Tuesday, April 5, 2011

Contract risks that could become costs


Contracts define:
  • Who is responsible for certain costs in the relationship
  • What's included in the Price, who bears the cost for Delivery, Warranty, etc
  • The administrative processes for how the relationship will operate
  • Ordering, rescheduling, cancellation, warranty returns, payments, etc.
  • Responsibility for various risks that may occur and the standard of responsibility for protecting against that risk..
 To negotiate contracts you need to understand risks because many contract terms are included to help manage against risks and their potential resulting cost.

There are a substantial number of potential risks in Procurement. The primary vehicles to manage the risk are:
  • Supplier selection
  • Supplier and product or service qualification
  • Ongoing supplier management
  • The management and/or transfer of costs and risks by contract

Typical Risks Managed
  • Financial. Is the supplier financially qualified to perform the work and stand behind all the contractual obligations?
  • Production. Is the supplier capable of producing the product or providing the services in the volume required and in a consistent high quality manner?
  • Supply Chain. Does the supplier have a supply chain that is efficient and compatible with your requirements?
  • Quality. Does the supplier have quality management systems and programs to ensure consistent high quality product?
  • Specification. Does the Product or Service meet the specification?
  • Application. Does the Product or Service work in the specific application?
  • Competitive. Is the Product or Part price competitive today and for the future?
  • Life Cycle Support. Will the Product, Service FRU's, part and repairs be available and be price competitive to support the entire life cycle of the Product or Service?

Types of Risks that may be managed in the Contracts by contract terms.
  • Third Party Claims
  • Supplier Claims
  • Risks In the Contracting Parties
  • Risks In Defining And Getting What You Want
  • Risks With Changes To The Product, The Relationship, or Your Demand 
  • Risks in Pricing and Payment
  • Risks in Long Term Support
  • Risks in Continuity Of Supply
  • Risks that are traditionally covered in standard Warranty provisions
  • Risk With Warranty Redemption
  • Risks with Delivery And Flexibility
  • Risks in accountability
  • Risks in Contract Enforcement
  • Risks with the Import
  • Contract Writing Risks Creating Enforceability Problems
  • Risks with Supplier Performance

To give you a better understanding of each of these risk the following provides examples of each

Third Party Claims
  • Product Liability - Personal Injury, Property Damage
  • Auto Liability (under potential claim of agency) for Personal Injury, Property Damage
  • Premises Liability (Guests and business invitees), for Personal injury
  • Third party Financial claims to the Product such as Security Interests in the product, or Liens
  • Claims of infringement of intellectual property contained in product such as  Copyright, Patent, Mask Works, Trademark, Misappropriation of a Trade Secret claims, and the cost to correct the problem
  • Claims from Other Suppliers for things like Unfair trade practices, Defamation, Libel, Slander
  • Claims relating to Supplier Employees - Personal Injury (as Guests or Business Invitees) As workers: Workers Compensation, Employers liability, Claims for Employment rights, Government claims for Withholding Taxes
  • Claims by governmental agencies for complying with laws, regulations, ordinances and licensing or permit requirements

Potential Supplier Claims
  • Breach of Contract
  • Breach of Confidentiality obligations
  • Damages to supplier's property on Buyer's site
  • Loss of anticipated profits
  • Claims for delays, extra costs
  • Claims For Misappropriation of trade secrets
  • "Agency" Risk
  • Buyer's Responsibility For Specific Requirements Or Instructions
  • Claims for cancellation or termination

Risks In the Contracting Parties:
  • Definition Of The Supplier And Contracting Parties
  • Financial Resources To Support Contract Obligations
  • Purchases From Resellers
  • Risks Created By Purchases By or From Affiliates

Risks In Getting What You Want / Need are managed by
  • Product Description And Requirements,
  • Definition of "Product", Definition of "Services"
  • Rights of acceptance or rejection of non-conforming materials
  • Responsibility For Costs Associated With Non-conforming Product
  • Right To Accept Or Reject Product Lots
  • Acceptance, And Acceptance Criteria
  • Acceptable Quality Levels And Responsibility For Failure To Meet Those Levels
  • Quality Management requirements
  • Supplier's Use Of Subcontractors - Responsibility, Approval And Changes
  • Control over changes

Risks With Changes To: Product, Relationship, or Demand
  • Right Of Buyer To Make Changes To Product Specifications
  • Effective Date Of Changes
  • Supplier Changes Authorized By The Agreement
  • Termination Rights
  • Cancellation Rights 
  • Ability To Reschedule Orders Based On Changes In Demand,
  • Responsibility To Mitigate Costs,
  • Amendments To The Agreement,
  • Assignment
  • Managing change and amendments

Risks in Pricing and Payment
  • Price Firmness, and Competitiveness
  • Price Changes
  • Long Term Pricing Competitiveness
  • Currency
  • Payment terms
  • Taxes and Duties

Risks with long term support

  • Availability of Spare Parts, Consumables, Repairs, Technical Support to support products during their useful life
  • Competitive pricing for and Spare Parts, Consumable, Repairs,
  • Technical Support needs.

