Ardent Partners’ analyst team attended the 100th annual Institute for Supply Management (ISM) conference in Phoenix a couple of weeks ago. Risk, in many of its forms, was a regular topic throughout the event – from Dr. Robert Gates’ opening keynote on global instability, to discussions about conflict minerals compliance, food risk, contract risk, and sustainability issues that occurred over the course of the event. As students of risk (new ones seem to pop up every year), we sat in on many of these presentations and thought that an interesting way to highlight them would be to present a series of discussions on the speakers and how each contributed to the conversation about global supply risk.
Today’s discussion is on the hidden risks lurking within an organization’s contracts and supplier relationships, which was presented by John T. Shapiro and Jeffrey Mayer, partners at Freeborn & Peters, LLP.
Contracts – The Ties that Bind
One of the first things that Shapiro and Mayer said was that risks underlie every supplier relationship – especially in electronic communications, as it is never entirely clear who a person is dealing with. With identity theft, user fraud, and other unethical behaviors, it is relatively easy to betray the trust earned between trading partners. That is why for Shapiro and Mayer, contracting is about the allocation of risks, and it can be seen in a contract, itself. Indeed, they codify the relationship, detail prices, terms, conditions, service-level agreements, and establish liability between both parties. And according to Shapiro and Mayer, part of risk allocation is about establishing leverage within the contract – who is in a position of power within the relationship and can benefit from the relationship the most.
Risks Lurking Within Supplier Relationships
Typically (and hopefully), two trading partners enter into an agreement with each other understanding their responsibilities, liabilities, and the inherent risks. But as Shapiro and Mayer illustrated via a number of legal cases, some supplier relationships can become quite murky under various circumstances.
For example, sometimes negotiations can turn into de facto agreements even though parties have not formalized an agreement or signed a contract. In some states and in certain industries, customs and emails between buyers and suppliers during negotiations can be used as evidence of a de facto agreement, even though nothing was formalized and signed. Shapiro and Mayer litigated a case in which this occurred, where one party backed out of supplier negotiations and the other filed suit, claiming breach of contract. Surprisingly, even though there was no contract in the traditional sense, industry customs and local laws dictated that there was an agreement in place, and a judge ruled that it had been broken.
Other times, fixed risks can become unknown risks in unexpected ways. For example, trading partners can unintentionally alter agreements and the risk profile simply by exchanging late-night emails wherein parties make offers, agreements, or amendments to agreements that are still “on the books”. In many jurisdictions, it could be argued successfully that such correspondence constituents a binding agreement, but chances are, the allocation of risk and corresponding leverage haven’t been carefully considered by each party. If two parties – a procurement department and a supplier – agree to scale up their relationship, but the commodity in question suddenly becomes embargoed by a third party, or the supplier ends up on a sanctions list and they cannot deliver on the new agreement, both parties would then experience heightened contractual, legal, and supply risk. Did each side weigh the risks adequately? Possibly not. But would the correspondence constituent a binding agreement? In some jurisdictions, yes.
The last point that Shapiro and Mayer made was that of contract and supply risks vis-à-vis force majeure – i.e., man-made disasters, natural disasters, and war. Many organizations – on both sides of the table – attempt to protect themselves from liability over these issues by inserting industry-standard language into their contracts. But as they noted, boiler-plate language inserted into contracts without negotiation/modification can cause one or both parties to misunderstand their liability or protection in the event of a disaster – man-made or natural. In essence, force majeure clauses aren’t a foolproof way to mitigate risk – it all comes back to how they are worded, how risk is allocated, and who they protect the most.
Final Thoughts
Shapiro and Mayer’s presentation cast some new light on the nuances of contract risk that lurks within supplier relationships. Clearly, there is more to consider during supplier negotiations than just optimal price, terms, and conditions. Enterprise procurement teams may be altering their risk profile in unexpected and profound ways. Chief Procurement Officers and supply management leaders ought to tread carefully over supplier negotiations, particularly those that occur offline or outside of business hours. They can constitute an agreement, even if nothing was signed. Moreover, a closer read and a deeper understanding of the fine print – along with close consultation with one’s legal department – ought to keep the enterprise out of hot water when negotiations go offline.
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