ABA Section of Business Law
ABA Section of Business Law
Business Law Today
September/October 1998
How Y2K Could Affect the Supply Chain
A problem for day-to-day contracts
By DONALD A. COHN and PAUL S. WITTMANCohn is a corporate counsel in the E. I. DuPont de Nemours and Co. Legal Department. Wittman is a contract attorney assisting E. I. DuPont de Nemours and Co. with matters relating to its Information Systems Business Center. The authors would like to thank George Anderson, Amelia Boss, Mary Jo Dively, Robert Feldman, Kevin Holian, Thomas McCarthy and Joel Stern and for their assistance in preparing this article. All of the opinions expressed in this article are those of the authors and not necessarily the opinions of E. I. DuPont de Nemours or any individual that has reviewed this article.
Who will bear the costs associated with Y2K failures as they affect commercial transactions, including the high cost of litigation? This article will focus on license and development commercial transactions - not including system software - such as the purchase and sale of chemicals or finished goods. What, if any, impact will Y2K have on these contractual relationships?
A great deal has been written about the relative responsibilities of software licensors and licensees where the license is silent on this issue, but little or no attention has been focused on all of the other types of commercial transactions and contractual relationships that may be affected.
The series of contractual relationships - the "supply chain" - is what links suppliers and their subcontractors, consultants and distributors with their customers. A series of subcontractors (and the subcontractor's subcontractors ad infinitum) provides goods and services to a company that is viewed as the customer for this aspect of the transaction. The customer/company then takes the goods and services, hopefully adds value, and becomes a supplier/contractor to its own customers.
While this process is going on, all of the private parties rely on various levels of government and other public and private institutions with which they have no direct contractual relationship to provide an infrastructure within which this chain of purchases and sales may be transacted (these noncontractual, but vital, relationships will be referred to in this article as "infrastructure"). In many markets, suppliers and customers are the same legal entities interacting in different roles. The supply-chain relationships exclude licensor/licensee interactions.
From a corporate perspective, the goals of a viable Y2K supply-chain program should be:
- to avoid disruption of long term supplier/customer relationships;
- to avoid large-scale wasteful and unnecessary litigation and legal costs for all parties in the suply chain:
- to positively induce suppliers to work with their subcontractors and customers on substantive remediation to reduce the risk of Y2K problems affecting the supply chain and minimize disruptions; and
- to discourage suppliers and customers in their current attempts to shift risk as a "hot potato" among various participants in the supply chain.
These attempts to shift risk may or may not be effective or enforceable, depending on their form, but, in any event, reflect short-term, risk-adverse "legal" solutions to a predominantly strategic business issue.
The purpose of corporate activity in this area should not be to receive assurances that a company is Y2K compliant. It should be to gain confidence that the Y2K problem will not result in a company being unable to fulfill its contractual obligations. For example, if a company is able to continue to perform its contractual obligations without using Y2K-affected software, the customer should not be concerned whether the supplier is Y2K compliant or not.
The issue is bilateral. It affects the supplier/seller in performing its obligations to deliver goods or services under a supply contract. It also affects the customer/buyer in fulfilling its contractual obligations to receive and accept goods or services. The customer may have specific obligations in a supply contract regarding notification and certainly about paying for goods and services that may be dependent on having fully functioning equipment and computer systems.
In many instances, a company is both a supplier and customer in its supply chain relationships with other suppliers/customers in an industry. It will be very difficult to propose one risk-allocation formula as a supplier and another formula as a customer in these integrated industries. Even if a company has overwhelming negotiating power in a contractual relationship and has "strongly" drafted risk-allocation provisions in its supplier and customer contracts so that the burden is always effectively allocated to the other party (and it will be rare that a company will have such "strong" bargaining power in both directions) it would be strategically unacceptable, and possibly suicidal from a business viewpoint, to attempt to assert such protection in both directions to completely avoid risk.
