Tuesday, March 22, 2011

Effective Dates


When you refer to an “effective date” when discussing contracts it means the date that the parties agree that the contract will commence or be effective from that date forward.  You can set any date as being the “Effective Date” as long as the parties agree.

The effective date may be established a number of different ways.

A retroactive date to cover purchases made in anticipation of the contract.
  • This contract shall be effective retroactive to January 1, 2011.
A firm date established in the contract body.
  • This contract shall be effective on July 5, 2011
The date the contract is last signed by the parties.
  • This contract shall be effective on the date last signed by the parties
A date in the future.
  • This contract shall take effect on December 5,2012

From a practical standpoint, the effective date needs to take into account the term of the Agreement.  What you don't want to do is have an effective date that starts the term and have that cut into the length of your contract coverage period when you are not buying anything.  If there is going to be a delay in making purchases or getting deliveries, the earlier you make the effective date, the longer the agreement term you would want. For example, it could be effective today and have a 3 year term, or it could have an effective date a year from now and have a 2 year term and both would provide the same length of coverage.  The key is the length of coverage and making sure that the effective date doesn't reduce that term of coverage.

If there is a possibility that a key date that could start the use of the contract could slip, you could also work that into the term.  For example:
"the Term is based on an expected completion of ___________ by ______ .  For any delays to that date the parties mutually agree that the term shall be extended on a day for day basis."

You would normally want to establish a retroactive effective date when you have already purchased something and you want the purchase terms to be applied retroactively to those purchases. In making those purchases you could mutually agreed that the terms of the future agreement will retroactively apply to those purchases. In that case the effective date of your agreement would not need to be retroactive as the parties already agreed to apply those terms to those purchases.

In negotiating the combination of the effective date and the term need to be worked closely together. In most cases you want to have a fairly long term for purchases.  For example if you made the effective date be the date the agreement was signed, and had a one year term and the product you were purchasing had four-months lead time prior to delivery, the real effective period of your contract is 8 months rather than a year. If you wanted a full twelve months of contract deliveries you would need to change either the effective date or the term. For example, you could have the contract become effective on the first delivery and remain in effect for 12 months. Alternatively you could have the contract be effective immediately, but have the term be 16 months to take into account the impact of the lead time on your deliveries. 

Whether you need to be guaranteed a full term for purchases really depends on a number of things such as how easy or costly it will be to switch Suppliers. For example, if you had to exercise an option relating to future periods where you would have significant liability if you were to terminate the agreement for convenience after that, you would want as long as possible to evaluate the Supplier’s performance before you have to act on the option.   

In addition, you may have either a condition precedent or a condition subsequent that can affect the enforceability of the agreement.  If you have an effective date established for the future, a condition precedent could affect whether the agreement actually takes effect.
For example:
This Contract shall take effect on July 5th, 2012 provided that the prime lending rate is no greater than ____%

In this example the prime lending rate being below the specified percentage would be a condition precedent to the contract taking effect. If the prime lending rate was higher than the agreed percentage, that condition precedent would not have been met and that Contract wouldn’t take effect.

If you have an effective date established and at some time in the future and a condition subsequent is met, your commitment could end or it could force a re-negotiation. For example:
This Contract shall take effect on July 5, 2009 and shall remain in effect as long as the exchange rate between the U.S. Dollar and Japanese Yen is no less than ____ and no greater than ____.  
The range is called the “band-width” and if the exchange rate is outside the band-width and the parties fail to reach agreement on a revised Price, either party may terminate this Contract without liability as the condition subsequent has not been met.

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.

Escrow


An "escrow" is an arrangement where a third-party holds something that was agreed by the parties that may be released in the event certain events occur.  The most common use of escrow in procurement contracts deal with both continuity of use or continuity of supply. For example, a software license agreement may require that Source Code be held in escrow for potential release to the Licensee if certain events occur so the Licensee may continue to use and make future changes or corrections to the Software that they licensed.  A Buyer might require the escrow of a “Manufacturing Package" in the event certain events occur so the Buyer can continue to make or have the product or equipment made without the Supplier so they have continuity of supply for both Production or Service requirements. Other types of activities could potentially require escrow if the Supplier had something that was unique in the provision of the good or service where Buyer could not quickly or inexpensively migrate to another Supplier in the event of a problem.  Escrows are always used in conjunction with a license to use the materials that were held in escrow..

Escrows require several things:
  1. The agreement of the parties that certain materials will be provided to be held in escrow.
  2. The establishment of an agreement with the third party (an Escrow Agent) for them to hold the materials until an event occurs that triggers the release of the materials to the other party.
  3. License language that establishes how the materials may be used if they are released by the Escrow Agent and what, if any, royalties may be required.
  4. The events or actions are cause for the Buyer to request the release of the escrowed materials from the Escrow Agent.
  
