Tuesday, March 22, 2011

Enforceability Problem Costs

One cost that’s within the Buyer’s control is the costs that can occur simply because the Contract wasn’t properly drafted or managed. Drafting problems with Contracts can affect the interpretation or requirements, the coverage and the enforceability of certain terms. Doing a great job of negotiating the deal can be quickly lost if you don’t ensure that you have a solid, enforceable Contract. Here are several things to always check in your drafting of Contracts or Purchase Orders:

1. Terminology. The terminology used in your Contract and attachments needs to be consistent. For   example, if you define the other party as “Supplier”, the term “Supplier” should be used in all places where you are referring to them.  To help with this, learn how to use defined terms so it always has the meaning you defined.

2. Be consistent use of the Defined Terms. For example, if one document refers to an Epidemic Defect Rate, the other documents addressing the same thing should also refer to Epidemic Defect Rate. If you define the term “Product”, every time you want to describe a commitment that applies to all Products you purchase, make sure you use the capitalized defined term “Product” and not “product”. For any words that have a dual meaning, used the defined term to define the intended meaning.

3. Check to ensure that you closed the loop on establishing requirements. If one document defers to another document to establish a term, make sure the other document actually establishes the term. This may seem like common sense, but I’ve seen many problems arise because commitments have not been properly established. For example the Contract may defer a number of items to be established in an Attachment such as the definition of Products and Services, the Price, the Delivery Terms, the Payment term, Period for acceptance of the Product, Quality levels required to reject lots, Warranty period for defects in materials and workmanship, Epidemic Defect rates, and there terms of sale such as Minimum Order Quantities, lead time, terms for flexibility, cancellation etc. If the Contract points to an Attachment to further define the item or requirement, check to ensure that document referred to properly establishes the commitments. For example, if the Contract says that the delivery terms will be specified in Attachment A, Attachment A should be called Attachment A and should include the specific delivery term and the delivery point such as: Delivery shall be FOB Origin, Supplier’s Dock at Penang, Malaysia.
4. Create an “Order of Precedence” between all documents to eliminate conflict and make sure it establishes the correct priority. The Contract and all documents incorporated by reference into the Contract are looked upon as a single document that is complimentary with all requirements having the same weight unless the Contract specifically establishes precedence between documents. As there is always a potential for conflict between the two, you need to define which of the documents has priority. If your Contract is made up of several documents like a contract and a statement of work, establish the priority between those documents. If you have a drawing and written specification that defines the requirements of your purchases, you should establish the priority between those documents in the event there is an inconsistency between the two. If you incorporate Supplier documents as part of your contract its especially important to ensure that they do not conflict with or diminish the commitments being made under your contract and one way to do that is by placing those documents at a lower priority in the order of precedence. 

5. Carefully Review Any Limitations Of Liability And Other Potential Conflict Areas. Documents will be read together. Unless language is clear that any limit is limited to one specific thing, it can override or limit other commitments. For example:
If you have language that says “In no event will either party be liable to the other party for any lost revenues or profits, incidental, indirect, consequential, special or punitive damages” that would limit all damages to only direct damages and would preclude any damages that you might want to recover that are incidental in nature which may not be what you want to do as there may be certain specific incidental damages you would want to recover. Be especially careful with dollar caps on liability. If you have language that caps the total dollar liability of a party under the contract, that will cap items that you may not want to have a dollar cap on such as 3rd party claims for Intellectual Property infringement or claims for personal injury claims. To prevent that you could include any limitation in the specific section so it applies only to that section or you could refer to the specific section(s) that are excluded from the cap on liability.

6. Tailor Documents To Your Needs. Most standard templates are designed assuming that:
a.     The purchases aren’t complex.
b.     There are alternative sources where the Supplier may be easily replaced
c.     The Supplier and the purchase presents minimal risk.
This means you may need to tailor your Contract based on the potential risks involved with: what you are purchasing; the impact to you if there are problems; or any concerns you have with the Supplier, the Supplier’s product or services or their potential performance. The more dependent you are on them and the greater the potential risk, the more you may need to add alternative requirements or additional remedies in the event of a problem. For example, if a sole sourced supplier fails to ship product, a remedy of cover (having the supplier pay for the incremental cost to buy from another source) may provide you nothing, as there may be no other feasible source. Let’s look at some of the specifics that probably will need to be tailored:

7. Avoid Ambiguities.  Words can confuse or mislead and many words have multiple meanings that can allow for multiple interpretations that creates ambiguity. One of the best ways to avoid ambiguity is through the use of very precise terms that leave no room for misinterpreting what was meant or agreed. If you can’t find a precise term and a word has multiple meanings, create a “defined term” providing a precise meaning for that word so that every time that word is used and is highlighted as a defined term (by using Caps) it has only that precise meaning contained in the definition. If you have possible confusion of difficulty making it precise, use examples to describe exactly what is meant so it is clear to all that read it. Leave no interpretation to chance. When writing is ambiguous and could be interpreted multiple ways, when things are good they may interpret it the same way as you, but if there is a problem and they are seeking to avoid liability or cost, Suppliers may times choose to interpret it using the definition that is in their best interest.

