How to Navigate COVID-19 Driven Requests for Price Increases in the Automotive Supply Chain
To say that COVID-19 has wrought havoc on automotive supply chains over the last 8-12 months may be an understatement. With significant portions of their supply chain located in China, automotive suppliers and their customers had to contend with significant challenges even before COVID-19 brought automotive manufacturing in the United States to a standstill in March. Although production has restarted, suppliers must deal with a multi-faceted set of new challenges that are affecting their cost-structure. Health and safety measures to protect workers have added new costs, while social distancing, additional cleaning, and maximum occupancy requirements may result in restricted production capacity. Many suppliers are seeing significantly lower overall volumes from their customers, which, while potentially a benefit in the short term as suppliers restart their operations, could have significant impacts on profitability and recovery of capital investments if they continue in the long-run.
All of these factors have combined to create significant pricing problems for many companies. Some programs, which may have seen high volumes and favorable pricing, suddenly are underwater. Other programs that may have been problematic before the impact of COVID-19 now look exponentially worse.
Against this backdrop, many automotive suppliers are receiving demands from their own supply chain for revised pricing. Some may be making, or preparing to make, similar requests to their own customers. While many of these disputes are resolved amicably through commercial discussions, they have the potential to destroy long-standing relationships and cause further disruption to the supply chain.
This article provides a summary of some of the key issues that both buyers and sellers should consider when engaging over pricing issues. As has been the case with other significant events in recent years (e.g., tariffs and other trade-war issues), the fact that an outside event may have resulted in higher costs or lower volumes does not automatically entitle a supplier to new pricing. Any such request depends on the parties’ rights under their particular contract and the particular facts of each situation. While the impact of COVID-19 may be greater and more wide-ranging than other system shocks in recent decades, the legal principles at issue largely remain the same. Among the most important factors that suppliers should consider are:
Force majeure and commercial impracticability
During the initial phases of COVID-19, many automotive suppliers were involved in declarations of “force majeure” and “commercial impracticability” under Section 2-615 of Uniform Commercial Code (“UCC”), and in many cases, companies have been on both sides of the divide as they likely received notices from their suppliers while providing their own notices to customers. Many suppliers now are attempting (implicitly or explicitly) to invoke these same doctrines in order to justify a price increase or other commercial demands. While somewhat different in operation, both the doctrines of force majeure and commercial impracticability generally require that a party who is able to perform its contractual obligations must do so, even if such obligations have become more difficult or more burdensome. Higher costs alone usually will not justify non-performance or allow for a price adjustment.
Does the contract have a fixed price or allow for pricing changes?
One of the first and most basic questions a party must consider is whether the contract includes a fixed price. Most contracts, on their face, provide for a specific fixed price. However, it is not uncommon for contracts to include provisions that allow (or even require) changes in the price under certain circumstances. Oftentimes, a seller’s documents will include a right to increase prices while the buyer’s documents state that the prices are fixed and are not subject to change, requiring the parties to engage in a “battle of the forms” analysis to determine what the contract actually requires regarding price. Of particular note in this area are provisions that may allow for periodic “negotiations” or “requests” concerning price, without imposing any specific obligation on a buyer to agree to revised pricing. While such provisions often are of limited utility to a seller, unlike, say, increased costs for labor and raw material, it may be more difficult for buyers to characterize the burdens imposed by COVID-19 as being of the type that sellers should have considered and assumed the risk. Even if non-binding, a provision allowing for periodic price negotiations remains subject to the general requirement under UCC 1-203 that every contract “imposes an obligation of good faith in its performance and enforcement.” While it remains to be seen how such issues will be treated by the courts, companies should be careful about rejecting a request for a pricing adjustment under a non-binding price review provision without giving the request an appropriate review and consideration.
Does the contract have a specific term or is the term indefinite?
In addition to price, the parties must consider the term of the contract. In other words, if the contract requires supply at a fixed price, how long is the supplier bound to this obligation? If the contract does not include a specified term, it likely will be considered a contract of indefinite duration. Under Section 2-309 of the UCC, a contract of indefinite duration may be terminated by either party upon “reasonable notice.” Although what constitutes “reasonable notice” may be the subject of debate, the ability to terminate a contract of indefinite duration gives suppliers an ability to terminate the current agreement and require higher prices under any new agreement.
When does the contract expire?
Assuming that the contract is not one of indefinite duration, when does it expire? If the relevant contract is expiring in the near future, a seller may be able to leverage its right to refuse to extend the contract in order to increase prices. Conversely, a buyer that knows its seller is unhappy with the current arrangement and unlikely to renew the agreement should make sure it has a contingency plan in place.
As a corollary to understanding the expiration date of the contract, the parties must consider any provisions under which a contract may be renewed and any related requirements. For example, a contract may renew automatically unless one party or the other gives formal written notice that it will not renew the agreement. Many contracts also give one party (usually the buyer) some measure of power to unilaterally renew the term. Both buyers and sellers should be aware of these terms and make sure that they comply with any notice or other requirements. Failure to give notice that a party will not renew may result in the party being locked into a contract that otherwise would have expired, and therefore losing the ability to demand a different price for any new contract. Conversely, a party that wishes to keep current pricing in place may lose that ability if it fails to take any steps necessary to renew the agreement.
Does the contract allow early termination?
Even if a contract is not about to expire, the parties should be aware of any rights to terminate the agreement before its natural expiration. In the manufacturing supply chain, rights to terminate “for convenience” usually are limited to the buyer. However, it is not unheard of for contracts to include a mutual right to terminate upon giving a specified notice period. Upon termination of an existing contract, the parties usually are free to demand new pricing as a condition for entering a new agreement.
Does the contract include a specific quantity?
Under Section 2-201 of the UCC, a contract for the sale of goods cannot be enforced beyond the quantity of goods specified in writing. For example, if a contract specifies that it is for five widgets, the buyer cannot force the seller to supply ten widgets, just as the seller cannot force the buyer to purchase ten. A quantity may be measured by the buyer’s requirements or by the seller’s output. However, where a contract contains no quantity term at all, it cannot be enforced to require further shipments by the seller (or purchases by the buyer).
What other commercial considerations exist?
Finally, regardless of their respective contractual rights, buyers and sellers should take care to consider the full picture of their relationship and all other commercial considerations that are involved. For example, a seller that succeeds in obtaining a price increase worth a few hundred thousand dollars may have won the battle, but will lose the proverbial war if, in doing so, it so angers a key customer that it misses out on millions of dollars in future business. Similarly, a buyer that succeeds in holding the line on prices may find that the supplier is not interested in taking on new business from the customer, resulting in less competition for future programs, which can lead to higher prices.
While all disputes must be addressed in light of the specific contracts and circumstances involved, the issues addressed above represent some of the most important considerations that are common to most pricing disputes. Although COVID-19 has created a new set of challenges for both buyers and sellers, the legal parameters surrounding any disputes over demands for new pricing remain very much the same as the have been in the past. Buyers and sellers should consider these issues as part of their strategy for seeking, or opposing, any requested changes in price due to the impact of COVID-19.