Recent extreme price volatility in the cotton market, both physical and futures, has produced an unprecedented number of contract defaults, according to the International Cotton Association.
With a record range in prices in the past year of approximately $1.25 per pound - from a low of around 70 cents to a high of around $2.25 per pound - the industry is still seeing parties failing to honor their contractual obligations, the ICA reported in its January 12 Newsreel.
In 2011, we received 242 requests for technical arbitration - over five times our normal yearly average and more than double the prior record high of 2008, said the Liverpool, England-based organization, and the pace does not seem to be slowing down.
Consequently, contract sanctity, always important, has become the most critical issue facing the industry today. In view of basic economic uncertainty around the world, traders are no longer afforded a few mistakes along the way. Global lending institutions, facing their own restrictions, have become unwilling to extend their clients the financial leverage offered just five years ago. Therefore, the financial well-being of a company is even more dependent on the honesty of its trading partners.
The concept of contract sanctity centers on the general idea that once parties duly enter into a contract, they must honor their obligations under that contract. When markets undergo a period of extreme fluctuation, however, buyers who purchase cotton often try to delay or refuse shipment, if prices in the interim have fallen appreciably. Moreover, it is not uncommon for sellers to do the same, if prices have risen sharply from the point of sale.
A general idea exists that parties should feel free to breach a contract and pay damages, if it is more economically efficient than performing under the contract, thus the record number of arbitration requests last year. The cause for the defaults are many – a weakening consumer market, cancelled orders, price drops. The impact of these actions can be felt along the entire supply chain and put many supply chain actors at risk.
“The ICA's major guiding principle is the fulfillment of contracts,” said ICA President Antonio Esteve. The organization works to ensure and promote equitable cotton trading practices through its bylaws and rules, and provides an impartial and effective dispute resolution service through arbitration, which has been upheld by courts around the world.
If a company fails to honor an arbitration award brought against them, it is placed on the "ICA Default List". Defaulters' names are posted and circulated across the cotton community so that they are marginalized from the normal course of business. ICA members are not allowed to trade with counterparties on the default list and, if members do not fulfil their contractual obligations, they face being expelled from the association.
In a move to improve the economic sustainability of the cotton supply chain, the ICA has expanded its outreach by working with organisations that can reinforce its efforts, such as other global cotton associations, the Better Cotton Initiative, the International Textile Manufacturers Federation, major retailers, banks, insurance companies and rating agencies, the ICA president said. We have also developed a training course for spinners and agents to promote "responsible contracting", which focuses on the behaviour of the cotton market, the use of risk management tools and the ICA Bylaws & Rules. The cotton supply chain is very long, but by reaching out in this way we know we can help promote a safer trading environment.
"The cotton industry is at a crossroads,” said Mr. Esteve. “Our attitudes towards contract performance will shape the industry for years to come. The cotton industry needs to stand united. If not, it will suffer the consequences.
“It is easy to succumb to the attraction of short term gains, but history shows that this will create irreparable damage that will affect the long term economic sustainability of the cotton supply chain."
Questions: Is education and partnering with allied organizations an effective way to guarantee the execution of contracts?
What other efforts might be made to ensure sanctity of contracts?