(b) International long-term supply of goods

Main idea: If the parties enter into a continuous relationship for the supply of goods, it is helpful to reflect this in a long-term supply agreement. This ITC Model Contract is intended for use in connection with manufactured goods, rather than commodities, which have their own special features and are often sold on standard forms provided by associations of producers or dealers. The Model Contract on the international long-term supply of goods is not intended for use in cases where goods are supplied for resale by a distributor (for those cases, see the ITC Model Contract for the international distribution of goods).

Purpose. While a contract for a long-term supply of goods would mainly be a sales contract, the parties can focus on various relational elements to improve the quality of logistics, delivery and the goods themselves. The larger contracted sales volumes give the parties more freedom to tailor their relationship. The purpose of such a contract is not only to arrange for the sales related aspects, but also to improve the supply relationship by providing for:

  • ensuring continuity of supply;
  • logistical aspects of supply aimed at a shortened lead time (the time between order and delivery);
  • improvement of product quality;
  • continuity in product specifications (and a mechanism for changing product specifications in case of technical developments, a change in raw materials or other developments);
  • flexibility in modifying the applicable Incoterm;
  • fluctuations in purchase prices (including price developments related to raw materials or components);
  • flexibility as regards payment (i.e. no costly L/C or other payment mechanism is required);
  • a limitation of liability by reference to the (long) duration of the contract;
  • permissible events of force majeure, tailored to the particularities.

How to decide: Supply or manufacturing? A supplier may or may not be the manufacturer of the goods under contract. If the manufacturing aspect is predominant, it is recommended to use the ITC model international manufacture agreement.

Change of specifications. In a long-term supply relationship, it is probably inevitable that each party should have a right to change the specifications of the goods. The customer may need such changes to fit them into its own products (which may be subject to change) or to meet the end-users’ desire to buy a state-of-the-art product. The supplier may require flexibility because it might need to shift to other suppliers, have to cope with a varying quality of raw materials or components, or want to cease old production methods or processes. In this ITC Model Contract, Articles 1.2 and 1.3 provide for a mechanism to change the product specifications, subject to reasonable notice and price adjustments. The parties may even agree on a product ‘roadmap’ reflecting improvements to be made to the contracted goods.

Minimum volume commitment. The more volume (i.e. certainty) a customer can commit to in its estimated purchases, the higher a discount a supplier can offer. This is reflected in minimum purchase commitments (see the ITC Model Contract’s optional Article 1.4). For large customers, such commitments effectively imply more exclusivity (and less opportunism) regarding the supplier that will be chosen. A long-term supply relationship allows the parties to alleviate any undesired effects of minimum volume commitments: circumstances of force majeure and shortfalls in any year can be compensated in subsequent years.

Framework-character and ordering. A long-term supply agreement is normally a framework agreement: the framework for ordering and delivering the goods is established in the contract, but actual deliveries are subject to a purchase order that must be accepted by the supplier. This mechanism does not reflect the contract formation procedure of the Vienna Convention (see Article 14-24 about offers, counteroffers, modified-acceptance and similar negotiation stages): rather, it is meant to ascertain that the customer is firm in its wish to purchase a certain quantity and quality of goods, to ensure that that the supplier has received such an order, and to fix the moment in time as of which both parties are bound to a single delivery of goods. The (software) accounting and enterprise resource planning (ERP) systems work this way.

Forecasting. Especially in cases involving complex products, a supplier needs to purchase raw materials and components, and manufacturing may depend on the availability of (fine-tuned) production lines. For those purposes, to optimise the production process for the supplier, and allow it to acquire raw materials or components at a discount, the ITC Model Contract contains a so-called forecasting mechanism. For a lawyer, a forecasting mechanism is a strange animal: every month, quarter or year, the customer is requested to submit a good faith estimate of its product requirement for the forthcoming periods, without being bound to actually purchase such estimated volume.

Inventory management and discontinuation of products. The advantage of a forecasting mechanism is that it enhances a supplier’s ability to improve the product lead time – the time between receipt of a purchase order and delivery of the ordered goods. Although reflected weakly, the ITC Model Contract’s Article 2.9 provides that the supplier will make commercially reasonable endeavours to meet its obligations (expeditiously). The same Article provides for a discontinuation of goods if technological developments, decreasing order volumes or other efficiency-decreasing factors force a supplier to stop supplying a product. In such cases, the supplier must give written notice (allowing the customer to submit an ‘end-of-life purchase order’).

