Supply Chain Partnering and Most Favored Nations Pricing

Given the events of recent global trade disputes and the need to minimize their risks, companies have become increasingly and frantically aware of the heightened need for alternate suppliers to ensure their growth and meet the demand for their products.

That said, “Strategic Partnering” has become a common theme with manufacturers/distributors and their vendors. Often, these strategies develop and enhance relationships where the parties eventually become mutually dependent on one another, contracts are signed and typically an assortment of covenants and provisions governing the relationship are condensed to a supply agreement. We often see a “Most Favored Nations” (MFN) clause embedded in these contracts, which is typically reserved for the policy wonks at the State Department, but is an important feature to a number of companies. To understand the underlying implications and consequences of this term, consider the following:

Background and Example

Each month, Coyote Manufacturing commits to purchase 5,000 metric tons of an ingredient from Road Runner Supply (BEEP BEEP – yes I am a Baby Boomer). The raw material is essential to the production of a component that is Coyote’s “Cash Cow”, so the continuity and quality of the supply chain is critical. Road Runner is joined at the hip too, since the relationship represents 75% of their production capacity and top line. Mutual dependency is front and center and there are economic rewards and penalties embedded in the contract when sales volumes exceed minimum tiers or Coyote fails to purchase (or Road Runner fails to deliver).

In return for Coyote’s commitment and guaranty of purchases, the parties agree to a “Most Favored Nations” clause, stipulating that the pricing afforded to Coyote for this raw material will be the absolute lowest price that is offered to all other Road Runner customers operating in a defined industry and/or a geographic region (e.g. the Eurozone, Latin America or North America).

While this pricing guarantee seems pretty straight forward and Coyote’s negotiated price is a bright line threshold, we have seen a multitude of mistakes and missteps in monitoring compliance with these terms. If there’s a penny difference on each pound of material sold in this example, this issue becomes a $1.3 million annual problem.

Common Problems

Suppliers, like Road Runner, often fall victim to:

Ignorance/Apathy
The contract has been in place for years and Coyote has never raised a concern or question. On the other side, the financial staff of Road Runner isn’t aware of the MFN clause in measuring liabilities and/or closing their books. Amendments to the contract are often not distributed to the appropriate level of management or ignored.

Motivation
Road Runner’s sales force is charged with bringing in new business and, in an effort to grow the top line, unknowingly offers other companies a price lower than that negotiated with Coyote.

Misinterpretation
Rather than assessing compliance with the definitions espoused and stipulated in the contract, suppliers have been known to follow the “spirit” of the contract in their monitoring activities. They will ultimately discover that the written contract trumps the spirit of the agreement.

Hearsay
Rather than reading the contract, people often rely on third-party interpretations of the terms or discussions as to what sales should be included in measuring compliance. An officer of Road Runner was quoted as saying…. “I’ve been told that the contract has no geographic limitations on who we can sell to and these other sales are exempt from the MFN guaranty.” Well, guess what, the contract says just the opposite!

Deception
Knowing that sales to a third party are subject to the MFN clause, schemes can range from the simple…

• Road Runner offers a lower net price to a third party through back-ended rebates and allowances that are granted or funded after year-end.

To the complex…

• Road Runner bundles two or more products with the sale of the material or throws in free or heavily discounted goods. While the gross price of an invoice appears to comply with the MFN, when you peel the onion back, the recomputed net price does not.

Turnover
Since the contract’s inception, all of the personnel who negotiated the contact have retired or moved on to other careers. Continuing management has no sense of what the negotiated issues were then or how to address them now. Finally, analyses prepared in previous periods with computational mistakes are carried forward year after year.

Take a Fresh Look

Whichever side you’re on (vendor or customer) companies need to be aware of these items and consider the following:
Vendor/Supplier

• Implement a contract management system to ensure that salient paperwork, memoranda and contracts are maintained for current and successor management to reference and to use as a basis in negotiating new terms.
• Read the contract and all amendments, not just someone’s interpretation of the deal, to capture all the facts and terms.
• Stipulate that the MFN guaranty should only apply to other companies that purchase comparable volume. Over the life of any contract, circumstances change. If a brand new customer purchases twice as much product, the respective pricing may not be “apples-to-apples”.
• Ensure that all pertinent levels of management, especially the sales force, are aware of the MFN clause and that the pricing to other customers is monitored. Companies have reacted to this requirement by establishing a “Disclosure Committee,” that includes representatives from pertinent units or departments (e.g. legal, finance, sales, procurement, treasury, etc.) so that these contracts are monitored through a number of different lenses.
• No one is perfect, so consider establishing a monetary amount or percentage threshold before a customer can assert damages for a pricing violation.
• Document your financial and accounting conclusions at each monthly or quarterly close.
• Maintain sales journals and all appropriate documentation, as a customer audit could encompass several years.
• Since market prices can vary in this global economy, be as specific as possible on what markets the MFN price is effective in and consider volatile commodity costs, tariffs, duties and freight costs as you negotiate.
• In the spirit of a true partner, self-report any violations of the MFN.

Customer

• Periodically ask the supplier if there are any identified violations of the MFN — this will serve as a reminder that the terms are out there.
• Insist on audit rights — that is, independently validate whether the third party pricing complies with the MFN terms. Typically, audit rights for a given year, if not exercised, will lapse and that year will be considered closed. If there are compliance issues in recent years, you should retain the right to open up earlier periods. Indicate who is on the hook for these professional fees, in the event of a monetary finding.
• Utilize calculations as illustrations in drafting the financial terms of the contract to mitigate any ambiguous language in the text. Insist on US Dollars to be the standard in determining pricing.
• Negotiate that other customers should not receive extended payment terms (or cash discounts for quick payments) greater than you yourself are afforded. With the time value of money, this puts you at a competitive disadvantage. If these aren’t price reductions, what are they?
• If you feel that there are operational and business continuity risks with the concentration of volume flowing from one supplier, consider the need for a back-up “Plan B” relationship.
• In drafting a supply agreement, companies would be wise to implement a legal review to ensure that regulatory matters are evaluated, if competition and anti-trust concerns are apparent.

Moving Forward

These strategic alliances make a lot of economic sense, so continue developing and enhancing these relationships in a true “win-win” mindset; however, due to the concentration that’s created on both sides, be careful in assessing the inherent risks. As in any business relationship, look ahead and envision how to resolve any future discrepancies with your strategic partner.

Make the most of your strategic partnership by contacting a trusted Withum advisor to ensure that all parties are compliant under the terms of your supply agreement.