Tuesday, June 26, 2012

Why are they asking that?

I recently responded to an individual's question about a company that issued an RFI and was looking for the companies to provide them with a list of exceptions or objections. Any time you have an unusual request, and asking for exceptions or objections at an RFI stage is in my opinion unusual, you should always ask yourself “Why are they asking for this and how will the use this information?”

The simple fact is RFI’s are never a binding document. Frequently companies will change things between RFI requirements and what they include in a RFP or IFB, so you want the flexibility to change your position based upon both any changes they made. You also may want to make changes to reflect changes to your business that may have occurred in the interim. If you have business near capacity you may be stricter in what you require versus when you need the work.

My opinion was the company may have been be doing that to screen out potential suppliers based upon the exceptions or objections. Alternatively they may want to be use it as a negotiation tool for when there is a RFP or Bid situation, where they would point out that you didn't object to them in the RFI. The consensus was to keep any exceptions or objections you provide to an absolute minimum if you want to be considered for the work. If I did provide exceptions or objections, I would also make it clear that they a subject to change either way and are based only upon the information that you have seen in the RFI. As such, they may be expanded upon or could be eliminated once you see the full documents for the bid or proposal. That way you are not giving them ammunition to eliminate you from consideration and as there undoubtedly will be changes between the documents, you have reserved the right to change your positions. Another reason why I would avoid providing a list of exceptions or objections at that stage comes from the old saying “you only have one time to make a first impression”. If you set a negative example, not only may you not get to bid on that work, you could also be not considered for other work in the future.

The same advice goes in part when you are bidding work. If the Buyer request prices at different volumes and you know that some of the volumes are far in excess of what they will purchase, beware. Ask the same questions, “why are they asking it and how will the use it?” It’s not uncommon for a buyer to want to buy at a 100,000 unit price, when they are only buying 10,000 units or less. If you must bid those volumes you could propose them as step pricing, where the actual pricing only goes down after the customer has purchased those volumes. Alternatively you could offer that price with a bill-back requirement if they fail to meet those quantities. One of the things you discover is when there is a cost that will be charged back if they fail to purchase those volumes, the volumes get more realistic.

Supplier non-confidential information – can you and should you share it?

In another forum a procurement person asked whether they could share one supplier’s specifications with another supplier. Aside from the ethics of doing this, before you share any information that you received from one party with another party you need to do your research.

The first question to ask is under what conditions did I received the information? Many times a company may require a non-disclosure agreement for receipt of detailed specifications. If you didn’t receive it under an NDA that doesn’t mean that you can share it. The second question to ask is whether the documents are copyrighted? Most technical specifications are copyrighted. If they are copyrighted you then need to read the copyright notice to determine what, if anything, you are authorized to do with that copyrighted material. For example the copyright notice may restrict you from copying the material or may limit your use of those materials to your internal use, which would prevent your sharing of the materials.

If you didn’t receive it under confidentiality obligations and it wasn’t restricted to internal use, you could potentially allow the other supplier to view it. That is where the issue of ethics comes into play. I believe that you should treat supplier non-confidential information in the same way you would want your non-confidential information to be treated. If you don’t want them sharing your information with their other customers (who may be your competitors) then you shouldn’t be sharing their non-confidential information with their competitors. You probably don’t need to
as these days many suppliers post their data sheets or technical specification for their products on-line for prospective buyers to view them. If the other supplier knows what product you are buying and who you are buying it from, they should be able to do the research themselves. As they are competitors they should already know exactly what their competition is selling. Many times they probably have also purchased the competitors product to do a technical analysis of the product, how its made, the materials used, etc..

Monday, June 25, 2012


On LinkedIn, an engineering student, Lina Maria Arroyave Gutierrez, posted a questionnaire about whether construction was risky. I wanted to expand upon that post in terms of discussion of not just the risks but also how those risks are managed. Construction like many other commodities has a number of inherent risks because of the nature of the work. It also has many of the risks that are common with other types of procurement. One differentiator between construction and other commodities is in the potential magnitudes of the risk. A second differentiator is while the purchase of goods has many laws such as the UCC that apply, construction is a service and those laws do not apply. Management of the risk with construction is done in a number of ways and throughout all stages of the work.

