Managing Legal Risks with the Supply Chain

Typically a customer will engage a supplier and will expect that supplier to provide the goods or services itself. However, there are many instances where the selected supplier may need to subcontract its obligations to a third party subcontractor.
Managing Legal Risks with the Supply Chain

The subcontractor may then in turn need to further subcontractor to another third party and this could be the beginning of a complex supply chain. How can the customer manage the risks related to a third party in the supply chain failing?

It is usual, although not always the case, that where a subcontractor fails to perform its obligations in accordance with the subcontract, this will lead to a breach by the supplier under its contract with the customer. Clearly, a failure by a subcontractor to perform its obligations under a subcontract leading to the breach of the contract by the supplier will be of concern to the customer.

The rights the supplier will have against the subcontractor will depend on the terms of the subcontract. Generally, due to the concept of privity of contract, the subcontractor will not be contractually liable to the customer. However, the subcontractor may be liable to the customer for acts or omissions carried out in performance of the subcontract (for example, in negligence if it can be established that there is a breach of a duty of care owed by the subcontractor to the customer) or for breach of a statutory provision. The customer can also obtain direct contractual rights against a subcontractor via a deed poll or collateral warranties.

Subcontracting may occur in respect of most contractual obligations. However, where the obligation imposed on a contracting party is personal in nature in the sense that its performance involves the exercise of individual expertise or the identity of the party is important, case law provides that appointing a third party to undertake these functions is a breach of contract unless the contract expressly permits subcontracting.

For that reason, consideration must be given on a case by case basis as to whether a supplier should be permitted to enter into subcontracts, and if so, the terms, conditions and restrictions which will apply to such a right. However, the contract may expressly permit or prohibit subcontracting.

When determining the approach to supply chain risk management, the customer should consider the following.

  • Should subcontracting be permitted at all? If the nature of some of the matters the customer deals with are highly confidential, or require specialist expertise, the customer may wish to remove any right the supplier may otherwise have to subcontract its obligations.
  •  If subcontracting is permitted, should it be permitted in respect of the whole or part of the subject matter of the contract? Again, the answer to this question may depend on the subject matter of the contract. Contracts of requiring specialist expertise which the supplier possesses would, in all likelihood, contain limited subcontracting rights. Conversely, relatively standard contracts, dealing with day to day type matters, may contain broader subcontracting rights.
  •  If subcontracting is permitted, on what basis can the customer withhold its consent to subcontracting? For example: (a) does the customer have absolute discretion; (b) does the customer need to act reasonably; (c) does the customer only require written notice, etc. Obviously, the basis upon which the customer may grant consent will again depend on the circumstances.
  • Does the customer require the right to review the terms of the subcontract (with/without pricing)? By retaining this right, the customer can ensure the terms of the subcontract are consistent with the terms of the main contract. Following on from this:
  • Does the customer require the right to mandate the use of a prescribed form of subcontract, or for specific clauses to be inserted into the subcontract which are consistent with the contract? This right may be particularly relevant where the customer is aware the supplier will be subcontracting an important or substantial amount of the scope of works, or subcontracting to a subcontractor with specialist software. In the case of specialist software subcontracts, the customer may exercise this right to require any subcontract to contain appropriate escrow arrangements. Further, the customer can use this right to ensure other important provisions are contained in the subcontract (for example, confidentiality undertakings).
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  • This right will also allow the customer a degree of control over the consistency of the forms of subcontracts used by suppliers. However, it is important for the customer to acknowledge that the exercising of such control will impose an administrative burden on the customer, without necessarily improving the customer's legal position against the supplier or the subcontractor. In fact, it is possible that exercising such a degree of control over the subcontracting process will weaken the customer's legal position against the supplier. This issue is considered in more detail in below in relation to nominated subcontractors.
  • Does the customer require that the supplier should not be able to make or agree to any variations or amendments to the terms of the subcontract without the customer's consent?
  • Are there situations where the customer will nominate or select preferred subcontractors? If there are, this may impact on the rights a supplier may have against the customer. Issues relevant to nominated subcontractors are analysed further below.
  • Is the subcontractor permitted to subcontract its obligations?

