Australia has enjoyed a record 28 years without a recession.  Neither the dotcom bust in 2001, nor the global financial crisis of 2007 were able to end Australia’s relentless economic growth.  But with the COVID-19 pandemic that has now all now changed.

The RBA has warned of a “major hit to economic activity and incomes in Australia that will last for a number of months”.  Consumer confidence has fallen off a cliff.  Unemployment and underemployment are racing towards their highest levels in a generation.  And although Australia may not have endured a recession recently, businesses can still learn from previous downturns and the experience of other markets. 

Businesses are already busy scrambling to prepare for the upcoming COVID-19 recession.  Some are raising capital while they still can.  Some are putting a freeze on new hires.  But all businesses should be considering what impact a recession will have on their supply chains and the way that they manage their contracts.

Contracting in the good times

When economic times are good, most of the focus is on growth and speed.

In customer-facing functions, business development managers and sales teams want to hit target.  There can be pressure to bend the “rules” and agree to the customer’s contract terms.  Everyone wants to get on with the business relationship, often without bothering too much about what the contract says.

Likewise, in supplier-facing functions such as procurement, the focus is often on getting to the best price.  A better price might previously have justified less focus on contract and legal risk.  Or operations or logistics managers might have an urgent need to boost capacity, so a supplier or service provider’s T&Cs are accepted with little scrutiny.

With a recession, all of this changes.

What happens to supply chain contracts in a recession?

As the economy moves into recession, businesses experience the following:

• Customer orders decline quickly.  Orders may be cut back or delayed.  Customers start to look for cheaper alternatives and only order smaller quantities.  The sales cycle gets stretched out and more significant expenditure gets deferred.
• Customer payments dry up quickly.  Debtor days increase, invoices get challenged, companies experience more pressure to discount.
• Contract parties scrutinise existing contracts more closely.  They want to make sure they are getting the full value to which they are contractually entitled – even if that hasn’t been the “spirit of the agreement” until now.  If the relationship is going to become terminal, there is more incentive for the other party to extract as much value as possible while they still can.
• Key contracts with suppliers or customers that worked well for one set of conditions start to become onerous.  Better short-term deals or opportunities can become available – for example, as a different supplier is forced to liquidate stock.
• Contract-related disputes and litigation increase.

How can the right contract strategy help us prepare for a recession?

Your organisation’s response to preparing for recession should include a strategic review of how various potential scenarios would impact the business.  Different scenarios might include quick recovery, a downturn that lasts for the remainder of this year or a prolonged and ongoing recession.  This exercise is wide-ranging – covering, for example, the company’s financial position, workforce, facilities, operations and risk profile. 

The review should look at the impact on your suppliers and your different customer segments.  How will they be impacted?  Ideally this will also include a financial assessment.  Depending on the nature of your business, this could be for top 10 customers, or be done by customer segment.  It might look at your business-critical input suppliers.  You want to understand what might happen among these suppliers and customers, so that you can test the impact on your business.

This review might lead to new internal processes (more regular credit checks on customers, stricter sign-off requirements for extending credit, obtaining security such as a director personal guarantee). 

The review should also include plotting out a new contract strategy.  The key questions for your contract strategy are:

What do we need to do now to make sure we are in the best possible position to manage the impact of a recession?

How do we do this without risking existing customer goodwill, or putting off future good customers?

What are the key contract terms we need to approach differently?

Now is the time to look at your standard contract arrangements (such as standard customer terms, or procurement terms).  It’s also time to re-consider any business-critical contracts you are currently looking at.  Here are the key terms that you might want to start thinking about differently.

Contract term (duration)

With a recession coming, businesses should think about whether they want to aim for shorter- or longer-term contracts.  Normally the rule of thumb for surviving a recession would be to aim for:

• Longer terms for customer contracts.  Longer term contracts provide more predictable revenue, although this must be balanced against the credit risk and the importance of not relying too heavily on a small number of customers.
• Shorter terms for supplier contracts.  As we go into a recession, you do not want to be locked into upstream contracts that have suddenly become too expensive.

Consider if this works for your business.  There might be advantages in ignoring these rules of thumb- for example to secure supply of a key input.  You can also consider alternatives, including a short initial contract term, with regular options to extend the term.

Exclusivity and minimum volume commitments

With rapidly changing market conditions in a recession, be wary of exclusivity arrangements or minimum volume commitments.  Nobody wants to be committed to continue to supply or purchase a particular level of goods or services where there is no longer a market for them.