The most common methods of managing risk starts with location / site analysis. In location and site analysis you would be considering a number of factors that Lina Maria listed such as:
•Advance site review and analysis (preventative risk management) :
•Permits and government approval required
•Potential for War and civil disorder
•History of Labor problems / Strikes
•History of Corruption & Bribes
•Availability of resources and materials
•Opinion of neighboring community
•Safety (personal, property)
•Potential conflicts due to differences in Culture (Language, religion)
•Local laws and requirements
•Environmental / Conservation Restrictions
•Inconsistent/different site conditions
•Poor accessibility, site surrounding conditions
•Geological Conditions

One you have determined that the location and site are acceptable for your needs the next step in the process is to determination of conceptual requirements as part of preventative risk management. This may be done as part of what is called the “programming” phase of the design where the designer will meet with the customer to determine the specific needs of the customer for size, functionality, capability, use, capacity, flexibility and future growth or expansion. Some customers may totally know what is needed and will tell the designers that while others need to work with the designer to go through the thought and review process to determine what’s required. This identifies the general scope of what’s needed. The better you are at determining these requirements, the fewer changes there may be to the overall scope of the work.

The next step is the prequalification of the architect, engineers and consultants that will be used to design the project, and possible review and manage the performance. This is another preventative risk management tool. Pre-qualification includes interviews, reference checks, financial checks, prior customer feedback. For specific projects that would be similar to yours it may also include verifying that individual members of the proposed team have the required experience, as they will frequently be different than the team that delivered the prior successful project. As a buyer the last thing you want is for someone to be learning at your expense either as billable hours or in errors made that need to be corrected. Having design standards that establish the quality of what you want designed and the types of materials that you want to be used is a good way to manage against the cost of over-design as you are limiting what the designer may use for the design.

The contract with the architect or engineer will allow the Owner to manage certain costs and transfer certain risks to the designer. This is done through a solid description of the services they need to provide and their standard of performance in performing those services. For example to transfer the risk of errors or omissions in the design to the designer normally is done through three things. First is the establishment of the designer as an expert, which requires the highest standard of care. A disclaimer of any buyer knowledge of the subject is second, so it is clear that the buyer is relying upon the supplier for performance. The third may be to require Errors and Omissions Insurance policies for errors or omissions to the design of the work.

The next step in managing the cost and risk is the management and review of the design during the design process to ensure that the design meets the customer’s business requirements and any design standards provided. As some design contracts fees are based upon the cost of construction it’s important to avoid the design in of materials that add no additional value, only cost. To avoid assuming design risk, the Buyer or owner may make suggestions that the designer has the right to accept or reject. If the buyer was to direct the supplier to manage the design in a specific way, that direction could absolve the designer from liability if that direction was the cause for the error or omission. So part of a buyer’s managing its risk is the management of its own people.

The next step in managing risk and cost is the prequalification of the contractors, subcontractors and equipment suppliers that will be used in performing the work. This is done for preventative risk management to ensure that the supplier or contractor has the skills, experience, capacity, equipment and personnel to perform the work. Pre-qualification includes interviews with the contractors, reference checks with other customers, financial checks of the supplier, prior customer feedback, etc. Depending what is discovered you either may determine the supplier or contractor is not qualified to perform the work or that you may need additional terms and requirements in the contract to manage against risks you identified.

In construction procurement there are a number of different contracting strategies that may be used and each contract strategy has different inherent risks that may need to be managed in the contract terms. Different strategies also require different levels of management and different skills sets of the individuals involved. The contracting strategy will also have a potential impact on the work schedule so there will be a trade-off between the desire to have the work completed quickly versus the different costs and risks associated with each contracting strategy. For example, having a complete design for bid or proposals is probably the least risky, but it also takes the longest time for the work to commence. Approaches that allow the commencement of some of the work earlier have risks that need to be managed.

The next step is analysis of potential risks with specific contractor or subcontractor selection. Not all potential contractors are equal in terms of size, financial stability, capabilities, management tools and personnel capabilities. As such with each potential supplier you need to determine what changes, terms or other commitments are needed to ensure the specific contractor performs. There are four basic approaches to manage the risk of performance. Those tools are:
1.Relationship building with the Contractor,
2.Structural management (such as requirement meetings and reviews) and management escalation rights.
3.Formal management under the contract (such contract notices).
4.Financial (such as liquidated damages).