A benefit to the bilateral nature of these issues is our belief that these relationships should have a moderating effect on strategic business and legal proposals advanced to address this issue and should force the participants in a supply chain to search for a fair and reasonable balance. Unless there is language in existing or new contracts addressing and excusing performance for Y2K specifically, there is no underlying legal theory that will excuse performance of a supply contract by a supplier because of an internal breakdown in the supplier's systems relating to the Y2K issue.
A number of legal theories may be advanced where there is an "upstream" supply-chain breakdown relating to the Y2K issue. Unless there is language in an existing or new contract relating to "a failure of supply," using these theories will be very difficult. A much stronger argument excuses supplier performance if the failure is predominantly caused by a breakdown of the infrastructure.
Corporations need a reasoned, strategic approach to deal with Y2K. The approach proposed in this article includes the following key elements:
Existing supplier and customer contracts should be reviewed and amended to provide for the effect of performance failures caused by a Y2K problem. Contracts should be amended only when justified by a risk/benefit and cost/benefit analysis. Emphasis should be placed on amending existing longer-term contracts that will continue to be in force as we approach the Year 2000. Existing spot orders and other short-term contracts should have a lower priority and may not require any action. New supplier and customer contracts (including both negotiated and printed form agreements) should include provisions to appropriately and reasonably allocate responsibility in dealing with the Y2K issue.
With regard to suppliers, both existing and new contracts should provide that a supplier is obligated to be Y2K compliant in computer systems or equipment that is used, owned, licensed, leased or otherwise controlled by the supplier to the extent necessary to avoid interference with a supplier performing its contractual obligations.
Suppliers will be obligated to include comparable language in their contracts with their subcontractors who are needed by the supplier to fulfill the supplier's contractual obligations to the customer. The supplier's obligation would be to request the language in subcontracts obligating its subcontractor and other subcontractors up the supply chain to be Y2K compliant. The customer would not impose liability on the supplier to guarantee that all of the subcontractors up the supply chain become Y2K compliant. Suppliers and customers will each take on the risk that the subcontractors of the other party will not interrupt the supply of goods or services between the customer and the supplier because of Y2K noncompliance.
This proposal confirms current commercial practice. Well-drafted force majeure clauses excuse a supplier for a "failure of supply" caused by a third-party subcontractor. To impose an absolute guarantee obligation on a supplier or customer for all subcontractor failures places an unreasonable burden on the party assuming that risk and is a burden that is normally not otherwise assumed by contract.
To the extent that suppliers are prepared to accept these obligations, they will be excused from performance of their contracts to the extent that a Y2K problem of their subcontractor or a failure of the infrastructure is the predominant cause of such a failure.
With regard to customers, both existing and new contracts should have comparable language that a customer is obligated to be Y2K compliant in computer systems or equipment that is used, owned, licensed, leased or otherwise controlled by the customer to the extent necessary to avoid interfering with the customer performing its contractual obligations.
Customers will be obligated to request comparable language in their contracts with their subcontractors needed for the customer to fulfill its contractual obligations to the supplier. The supplier would not impose liability on the customer to guarantee that all of the subcontractors down the supply chain become Y2K compliant. Suppliers and customers will each take on the risk that the subcontractors of the other party will not interrupt the supply of goods or services between the customer and the supplier because of Y2K noncompliance.
To the extent that customers are prepared to accept these obligations, they will be excused from performance of their contracts to the extent that a Y2K problem of their subcontractor or a failure of the infrastructure is the predominant cause of such a failure. These bilateral principles are incorporated into language suggested in the accompanying sidebar, "Proposed wording."
Article _____. Year 2000 compliance.
B. Provided a party complies with section A, it will not be liable to the other party for any failure to perform obligations under this agreement to the extent that such failure arises from a Year 2000 problem (1) affecting one of the nonperforming party's suppliers or (2) beyond that party's reasonable control (such as, a Year 2000 problem affecting a governmental entity). IN PARTICULAR, SUCH NONPERFORMING PARTY SHALL HAVE NO LIABILITY FOR ANY DAMAGES, INCLUDING DIRECT, INDIRECT, INCIDENTAL, SPECIAL, CONSEQUENTIAL, PUNITIVE OR EXEMPLARY DAMAGES.
