By John Titley, Peter Roth and Brion Doyle

Law360 (May 7, 2021, 5:47 PM EDT )

John Titley

Peter Roth

Brion Doyle

Chips, foam and rubber.

What sounds like a strange smorgasbord of automotive inputs all share the common thread of being in short supply, due either to unexpected levels of demand in the wake of COVID-19, or to exogenous events ranging from unseasonal weather to congestion in global trade channels.

With the shortage of semiconductor chips becoming an increasingly frequent rationale for suspending or otherwise reducing production at the original equipment manufacturer, or OEM, and supplier level, this article examines some of the underlying legal issues — and presents some proactive measures auto suppliers can take to protect themselves from liability, or to ensure payment consistent with their customer contracts.

Specifically, we address contractual force majeure clauses, and ways to effectively leverage this language in the broader context of the supplier-OEM relationship. Suppliers should look to their contracts to determine whether they have the right to declare force majeure with their customers in the event of a supply chain disruption caused by the shortage of semiconductor chips.

Suppliers should also review their contracts to determine their rights in the event that a customer claims force majeure, and refuses to accept delivery due to production delays.

Force Majeure Provisions

Force majeure clauses — also known as excusable delay or excusable nonperformance clauses — are intended to allocate risk for events that are not within the reasonable control of a party, and will generally excuse performance when it is delayed or prevented by such events.

A shortage of semiconductor chips may or may not entitle a party to invoke a force majeure clause or claim impracticability, depending on the underlying facts and the language of the contract. If a contract does not contain a force majeure clause, depending on the jurisdiction, there may be a common law or statute-based right to claim a remedy that is similar to force majeure — i.e., impracticability under most states' Uniform Commercial Code.

There is no single standard force majeure clause. Some contracts will list a number of specific events that qualify as force majeure, while others take a more general approach and include any events outside a party's control. The language will vary widely among contracts, particularly between different industries.

Some clauses contain specific exclusions for circumstances over which a party has some control: subcontractor or subsupplier default; inability to obtain equipment failure; employee strikes; etc. Also, it is worth noting that increased inconvenience or added expense, in and of itself, will generally not excuse nonperformance or provide other relief under a force majeure provision.

Within the auto industry, many OEM terms and conditions follow a similar approach to force majeure/excusable delay matters. A majority of OEMs' standard terms and conditions include as force majeure events any event beyond the reasonable control of the affected party that is not attributable to its fault or negligence.

Such force majeure terms typically include a number of exceptions, such as labor problems of a supplier or its subcontractors; the inability to secure power, materials, labor equipment or transportation; or other industrial disturbances. Some OEMs, like Tesla Inc., use a narrower definition of a force majeure event — i.e., only events caused by acts of God or war — while others, like BMW and Ford Motor Co., include fewer exceptions.

Notice

To invoke force majeure protection, the affected party will generally have to give notice to the nonaffected party. Force majeure clauses vary in their notice requirements.

Some require notice within a certain time of the occurrence of the underlying event, while others only require "prompt" or "reasonably prompt" notice. The contract may additionally require the notice to state the anticipated consequences and duration of the force majeure event.

Some contracts include a time-bar clause that requires the affected party to provide notice within a specified period from when it first learned of the force majeure event, or lose the right to claim force majeure.

Given the uncertain and dynamic nature of the COVID-19 outbreak, and resulting disruptions to supply chains, some suppliers have issued "protective" or "rolling" force majeure notices which take into account the developing impact that the outbreak has upon the performance of their obligations under their contracts.

Mitigation and Allocation

Even if an event is clearly included in a contract's force majeure provision, the party seeking to excuse nonperformance must take reasonable steps to mitigate the foreseeable consequences of its nonperformance.

A party would be unable to invoke force majeure if its nonperformance could reasonably have been mitigated, or if it could have found another way to meet its obligations. Put simply, if a party is able to meet its obligations under a contract, it is generally required to do so, even if it means greater inconvenience or higher costs.

Another issue is what a supplier should do if it has capacity to fill some, but not all, of its outstanding purchase orders. Absent specific contractual language, the general rule is that a supplier facing production shortages or restrictions must allocate production pro rata among its customers.

Some OEMs, like Tesla, have terms and conditions that require suppliers to fill that OEM's orders first in the event of a shortage.