As part of managing cost and risk you need to manage the contractual transfer of certain risks to the contractor. This is done by
1.Establish responsibilities and tasks to be performed.
2.Establish “standards of commitment” for each task.
3.Include contractual remedies for non-performance (For example include liquidated damages).
4.Require indemnifications for certain third party claims that are caused by the Contractor or their sub-contractors
5.Require insurances from contractor for all possible perils.
6.Include contract terms that transfer other risks.
7.Include requirements for contractor to establish and manage both quality and safety programs.
Do not direct the contractor on how to do either as that could make you responsible if they follow your instructions and there is a problem.

Another key in managing cost and risk is to ensure the contract is written in a manner where it will be enforceable. For example this would include making sure the party that signs the contract has the authority, making sure the entity you are dealing with can be held accountable and has the necessary assets to stand behind the commitments they make.

Perform on-going management and review of the work as part of managing quality, compliance to the drawings and specifications, performance and management of risks. If needed, include financial protections against certain risks such as financial guarantees, or bonds for payment and performance of the work.

You may use of specialists and consultants both in advance (such as site surveys, boring samples etc.) and during construction for testing, management of quality and compliance with the specifications and drawings as part of testing and acceptance or the work.

Establishment an owner representative or project office on site for management of change, claims and frequent reviews of progress and performance by all parties involved helps manage performance and reduces potential claims for delays and problems can be acted upon promptly.

Contractual Risks that may arise may be broken down into two categories:
1)Those that you can perceive in advance and address in your contract and
2)Those that are not contemplated and may need to be addressed during the contract term.
Examples of some of these risks cited by Lina Maria along with some of the ways they may be managed are listed below:

a) Change in government. A change in government if perceived in advance can have certain risks be managed in the contract such as rights to terminate the contract if project was government funded and funding is cut. Potential economic policy changes where work performed after that date may be subject to adjustments based upon changes in inflation.
b) Changes in mandatory labor rates would normally allow for claims to be made by the supplier for work performed after the change in rates.
c) Changes in currency exchange rates may be managed a number of ways in the contract for items that will be required to be imported as part of the work or could be managed by advance purchase or hedging
d) Change in customer requirements are normally addressed through the changes provision
e) A change in customer’s need for the work may be addressed by rights to terminate the agreement without cause or issue a change order to significantly reduce the scope of the work
f) Obsolescence is normally dealt with via changes to the project scope.
g) Use of new materials or technological advances are managed by changes to the scope of the work.
h) Technical complexity is managed in part by pre-qualification and selection or qualified designers and contractors.
i) Safety risks are managed by transferring the risk to the contractor and requirement that they manage programs and also carry insurances.
j) Natural Disasters are managed in contracts by both “force majeure” provisions that excuse performance and insurances against such perils. For a contractor their loss revenue during the period may be managed by Business Interruption Insurance policies.
k) Weather conditions (wind, temp, rain, etc.) Normal weather conditions are a risk that the contractor assumes although they may make claims for additional time and cost for excessively bad weather conditions versus historically normal conditions.
l) Changes in requirements are managed via change order or variation provisions
m) Funding issues and payment delays are usually managed by payment requirements, interest on late payment and the ability to file liens against the work and the contractor’s ability to stop work and claim breach of contract for late payment. They may also be managed by third party payment guarantees.

The following risks listed by Lina Maria are normally managed by assignment of trained, skilled team members of all parties involved in the project and may be enforced by approval rights over all project personnel.
•Lack of coordination
•Poor communication
•Poor and incomplete drawings
•Inadequate specifications
•Design/scope changes
•Lack of standards
•Documents not issued on time
•Delays in subcontractor works
•Poor project/plan schedule
•Low productivity/ Incompetence/quality
•Organizational stability/change in staff
•PM team responsibilities ill defined
•Incompetence and lack of skills

