Background: Increasing Disruptions to Global Supply Chains
Global supply chains are vulnerable. The recent blockade of the Strait of Hormuz is just one example of this, leading to delivery delays, product shortages and significant cost increases.
The effects are not limited to individual companies. Instead, a ripple effect is evident throughout the entire supply chain, affecting consumers too. Therefore, it is all the more important for companies to make their supply chains resilient to geopolitical crises.
Purchasing contracts are a significant means of increasing a company's resilience. This is because they enable direct influence over the company's supply chain.
Now, more than ever, companies should review their procurement contracts to ensure they cover current risks and are legally versatile and flexible enough to enable foreseeable tensions to be identified, avoided or mitigated early.
Why review contracts for resilience?
The positive effects of doing so are by no means limited to reducing the risk of disruptions to your own supply chain. Rather, resilient contracts also offer significant advantages in other areas that go beyond mere risk mitigation, particularly with regard to:
Financing terms: banks are increasingly granting loans linked to defined, measurable sustainability targets (so-called 'sustainability-linked loans'). Meeting these KPIs can result in interest rate discounts of typically 2.5 to 5 basis points, and there is a trend towards even larger discounts in the future. For large investment amounts, this can result in interest savings in the millions. ESG ratings from specialised agencies serve as key KPIs. Companies with higher ESG ratings benefit from lower interest rates. Ratings are particularly influenced by the extent to which sustainability criteria are integrated into contracts and guidelines. Even the mere inclusion of such provisions can improve the ESG rating. Resilient contracts can therefore be used to manage financing terms.
Legal compliance requirements
Companies face growing regulatory requirements that influence contract drafting. The Critical Raw Materials Act (see Art. 24) requires certain large companies to assess the risk to their raw materials supply chain, including vulnerability to supply disruptions, at least every three years. The risks of supply disruptions can be mitigated through contractual provisions such as supply guarantees, force majeure clauses or early warning mechanisms. In addition, laws such as the German Supply Chain Act, the EU Deforestation Regulation, the Critical Infrastructure Umbrella Act and the NIS 2 Directive require adjustments to supply contracts, e.g. through information and disclosure obligations or audit rights. Resilient contracts are therefore essential for fulfilling legal compliance obligations.
Competitive advantages
Companies are increasingly facing challenges such as volatile supply chains and price fluctuations. Contracts often determine whether production continues or comes to a halt. Without forward-looking provisions beyond traditional force majeure clauses, contracts can have a significant impact on companies in a crisis, as was seen during the semiconductor crisis. While some companies suffered production stoppages, others benefited from cleverly drafted contractual obligations that led to an increase in order intake. Resilient contracts can therefore also serve as a tool for safeguarding a company’s competitiveness.
Preserving your reputation
Reputational damage often arises from violations in the supply chain, such as human rights violations, environmental violations, sanctions violations and corruption. Such damage can have financial consequences. It is therefore crucial to draft contracts in such a way that the company can influence the resolution of such violations. The public tends to view termination rights or contractual penalties that do not resolve the issues less favourably than a remedy developed jointly with the supplier. This requires contractual obligations regarding information, cooperation and remediation. Resilient contracts are therefore key tools for managing reputational risks.
Which contracts should be reviewed for resilience?
It is by no means necessary to review all contracts. For example, contracts with a local catering service provider will be less risky than those with a supplier of production-critical materials.Therefore, it is crucial to first identify those that are particularly prone to risk. Companies can use the following guiding questions, among others, to identify the contracts that should be reviewed as a priority:
What impact would the supplier’s failure have on the company’s own business operations?
For example, there is a risk of significant revenue losses because the supplier provides materials for the company’s core business.
How dependent is the company on the supplier?
For example, because there are no alternative suppliers available or because lengthy qualification processes for alternative suppliers would be required.
How risky is the supplier?
For example, according to your own risk analysis, is the supplier located in a particularly high-risk region? Have there been any disruptions or escalations in the supply relationship in the past?
What bargaining power do you have with the supplier?
For example, because your company is the supplier’s main customer.
Contractual resilience: The case of the Hormuz blockade
The advantages of drafting contracts that account for potential risks can clearly be seen in the current blockade of the Strait of Hormuz.
Companies that have incorporated force majeure clauses and associated adjustment or termination rights into their purchase contracts as hedging mechanisms generally have an initial lever at their disposal to absorb the risks associated with such a blockade (e.g. delivery delays) without incurring additional costs.
However, the situation is different if the supplier cannot deliver products on time as a result of the blockade, and these products are essential for the company’s own business operations because they are a direct component of the company's manufactured product, for example. In such cases, if there is also dependency on the supplier (e.g. because there are no alternative suppliers, or only substitute suppliers that would be economically unviable due to high procurement costs), production stoppages and significant economic losses are likely.
Rights of adjustment and termination (e.g. based on force majeure provisions) or rights to damages – which would likely be futile in the absence of fault – are ineffective in this case. While these may allow for release from the contract, they do not solve the underlying problem of impending production stoppages.
So, if the vulnerability of the supply relationship had been identified early on, how could you have prepared for such a situation contractually? Or, how can you prepare for such a supply chain disruption in future?
Legally effective measures can be created by including the following provisions in the relevant purchasing contracts:
- Minimum quantities, e.g. a contractual obligation to supply minimum quantities in order to receive priority delivery over the supplier’s other customers.
- Consignment stock, e.g. an obligation on the supplier to establish and maintain a sufficiently stocked consignment warehouse on the customer's premises.
- Duty to provide information, e.g. in the event that any transportation difficulties arise or are foreseeable.
- Precautionary measures, e.g. an obligation on the supplier to take precautionary measures such as maintaining stock of the relevant material at multiple locations outside the affected transport route.
- Alternative proposals, e.g. requiring the supplier to evaluate and propose alternative transport routes.
- Cost allocation: e.g. requiring the supplier to bear any additional costs incurred due to alternative transportation.
This list is not exhaustive, but aims to illustrate the various levers that can be utilised to manage supply chain disruptions through skilful contract drafting, beyond 'traditional' contractual provisions.
In addition to legal considerations, business aspects must also be taken into account when adapting vulnerable contracts. For example, switching from single-sourcing to dual- or multiple-sourcing can reduce dependence on a specific supplier. Where possible, building up your own inventory can also help to mitigate the risk of transport restrictions.
Conclusion and outlook
Given the latent risk of further 'crisis hotspots' along the supply chain (e.g. impending punitive tariffs and increasingly frequent natural disasters worldwide), companies should assess the following:
Which supply relationships are particularly vulnerable?
When and how can contractual adjustments be made (e.g. due to existing 'bargaining power')?
Which contractual mechanisms are suitable for mitigating the risk of supply chain disruptions?
In order to make appropriate contractual adjustments for risk management in purchasing contracts.
We would be happy to assist you with this, using AI to review your contracts for standard procurement issues (e.g. liability provisions), delivery default risks and compliance matters. Our added value for you: We have a comprehensive collection of around 100 'resilience topics' that we use to analyse your contracts, as well as a specially developed clause database with custom-formulated model clauses integrated into the AI to identify and close contract gaps precisely and effectively. We also naturally offer ad hoc support, for example in fine-tuning individual clauses, as well as assistance in negotiations or disputes with suppliers, tailored to your specific needs.
We are also happy to help you with your contract drafting.