Escrows are usually established using two documents. In the agreement between the Buyer and Supplier or between the Licensee and Licensor, that Agreement will:

    1. Require the establishment of the escrow,
    2. Require the placing of it with the third party and the timing for placing the materials with the escrow agent.
    3. Describe the contents that are required in the escrow,
    4. Describe the responsibilities of the Supplier or Licensor to maintain, update and keep the Escrow current.
    5. Audit rights provided to Buyer or a third party to verify compliance
    6. The triggering events that will allow for the Buyer or Licensee to demand the release or the escrowed materials.
    7. The license granted for the use of the escrowed materials.
    8. Any license fee that must be paid for the use of the materials and when the license will be royalty free.


The second agreement is the Escrow Agent agreement that is signed by the Buyer, Supplier and the Escrow agent (or Licensor, Licensee and Escrow Agent). The Escrow Agent Agreement will usually contain:
    1. The coordinators for the escrow from all three companies.
    2. The responsibility for the payment of fees to the Escrow Agent for performing their services.
    3. The responsibilities of the Supplier / Licensor in establishing and maintaining the escrow materials current.
    4. The responsibilities of the Buyer/Licensee, if any
    5. The responsibilities of the Escrow Agent.
    6. The triggering events or procedure that is used for demanding release of the escrowed materials including notifications to the Suplier or Licensor that demand had been made.
    7. How it will be released and the responsibilities of the Buyer/Licensee in the materials that are released.
    8. Remedies that the Supplier or Licensor may have if the release was not warranted.

The real value of any escrow will always be dependent upon the Buyer or Licensor's ability to use the 
materials and license to meet the their future needs.  As the Buyer or Licensee may not have the resources or capabilities to internally use the materials most licenses should provide for the Buyer to have the right to have a third party use the escrowed materials and license to perform things within the scope of the license on behalf of the Buyer or Licensee. If the Supplier or Licensor was having a 
third party perform the work on their behalf,  the agreement between the Buyer and Supplier as part of the license grant the Buyer should have the right to use that third party and require that the Supplier
assist them in establishing a relationship with that third party.  For example if the Supplier had the manufacture of the product performed by a contract manufacturer, the Buyer would want the right to 
have the product continued to be produced by the contract manufacturer and have the Supplier assist the Buyer in establishing that relationship so there will be a quick transition.

Excess Costs of Re-Procurement ("cover")


I’ve seen Suppliers attempt to disclaim any excess cost of re-procurement. Most procurement contracts include a limitation of liability clause that disclaims a number of different types of damages such as consequential, incidental, special damages, lost revenue or profits except for certain specified contract sections. The impact of such a limitation of liability is that for the breach of any of remaining contract sections, you recovery would be limited to only direct damages.

One of the primary direct damages that you would have is the excess cost of re-procurement that is also referred to as the cost of “cover”.  Both terms mean the difference in price between what you would have paid the Supplier for the work versus what you have to pay for another Supplier to perform the work.

When a Supplier wants to exclude excess costs of re-procurement they are proposing to eliminate the primary remedy you had for the breach of any term that wasn’t excluded from the limitation of liability.  For example, if the requirement for on time delivery wasn’t excluded from the limitation of liability, they could fail to deliver and have no liability at all if you agreed to exclude excess costs of re-procurement. If the Supplier were adamant about not being liable for excess costs of re-procurement I would find another Supplier as you can’t count on them to perform.  If they divert product to another customer who will pay more and can do that without any liability, you don’t have a source of supply you can rely upon.

Many times what the Supplier really wants is to limit the potential cost of the re-procurement as a way of managing their potential cost exposure. That may be reasonable if the limit on their liability is high enough to drive the right behavior on their part.  If it’s too low any time there is a shortage of supply or excess demand you can expect that products that should have been shipped to you will be shipped to another customer who will pay more and even after paying you the excess cost amount agreed the Supplier will still be making more money.

If you must use the Supplier and they are looking to cap their potential exposure, you could always propose to limit it by proposing that the costs must be reasonable. If the Supplier insists on a fixed amount or multiple of the purchase price, make sure that the amount or multiple will drive the right behavior and provide you what you would need to get the work completed. If the Supplier sells the same product through distribution, I would always want the actual price paid to distribution to be included as part of what is considered reasonable or acceptable.

For example:

“Supplier’s liability for any excess cost of re-procurement shall not exceed two times the Price or Buyer's cost to purchase the Product from Supplier’s authorized distributors, whichever is greater.”

“Supplier shall be liable for the reasonable excess cost of re-procurement. The cost of any purchases from Supplier’s authorized distributors shall be deemed reasonable.”

Excuse of Performance


Once a contract is signed a party, unless it is either void or voidable the parties must discharge their duties to perform by either providing satisfactory performance or be excused from performance by certain conditions. Conditions that would excuse performance are:
  • Subsequently illegality such as a change in the law that makes the performance illegal,
  • Impossibility, where the work cannot be done.
  • Impracticability, where the work is not capable of being done
  • Frustration, such as one party failing to meet their obligations can frustrate the other party allowing them not to perform.  
  • Where the parties agree to rescind or stop the agreement.  
  • Novation, where the parties agree that another party will complete the work and the original party is excused from performance, and
  • Lapse; such as where the contract term may have lapsed without the work being completed

An assignment does not discharge the assigning party from their obligation to perform. The assigning party will remain secondarily liable for performance unless there is also a “novation” where the original contracting party excuses the assigning party from performance and agrees to only look to the new party for performance. Requirements for a novation will vary from location to location. For example under New York law for there to be a novation it must specifically state that it is a novation.