Construction Procurement is no different from many of the standard contract risks that exist in supplier relationships, of which many of those you seek to manage through your contract terms. Every procurement activity can have the following risks:
1.Performance risks with contract deliverables, quality, schedules, on-time delivery
2.Risks from third party claims
3.Risks of supplier claims
4.Contract enforcement risks
5.Risks in defining and getting what you want.
6.Risks with change to the product, the relationship, your demand, the circumstances.
7.Risks in pricing and payment
8. Risks in long term support
9. Availability and continuity of supply risks
10.Legal risks associated with the product or service complying with laws
11.Risks with defective products or services and warranty redemption, warranty support
12.Risks with delivery performance and the need for flexibility
13.Risks dealt with in the various types of insurance coverage.
14.Risks with the import / export
15.Risks with the supplier performance or interruptions to performance
16.Risks in recovery should something go wrong
Within each of the above general categories there are a number of different risks that may be involved. For example, to manage enforceability risks requires that the contract be written in a manner to ensure that all the terms are clear and enforceable. Problems with contract terms can negate the transfer of risk or costs and they can impact the ability to recover costs and damages for a breach or even being able to claim a breach.

Common risk management techniques for any procurement also apply to construction. Those are:
1. Clarify all requirements in advance
2. Pre-qualify and use qualified, stable suppliers.
3. Select a contracting strategy you can best manage with the people and skills you have.
4. Use the contract terms to transfer risks and responsibility to manage performance to the party that is most capable of managing those.
5. Train internal personnel to manage risk and performance
6. Manage financial risks with bonds, insurances, warranties and guarantees.

Friday, June 22, 2012

An invitation and a word of thanks

As readers of this blog through my website I've always had the page where you could submit a question about contracts to me and if I had the knowledge I would respond to it with a post. I haven't had many questions but want to provide the ability to expand the knowledge base from other people who can also help in responding to contracts questions. As such I would like to invite all of you to a LinkedIN contracts group I established called "contracts questions and answers" It is intended to be a non-promotional, non-self-serving, group where individual can ask questions and get the best answers. Comments that either aren't correct or that add no value will be blocked.
To be part of this you must join LinkedIN and then using the search function at the right top of the LinkedIn page and "groups" search criteria type in the group name Contracts Questions and Answers and then request to join. If there are great questions and answers that I haven't addressed in the blog I will still summarize them here.

The second thing is this is my 500th post and today I reached 50,000 page views. I want to thank everyone that has visited the site and read the posts. I've had fun writing it and I hope that all of you now know more about the knowledge you need to negotiate or manage contracts.

John C. "Jack" Tracy

Assignment strategies that can help the Buyer

When I managed construction contracting for fast track programs and we would make advance purchase of long lead-time items prior to the prime contract being bid or negotiated. In those agreements we would include two requirements. One would be that the supplier would agreed in advance that the contract could be assigned to the prime contractor that we selected and second that we would be a third party beneficiary to that contract once it was assigned. Then in our bid documents and contract we would identify the specific contracts that would be assigned and include the requirement that the prime contractor would assume those assigned contracts. Whether we sought a novation of those agreement would normally be dependent upon the value of those advance purchases and whether the supplier had concerns over payment by the prime contractor.

This approach allowed us to shorten the schedule for competing the work as the activity could be done in parallel rather than serially waiting for the design to be completed and bid. It also eliminated the potential of there being a problem where those advance suppliers and the prime contractor were pointing fingers at each other with our company being in the middle of the dispute. Once the contract was assign, the total responsibility for performance rested solely with the prime contractor. If there was a problem it needed to be worked out between the prime contractor and those suppliers. This also places the responsibility for coordinating all of the work on the prime contractor and it eliminates the potential for claims from either party that would occur if they remained our contractors. So while the prime contractor may charge additional cost to assume that responsibility, you avoid those claims.

The reason why we wanted to be a third party beneficiary to those advance contracts was because some of those advance contracts had obligations that extended beyond the period of the construction such as warranty obligations and we wanted to be able to directly enforce those directly with the suppliers.

In situations where there was not an assignment and novation, meaning we could still be liable to pay those suppliers if the contractor prime didn’t, we could protect against that risk by payment bonds, requiring a waiver and release of liens from those supplier as a condition for future payments or we could issue dual party payee checks that were written in the Prime Contractor and suppliers name so the supplier couldn’t cash it, they could only endorse it for the supplier to then endorse and deposit. The check couldn’t list both parties or use “or” as the prime contractor could potential deposit those. The “and” requires both signatures for deposit or cashing.

While this approach works well in construction there are clearly a number of other areas where it could be used as a tool to fast track work and not leave yourself with a problems where what you purchased isn’t working and you have both sides pointing fingers at each other as to the reason for it not working with you standing in the middle.