Risk allocation

There are various mechanisms available to the customer where it can allocate, manage or transfer the risk that is inherent in subcontracting. Some of these mechanisms include:

  • Despite subcontracting, the supplier can be made to remain entirely responsible and liable for the scope of work/services under the contract. Under such a clause, the supplier would not be entitled to any relief from its obligations under the contract notwithstanding the supplier's failure to perform is directly attributable to the subcontractor's failure to perform. Such a requirement is relatively standard and should be included in all contracts that permit subcontracting
  • There may be circumstances where the customer wishes to obtain direct contractual rights against a subcontractor. As noted above, collateral warranties create a direct legal relationship between the customer and the subcontractor. Collateral contracts and warranties are most commonly used in the following two situations.
  • Where the customer nominates a subcontractor for use on a particular project. The use of a collateral warranty will give the customer direct rights against the subcontractor, which is important because the customer's rights against the supplier might be compromised where a subcontractor has been nominated
  • Where the subcontractor provides, or receives, manufacturers' warranties in respect of goods, the customer might want the benefit of these warranties to be assigned to it. This will enable the customer to have direct legal recourse against the manufacturer pursuant to those manufacturers' warranties.
  • The customer should require the supplier to provide it with written notice when subcontracts are terminated and the reasoning behind that termination. Again, the supplier should remain entirely responsible and liable for the scope of work/services under the contract despite the termination of subcontractors.
  • The customer may require the right to "step-in" or take over key subcontracts by assignment or novation. Situations in which the customer may require this right include where, for example, the supplier is in major default under the contract, or if the customer wishes to terminate its contract with the supplier but still receive the benefit of the subcontract.
  • The customer may achieve this by inserting a clause in the contract under which the supplier agrees to assign or novate a subcontract at the request of the customer and undertakes to include a similar clause in the relevant subcontract. The subcontractor would not be legally bound to the customer by the clause in the subcontract, but this is the best that can be achieved other than obtaining a deed from the subcontractor.
  • The customer should require suppliers to ensure that subcontracts contain confidentiality, privacy and security provisions that enable the supplier to comply with its relevant obligations to the customer. The customer should also consider whether there are situations where the customer should seek confidentiality undertakings directly from subcontractors via collateral warranties (as explained above).

Insolvency

Mechanisms that the customer can utilise to minimise the customer's exposure in the event of the insolvency of a subcontractor include:

  • as set out above, ensuring the supplier remains entirely responsible and liable for the scope of work/services under the contract despite insolvency of subcontractor(s);
  • maintaining control over the appointment of subcontractors to minimise risk of suppliers appointing subcontractors with a high risk of insolvency; and
  • having input into the terms and conditions of the subcontract particularly in relation to key subcontracts or subcontracts involving subcontractors with specialised expertise or intellectual property.

Nominated Subcontractors

The following issues should be considered when the customer wishes to nominate subcontractors:

  • If the customer wishes to nominate specific subcontractors on a project, it should ensure the contract contains a provision dealing with nominated subcontractors. The provision usually reserves to the customer an express power to effect nominations of subcontractors with whom the supplier is obliged, usually subject to a limited right of objection, to enter into a subcontract.
  • The obvious benefit to the customer in the system of nomination is that it can exercise a degree of control over the quality of the work by specifying particular subcontractors that the customer is confident have the capability to provide appropriate goods and services in the relevant circumstances.
  • It should be noted that, express contractual provisions aside, the nomination of a subcontractor by a customer will not ordinarily affect the relationship between the customer and the supplier. Generally, there will be no privity of contract between the nominated subcontractor and the customer.  Further, the mere nomination to a supplier of a particular subcontractor will not of itself bring into existence a contract between the customer and the subcontractor. In nominating a subcontractor, the contract administrator does not automatically become the agent of the supplier.
  • The customer will ordinarily have no liability to the supplier for the nominated subcontractor's breaches of the subcontract. However, the customer's legal recourse against the supplier might be diluted by the fact the customer has exercised a degree of control over the contract by nominating a particular subcontractor. This arises due to the fact the customer has effectively recommended the subcontractor to perform the particular works, and as such has fettered the supplier's ability to use its own discretion as to the most suitable method (and subcontractor) to perform the particular works or services.
  • The use of a collateral warranty in such circumstances grants the customer direct rights against the subcontractor, which is important because the customer's rights against the supplier, under the subcontract, might be compromised. The collateral warranty should provide an undertaking by the subcontractor that it will perform the subcontract works in accordance with the subcontract.

Whilst there are risks with complex (or simple) supply chains, there are mechanisms which can be adopted by customers to ensure that such risks are managed appropriately.

Managing Legal Risks with the Supply Chain

by Dr Sam De Silva

Partner - Head of IT Law and Outsourcing Law, Penningtons Manches LLP

Dr Sam De Silva is a partner and the head of the IT and Outsourcing practice at leading UK law firm Penningtons Manches LLP. His main areas of practice are technology projects and the outsourcing of technology and business processes.  He has been published widely and speaks regularly on these topics and is Chair of the Law Society's Technology and Law Reference Group. Sam is also one of very few UK solicitors who is a Fellow of the Chartered Institute of Purchasing and Supply (FCIPS), Fellow of the British Computer Society (FBCS) and a Chartered IT Professional (CITP).  He is also an IT Law Accredited Member of the Society for Computers and Law.  

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