Supply Agreements

A contractual approach to supplier risk management

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Slug: best practice supplier risk management


Suppliers in the chain of distribution often deal with two competing customer demands: just-in-time delivery and lower pricing.

Accessing lower costs means buying in bulk, yet customers want product only as and when they need it and at the best possible price. Customers don’t want extended inventory commitments on their books, yet want pricing as if they had booked long-term commitments.

To service these demands, suppliers may book bulk inventory commitments with their upstream suppliers or manufacturers, and attempt to manage their customer’s inventory requirements.

This carries the risk, particularly in a falling market, of customers sourcing lower priced product at spot prices, and leaving suppliers with expensive product on hand or on order. Even large suppliers in the chain of distribution are wary of, or are unable to negotiate terms of purchase with their upstream manufacturers or suppliers, for example steel mills or other raw material producers, and risk being “stuck” with product.

Managing this risk can be tricky. Getting an extended supply contract is usually a major achievement and the lifeblood of any business. Suppliers are reluctant, for obvious reasons, to push back on a large customer to address this risk.

Yet, carefully crafting the contractual terms of supply can help to effectively manage this risk. While lead in-house counsel to a major North American steel service center group, one of my primary objectives was meeting customer expectations while concurrently ensuring that my client was not left commercially or legally exposed.

There is a fine art to getting this right. I find, almost without exception, that large and established downstream customers, particularly industrials and OEMs insist on using their terms of purchase. These often comprise term supply arrangements, with little or any obligations on the customer. While the supplier is obligated to sell at a fixed or determinable price, there is rarely any purchase commitment. A commitment is only really made against a specific purchase order or, even later, inventory release orders, leaving the supplier to carry the risk of any inventory not purchased.

In managing this risk, the fine print can be key. I have seen the meaning of a few paragraphs in a supply agreement hotly litigated, with inventory worth millions of dollars at stake. Having language in the agreement that pinpoints the supplier’s concerns may not only be very helpful in the event of a dispute but may also help avoid one.

It can be very helpful to get on the same page early in the process by contractually delineating forecasting, reporting and inventory management expectations and responsibilities.

Here are a few observations for suppliers from my experience, which may assist in contractually mitigating risk in supply agreements.

Forecasts. Agree to the need, form and management of regular inventory requirements forecasts. Even though forecasts are usually non-binding commitments, the customer may expect you to hold minimum inventory levels to service its ‘just-in-time’ needs.

Meetings. Provisions for when inventory levels will be reviewed and by whom, and for joint “monitoring,” can all be helpful. Regular discussion, forecasts and aged-inventory reports review and other “customer buy-ins” to your inventory management process will help regulate disposal of inventory, increase efficiency and may help with any inventory-level disputes down the line. Record the conclusions of each meeting.

Customer Buy-in. Use the supply agreement to record the parties’ objectives, even if couched in loose terms, for instance, the mutual objectives of ensuring continuous and uninterrupted supply and securing the inventory investment you have undertaken on the customer’s behalf. Writing in language that says that the customer would make every effort (if not commit) to issuing product releases in accordance with the forecasts, may also assist.

Agree to Holding Periods. If applicable, you may want to include the period that you agree to hold inventory for, after which you would be free to sell to third parties.

Slow-moving Inventory. If you are holding inventory that is not being bought in accordance with the original forecast, asking the customer to agree to help you move that inventory at the get-go can help avoid disputes down the line. Again, writing in regular meetings and aged-inventory review can be helpful.

Customer Commitment. A primary point of risk mitigation is not over-extending your buying commitments to your upstream suppliers. A firm customer commitment for a minimum level of inventory tied into either or both of your customer’s minimum requirements and your own purchase lead times, for example, “90 days’ of inventory commitment,” can be very helpful.

Forecasts Change. This even happens on a daily basis, so you may want to tie your customer's commitment to specific inventory forecasts, for example as it appeared at the date of your order from your upstream supplier. I have seen differing interpretations of how commitments are interpreted lead to extensive litigation, even over a few words in a contract.

Termination Provisions. Customers want the right to walk at any time, particularly in falling markets. Termination “for convenience” provisions need not be struck out, but instead drafted round with a minimum inventory commitment on termination to cover your position. This could even be drafted as limited to any inventory not reasonably capable of being sold elsewhere. This is a good example of finding the right, minimally invasive drafting to please both parties. It also applies on expiry of the term of the supply agreement: you may want a run-off period or agree that your customer remains committed to a minimum level of inventory.

Pass Through Price Hikes. Transparent and fixed or determinable pricing is key for customers in term supply agreements. If the supplier you are buying from implements a surcharge or declares force majeure, you would want to include “pass-through provisions” passing both unilateral price hikes or surcharges and the risk of supply stoppages on to your customer.

These are just a few examples of how a well-drafted supply agreement can help you mitigate inventory and price risk, without over-lawyering. It is a fine art to getting this right and requires knowledge not only of the legal implications, but also the commercial practicalities in managing inventory. It is indeed possible to effectively manage your inventory and supply risks contractually without losing the business, and good legal advice can go a long way to achieving this in your specific supply circumstances.

Sam Miller is a corporate and commercial transactional attorney, and is a member of Dykema Gossett LLP's corporate finance team, based in its Los Angeles office. Before returning to private practice, Miller established and led the legal department of Kloeckner Metals, the third largest metals service center in North America, comprising Namasco Corp., Macsteel Service Centers USA and other subsidiaries. He also is founder of the pioneering online legal advice platform, SvPerbar which uses technology to make lawyers, legal advice and pricing more accessible, transparent and efficient, with an emphasis on standardizing legal advice and providing access to flat-fee legal products.