Thursday, June 21, 2012

Assignment versus Change of Control

What is the difference between Assignment and Change or Control provision? That was a question someone asked in another forum and I thought I would share and expand upon my response.

Contractually you are able to prevent assignment of the contract to another party. You do this because you were confident in that other party and were relying upon that other party for performance. You don’t want to be dealing with someone else unless you approve.

As Directors and Executives of companies have the fiduciary responsibility to do what is best for their shareholders, they would never agree that they cannot merge with or be acquired by another company as that would violate their fiduciary responsibility. Since you can’t restrict those activities from occurring, you use the change of control provision to protect your company when those change of control situations occur.

A change of control provision normally includes a right for the other party to terminate the agreement without liability within a specific period after the change of control. A good example of why you would want a change of control provision would be if a competitor acquires one of your suppliers and you no longer want to do business with the supplier as a result because of competitive concerns. The change of control provision should allow you to terminate the agreement without liability for the termination. It should be without liability, as the party who merges with another knows that this is a risk they have if they agree to a merger and a merger is a voluntary thing they can control. If there is an acquisition, as part of the due diligence the acquiring company knows that this is a risk where you could walk away without liability.

In negotiating a change of control provision you want the period you have to be long enough for you to develop and implement an alternative strategy if needed. Many times you may be happy with the merger of acquisition, as it will provide you with a bigger more financially stronger business partner. I'm sure there can be a number of variations where in addition to you having not having liability for termination you could also have them reimburse you for any un-liquidated portions of investments made. In those it would probably require that the change of control posed a real and significant threat to your business.

Where the inclusion of a change of control provision is extremely important is if you are dealing with a company that is venture capital funded where if the if the funder isn’t seeing the growth they want they may want to company to be merged or sold to another. I would also include it in any agreement where I had a long-term firm purchase requirement. I would do that as it would eliminate my having to meet that commitment if they merged with or were acquired by someone that would be a problem. I might also use it as a deterrent to the supplier wanting to merge or a company wanting to acquire them especially if your business volumes represented a significant portion of their business and your termination would significantly impact the worth of the company. Rather that surprising you they could always disclose their intent to you under confidentiality provisions to determine in advance whether it is a problem for you and if not get your advance agreement that you will not exercise the right to terminate for that specific change of control.

Delivery terms versus title transfer

In a post I had another individual tell me that under Ex-Works delivery terms that you would be subject to things like local fees and taxes such as VAT. He recommended using FAS or FCA. Barring anything else in the agreement he would have been right about ex-works. FAS would not automatically avoid those costs as the buyer takes possession of the goods prior to export clearance so technically a sale occurring within that country. FCA should avoid those costs as the seller has the responsibility for export clearance with FCA and usually once something has cleared customs it is treated as an international sale.

Tax and fees are based on the location of sale. INCOTERMS only deals with shipping responsibilities, payments of costs and duties and when the risk of loss transfers. They do not establish where the title transfers, and that can be a completely different location than where you take delivery responsibility and risk of loss. It is the point at which title transfers that creates the sale. The sale is then subject to taxes and fees.

You don’t need to have title to an item to export an item. In fact a supplier may want to retain title until payment is made. This means that if you used EX-Works, if you wanted to avoid those taxes and fees, you would want to specify that title transfer occurs after export customs clearance or even while the item is in transit in "international waters". That makes it an international sale and avoids paying VAT and local country fees that are applied to local sales.

Having the title transfer in a different location is common when you buy an item from a supplier in one country and want to sell it to a customer in another country without actually receiving the item. In that case you don’t want to buy it and take delivery and sell it from the supplier’s country, as you would then be conducting business in that country. If you conduct business there you would need to have a license to operate there. It would make you subject to the laws and taxes of that country. You don’t want to take delivery of it in the customer’s country for exactly the same reasons. There are three options on where you would want to take title.
1. You could take title after customs clearance in the supplier’s country location.
2. You could have title pass on the high seas.
3. You could also have title pass prior to the customs frontier at the port of import such as in a bonded warehouse prior to customs clearance.

