Supply Contract Termination Damages

Imagine you are a supplier of automotive parts and your company ("Supplier") just started a large production run of a custom product and your customer ("Customer") terminates the contract. How will you determine the damage this termination has caused to your company? These damages are usually referred to as Compensatory damages. This article will discuss some of the important aspects of compensatory damages relevant to a supply contract termination. This article will not discuss all aspects related to contract termination compensatory damages.

Compensatory damages are made up of:

1. Expectation damages: What should the Supplier have reasonably expected to receive from the completion of the contract?
2. Consequential damages: What impact did the termination have on other areas of its business that were reasonably foreseeable when the contract was entered into?

The first step in any contract termination dispute is to understand the contract. The contract may contain provisions that dictate how damages are to be determined.

If the contract has a termination for convenience clause, and assuming the termination was for a covered cause, then it will likely define the method for compensating the Supplier and/or Customer under this scenario. This may also be true for the termination for cause scenario. If these contract clauses exists, then the supplier's attorney will have to ascertain whether the termination was for convenience or for cause, and the damages expert will have to follow the procedures outlined in the contract to calculate what payment the Supplier is due as a result of the termination. Sounds simple, however, there are two important issues to watch in this situation:

1. In a termination for cause scenario, where the Customer terminates for a covered cause, the Customer may be able to claim "extra" costs incurred in order to fulfill the supply obligation with a successor supplier. Although the Customer is obligated to mitigate its damages, it may in fact not act with reasonable efficiency (e.g., issue a no-bid contract to a related party, or scrap good quality parts). It is therefore up to the damages expert to evaluate the Customer's performance subsequent to the Supplier's termination in order to determine if the Customer reasonably mitigated its damages and/or whether the Customer is charging inflated or phantom costs.
2. Additionally, if the contact has a liquidated damages amount specified for delayed delivery, and if the termination for cause results in a product delivery delay, then the damage expert will need to evaluate two important issues:
   1. Did the Supplier actually cause the delayed delivery?
   2. What is the actual cost suffered by Customer as a result of the delay? If the actual cost is materially less than the liquidated damage amount in the contract, then the Supplier may have a basis for asserting an adjustment to the Customer's liquidated damage claim.

If the contract does not contain language defining how reimbursement is to be calculated when the Customer terminates the contract, and if the termination was not the result of a breach by the Supplier, then the Supplier's damages will be the amount needed to put the Supplier in the position it would have enjoyed but for the termination. The most obvious element of this damage claim is the Supplier's lost gross profit, which is sometimes referred to as the contract's contribution to profit and fixed overhead. This lost gross profit will necessarily have to be net of the gross profit earned prior to the contract's termination.

There are many other potential damage elements that need to be quantified which may or may not be relevant depending on the unique circumstances of the Supplier's operations and the nature of the supply agreement. Following is a list of some of the items the damage expert should consider when evaluating what costs should be included in the Supplier's damage claim:

1. Unabsorbed front-end investment such as design costs or investment in plant capacity
2. Obsolete inventory (raw material, work-in-process, and finished goods) net of scrap value
3. Extra "demobilization" costs
4. Cost to dispose of excess capacity
5. Cost to re-task and/or terminate excess labor
6. Continuing costs that can be directly traced to the supply contract

The damage expert should also consider potential Supplier damages such as:

1. Lost profit from:
   1. Routine Customer contract renewals
   2. Affiliated parts and/or complimentary parts
   3. Different customers seeking similar parts
2. Brand damage:
   1. The value of lost intellectual property
   2. The cost to repair market brand image

In some extreme situations the wrongful termination of a supply contract can be the primary cause of the Supplier's bankruptcy. In this scenario, the damage expert will need to:

1. Document the linkage between the wrongful termination and the Supplier's bankruptcy
2. Determine the value of the Supplier at the appropriate valuation date. The valuation date will depend on the facts of the case and is frequently the date on which the wrongful termination occurred.

The preceding discussion covered only some of the considerations the damage expert will take into account with evaluating damages associated with the termination of a supply contract. The relevance of these considerations and numerous others will always depend on the specific facts of the matter being evaluated.

Resolution Experts PC, "ResX, PC", provides independent forensic accounting services for complex litigation and contract compliance and fraud. ResX is based in Michigan and serves clients throughout the United States. For more information and to learn about working with ResX, please visit our website: www.resxpc.com. Follow our page on LinkedIn here.

Published on July 6, 2017

Jim Schmid
CPA, CFE, CPA/ABV, CFF, CCA
Managing Director of ResX, PC