Contracting For Geopolitical Risk

With geopolitics impacting organizations at incredible speed and magnitude, it’s no wonder that supply chain risk has become a top concern for chief legal officers.

Every second is a challenge when you find yourself simultaneously staring down wars in both Europe and the Middle East, leadership changes in the Western Hemisphere, global trade wars, evolving sanctions programs and continent-wide treaty reviews. 

In such an environment, risk-appropriate contract terms are as essential as the strategic approach procurement teams must now take when going to market. The days of simply “dusting off” contract terms and using boilerplate POs as the only documentation for a purchase or sale are over. Many of those documents were not negotiated, let alone reviewed. 

Instead, contracting parties must clarify their expectations due to geopolitical risk. At the most basic level, this involves determining (1) how shocks to the system will be communicated between parties and (2) the response to those communications.

While similar to the root-cause analysis and corrective action plans developed in some technical trading relationships, this analysis is focused on outside factors rather than the other party’s performance alone. 

Additionally, contracting parties must understand that certain clear risks impacting supply chains — like the risk of U.S. Customs and Border Protection (CBP) detention and seizure — may also merit their own specific provisions. 

This Time, It’s Different 

Geopolitics impacts business practices — and these necessary changes in business practices are influencing contract terms deployed by procurement teams and law departments. 

Such changes include: 

• Companies find it’s no longer efficient to have a staggering breadth of product portfolios, which is leading them to reduce raw input variance and the volume of finished-good SKUs produced. 
• Product categories, service lines and markets are also being rationalized in some verticals, with a renewed focus on core competencies and profitability. 
• The tariff burden, the loss of the de minimis exemption for low-value imports to the U.S., and inbound logistics disruption are challenging how organizations manage their inventory, often resulting in companies holding higher inventories closer to point of use. 
• Partnering with single-source suppliers is no longer viable for critical supply or in single non-U.S. countries, leading to increases in supplier diversity.

Thinking About Geopolitical Supply Chain Risk

Threats that manifest in supply chains have one thing in common — irregularities against expectations. Regardless of industry or geography, supply chain risk can occur, which prevents companies from performing as expected under normal operating conditions. This impacts not only the bottom line but can also spread up and down the supply chain in the form of a bullwhip effect. 

Risk assessments and strategic planning are two of the primary tools in the practitioner’s toolbox for anticipating such risks. Procurement practices and active supplier or vendor management — together with strong contracting practices — are tactical tools for managing risk.

Five types of geopolitical supply chain risks are:

Compliance variance risk. Suppliers, service providers or products may fall  out of compliance with laws or regulations. For example, you could find, mid-relationship, that items cannot enter through CBP because of inputs associated with forced labor. Or you could realize a supplier or provider is, or has become,  (1) listed on denied parties lists or  (2) subject to sanctions.

Cost variance risk. Increased costs to land products or fully receive a service is a unique type of financial risk. It does not prevent the purchase, but it does challenge the commercial viability of continued procurement. Severe variance will destroy margins and, as we’ve seen recently, even challenge the financial viability of a company.

Examples of this type of risk include the recent reciprocal and universal tariffs imposed on most imports. Landing product in the U.S. became cost-prohibitive for many companies and resulted in forced negotiations or downstream notices. Some equipment and raw input suppliers that had lengthy production cycles for essential purchases were subject to multimillion-dollar tariff exposure.

Availability variance risk. Product supply can be short or services unavailable, which immediately impacts company production and sale. Examples include a supplier’s inability to deliver as contracted due to upstream raw materials constraints from cost or availability.

Sometimes, these variances have nothing to do with the quality of supplier or service provider. The occurrences, such as force majeure events or acts of government authority, might be entirely outside the control of the contracting party. Still, the impacts can be significant, particularly in operations with low safety stock.

Quality variance risk. Products or services that fail to meet industry quality expectations, or those agreed upon in purchase contracts, have immediate negative consequences for operations and customer experiences.

Examples range from failure to meet specified dimensional or color specifications to breakdowns in (1) special conditions or (2) handling that yield total loss. These variances essentially amount to the buyer’s failure to receive what was contractually agreed upon. The magnitude of impact (and availability of damages) can vary greatly depending on the particular type of variance, its circumstance and contract terms.

Best Practices for  Managing Risk

Supply chain disruption risks are sometimes unavoidable. Still, professionals can approach relationships in ways that help reduce unforeseen risks and better position their companies should those events arise. 

Procurement professionals and their legal teams are commonly tasked with developing a go-forward strategy for keeping supply lines humming. This is a challenging time for sales professionals and business operations teams, but best-in-class approaches can help them meet the moment:

Preparation to go to market. The first step to managing supply chain disruption risk is to gain a practical understanding of critical nodes in the supply chain. Many companies today perform supply chain mapping to determine the upstream value chain across companies and countries. Although this has become essential for companies with forced labor risk, it is a valuable exercise for other complex supply chains. 