You could do a simultaneously sale and transfer of title where the supplier transfers title to you and you transfer title to the customer at any of those locations. You could also acquire title at one location and transfer it at a different location. The main concern of either the Supplier or Customer is to ensure that their risks are covered contractually and with insurance. For example, when you agree to Ex-Works delivery terms you have assume the risk of loss or damage in transit. As further protection the Supplier may want you to also insure the goods for loss. The customer may be concerned with taking title and risk of loss with a delivery term that shifts the risk of loss to them while the item is in-transit, but that can be overcome by insuring the shipment, usually at 110% of the value.

Tuesday, June 19, 2012


There was a debate on LinkedIN about what the FOB delivery term means. As I thought people could learn from that, I wanted to share my response.

The Uniform Commercial Code, Article 2 defines FOB and allows both FOB Origin, FOB Destination terms. The UCC applies to only for the sale of goods on transactions within in the U.S. or where the applicable law is one of the States of the U.S.. The problem is the UCC definitions don't match INCOTERMS Definitions published by the International Chamber of Commerce.

In the UCC FOB term has nothing to do with ocean shipments. It could be free on board any carrier. Under INCOTERM FOB only applies to Ocean shipments. So what the UCC defines as FOB Origin, INCOTERMS refers to as Ex-Works.

To avoid conflicts and claims based upon different interpretations between the parties, when you specify the deliver term, you should always make reference to the specific source of the definition you want to apply. For example
"FOB Origin (Named Location) as defined under the Uniform Commercial Code" or
"FOB (Specified Port and Ship) as defined by INCOTERMS 2010."

My personal preference has always been to use the INCOTERMS.
1. They can be used both domestically in the U.S. and internationally.
2. They apply to everything that may be shipped not just goods.
3. Each term has a clear definition of the responsibilities of both parties for all the required activities.
4. They clearly establishes where the risk of loss transfers.

When I'm purchasing something of high value I want to select the right term so I can manage the risk. For example with a high risk item I probably want to use Ex-works so I can manage and control the selection of the carrier, the shipping lanes, as both of these may have different risk. I want to specify how the item will be packed and packaged to prevent loss. I also purchase the right insurance for the potential loss etc. as standard insurances may not cover the full value if its lost of damaged.


A waiver is the giving up of a right. You may have express waivers that are set forth in a contract. For example, many companies include a waiver of jury trial provision so that in the event there is a dispute between the parties, the dispute will only be heard by a judge who will make their decision based upon the law, the contract and the facts. Companies want waiver of jury trials as in many cases they feel that their will get a fairer decision as any personal prejudices of the jurors won’t be taken into account. They may also feel that the size of the awards will be less than what a jury might award.

Waivers can also occur through a party’s actions. For example. if you have a right, and fail to enforce it, in the future you may be prevented from enforcing that right by you previous failures to enforce it. Most of contracts will include Waiver clauses where they make the intent clear by stating that the failure to enforce a right shall not
constitute a waiver of future rights.

Waivers are also traditionally used in the settlement of claims where for a party to make an agreed payment of an agreed settlement amount, they require the other party to waive and release any future claims on the subject matter of the settlement.

Other types of waivers that you may find in contracting are:
1.Waivers of liability which may be used when a person is entering a business premise where there could be potential injury,
2. Waivers of fees. For example, a form of discount could be a waiver of certain fees to be paid for a period of time in the future.
3.Waiver and release of liens. This has subcontractors give up the right to file a mechanics or materialman’s lien against real property they performed work upon for which they have not yet been paid.
4.Insurances frequently have waivers. For example for certain losses there could be a waiver of deductible so the insurance company pays the entire loss.

Security Interests

A security interest is a method by which a supplier or financer can protect their interests in the equipment or goods until paid. It’s similar to a lien against the title to that item. It puts other parties on notice of that interest and makes any subsequent sale also subject to that claim. A buyer may also have what is called a Purchase Money Security Interest to the extent the supplier has taken or retained all or part of the price in the goods or equipment.

In the United States Article 9 of the “UNIFORM COMMERCIAL CODE - SECURED TRANSACTIONS; SALES OF ACCOUNTS AND CHATTEL PAPER” is the law that governs security interests. Security interests may be created by a separate agreement or the terms of an agreement could establish a security interest for the Supplier until the buyer makes complete payment.