Semiconductor Chip Shortage

The big question, of course, is whether the shortage of semiconductor chips will excuse (1) an auto supplier's performance under OEM/customer contracts, or (2) an OEM's obligation to accept delivery of products. Each analysis depends on the language of the applicable contract and the specific facts and context of the claim.

If a supplier claims excusable delay/nonperformance due to chip shortage, an OEM may argue that (1) the chip shortage was foreseeable, (2) the default was not caused by COVID-19, but rather by a breach/default of a subsupplier, or (3) that the supplier should have done more to mitigate. A supplier might reply that, regardless of foreseeability, the shortage is outside of its reasonable control, and makes complete performance under the contract impossible.

And, given the industrywide impact of the chip shortage, it's difficult to imagine what steps a supplier could take to mitigate. Suppliers may also have additional support for a force majeure claim if their subsupplier was an OEM-designated sole supplier of semiconductor chips.

If an OEM is unable to accept delivery due to decreased or suspended production, it may also claim force majeure, and the arguments listed above would apply. It is worth noting, however, that OEMs may have other grounds on which to refuse delivery of supplies.

Depending on the language of the contract, the OEM may have the right to defer, rather than refuse, delivery of products, even if ordered under a firm release. This could allow them to prevent delivery of products, perhaps indefinitely, depending on the language of the contract. OEMs may also have rights to refuse delivery under capacity or release provisions of the applicable contract.

Finally, an OEM may have the right to terminate the contract for convenience, which gives them significant leverage in any failure-to-perform dispute. Of course, an OEM's terminating for convenience is less of a concern for sole-source suppliers, or if the OEM does not have an alternate supplier available and tooled up.

None of us have a crystal ball, but it seems that the chip shortage gives suppliers and OEMs grounds to make a force majeure argument, although the nonaffected party will likely push back unless the contract specifically includes epidemics or government orders as a force majeure event. However, even if a supplier is confident in its force majeure claims, it should consider the broader picture of its relationships with the applicable OEM.

A supplier may prevail on an individual force majeure claim, but doing so could damage the relationship with the OEM, and cause it to lose out on future business with that OEM. Transparency is a best practice in this situation. Suppliers who provide customers with clear and timely communications are more likely to reach a negotiated resolution to a potential breach of contract dispute.

Best Practices

To lessen the impact of a potential default or breach under a customer contract as a result of the semiconductor chip shortage, there are a number of proactive steps you can take:

• Develop a contingency plan for supply shortages and consider purchasing business interruption or force majeure insurance.

• Review all contracts for applicable force majeure provisions, and determine whether a force majeure event has occurred, and the scope of the parties' respective rights and obligations under the contract. Meet any notice requirements as soon as possible, and consider issuing protective or rolling force majeure notices.

• Mitigate damages:
  
  
  • Require subsuppliers to provide current and detailed information on realistic inventory and production volumes, and discuss possible alternatives with them.
    
    
  • Examine and understand current capacity, inventory on hand, and whether there is a parts bank or alternative manufacturing facilities available.
    
    
  • Determine a plan for allocating available capacity among existing customers.
    
    
  • Consider offering customers older parts or parts that may have been built under earlier specifications.
    
    
  • Analyze any alternative methods of production or other impacted performance, including supplying from other countries or subsuppliers.

• Communicate proactively and clearly:
  
  
  • Actively communicate with customers and give them as much information about the specific force majeure event as possible, including the expected timing/duration of the event, the number of impacted parts/facilities, and alternatives that are being investigated. Supplement all notices as additional information becomes available.
    
    
  • Show customers that you are using good faith efforts to resolve the issue and mitigate the damages, and communicate these efforts.

• Understand the customer's rights if force majeure is invoked, which may include the right to terminate and/or source from an alternate supplier.

• Check with your insurance agent as to whether there is coverage under a business interruption or other policy.

• If the contract provides for foreign law, obtain guidance from an expert in that jurisdiction.

• If you make any disputed payments directed by a customer, clarify that you are making them under protest.

Conclusion

The COVID-19 pandemic, and the resulting disruptions to various supply chains, are unprecedented events in our history, and we don't know how courts will evaluate resulting claims of force majeure.

If a supplier finds itself in a position where it is difficult to meet contractual obligations due to lack of semiconductor chips, or finds an OEM is unwilling to accept delivery, it may be time for the supplier to review supply contracts to understand its rights under a force majeure clause or other legal protections.

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John Titley, Peter Roth and Brion Doyle are partners at Varnum LLP.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

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