1. Widespread problems and challenges
The business slowdown due to the COVID-19 epidemic and the subsequent shutdown of production facilities have involved most industries and sectors, including fashion.
The main goal is to ensure long-term business continuity and accelerate production throughout the supply chain once activities can be fully or even partially resumed.
At present, fashion brands may face a range of different problems, including suppliers’ inability to deliver orders on time, suppliers’ liquidity problems, and potential liability for abuse of economic dependence if brands act to terminate their relationships with suppliers.
The reopening may make it necessary to speed up production, and suppliers will not necessarily be able to guarantee delivery to meet each brand’s deadlines.
This inability may be caused by low liquidity and consequent problems with the supply of raw materials or semi-finished products and workload.
A brand may put in place certain measures to support its supply chain, such as implementing invoice financing, shortening payment times, and providing access to reverse factoring platforms (if conditions are met). Brands may even consider the option of opening bank credit lines dedicated to paying their suppliers, using the liquidity measures introduced by COVID-19 laws (as FCA is doing with Banca Intesa San Paolo on a very large scale). Suppliers could obtain additional liquidity by factoring their receivables. Unfortunately, supply agreements often exclude the right of suppliers to factor receivables. This is often imposed by the brands, which much prefer to have suppliers rather than banks as their creditors. Business associations have been lobbying for the government to suspend the enforcement of clauses that prohibit factoring of receivables, but so far these attempts have not been successful.
Still, it remains possible that brands will be forced to cancel or decrease orders or to spread them among several suppliers. This may create a number of problems:
(i) under certain circumstances, although cancellation of the orders by the brand may not qualify as a breach of contract, at the same time there is a need to protect suppliers and especially subcontractors as weaker contractual parties;
(ii) to strengthen its position, a brand could ask suppliers to estimate delivery times in order to induce them to declare their potential inability to fulfill terms, which would put the brand in a better position;
(iii) although it can be argued that a drastic and sudden reduction or cancellation of orders does not constitute an abuse of economic dependence, nevertheless the brand should consider that purchase orders are usually imbalanced in favor of the brand, so there is an imbalance in the parties’ positions with regard to rights and obligations.
2. Abuse of economic dependence
It is highly likely that suppliers whose turnover is more than 50% dependent on a single brand will react to that brand’s decision to cancel orders by arguing that this amounts to abuse of economic dependence of the suppliers pursuant to Sect. 9 of Law No. 192/1998.
Based on relevant Italian case law and scholarship, what follows is a limited list of just some of the factual circumstances suppliers may try to employ to ground their claims:
- materiality of the turnover realized by the suppliers in relation to orders from the dominant partner;
- duration of the overall relationship between the parties;
- significant capex made in order to satisfy brand’s quantity and quality standards;
- breach of the general obligation set out in Sect. 1375 of the Italian Civil Code, pursuant to which the parties must act in good faith when performing the contract.
In this scenario, a brand may challenge suppliers’ claims by alleging the following exculpatory circumstances (to be verified case by case in the applicable scenario):
- COVID-19 has made two remedies applicable: hardship (ITA: eccessiva onerosità sopravvenuta), where unforeseeable and extraordinary events materially change the equilibrium of a contract in such a way that performance would become excessively burdensome for one party; and force majeure (ITA: impossibilità sopravvenuta), where extraordinary and unforeseeable events prevent a party from fulfilling its contractual obligations;
- there is not “any excessive imbalance of rights and duties” and the suppliers have an “actual chance to find alternative satisfactory clients on the market”;
- the decision to reduce and/or interrupt production orders is not arbitrary, but corresponds to the brand’s need to reorganize production;
- investments were not made by the suppliers upon brand’s request and, in any event, were not tailored to the brand’s specific needs and hence can be easily and cost-effectively used for other forms of production.
3. How can a brand lawfully end its relationships with suppliers?
That said, under Italian law, a brand is not obligated to continue its contractual relationships endlessly with suppliers. However, termination of supply contracts must be carried out in a way that ensures a correct balance between the brand’s economic interest in reorganizing its business and the suppliers’ need to replace the brand with new clients.
To that end, in a long-term contractual relationship, a brand is entitled to terminate the contract, provided that the supplier is given reasonable notice (for examples, for supply contracts see Sect. 1569 of the Italian Civil Code and for agency contracts see Sect. 1750, according to which “the notice period can in no event be less than one month for the first year of duration of the contract, less than two months for the second year commenced, less than three months for the third year commenced, less than four months for the fourth year, less than five months for the fifth year and less than six months for the sixth year and all subsequent years”).
In light of the above principles, to avoid the risk of being held liable toward their suppliers, brands should withdraw from supply contracts (or significantly reduce their order volume) upon due notice to the suppliers.
As to the reasonable length of the notice period, Italian courts have generally deemed a six-month notice sufficient for multi-year supply contracts.
In theory, the notice period may be replaced by payment of an indemnity (indennità di mancato preavviso), which is liquidated on the basis of the profit that the supplier would have earned had notice been given properly.
That said, there might be room to argue that the COVID-19 emergency can affect the definition of “reasonable notice,” specifically by allowing a contract to be terminated with shorter notice or allowing brands to reduce their orders during the notice period. A deep analysis of this issue should be carried out on a case-by-case basis.
4. Miscellaneous questions that come to mind when discussing the above issues
Further items that should be addressed from brands’ side may include the following:
– Given the extraordinary circumstances, is there room for mitigating the brand’s liability regime for labor law issues (i.e., joint and several liability for debts to employees and the risk of requests for conversion of employment relationships in the event of dismissal)?
– Is there any suspension of the obligations introduced by the law on the documentation to be produced and the amount to be withheld with regard to joint and several liability for withholding tax in contracts?
– Is there room to mitigate the brand’s liability regime in the case of supplier bankruptcy?