8. Product or Service Definition.
Definition of the Product or Service is critical as it defines what the Supplier is obligated to provide. It establishes the basis by which you can accept or reject the Product. It also determines what the product or service must do in situations where the product fails to work under warranty or defects situations. The Contract should clearly establish the Product Specification or Definition of the Services to be performed. That specification should take priority over all other attachments and the contract should not conflict with it. The specification or definition of services is an area where you need to make sure the requirement is not ambiguous. When you are dealing with both specifications and drawings that define requirements the two could be in conflict so you need to make sure that as between those two documents there is an order of precedence and you need to make sure that the document that has priority is unambiguous. Having worked in Government contracting doing construction contracting I found that a number of suppliers would have people on staff who specifically focused on looking for problems or conflicts between the documents as that presented an opportunity to make money through the change order process. They would bid low by taking the most favorable interpretation to them, and then when someone wanted it changed, there was always a cost.

9. Acceptance Requirements.
For activities that require a development activity, you need to include all the specifics regarding the development such as the Plan, Critical Milestones, Checkpoints, interim Deliverable(s), Ownership rights, Acceptance and test criteria for completion of the development, and any specific requirements of the development including testing (Component, Function, System, Application, performance, compatibility). You would also include any management requirements to help manage the development such as Reports, Documentation, Design Standards, Certifications, Customer Requirements, Operating environment, and requirements for samples or prototypes. Even if there isn’t a specific development activity involved, you may establish specific acceptance and test requirements that must be done for acceptance based on Function, System, Application, performance, and compatibility. This is to ensure that their standard product you are buying meets your needs. Your requirements for acceptance should always have priority and not allow for Supplier requested loopholes like their product will “materially comply” with the requirements.

10. Unique Business Terms.
Depending on the nature of what you are buying and the frequency or purchase, your contracts will need to have product unique business terms that may vary from product to product such as: Warranty terms and Warranty Period, Re-scheduling, Cancellation rights, Ordering requirements (such MOQ, Lot Sizes), Price related terms (such as Price Changes, Effectivity Dates for Prices, Discounts, Rebates), Lead Time, Delivery Point(s), Delivery term(s), Payment term, Responsibility for Taxes, Duties, Defects, Epidemic Defects and Epidemic Defect Rates, Product Supply/ Availability,
Change controls for products and processes, one time costs, reimbursable expenses, and other things that are included in the price (such as service, maintenance, documents, training)

11. Performance Management Terms.
In addition to the Product Specifications, Deliverable(s), Milestones, Acceptance and test criteria, you may also need progress reviews, scorecard reviews, management escalation processes, specific performance related remedies and damages the are authorized (such as liquidated damages)

12. Service and Support Requirements.
Most purchases may require some degree of on-going support or service such as the ability and cost to purchase FRUs, Spare parts, Repairs, Maintenance, Support, Support Services and End of Life Purchases. It may also require the inclusion of hours of operation, response times, and problem escalation processes. If you are providing self-maintenance it may also require all of the above plus things like options to make end of life purchases, purchase of back-up support and service maintenance training.

13. If its important to you, make sure that its performance is measurable!
1.     Product has specifications,
2.     Services have specifications or statement of work
3.     Performance has agreed quality, reliability levels or standards
4.     Delivery performance is established (lead-time, on-time delivery)
5.     Warranties are committed
6.     Changes that can impact quality and performance are controlled
7.     Basis for pricing and discounts is clearly established
8.     Methods for determining applicable remedies are clearly defined
9.     Required protections such as Indemnities or Insurances are clear
10.  Rights of termination by either of the parties are clearly defined.
11.  Flexibility commitments are established

14. Every commitment needs a time established for its performance.
Contract term, Period of Product availability, Delivery lead-time, Acceptance time,
Replacement period for rejected products, Warranty period, Time for payment by Buyer or Seller, Period for warranty replacement, Time to issue return material authorizations, End of life notice periods, Time to exercise options, Time for other notices, Time standards for performance such as promptly, Cure period for any breaches, Other notice time periods, Frequency of performance for things like services, Response times for services or problems, Times and levels required for problem escalation. One of the most important factors in establishing time for performance is to define the measurement.  For example, if its hours, is it clock hours or business hours. It its days, is it calendar days or business days? The difference between the two in both instances can be substantial. 70 business days equals at least 98 calendar days and probably more when you take into account holidays or other non-business days. If it’s business days, which of the parties’ business days are used to calculate the number of days?  Business days will be different from company to company and from location to location. Use calendar days whenever possible.

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