspend purchases or reallocate volumes when the supplier is affected by a Force Majeure event.
3. Delivery Delays
In the supply agreement, the buyer should also have the right to cancel a PO if the supplier has not delivered the ordered goods by the scheduled or agreed delivery date for the order. Such delays constitute a material breach for which the buyer will normally be entitled to compensation under the agreement terms. If you don’t negotiate compensation into the supply agreement, you risk a lengthy and time-consuming claims process through the court. Therefore, it is advisable for the parties to agree a certain amount of compensation for delays in delivery or non-delivery of goods. This is typically calculated on a daily basis as a percentage of the contract value being delivered e.g., 0.5% per day up to a maximum
amount, often 5% to 10% of the contract value. The supply agreement should also grant the buyer the right to cancel the PO without any liability to the supplier in the event of such delay or non-delivery.
4. Changes in Customer Demand or Business Plans
Your company may need to cancel a PO (in whole or in part) due to a fall in customer demand or a change in the buyer’s business plans. This right should be specified in the supplier agreement. The buyer should give the supplier reasonable notice before the delivery date, but the supplier may require payment of all costs incurred in connection with the production of the goods. In case the goods are not yet produced, the buyer might have to reimburse the supplier’s cost of all materials purchased to fill a cancelled purchase order. You should however ensure that it is not possible for the supplier to use these materials for other customers or transfer them to other manufacturing operations before reimbursing the supplier.
There are several circumstances in which you may need to cancel, suspend or modify a PO: deficient goods, Force Majeure, delayed deliveries, and changes in customer demand or buyer’s business plans. Negotiating strong terms and conditions to cancel, suspend or modify POs will preserve your company’s rights and protect it from litigation. As these are contractual rights, your company’s legal ability to enforce them relies on their inclusion in the agreement or PO.
Note: This is a two-part Article. This first part discusses the circumstances that can allow a buyer to modify or cancel a purchase order. The second part will discuss the costs associated with such modification or cancellation.
1.See UCC § 2-513.
Illustration by Usha Kumar