A force majeure is not an excuse to performing the Agreement, it excuses performance only during the term of the force majeure event.

Exhibits


 Exhibits can be used to explain things in either the Agreement or in an Attachment. If they are to explain something in the Agreement, they should be incorporated by reference into the Agreement. If they are to explain something in an Attachment, they should be incorporated by reference into the Attachment so that it is clear that it applies only to that specific Attachment.

Exhibits should have the following on each page:
                      1.  A title.
                      2.  A date.
                      3.  Reference to the Agreement it applies to, or
                      4.  Reference to the Attachment to which it is an Exhibit; and
                      5.  Page numbers.
     
Incorporation of Exhibits may be done in the same manner as incorporation of Attachments where they are either incorporated where they are first mentioned or listed within the document they become an Exhibit to.

Example of incorporating an Exhibit where first mentioned:
  • (As set forth in Exhibit 1 entitled, “Lead-times”, 2 pages dated February 1, 2011)

Example of Listing Exhibit:
  • Exhibits.
The following Exhibit are attached to and made a part of this Attachment:
            Exhibit 1, entitled “Lead-times,” 2 pages, dated February 21, 2011

Features and Benefits


A number of years ago I had the opportunity to read a sales training book that was created by Xerox. I believe that Xerox still sells sales training courses today. The key thing that I learned was as part of the selling effort the sales person’s goal was to try to convert their product’s features into benefits that the Customer values. The theory is if a customer sees a benefit from the product that provides value, the customer will be willing to pay for those benefits.

There are basically two types of Supplier’s that exist.  There are Suppliers that try to differentiate themselves from their competition so they aren’t directly competing. There are also Suppliers that are focused on competing based upon price.  Supplier that want to differentiate themselves from other Suppliers to reduce competition will try to:
·      Offer products with unique features that other Suppliers don’t have.
·      Offer a service with unique features.
·      Manage service and support differently.

Sales people are trained to work with potential customers to try to understand the customer’s needs and motivations for making the purchase. What problem does the customer have that they need to fix? As part of that activity what they are also doing is trying to understand whether any of the unique features of their product or service that are things that the customer needs or wants.  If the customer needs or wants those unique features, the Supplier knows that either they won’t have competition because that’s what the Buyer wants, or they know that the Customer sees benefits and value in those unique features for which they can charge a premium versus the competition.

The impact of the Supplier knowing that you need or want their unique features will affect your negotiation in a number of ways.  First they may simply refuse to enter into a cost based negotiation for commodities that may traditionally be negotiated based on cost.  For commodities where negotiation may be based more on value, its much harder to use value equivalence to drive pricing down as no other competitor is offering the same value as they don’t have the same features providing the same benefits. What you wind up doing is value equivalence where you may be able to identify the premium you are being charged for those unique features, but if they know the benefit you will get from them, and that outweighs the price premium, you probably won’t be successful in getting them to reduce their price. The best way to protect against this is to simply make sure that you don’t let the Supplier know whether you need, want or will benefit from any unique features that they offer.

If they become aware of the fact that you need or want the features that are unique to them, the best tactic that you can use is what an IT friend called the CIO crank. It applies to any function or business and requires the involvement of the financial approver. The simple fact is that every purchase, especially major purchases, is an investment. Every investment competes against other investments in both the business and company for funding. The sales person may know that they potential users or business may feel they need or want their product and may see benefits from purchasing it. What they don’t know is all the other problems or needs the financial approver has that require investments and the relative priority between them.

The financial approver (such as the CIO) can simply tell the Supplier that while his people feel that they need or want the product with functionality that the Supplier has to offer, when they compare the return on investment from the Suppliers product versus other investments they need to make to solve other problems they have a problem. That moves the competition away from the Supplier’s direct competitors where they know where they stand, to competing investments where they don’t know where they stand, especially from an ROI perspective. This sends the message that they need to improve the price or proposal or the purchase itself may not be made. It can also send the message that they company may be willing to purchase something that doesn’t have the same functionality simply because the premium they want for their product may be better spent on other investments they need to make.  The goal is to create uncertainty that they will get the business because its uncertainty that drives the fear of losing the business which helps drive pricing down. 

This won’t work if a Supplier has excess demand and can easily walk away from the sale.  I also wouldn’t use it frequently as that’s something that would get around in the Supply base making it less effective. However when it is used it may be more effective as its not the Procurement negotiator who is paid to drive costs down telling them, it’s the Manager of the Business who can decide whether to fund it or not.