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UK: Inflation is back – What does this mean for commercial contracts?
Up nextUK: Inflation is back – What does this mean for commercial contracts?
24 January 2022
After a decade of relative stability, inflation is back with a bang. In the UK, the Consumer Prices Index (CPI) reached 5.4 per cent in December, the highest since March 1992. This is matched by rises around the world, such as in the US, where CPI has increased to 7 per cent. We consider the implications for commercial contracts.
Impact on commercial contracts
The jump in inflation will not only have an impact on wider society through increases in the cost of living, but will also have a significant impact on some commercial contracts.
The current UK inflation rate means that – absent an express indexation right or other right to vary price – suppliers face a 5 per cent. year-on-year reduction in their charges in real terms. Faced with wage inflation and cost increases from their own suppliers, any supplier that cannot pass those increases on to its customers is likely to find its contracts rapidly become unprofitable and, if inflation is sustained, potentially unviable.
Obviously, the actual impact will vary from case to case. The general trend for IT contracts has been for shorter contracts with more flexible termination rights or charging provisions, which should mute the impact. However, after a decade of low and stable inflation, indexation has become something of a “forgotten clause” and in some long-term contracts its omission may come back to bite the supplier.
Is there relief under English law?
Absent express provisions, it is highly unlikely a supplier will obtain relief from the effects of inflation. The mere fact that inflation is causing the supplier hardship or has made the contract loss-making is not sufficient. For example, while each contract must be considered on its facts:
- It is highly unlikely a rise in inflation is a force majeure event. Force majeure does not have a precise definition in English law and instead has the meaning given to it by the parties. However, it is typically limited to obligations that are rendered impossible to perform and economic hardship is generally not sufficient (Tandrin Aviation v Aero Toy [2010] EWHC 40).
- It is highly unlikely there will be an implied term that prices can be increased in line with inflation. In Marks & Spencer v BNP [2015] UKSC 72, the Supreme Court took a restrictive view of the circumstances in which a term will be implied into a contract, emphasising that the court should only intervene where the term is so obvious that it goes without saying or is necessary for business efficacy. The Court suggested a term can only be implied if, without the term, the contract would lack commercial or practical coherence. It is very hard to see how an implied indexation clause could meet this high threshold.
- An express obligation to renegotiate the price might well be enforceable given the English courts’ increasing willingness to recognise such obligations within the context of a binding agreement (rather than treat them as agreements to agree), see ABP v Tata [2017] EWHC 694. However, most contracts do not include this sort of right and, even then, it may not be triggered by a rise in inflation.
In all likelihood, affected suppliers will have to explore other options such as seeking a commercial negotiation or using the general termination provisions to try and escape the contract.
What should I be thinking about?
The starting point is to identify the potential impact of inflation on existing contracts with both customers and suppliers, particularly long-term contracts. Can you increase your prices to reflect inflation and can your own suppliers do likewise? While English law holds parties tightly to their bargains (above), any renewal or extension of that contract might be a good opportunity to address this point.
The next step is to consider carefully if any new contracts should contain indexation clauses. The key issues in relation to indexation clauses are typically:
- What is indexed? Clearly the price should be indexed but what about other parts of the contract such as service credit or liability caps? Put differently, would you be happy with a 5 per cent. year on year reduction on the amount you can recover in the event of a breach?
- What index? The indexation process should, so far as possible, reflect changes in the underlying cost of the service. You need a trusted and objective index that reflects the changes in those costs. This is not always easy. For example, if we assume the supplier’s main cost is IT staff – their wages are likely to rise significantly this year, but that rise might not directly match UK CPI or even wage-specific indices such as UK Average Weekly Earnings (as the pay growth for IT professionals may not match the wider market). In addition, the staff might not be in the UK and instead be in a jurisdiction which is subject to different inflationary pressures and does not have trusted and objective indices. The choice of index is not a small point. Different indices grow at different rates and so can make a big difference over the lifetime of the contract.
- What else? Depending on the commercial position, you might well want other controls such as a cap on any annual increase or to think about how often indexation will take place. This is typically done yearly, but could be done more frequently.
- Get the drafting right. The indexation clause will often be based on a mathematical formula, so check it works. In Monsolar IQ v Woden Park [2021] EWCA Civ 961, the rent for a solar farm was to be increased each year using the formula set out below. Read literally, this increased the rent every year by the total increase in RPI since the start of the contract (i.e. not just the increase in RPI that year). This meant the rent payable by year 25 of the lease could be just over £76 million, having started at just £15,000. In this case, the Court of Appeal decided this was clearly a mistake (Nugee LJ said applying the formula literally could be “described as commercially nonsensical or absurd”) and so interpreted as only allowing increases in line with RPI. However, the English courts are generally unforgiving of mistakes, so care is needed. Worked examples can be a useful way to clarify the intention of the clause.
