Executive Memo: First Call All the Lawyers

Difficult financial times are not the occassion to skimp on reviewing supplier contracts

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By Andrew K. Reese

As the fallout from the financial crisis spreads, many companies are realizing that they're ill-prepared for potential disruptions in their supply chains. In fact, a recent survey by UPS and the Economist Intelligence Unit found that just 16 percent of senior executives believe their companies pay sufficient attention to risk mitigation in their supply chains.

Erika Schenk spends much of her time helping companies avoid these disruptions. Schenk, a contract law attorney at international law firm Bryan Cave, works with clients to avoid the "contract meltdowns" that can occur when a buying organization or a supplier is unable to meet its obligations under a contract.

For supply chain executives dealing with suppliers that are not in compliance, the first question that must be posed is, Do we want to continue with this relationship? You must decide if this is a strategic supplier, one that is critical to meeting business goals. If so, can you bring the supplier to the table to salvage the relationship and come up with some strategies to move forward together? Or are your companies at a point of no return where the relationship is never going to be what it should have been, and you're going to have to pursue litigation or other strategies to get damages in court?

Most of Schenk's work these days — much more so than in the past — involves finding ways to salvage the relationship by working out current contracts and renegotiating. "Of course, there's risk in all of this, and you do have to evaluate that risk. But we're seeing clients really trying to come up with creative solutions out of this mess," she says.

For example, one client had a supplier that failed to deliver on time under the contract. The client renegotiated the contract and agreed to pay the supplier incentives associated with on-time performance because receipt of the product was critical to the client's own launch strategy for its whole business line. Why go down this route? Simple: The client estimated how much it was costing for every day that the supplier didn't deliver on time and calculated it would be cheaper to incentivize the supplier to prioritize getting its work done on-time rather than to let the company default. "This has allowed the client to recapture what otherwise would have been losses," Schenk says.

Other clients are using escrow accounts with suppliers experiencing financial difficulties. The clients needed the supplier, so they negotiated putting money into an escrow account that the supplier could tap into to buy raw materials to produce the goods that the clients needed. "As the supplier needed to purchase the supplies necessary to perform under the contract, it would submit the invoices to the escrow agent, the client would get notice of that and a copy of the invoice, and the client had to approve the payment in order for it to go through," Schenk explains.

Other examples of precautions that can be built into contracts: Include a security interest in goods being sold to a customer, so if the customer doesn't pay, you can reclaim the goods. Segregate goods and indicate on them that they belong to you, so if a supplier goes under and a creditor comes to seize assets, they'll know those assets don't belong to the supplier and are not subject to seizure.

Or, run publicly available lien searches on a supplier to see how many and what kind of liens are against their company — lots of liens could mean the supplier's got a lot of debt. That gives you a better understanding of what their risk exposure is and whether you want to do business with that company. It also can help you see what kinds of assets the supplier has that have liens against them, so you can figure out whether you can get a first-priority lien on a given asset that you need.

Schenk's bottom line: Difficult financial times are not the time to skimp on reviewing the contract, because you want to make sure that you are thinking very clearly about what that contract says, making sure that it matches your business goals and does the best job it can at articulating the situations in which one party or another might need to exit from the relationship.

After all, Schenk says, "When times are good, nobody looks at the contract. But when times are tough, that's when people pull out the contracts — and sometimes they can be surprised at what they see."

How is the financial crisis affecting your supply chain relationships? Are you spending more time with your legal counsel these days? As always, you can write me with your thoughts at [email protected]. I'll look forward to hearing from you.