Strategies for Manufacturers to Protect Against Extraordinary Inflation Risk

Sept. 1, 2009
Careful contracting practices now can help to control the impact of the unknowable economic future.

It is no secret that as the current recession ends and "green shoots" and tender buds develop into sturdy stalks of renewed economic growth, manufacturing's next economic fear will be inflation of wages, commodity prices and the cost of other production inputs. Is there something the industrial sector can do now to protect business against future inflation risk? Yes.

Media reports of inflation assume that wages, costs and prices all rise uniformly across goods and services. This oversimplifies the reality of the business world. A business often cannot immediately raise prices in line with market forces. For long-term sales relationships, it can be essential to include "cost of living adjustment" ("COLA") clauses in contracts rather than be locked into a fixed price as the seller's input prices are pressed up through inflationary forces. Many unions seek COLA protection for the workers they represent, and there is no reason why a business cannot seek similar protection against a cost-price squeeze in its own long-term contracts. If a manufacturer's overall costs of production double, but it is locked into a long-term sales contract at a price that must be held firm, profitability will fall dramatically, and perhaps even the relationship will become a money-losing proposition.

A typical COLA is tied to a particular government index for prices in general, or for a specific industry. The U.S. Government's Bureau of Labor Statistics publishes various forms of a Producer Price Index and a Consumer Price Index. Thus, a contract may read: "The price in each contract year will be the greater of: (a) $1,000,000; or (b) $1,000,000 times the consumer price index as of the date of delivery divided by the consumer price index as of the date of this agreement."

Problems can arise with a COLA tied to a specific index, however. These indexes are built by government statisticians and economists for use by government policymakers. Sometimes the government will change the composition of the index. There may be sound macroeconomic reasons for such changes, but these reasons may not reflect what is happening in a particular industry. Changes to the index also may be influenced by political factors that do not track facts in the marketplace. Thus, a COLA tied to an index can provide either too little or too much protection against inflation risk.

Another practical problem is that there can be a several month lag before relevant data is reported, as the figures going into government indexes can take time to be compiled and analyzed. In a rapidly-changing market, government index data may arrive too late for the parties to settle their accounts most efficiently.

Fear of inflation has been present in the business world since the invention of money, and some historic solutions may again become useful. Inflation existed and was a worry long before general price levels were measured by government indexes. Before major economies had central banks expressly tasked with controlling inflation, businesses often would protect against inflation (or currency value) risk by including "gold clauses" in contracts. Such clauses allowed a seller to demand either the local currency or a fixed amount of gold in exchange for delivery of goods. In this way the seller could be protected if authorities took action tending to devalue paper money in circulation.

During the Great Depression, however, laws were enacted prohibiting enforcement of gold clauses in U.S. contracts. This was done to centralize federal control over the economy and to restore confidence in a banking system based on paper currency. (Most private ownership of gold also was prohibited as "hoarding" at this time.) In 1977, however, Congress repealed the ban on gold clauses. This did not result in their renewed use, but to the extent inflation (or devaluation of U.S. currency in comparison to foreign currency) is a fear today, a gold clause has the benefit of being simple to understand, with relevant price data often more rapidly available than government index data. A downside, of course, is that gold prices themselves can be affected by speculative forces.

As industry often has a specific need for one or two strategic inputs, a business could write the equivalent of a gold clause into a contract to protect against price increases in the specific input. When petroleum prices spiked in 2008, for example, many airlines added fuel surcharges to ticket prices. Similar terms could be negotiated in a wide range of settings, allowing for price adjustments based on the cost of specifically identified commodities, and to protect against the risk of sudden future price increases just at the time those commodities will be needed.

A potential additional benefit of building these potential adjustments directly into contracts is that it might avoid the costs and accounting implications of hedging commodity price risks through separate derivatives contracts. If a derivatives contract is purchased to protect against the risk of price increase, but prices actually fall, the purchaser may be forced to recognize losses based on the value of the commodities contract. A regular sales contract with a provision allowing for adjustments in response to increases in input prices, by contrast, will not typically result in the same accounting treatment -- if the adjustment clause never happens to be triggered.

Major price and cost adjustments, either up or down, do not hit all segments of the economy equally. We have seen an unusual run-up in prices of technology stocks (and then a collapse), followed by an unusual run-up in prices of real estate (and then a collapse), followed by an unusual run-up in prices of petroleum (and then a collapse), to follow by what is anyone's guess. These events of course affect the general economy, but are felt most acutely in the sectors where they occur. If inflation comes, no one can really be sure where it will strike first or most intensely. It is quite probable that inflation, if it comes at all, will be "lumpy," in that it will strike certain commodities, currencies or sectors very intensely, but leave others mostly unscathed. Careful contracting practices now can help to control the impact of the unknowable economic future.

Stephen J. Newman is a Partner at Stroock & Stroock & Lavan LLP, in Los Angeles.

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