With Rising Raw Material Prices, Companies Should Prepare For Pressures on the Supply Chain
As we have covered previously, earlier declines in demand for most raw materials during the early months of the coronavirus pandemic caused many suppliers to reduce capacity. This is now resulting in higher prices and more limited supply of many raw materials, such as steel (click here to read our earlier article on the topic). Many automotive suppliers and other manufacturers face complications in procuring enough raw material, including the prospect of paying higher prices to meet customer demand.
In addition to the commercial considerations outlined in our prior article, companies also must consider the impact of Section 2-615 of the Uniform Commercial Code (“UCC”), which defines the doctrine of “commercial impracticability” and sets forth obligations concerning allocation of limited supply. The defense of commercial impracticability is available to a supplier of goods that is unable to make delivery as required by contract, either in whole or in part in certain circumstances. Specifically, the supplier must show that delivery of all goods required under a contract has been rendered commercially impracticable “by the occurrence of a contingency or the non-occurrence of which was a basic assumption on which the contract was made or by compliance in good faith with any applicable foreign or domestic governmental regulation.”
Courts generally apply a three-prong test to determine whether the definition of commercial impracticability under UCC 2-615 is available to a nonperforming seller: (1) the seller must not have assumed the risk of some unknown contingency; (2) the nonoccurrence of the contingency must have been a basic assumption underlying the contract; and (3) the occurrence of that contingency must have made performance commercially impracticable.
Regarding assumption of risk, foreseeability is a major factor. If the contingency was foreseeable, the parties should have made their contract with the expectation that such contingency might occur. Consequently, if a seller foresees a particular risk, it is imperative the seller incorporate a provision within the contract against assuming such risk. In the event the seller fails to allocate foreseeable risk within the contract, a court will view this as evidence the seller assumed the risk. Even in sole-source supply agreements, where the sole-source supplier fails to deliver materials or parts, courts are reluctant to excuse performance based on commercial impracticability unless the failure was truly unforeseeable at the time of contracting.
As for whether performance has become “commercially impracticable,” the issue is akin to the contractual force majeure context, and turns largely on the cost or ability to perform. However, in most cases, increased prices for raw materials alone is not sufficient to show that performance is impracticable, even if it means that the supplier must accept a loss. Before a court will excuse performance as commercially impracticable, the affected party must typically establish that continued performance would result in “grave injustice” because the cost has become so exceedingly excessive and unreasonable. The circumstances under which a court will allow a nonperforming party to escape culpability is limited to truly extraordinary and wholly unexpected circumstances.
Even if a situation otherwise qualifies for protection under the doctrine of commercial impracticability, suppliers still have an obligation to make a “fair and reasonable” allocation of any available goods. In such circumstances, the supplier must look to allocate its limited supply across its customer base. What constitutes a “fair and reasonable” allocation may fairly be the subject of debate in many cases. However, most courts generally are inclined to consider an allocation scheme “fair and reasonable” where a seller uses objective data to source scarce supply to various customers. For example, an allocation scheme that looks to customers’ past sales history or monthly volumes to allocate product on a pro rata basis will likely be deemed “fair and reasonable” in most cases. Another key aspect is lack of bias. When devising an allocation scheme, suppliers cannot simply cease shipment to a disfavored customer in order to prioritize favored customers. Courts do not look favorably on such behavior and may strike down an otherwise legitimate defense of commercial impracticability if the seller fails to fairly and reasonably allocate limited supply.
In summary, UCC 2-615 presents an opportunity for a breaching party to excuse its nonperformance. While the bar is high, in appropriate circumstances commercial impracticability is a defense that sellers who experiences an unforeseen shortage can, and should, raise. In the event that a shortage leads to an allocation scenario, the seller’s allocation must be “fair and reasonable” but need not always treat all buyers equally.
Companies should remain cognizant of the challenges that lie ahead, particularly in the raw material market. Although there is tremendous reason to be hopeful as we enter the New Year, the effects of 2020 are sure to carry forward into 2021 and beyond.