  • Continuity of Supply Risks
    Product Availability During Term Of Agreement
  • Supplier Product Withdrawal - End-of-life
  • Contract Term - Length of the Agreement
  • Obligation To Accept Conforming Purchase Orders
  • Access To Future Products And/or Services
  • Responsibilities In The Event Of A Force Majeure

Risks covered by Warranties
  • Legal Right To Enter Into The Agreement (Authority Of Signing Party)
  • Performance Complies With Laws, Regulations And/or Ordinances
  • Compliance With Applicable Export And Import Laws
  • Avoidance Of Claims, Liens, Actions That Interfere With Buyer's Use Or Sale 
  • Products Are Free From Defects In Design, Material, and Workmanship
  • Products Conform To The Warranties, Specifications And Requirements
  • Products Are Safe
  • Products Don't Contain Ozone Depleting Substances
  • Products Are New And Do Not Contain Used Or Reconditioned Parts
  • Products Don't Infringe Any Intellectual Property Right Of A Third Party
  • Risks with Warranty Redemption

What constitutes a defect?
  • What are the Supplier's Responsibilities for defective material
  • What is the Warranty Redemption Period And What Starts The Warranty Period
  • What costs are covered by the product warranty
  • What is excluded from the warranty
  • Obligations for Post Warranty Support

Risks with Epidemic Defects
  • Epidemic defects is a situation where, because of the severity of the defect, the Buyer wants to recover more than just warranty replacement and wants to cover its real costs such as the field cost associated with the defect.
  • Risks to manage are:
  • Ensuring that the limitation of liability does not prevent such recoveries (e.g. epidemic defects is carved out of the Limitation)
  • The basis for epidemic defects is clearly defined with applicable trigger points
  • The basis is appropriate for the risk and volume of business.
  • Any limitations or caps are clearly defined (e.g. per incident, per product, per year, etc.)
  • Costs to be recovered are established

Risks with Delivery and Flexibility
  • Predictable Lead-time
  • Delivery Term / Location,
  • Forecasts And Responsibility/Liability For Forecasts,
  • What constitutes on-time delivery
  • How are Early Shipments managed
  • Remedies if shipments are late or are never made
  • What happens with Allocation Of Supply,
  • Supplier's Responsibilities for Packing And Packaging,
  • Responsibility for Shipping
  • Who selects the Carrier
  • Who bears the risk of loss or damage to the product while in transit

Risks in accountability
  • How do you keep from problems where you don't have a single point of responsibility multiple parties are involved and each could be blaming the problem on the other?
  • For example, Supplier claims the reason that the product doesn't work correctly is because it was:
  • damaged in shipping that they weren't responsible for,
  • or damaged or not properly installed by the party who installed it
  • Risks with Insurance Coverage:

Many third party risks are covered by insurance requirements, so there are insurance risks that must be managed such as coverage for
  • Comprehensive General Liability Insurance (for personal injury and property damaged caused by the Supplier
  • Workers' Compensation Or Employer's Liability Insurance (for injury that may occur to their employees)
  • Subrogation Rights Against Buyer (to make sure the Buyer isn’t sued as partly causing the problem
  • Automobile Liability Insurance (to cover personal injury or property damaged associate with autos)
  • Financial Requirements For Insurers (to ensure that the risks are financially covered by the insurance)

Risks in Contract Enforcement:
The typical clauses in an contract that focus on enforcement issues are:
  • Choice of Law and Forum (to ensure that it is favorable)
  • Waiver of Jury Trial (so decisions are made on the facts and not sentiment)
  • Limitation of Actions (to prevent aging claims)
  • Requirements for Notices (so proper notices and actions may be taken)
  • Conflict Between Documents (to establish precedence in interpretation)
  • Survival (to determine the enforceability of certain terms after the contract has expired or been terminated.
  • Waiver Of Rights (to establish what constitutes a waiver of rights)
  • Enforceability of Electronic Commerce (to ensure that electronic transactions are enforceable,
  • Severability Of Terms (to make sure that the contract remains in effect if one term is no longer enforceable)


For example, to protect against the risk of third party claims for personal injury caused by the Supplier or the Supplier's personnel, a contract will include a general indemnification by the Supplier to defend, indemnify and hold the Buyer harmless against those claims. To further protect against the Supplier not having sufficient assets to meet those commitments, a contract would include the requirements for
insurances for the types of perils that would represent those types of injuries (Automobile Liability and Comprehensive Liability).  To ensure that the limitation of liability does limit what may be recovered,
the Indemnification would be carved out of the limitation of liability. 

1 comment:

  1. Thank you, an illuminating review of contract risks!

    ReplyDelete