Doing so allows for risk assessments of key nodes and identification of where visibility, or documentation, of third-party operations may be low. Risk-appropriate measures can then be implemented to address those known concerns.

Bid processes and supplier management. Procurement teams then use these learnings when going to market for new goods and services. Risk assessments often yield (1) specific RFP or RFQ questions, (2) more discrete populations of potential suppliers and (3) tailored onboarding processes. These are tools for supplier and provider due diligence, which is fundamental from a lawyer’s perspective.

High-impact review points may have serious implications as to whether a supplier moves forward in the process and how the relative risks among suppliers are weighted. These include such factors as party screening against sanctions lists, determination of trade compliance risks for a country or region, sectoral compliance risks for a product or industry, maintenance of required licenses and permits, and more traditional financial diligence. 

As part of onboarding, targeted written confirmation of diligence questions could be  implemented. Periodic certification can occur throughout the relationship life cycle to demonstrate ongoing compliance.

Selling and delivery processes. Sales and business operations teams are also on the front lines of risk arising from the downstream supply chain. Serious challenges can emerge very quickly around the customer, the customer’s customer, company products and delivery routes. 

Processes around best-in-class customer onboarding and management are essential. There is no reason to pursue accounts if you are prohibited from doing business with them or if they are prohibited from paying you. 

Onboarding questionnaires are key to obtaining required information for sanctions screening, as well as financial and commercial diligence. Depending on a customer’s role and risk profile, additional questions and periodic certifications may be needed to verify ongoing compliance. 

The other critical activity is order fulfillment. Operating procedures enable customer names to be screened daily or at the time of fulfillment. Also, export control numbers and the necessity of license are validated for every shipment.

Risk-Appropriate Contract Drafting

The fundamental aspect of contract law is that expectations between buyer and seller need to be established. This is accomplished by framing risk around these tangible concepts, then managing them under contract. 

These concepts also provide a framework for active management of suppliers and providers, in which each party can use its best efforts in operational planning — and even contingency planning — to maintain strong, mutually beneficial relationships. This framework includes:

Compliance and risk tools. Compliance variance risk is top of mind for both product or service specification and legal compliance. Today, thoughtfulness in contract structures allows for use of such ancillary documents as POs and supplier codes of conduct that allow for dynamic change as the risk assessment evolves. 

Distinct terms can be used to reasonably address every identified risk. For example, appropriate compliance representations and warranties regarding goods or services are protective, particularly when paired with indemnity for breach or third-party claims.

In today’s compliance environment, it’s critical to create adequate visibility into third parties and their banks (sanctions risk) as well as end uses and ultimate end users (export controls risk). With upstream suppliers, such visibility can ensure the absence of forced labor (import compliance risk). 

Creative pricing and payment terms. In recent years, cost variance risk has been particularly challenging. Dramatic variances in landed costs (such as tariff impact) and the cost of service (such as inbound ocean carriage) have emerged in this decade. 

Creative tools can be used as needed to address these problems, which include required visibility to inputs, clarity on shared costs, and indexing of commodity good or service prices. Payment terms can be equally creative based on the fact pattern and relationship, including periodic payments based on performance or timing milestones. 

Some variance may be unavoidable depending on the market, but setting expectations for future credits or debits, and even discounting where available, can be creatively negotiated to balance the risk dispersion across parties. 

Operational forecasting. Availability risk is one of the more difficult obstacles to overcome in highly volatile commercial environments. In recent years, goods have been physically unavailable during the coronavirus pandemic, were unable to be physically moved due to the Russia-Ukraine war or could not be sold and purchased at a price that accommodates the customer market as a result of U.S. reciprocal tariffs. 

Building a cadence of periodic forecasting for supply- or demand-side expectations can greatly benefit both parties in managing inventories and production. Setting expectations for how parties address variance, including through management meetings followed by root cause analysis and implementation of corrective actions, can establish a reasonable path forward for managing through uncertainty. 

Ultimately, applicability of such terms as force majeure provisions and the triggers and processes for invoking them will be essential for tailoring contract terms to potential risk.

Relationship and performance management. Quality variance risk is one of the most frustrating challenges facing supply chain organizations. Contract performance happens within time and space, so even if both parties have best intentions, performance can raise serious challenges to production and sales. 

Two of the most commonly used tools for addressing this risk are tailored service level agreements and KPIs. These go beyond typical product specifications by addressing such aspects as order accuracy, inventory accuracy, claims ratios and customer complaint frequencies.

Parties can actively manage against those terms by agreeing to participate in periodic management meetings, requiring root cause analysis for failures, implementing corrective action plans to avoid reoccurrence, and even including bonus/malus provisions to incentivize desired performance. 

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Every enterprise has a unique supply chain with its own risks and operational demands that require tailored language and approach. Doing so produces clear articulation of the principal concerns requiring attention for best results over a relationship life cycle. 

Also, for in-house counsel, this approach yields the pragmatic, business- focused counsel that internal clients typically desire most from their legal teams.

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