C. A "Year 2000 problem" means a date-handling problem relating to the Year 2000 date change that would cause a computer system, software or equipment to fail to correctly perform, process and handle date-related data for the dates within and between the twentieth and twenty-first centuries and all other centuries.
There may be a series of critical customers and vendors that will require or demand special treatment. A usable corporate strategy should provide for a different process where needed. The variances may address a shifting of the risk allocation or a way to continue to provide the goods or services not using Y2K-affected systems or equipment.
Suppliers are being inundated with requests by customers for certifications, warranties and indemnities that the Y2K problem will not adversely affect the supplier's ability to perform a contract.
These certifications represent a radical approach by customers to reallocate risk, often in contravention of existing contractual terms and conditions.
The authors strongly recommend that suppliers do not sign these forms. Supplier's legal counsel should ask the following legal and strategic business questions:
The following actions should be considered in creating a strategic plan to deal with Y2K supply-chain issues:
Fortunately, while each type of contract provides a different practical challenge, the recommended treatment, from a legal perspective, is very similar for each type of contract. Emphasis should be placed on amending existing longer-term contracts that will continue to be in force as we approach the Year 2000. Existing spot orders and other short-term contracts should have a lower priority and may not require any action. The proposed language in this article can provide a fair and equitable starting point for these discussions. At the very least, proposing an amendment should facilitate open discussion of the issues, exchanges of accurate information and understanding of the real risks of dislocation.
Change printed-form contracts and templates for negotiated contracts to represent an explicit allocation of obligations and risks associated with Y2K problems and supply-chain contracts. It is our experience that most contracts have relatively short life cycles - the vast majority of contracts are spot orders memorialized by printed forms. It is hoped that by the Year 2000, most important contracts will either have appropriate language in them or, at least, will have facilitated discussions between suppliers and customers so that all of the parties to the supply chain are aware of the potential risks and weaknesses in their supply relationships.
To the extent that changes to all or most existing contracts and contract forms is impractical, prepare an analysis of critical supplier and customer contracts and contracts of long duration and work to modify them as needed. Special emphasis should be placed on "sole source" suppliers and business-critical customers.
Consider working within trade groups to define an industry model to deal with Y2K supply-chain issues. To the extent that a fair and equitable risk allocation consensus can be established to reflect an industry viewpoint and become accepted commercial practice, the costs of reviewing and negotiating hundreds or thousands of contracts can be significantly reduced.
To the extent necessary, as a customer or supplier, consider formally requesting a supplier to provide adequate assurances that the contract will be performed. UCC Article 2-609 suppliers should also consider whether allocation of supply will be necessary. UCC Article 2-615.
In any case, a party to the contract should:
The Y2K supply chain issues raised in this article represent a significant, but unknown, exposure for companies not engaged in the sale or licensing of software or software-dependent equipment as their primary line of business. It is important that these companies develop a comprehensive strategy to deal with these issues and then implement it.
There is relatively little time left to implement a business-oriented strategy. It is hoped that this article will be of some help in assisting corporations to formulate and implement their policies.
Proposed wording
A. Each party covenants and agrees that it will not permit a Year 2000 problem in computer systems, software or equipment owned, leased or licensed by it, its affiliates or subsidiaries to interfere with its performance under this agreement. Each party further agrees to request, from those of its suppliers whose performance may materially affect that party's performance hereunder, that each such supplier undertake the same obligation with respect to such material performance. The parties will use reasonable commercial efforts to cooperate and share information to further comply with this article, and to minimize the impact of any Year 2000 problem on performance of this agreement. Each party will inform the other party of any circumstance indicating a possible obstacle to such compliance, and the steps being taken to avoid or overcome the obstacle.
