Inflation is the mot du jour, serving as a focal point of discussion at both the Labour Party and the Conservative Party conferences.
After a decade of relative stability, the UK inflation rate for August was 9.87%. Political and fiscal contentions aside, the net hike in the UK’s Consumer Price Index over the last 12 months presents suppliers (and their customers) with a rare predicament. Many commercial contracts will have been negotiated and entered into with little or no thought about high inflation and its impact on contractual costs.
Here, I assess the impact of inflation on commercial contracts, contracting parties’ legal position, and ways businesses might mitigate potential losses.
Impact of inflation
As the cost-of-living crisis looms, consumers can already feel the impact of high inflation. Not entirely disconnected from this is a gradual erosion of suppliers’ profit margins. As the cost of materials, overheads, and operations (such as logistics) increases - unless a contract includes an express indexation right, or a price change clause – that contract could become unprofitable, because suppliers will not be able to pass on increasing costs to their customers.
What can parties do if a contract becomes difficult, or completely unviable, to perform?
What the law says
The legal position will depend in the first instance on what the contract says, and whether it includes rights to change or negotiate price part-way through the contract term.
An express indexation clause effectively removes inflationary risk by allowing the parties to periodically adjust the prices paid under the contract by reference to a nominated price index. These are more common in long-term contracts lasting more than 12 months, since short-term contracts are less likely to incur significant inflationary risk.
A general price change clause might enable the parties to negotiate price part-way through the contract. Where such increase is not made by reference to a specific price index (and there is therefore less certainty), there is always a higher risk of these negotiations failing and the contract being terminated altogether, or a dispute arising. It is important to note that, depending on how a price change clause is drafted, the right to re-negotiate price might not be triggered by a rise in inflation.
It is highly unlikely that a sharp rise in inflation will be deemed a force majeure event, irrespective of how widely the relevant definitions and clauses are drafted. Force majeure clauses are designed to protect a party from a beach of contract claim if it is unable to fulfil its contractual obligations as a result of circumstances outside its control. They typically cover things like acts of God, natural disasters, industrial action, pandemics, war, and actions taken by a government or public authority.
It is well established by English law that “a change in economic or market circumstances, affecting the profitability of a contract or the ease with which the parties' obligations could be performed, was not regarded as being a force majeure event” (Tandrin Aviation v Aero Toy [2010] EWHC 40). It is worth noting that this particular judgment ruled that even the collapse of the world’s financial markets did not trigger a force majeure clause.
While the courts may allow a term to be implied into a contract, they are extremely unlikely to imply a term into a contract that the prices can be increased in line with inflation. In Marks & Spencer v BNP [2015] UKSC 72 the Supreme Court ruled that “a term should not be implied into a detailed commercial contract merely because it appeared fair or because the parties would have agreed it if it had been suggested to them.” Rather, terms should only be implied “if, without the term, the contract would lack commercial or practical coherence”. In other words, the implication of the term should be so obviously that it goes without saying.
Ways to mitigate potential losses
Of course, it is easy to be wise after the event and parties negotiating new commercial contracts should consider whether those contracts should contain indexation clauses. It’s important to think carefully about what should be indexed. For example, it may be appropriate to index service credits and liability, in addition to price, depending on what is being supplied. The particular index and procedure opted for should also be appropriate in the context, and they should mirror potential changes in the cost of materials, overheads, and operations.
It might also be possible to agree to a cap on any periodic increase (which would be favourable to customers, rather than suppliers). However, this might only be a realistic option for parties benefiting from stronger bargaining power than their counterparty.
Where drafting includes formulae to determine how any price change or cap will be calculated, care must be taken to ensure that the formulae actually work and are correct.
Parties who are already tied into commercial contracts which are silent on price change and inflation might check the termination clauses and/or consider a commercial negotiation with the other party to the contract. There could be rights to terminate the contract for convenience, or simply by giving notice to the other party. If so, any relevant procedural requirements and obligations upon contract termination should be adhered to.
If a contract does not contain any rights to terminate, you might consider whether terminating the contract anyway and paying the cost of any damages claim makes more economic and commercial sense than stumping up the cost of performing the contract.
The most prudent option is likely to be a commercial negotiation. In most cases, the customer will want to avoid a scenario where products are supplied late or are of a sub-standard quality, and if a supplier becomes insolvent, it is a lose-lose situation. A party seeking to negotiate a price increase should be able to justify its request, and would ideally provide evidence demonstrating:
- why and how costs have increased;
- other ways that party has already sought to mitigate the impact of inflation; and
- an appreciation of how a price increase may affect the rest of the supply chain.
Negotiations should be conducted in a way that does not harm the parties’ relationship, particularly where a contract relates to a joint venture or long-term collaboration of some kind.
If you would like advice or support regarding inflationary risk and commercial contracts, please contact a member of our Commercial Team.
