Thursday, February 24, 2011

Modifying Contract Templates To Manage Risk

Most companies have a library of standard contract templates for procurement people to use. Standard templates are designed to deal with average risk purchases from average risk Suppliers. While the best protection is to deal with reputable, financially sound, experienced Suppliers, you may simply not have that luxury every time.

When you deal with higher risk purchases or higher risk Suppliers, those templates may not provide the degree of protection needed. Most templates are also structured based on the Supplier accepting all of the terms and risks. This means that if one term gets negotiated or changed where the Supplier is unwilling to accept certain costs or risks, those changes may require changing other terms or adding additional or different terms so the Buyer can manage the cost or risk they accepted. A simple recipe for disaster is to have known or potential risks where the Supplier isn’t responsible and the Buyer doesn’t have the necessary tools and controls to manage against the cost or risks.

Here’s a description of a number of different types of clauses that might be added to help manage against risks that may exist with the Supplier, or the item being purchased. Below that are examples of changes you may want to make based on risks that you could assume in the negotiation: 

Financial Risk of Supplier.
There are a number of things you could include in a contract to manage against potential financial risk or the Supplier:
  • You could require Performance Bonds in the event they fail to complete the work where the amount of the Bond goes toward your cost of completing the work
  • You could require payment Bonds to prevent against subcontractor liens on the work.
  • You could require the waiver and release of liens as a condition of payment to ensure the Supplier is paying their subcontractors.
  • If they are a Subsidiary of a larger company you could require a Parent or Company Guarantee.
  • As they may be susceptible to being acquired, you might want change of control terms so you can control who you may be forced to deal with in the future.
  • If you will be consigning or loaning the Supplier items, you would need protection of your ownership rights in that material and you may want offset rights so you could deduct anything that they owe you from your payments to them.
  • You could require information be held in escrow and be released to you in the event of certain events or triggers such as a change in their credit ratings.
  • You could require licenses in the event of certain triggers, such as licenses to make or have the item made, or license to any software along with the right to make any necessary changes or improvements.
  • If you have an assignment provision you want to make sure that it prohibits things such as assignment of receivables.
  • You also might want different termination without cause rights that trigger if certain conditions exist with reduced or no liability,

Control over charges
If your standard template doesn’t already have them you would want:
  • Audit or Examination of Books and Records rights to verify costs charged.
  • A formal Change Management Process that includes pricing formulas for changes, additions, and deletion of work.
  • Purchase options - Rights to purchase additional quantities, options.

“Bait and Switch” risks.
 To avoid problems with Suppliers that have the tendency to promise one thing and provide another you would want:
  • Rights to approve Subcontractors. Material Suppliers and any changes to them
  • Approval of personnel assigned and any changes to personnel.

Performance Risks
In managing performance there are tools you may want:
  • Inventory stocking and Alternative Logistics Model requirements if certain problems occur
  • Escalation Procedures so their management is aware of the problem
  • Licenses and Manufacturing rights if there are significant performance problems.
  • Downtime management tools  - Acceptable levels of downtime. Downtime credits.
  • Disaster recovery requirements
  • Rights to inspect Facilities
  • Termination rights.
  • Service Level Agreements – Periods, Response times, Service level credits
  • Performance / Risk Management Tools - additional controls, reviews, approvals, and any other requirements you need to manage them.
  • Alternative Payment Terms to help provide incentive to perform such as progress or milestone payments, rights of retainage, rights to withhold Payment if work is behind schedule.
  • Warranty of a Specific purpose. 
  • Additional types of damages that may be claimed, such as liquidated damages

Loss or theft Risks could require
  • Background Investigations
  • Fidelity bonds.
  • Employee Dishonesty and Computer Fraud Insurance

Concerns over character or actions that could negatively impact the Buyer’s image could require:
  • Restrictions For On-Premise Operations.
  • Control over Supplier, Supplier personnel or Supplier Subcontractors performing other work or activities at Buyer’s site

Competitive Risk Concerns may be managed by
  • Restrictions on work that would be a “Conflict of Interest”
  • Key Employee Restrictions
  • Ownership / Exclusivity Rights in developed materials
  • Limitations on sales to others for a specified period.
  • Prohibitions against Recruiting/Hiring of Employees

Continuity of Supply
  • Guaranteed availability of products, service
  • End of life requirements
  • Requirements for multiple production locations.
  • Requirements for dual source

During the negotiation any change to what the Supplier is willing to accept from a performance, cost or risk perspective needs to be evaluated before you agree. Ask yourself the following questions:
  • What is the potential impact of the change?
  • Does it impact other sections that relate to it?
  • What’s the potential performance impact?
  • What’s the potential cost impact or risk?
  • Do you have the tools to manage the cost or risk either in our apart from the agreement?

Here are a few examples.

1.     The Supplier wants to sell the item Ex-works their dock.  As that makes you responsible for any loss or damage in transit, do you have the tools in place to do that?
a.     Do you have the right to specify how the item will be packed and packaged?
b.     Do you have the right to select the carrier?
2.     The Supplier wants to have limited liability for defective items.
a.     Do you have control over things that can impact the quality such as:
                                                 i.     Who makes it,
                                                ii.     Where it is made,
                                               iii.     How it is made.
                                              iv.     What changes can they make to the product?
3.      The Supplier wants the Buyer to mitigate the costs of recall. Do you have anything in your agreement that says that they will pay you all reasonable costs associated with mitigating the cost?
4.     The Supplier wants to be free to change their product without your approval. Does your agreement require them to provide you notice and a sample to determine whether the changed product will work in your application?

Suppliers want to be free to do whatever they want. When they propose changes to terms where they want the Buyer to assume some or all of the risk, the Buyer needs control over what they can do as a way of managing the risk.  My position has always been it needs to be one or the other, but never both. If they want the Buyer to assume the risk the Buyer must have control. If they are willing to assume the risk the less control you need. 

When you need to have control to manage the risk, you can't accept language that would limit your control. For example a Supplier may want to propose that changes won’t affect the form, fit or function. What control does that provide? It really is only a minor limit on the types of changes that can be made. For example “form fit and function” would allow the Supplier to make changes in the materials used and significantly cheapen the product. It would allow changes to the process used that could impact the quality of the Product. If the required reliability weren’t spelled out in the Specification, “form fit or function” would allow the Supplier to make changes that impact the reliability of the Product and that impacts your life cycle cost. If the item you are purchasing needs to work with another item, form, fit or function doesn’t protect you against the item not working in your application unless the specific application is spelled out in the specification. The more risk the Supplier wants you to accept the more control you need!

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