Intellectual property rights. If the contract triggers or involves the creation or divulgence of any intellectual property rights or know-how, it is strongly recommended that this issue be addressed in the agreement. By default, intellectual property rights are owned by the creating party; if the creation was partly or entirely paid for by the other party, a reallocation of ownership or the grant of a licence may be necessary. Note that the ITC Model Contract for international manufacture agreement serves a similar purpose but focuses on product and manufacturing process improvement; various Articles from that contract can be used in a long-term supply agreement.

Flexibility in pricing. Not only may a change of specifications lead to an increase (or decrease) of purchase prices; other circumstances may also require price adjustments. The ITC Model Contract provides for a few options (in Article 3.3 and 3.4) to adjust purchase prices following considerable cost-price increases. Obviously, the question of whether to include these clauses is typically subject to heavy negotiation, in connection with which objective standards would be introduced to protect the interests of the customer. One objective reference could be a national price index or other indicator of inflation. It is appropriate to provide for a minimum notice period and to subject any purchase price increase to a stipulated maximum. Any excessive price increase should entitle the customer to terminate the long-term supply agreement.

Mitigated exclusivity (price comparison). Contractual devices that can strengthen the customer’s loyalty and order volume for products include, for example, an exclusive purchase arrangement, a minimum purchase volume commitment, volume discounts and improved supply chain arrangements. However, such devices demand a certain freedom for the customer to benchmark the prices imposed by the supplier. In the ITC Model Contract, optional Article 3.5 provides the customer with a right to compare prices offered by competitors.

Warranties: No third-party rights. Of course, the supplier must deliver goods free from third-party ownership rights (reflected in the warranty in Article 5.1.1). But consistent with the Vienna Convention (Article 42), the delivered goods should also not infringe the intellectual property rights of third parties: this would make the goods useless for the customer. In various industries, it is virtually impossible to avoid all infringements (and fortunately, in those industry sectors, monitoring of infringements is often limited to successful products only). The parties may compromise by starting the warranty in Article 5.1.2 with the phrase “to the supplier’s knowledge after due and careful investigation” or, even less strictly: “to the supplier’s knowledge” (see also section 5.2(f)).

Limitation of liability. The ITC Model long-term supply agreement does not contain an extensive limitation of liability for the supplier. Article 7 optionally excludes the supplier’s liability for any indirect, consequential losses or damages (but product-liability-related claims resulting in death or personal injury are not excluded). Especially in long-term relationships, a broader limitation of liability would be very appropriate (see section 4.6).

Duration. The ITC Model Contract also examines duration. As so many considerations could be taken into account, it is not possible to provide for all possibilities. Commonly, a contract of this type will cover several years, sometimes including the right of one party or both parties to terminate early either for convenience, breach of contract or insolvency of the other party. A maximum period may be imposed by applicable law, depending on circumstances (see Article 8). Also, a maximum duration – with express extension being required – of up to five years may be required by virtue of competition law (if the supplier or the customer is in a dominant market position with, roughly, a market share in excess of thirty percent).

Consequences of termination. In cases involving termination of a long-term supply agreement, both parties have an interest to provide for the period after termination: the supplier may want to dispose of excess inventory (or even raw materials, components and spare parts); while the customer may wish to avoid a situation where such goods are dumped by the supplier at market-deteriorating prices.

Miscellaneous provisions and no-subcontracting. Standard provisions have been included in the ITC Model Contract, including change of circumstances (Hardship) (Article 9), and force majeure (Article 10). Article 15 is worth mentioning separately: in a long-term supply agreement, the customer relies on a relationship with the supplier and will therefore prohibit that the supply as agreed in the contract (i.e. whether or not it includes manufacturing) be subcontracted or (partly) delegated to third parties. For more elaborate discussion of these type of clauses, see Chapter 3.

General terms and conditions. In some cases, a long-term supply agreement is used in connection with the supplier’s standard terms of sale or with the customer’s standard terms of purchase. In cases where these do not exist or are not intended to apply, the ITC Model Contract includes a set of simple additional terms of supply (schedule 4).