Price review clauses

Especially if your contracts have a long term, consider whether you should include the following types of clause:

• Price benchmarking (or meet the market).  This clause requires the parties to go through a price review exercise (perhaps once a quarter), to compare pricing under the contract with what else is going on in the market.  If more competitive pricing is available elsewhere, the supplier must either meet that price or

• Cost pass-through clauses.  If your profit margin is susceptible to changes in input costs (raw materials, energy prices, foreign exchange rates), consider whether the contract should allow for contract prices to be adjusted to reflect changes in cost.

Watch out also for supplier’s “standard” price review clauses (for example that are linked to changes in CPI) where they are drafted to be upwards only. 

Payment terms

A company is insolvent when it is no longer able to pay its debts when they fall due for payment.  As we go into a recession, it is therefore very common for customers to start asking for longer payment terms.  By agreeing to provide longer payment terms, your business is effectively providing a source of trade finance to your customers.  And as managing your cashflow is vital to surviving a recession, it’s important to have your strategy ready.  What criteria will you use to determine who qualifies for extended payment terms?

If you are extending credit, you have to approach this question in the same way that a bank or other finance provider would.  It’s important to have the right supporting processes in place – for example, do you do regularly updated credit checks to see if you should still be extending credit? 

Items to consider including in your contract:

• Rights to change future payment terms if there is a late payment.
• Late payment interest rate.  You can specify an interest rate that will apply if payment is late.  This might be your own overdraft rate, plus a margin of, for example, one or two percent.  This should be a floating rate, in case there are changes in rates during the contract term.  It also should not be so high as to be a penalty, as this will be unenforceable.
• Clauses that allow for recovery of administrative and legal costs spent chasing an overdue payment.

Other strategies that might work for your business include providing a prompt payment discount, or instalment or milestone pricing (with some of the price paid at the time of order, with the balance paid later).

Dispute resolution

It’s a good idea to have a dispute resolution clause that encourages a face-to-face meeting or mediation, before expensive litigation starts.  However, watch out for clauses that allow the other party a long period of time to remedy a default.  For example, a contract might give 30-day payment terms, but also say that a party has 30 days to remedy a default before action can be taken.  This might also be followed by a lengthy dispute resolution timetable.  It is easy to see how a dispute could be raised on an unpaid debt to extend out the time for payment.

Termination

Especially in a longer-term arrangement, it can become important to be able to get out of the contract – for example, where it has become unprofitable or because the company’s strategic direction has had to change.  Consider what termination rights you might need in different recession scenarios. 

Common termination rights include where there has been a serious breach of the contract or a failure to pay on time.

It is also still common to see clauses that suggest they allow termination if the other party becomes insolvent (or suffers an “insolvency event”).  These are called ipso facto clauses.  However, for many contracts entered since 1 July 2018, this type of clause has become unenforceable.  A party is not permitted to rely on this type of termination right if the reason for enforcement is because the other company has become gone into receivership, voluntary administration or a scheme of arrangement.

This makes it more important to have clear rights to terminate for non-payment.  It also makes it more important to consider having a termination for convenience clause, allowing termination without there being a specific reason and usually when a certain amount of notice is provided. 

Retention of title

For companies supplying goods or equipment, and extending credit, now is the time to revisit whether those supplies should be on a retention of title basis.

If you are supplying on a retention of title basis, remember that retention of title is a security interest and you will need to have registered your interest in the goods or equipment on the Personal Property Securities Register (PPSR).  If your interest is not effectively registered, and the customer becomes insolvent, a secured creditor (such as the customer’s bank) will take priority over your claim to the stock.

Other types of security

If you’re extending credit, now might also be a time to consider whether other forms of security might be appropriate.  This could include a director personal guarantee, a bank guarantee, a deposit or even a general security over your customer’s assets.  These are all strategies that a bank employs, and if you’re providing finance to your customer, they are all legitimate alternatives to consider.

Final word

Businesses that adapt the most quickly to changes in the market are those that are the most likely to survive.  Revisiting your contract strategy does not have to make your business harder or more difficult to deal with.  In fact, now is more important than ever to make sure that your business is easy to deal with – so all your contract terms are clear, accessible, easy to understand and in plain English.

Having your contract strategy ready will help your business survive this recession – and be ready to race forward when times are better.