Security interests are a form of credit protection where the seller is not relying upon only the credit of the Buyer but also wants to have the additional protection where other parties are put on notice of the fact that they have a legal interest in the item and as such the other party cannot transfer full interest or title to them until the security interest has been satisfied by payment and release of the interest.

In a number of negotiations I’ve dealt with suppliers that wanted to have security interests in the goods they sell until they receive payment. Assume you had sixty-day payment terms. What a security interest would do is prevent you from being able to sell the item you purchased for resale within that period with clear title. If you were using what you purchased in a higher level product what it would do is prevent you from selling that higher level product with clear title during that period. In these types of situations as a buyer it’s best to avoid providing a supplier with the right to have a security interest as it complicates the sales. It’s better to either make sure that they are willing to rely upon your credit ratings or even offer other assurances of payment if needed such as a letter of credit or bank guarantee. Situations where a security interest might be acceptable would be if you were purchasing a major piece of capital equipment under credit terms. In they situation where it is only for internal use, a cloud on the title in the form of the security interest would have no impact on your ability to use the equipment in the interim and it would protect the supplier against potential loss if your company were to file for bankruptcy.

Purchase Money Security Interests are provided for under the UCC and are restricted to goods and software. The advantage to a Buyer of establishing a Purchase Money Security Interest in goods or software, that they have paid for which have not been delivered, is in the event of Bankruptcy. Advanced payments are considered a form of financing and the UCC established PMSI as a super- priority that has precedence over other secured creditors. The priority in a bankruptcy would be first the payment of any taxes; then to any super-priority creditors; then to secured parties; then to ordinary creditors and lastly to any shareholders. So what a PMSI does is place you below any government claims for taxes, equal to other super-priority creditors and above secured creditors and unsecured creditors.

For paid finished goods being held at the Supplier, you would not rely upon a PMSI. Rather, once payment has been made they should be treated as goods that you own that are being consigned to them and have language in the agreement that establishes the consignment and their responsibilities as the consignee. The reason for that is simple, in the event of bankruptcy you as the consignor of the goods own them. As the owner you would have the right to enter the supplier’s premises to recover your owned material that is consigned to them. PMSI gives you a higher place in the line of creditors where you may be able to get the goods or recover some of the monies paid if there are any after taxes are paid and as long as other super-priority creditors get the same according to their share, whereas consignment allows to fully recover the goods.

Friday, June 15, 2012

Software Maintenance Fees

Frequently I see questions on LinkedIn procurement and contracts groups about negotiating Software Maintenance fees. Just like everything else that you need to purchase from a supplier after the initial purchase of the product, equipment, of software, the best time to control your future costs is prior to making the initial purchase. That is when you have the most leverage.

That is when you can negotiate the best total deal because the supplier knows that not only do they lose that sale if you don’t agree, they will also lose all the annuity revenue and profits that flow from that sale. As it’s hard to predict what costs may be five or ten years in the future one tool is to allow negotiations annually with any increase not to exceed an agreed inflation index. Inflation indices are published by many countries. In the United States there is the Consumer Price Index (CPI) and the Producer Price Indexes (PPI). Both are published by the department of labor.
The standard industry classification (SIC) code 737 - Computer Programming, Data Processing, and Other Computer Related Services would probably be better to use than CPI as it measures costs affecting companies in that business.

If you cannot get the licensor to agree to a cost index, there are two things I would want. First I would want to ensure that the license does not require you to purchase maintenance for it to remain intact. If you have that requirement you have two options and both are bad. If you think their price is exorbitant you can not renew the maintenance and then lose your use of the software and the investments you made in it and in using it. The second option is you may wind up paying whatever fees they want to charge. When you don’t have the requirement to purchase maintenance, each time the maintenance comes up for renewal you have leverage to negotiate the fee. If the software is extremely stable, you could proceed without buying it and that potential loss of revenue is the thing that gives you leverage.

What should the fee be? I’ve seen people suggest that it should be anywhere between 15 to 22 percent of the initial license fee. Those are potential rules of thumb and I’m not all that convinced that a percentage is the best answer. The simple fact is you are buying a service and when you buy a service the price you pay should be based upon the cost of the services plus reasonable contributions to their overhead and profit. When you use a percentage of the initial license fee that doesn’t take into account any changes to the licensor’s underlying cost base that have occurred since you licensed their product. For example if the licensor moved their support operations from a high labor cost area to a low labor cost area in the interim, all a percentage fee will do is provide them more profits while you probably get nothing better than before. If you were buying any other service, and you knew the suppliers costs went down, wouldn’t you expect your price to go down?

