We are now over several months into 2023 and the chip industry continues to draw headlines. So, let's consider the issues businesses, that rely on chips, might start to see in the coming months or years, as volatility in supply and demand continues.
The backdrop to the market is important to understand how contracting practices might develop. The year 2022 drew to a close with demand for chips across a number of sectors weakening significantly. However, many expect this to rebound in 2024, if, as expected, economic growth improves (for example, in response to subsiding inflation and/or China’s exit from its zero-COVID strategy).
At the same time, certain sectors – notably, the car making industry – continue to experience acute shortages of the specific kinds of chips they need. Finally, political scrutiny over chip production is intensifying. Recent reports suggest Japan and the Netherlands will soon follow the US in imposing export controls restricting the transfer of advanced chip production equipment and technology to China.
All of this points to significant uncertainty, which may, in turn, lead to changes in how businesses contract with each other across chip supply chains. For example, car makers have started negotiating longer-term contracts with chip manufacturers to provide greater security of supply. More companies are investing in producing their own chips.
Buyers and sellers who are alive to the changing dynamics in the marketplace are likely to find themselves better placed to navigate future volatility. There are a number of issues that market participants may start to think about in connection with their current and future contracting arrangements.
- Balancing Security and Flexibility of Supply – Market volatility can cause a buyer’s and a seller’s interests to diverge. Tight markets with high demand suit sellers with products they can sell, not ones committed under preexisting, long-term contracts. Conversely, in periods of oversupply, long-term purchase commitments can become a burden for buyers. These trends are common in other commodity markets and put pressure on longer-term contractual relationships. We may see a similar proliferation of contractual disputes replicated in chip markets if market conditions continue to oscillate.
- Purchase Commitments – Countries around the world are increasingly looking to establish chip production capabilities within their own borders. Fabricating advanced chips is an extremely complex and demanding process, often requiring enormous capital investment. Alongside governmental support, chip manufacturers may start seeking more substantial purchase commitments from customers to underwrite this expenditure. Buyers may be happy to give these commitments now as they seek to shore up their supply lines. But will this still be the case if geopolitical tensions ease or technologies change? Parties negotiating supply commitments may wish to consider their viability in different economic or political environments.
- Issues Regarding Export Restrictions – Market participants should be alive to the possibility of more countries becoming involved in chip supply chains, following the lead of the US, and imposing restrictions on cross-border trade. Similarly, an expanding of existing restrictions cannot be ruled out. Increased political action may impact contracting habits. Sellers of chips or chip manufacturing equipment may want greater contractual protection governing what buyers can do with their products and who those buyers themselves deal with. How should these measures be audited or enforced? What should happen if they are breached? For buyers, key objectives are likely to be maximizing flexibility and minimizing exposure to supply disruption from any future government action.
- Interpreting Pre-existing Contractual Restrictions – International commercial contracts often contain provisions relieving a party whose performance is affected by external factors, such as a change in the law. As governments intervene more actively in chip markets, parties may seek to rely on these provisions with greater frequency. Whether they apply may involve questions of governing law that are not straightforward. Parties should carefully consider the specific scope, wording and inclusion of force majeure, change in law and/or material adverse change provisions in anticipation of potential future disruptions. In extreme scenarios, parties may try to argue that the contract has been fatally undermined – for example, through the common law doctrine of frustration. International conventions governing the sale of goods, such as the United Nations Convention on Contracts for the International Sale of Goods, may also apply if not excluded under the contract.
- Dispute Resolution and Confidentiality – With whom and where contractual parties choose to resolve their disputes is an important issue, but one that can be glossed over in negotiations. Commercially sensitive contracts may provide for arbitration, which, unlike most litigation before national courts, generally carries the expectation of confidentiality. However, as the chip industry takes on greater political prominence, resolving sensitive disputes behind closed doors may become cause for concern. Another key issue is enforcement. Parties may find that either arbitration or litigation offers a better route to successful enforcement, depending on the jurisdiction in which their counterparty is based or has its operations, although this will vary from case to case. Overall, parties will need to pay attention, perhaps more than ever before, to the appropriateness of the dispute resolution forums contained in their contracts.
These are just some of the trends we may see develop in coming months and years. Disruption in the manufacture and sale of chips is not a foregone conclusion, but businesses are paying closer attention to the sector than perhaps ever before. Active consideration of how their current and future contracts may be affected is, therefore, recommended.
*This article was first published on the Supply & Demand Chain Executive website on 11 April 2023.