Benjamin Franklin famously said “By failing to prepare, you are preparing to fail”. In these uncertain times, with contractual relationships coming under strain, spending time understanding your key dependencies and possible weaknesses in your key trading and supply contracts can be a worthwhile exercise.
From our recent experience of conducting contract reviews for clients, here are a few questions to ask when analysing your key contracts.
- Where is your Delivery location?
Where your delivery location is can affect your attitude to risk and the approach you take with your counterparty. For instance, if the delivery location is in a liquid trading hub (eg: ARA) this is likely to mean that replacement product can be easily obtained if your supplier fails to perform. Conversely, if your delivery location is less liquid and more constrained, this might suggest adopting a more cautious approach if your counterparty encounters difficulties in performing.
- Are there any other Delivery or Storage Options in the area?
To pre-empt the possibility that your delivery location may close or become constrained in some way (eg: because it is at full storage capacity), you should consider what alternative delivery and storage options exist in the vicinity? This factor may have a bearing on the extent to which an FM argument can be relied upon and the extent of your duty to mitigate.
- Who is your Counterparty?
How critical is your counterparty to your operations? For instance, is the type of product being supplied a specific chemical which is not readily available from others in the market, or does your counterparty have rights on a certain storage facility pipeline or throughput rights which are vital to your supply arrangements? If your counterparty is critical to your supply arrangements, you are likely to want to temper your approach accordingly in any renegotiation.
Also, it is worth bearing in mind that if you have several contracts with one counterparty, you may want to conduct a review of all contracts before embarking on a renegotiation of any single contract. Taking an aggressive position on one contract, for instance, could encourage your counterparty to take similar stances on other contracts which might not be in your best interest.
- What are your Quantity and Duration Commitments?
How large is the contract both in terms of volume and duration? Obviously, the loss of a large contract could have a large adverse impact on your financial situation, particularly if the cost of replacing that contract is sizeably greater than the lost one.
Does your contract contain minimum monthly or annual quantities? Is there a right to reduce volumes for any reason? The existence of such clauses will likely have an effect on your bargaining power in any contractual renegotiation.
In the absence of clauses allowing you to vary contractual performance in some way, it may well be that unless contractual performance can be excused by FM, as a buyer, you will be required to take a minimum contractual quantity failing which payment for under lifted volumes must be paid.
Even if a contract does allow for deferral of volumes, you may still want to push for a renegotiation of the contract rather than defer volumes to deliveries later in the year. Clearly, the latter option carries risk, particularly if a second wave of the pandemic takes hold.
As an aside, it is worth noting that some counterparties are now negotiating Covid-19 related price and volume renegotiation clauses into their new contracts.
- What mark to market exposures do you face?
You should consider the extent to which a counterparty failure and the loss of a physical position is mitigated by a hedging strategy.
- What are your suspension and termination rights?
It is important that you understand your contractual rights to suspend or terminate in the event that your counterparty fails to perform. For instance, some contracts allow for immediate suspension whilst others merely offer a termination right which can only kick in after a grace period has expired.
- What rights do you have to claim Force Majeure?
Does your contract have an FM clause? In the absence of an FM clause, are you able to rely on force majeure nevertheless? In Spain and France for example, the concept of force majeure is enshrined in law under their respective civil codes.
Under English law, adverse economic conditions and falls in market demand, are not typically force majeure events. To amount to force majeure, the event generally has to be something which prevents a party from performing its contractual obligations. So in the context of a supply contract, this typically means a physical impediment preventing delivery or acceptance of the product.
- Are there any other clauses in your contract that might assist?
It is important to conduct a thorough review of your contracts to see whether any other clauses might be relied upon. For instance, some contracts provide that the parties may renegotiate if a change in law or economic circumstances means that a party is financially disadvantaged when compared to when the contract was entered into. Also consider whether the law of the contract offers any assistance. In Spain, for example, if contractual performance becomes excessively onerous as a result of an unforeseen event, the affected party may request a renegotiation. If, subsequently, renegotiations fail, this can lead to termination by agreement or intervention of courts in some cases.
The above represent just a few considerations to bear in mind when embarking on a Covid-19 health check of your key contractual relationships. When considering contract renegotiations, it is likely you will want to adopt a variety of strategies depending on the exact nature of your contracts, supply needs and your counterparties.