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COVID-19 Product Shortages – Legal Pitfalls in Choosing Among Customers

March 25, 2020

Supply chains across the globe are being disrupted by the coronavirus (COVID-19) pandemic as manufacturers of “non-essential” goods curtail or completely suspend production based on worker shortages or government orders. The impacts of those realities will be felt for months or years to come by downstream businesses who assumed a certain supply of goods or raw materials when accepting orders from their customers. Given the lead times associated with manufacturing products, supply chains will not be refilled overnight. That means that many sellers may not have sufficient supplies to fill all customer orders in the short term or once the pandemic abates and consumer demand returns.  In those situations, sellers will need to carefully consider their legal obligations before picking and choosing among their customers in a limited supply context.

Some contracts will include mechanisms called force majeure provisions that allocate the risk and, therefore, financial liability, for certain business disruptions to either the seller or the buyer. However, less-sophisticated arrangements, including contracts formed through purchase orders and sales confirmations, may be silent on these issues. In those situations, US businesses may be surprised to learn that the state in which they operate most likely has adopted a statute through which some important commercial terms are implied as a matter of law into their commercial agreements. Those laws are modeled after something called the Uniform Commercial Code (UCC) which includes in § 2-615 a contractual defense known as “commercial impracticability.” This provision grants sellers of goods (i.e., movable personal property including finished goods and raw materials) with a defense to liability for unfilled orders in circumstances like the COVID pandemic.  

The details of how this defense applies to disputes between buyers and sellers could vary slightly based upon prior court decisions in certain states, but some general principles are likely to apply in most situations.  

  • The defense applies to the sale of goods, not to services. Contracts that involve both goods and services are covered by UCC provisions like commercial impracticability only if the sale of goods was the “predominant purpose” of the contract.    

  • The defense applies only if the disruptive event – in this case a pandemic – was unforeseen by the parties. It is not available when the evidence shows that the parties discussed the disruptive event while negotiating the contract or before orders were placed but chose not to address the risk through contractual provisions.  

  • The seller must demonstrate that no alternative means existed for it to meet the obligation to supply the products at issue. Sellers should document their unsuccessful efforts to procure goods from other sources, even competitors, to satisfy this requirement. 

  • The defense generally will not be sustained for sellers who elect to fully satisfy accepted orders from their “favorite” customer(s) while attempting to cancel accepted orders for other customers.  

  • Quantities available to the seller must be allocated among affected customers until supply constraints are resolved. There is no requirement for absolute equality in allocated supplies to customers. However, the allocation method must be fair and reasonable and ideally based upon objective factors such as pro rata percentages based on each customer’s past sales history.  

  • The defense is often forfeited through self-dealing in which a seller prioritizes orders from companies in which the seller holds a direct financial interest (i.e., subsidiaries, affiliates or joint ventures) over orders from “independent” customers.  

Subject to these limitations, the commercial impracticability defense will often determine which party in commercial transactions ultimately bears the financial losses caused by a shortage of goods. Given the significant losses on the horizon for supply disruptions caused by COVID-19, sellers and buyers need to be understand the implications of this defense for their business. Seeking advice from legal professionals while you are making supply decisions is highly recommended.    

Robert W. George brings a wealth of knowledge and skill to the firm’s litigation, corporate governance and regulatory practices. His focus consists of a multifaceted business litigation practice in both federal and state courts and includes defending clients against antitrust, securities, environmental and toxic tort claims, as well as commercial disputes involving fraud, non-compete agreements, or unfair competition.

Disclaimer: The information included here is provided for general informational purposes only and should not be a substitute for legal advice nor is it intended to be a substitute for legal counsel. For more information or if you have further questions, please contact one of our Attorneys.

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