There is also a strong relationship between the warranty the licensor provides and the maintenance fee. When you purchase hardware, you can usually negotiate a warranty term of a year or longer. When companies want a short warranty period one of two things is happening. One reason is they feel the product would be reliable over an extended period and they don’t want to incur the cost of fixing it. The other reason is because the sooner the warranty period ends, the sooner you have to purchase maintenance. If you bought a license for a product and paid US$100,000.00 for that and the maintenance fee was fifteen percent or $US15,000.00. The difference between having a 12 month warranty and a 90 day warranty is your purchase just cost you US$11,250 more plus the value of money on that from having to pay the $11,250 nine months earlier. Based on that I would want to pay a smaller license fee to offset that additional cost of the term.

Thursday, June 14, 2012

Knock-for-knock Indemnities

A knock-for-knock indemnity is a reciprocal or mutual indemnity that is frequently used in the oil or gas industry where injuries could occur only to the employees of the contracting parties and damage could occur only to the property of both parties. Under a knock-for-knock indemnity both parties agree to indemnify the other against claims for injuries or damages that they or their employees sustained regardless of who was at fault or who was negligent.

For example under a knock-for-knock indemnity, you could have Oil Company X and Drilling Company Y. In a knock-for knock or mutual indemnity Oil Company X will be responsible for any damages to Oil Company X’s property or employees and has to indemnify Drilling company Y against any claims and pay any damages awarded.The same would apply if an employee of Drilling Company Y were to sue Oil Company X for injuries they sustained from Oil Company X or Oil Company X’s employees negligence. In that suit Drilling Company Y would indemnify Oil Company X from those claims and would be responsible to defend and pay any damages awarded. Over time a number of companies have modified the true “knock for knock indemnity” where they exclude gross negligence or willful misconduct from those indemnities. The problem is when you do that it become similar to comparative negligence in that the parties have to establish those behaviors.

Knock-for-knock indemnities help avoid the cost of litigation that occurs with comparative negligence claims. A comparative negligence claims is one where both parties are sued and the court determines the percentage of negligence that applies to each of the parties. They share the responsibility to pay the damages based upon their percentage of negligence. Knock for knock creates a simple sharing of the risk where each party agrees to be fully responsible for any damages they sustain or that their employees sustain and not look to the other party.

Where a knock-for-knock indemnity doesn’t work or would need to be modified is when the property of a third party is damaged or a third party who is not an employee of either of the parties to the agreement is injured. Those types of claims are outside the scope of the knock-for-knock indemnity. If you failed to address claims by third parties if one party was sued and felt the other party was fully or partially responsible, they would need to enjoin the other company in the law suit and because there was no indemnification relating to third party claims, the court would decide the responsibility for damages. The damages would be apportioned based upon their percentage of negligence that was attributed to the parties.

Having an indemnity doesn’t fully protect a party, especially where it’s a Buyer / Supplier or Prime Contractor /Subcontractor situation Even if the court found the supplier or subcontractor to be 100% of the cause for the negligence, even that may not excuse the buyer or prime contractor from payment. Under the theory of agency, those parties are considered principals and the other company is consider an agent. Principals are liable for the acts of their agents.
So if the Supplier or Subcontractor didn’t have the insurance coverage to cover those damages and didn’t have the assets to make the payments, the principal could be forced to pay the damages.

Tuesday, June 12, 2012

Cloud Contracts – Data Protection

On the LinkedIn contracts group that I moderate (Contracts Questions and Answers) someone asked about liability for customer data in a cloud hosting agreement.

As a customer there are primarily several concerns about their data. One is their own potential damages if the data was disclosed. A second concern is what is their potential liability to third parties would be for information entrusted to the purchaser of the cloud service. E.g. Personal Data, Confidential Information. A third concern is where the data will be held as laws protecting the data are very different around the world.

The difficulty the cloud host has is they don't know, and won't try to identify the nature of the data being hosted. A similar type of problem exists when computer disk drives are returned as defective. There a disk manufacturer disclaims any liability for the data on the disk and requires that the disk come to them erased and the first step in their process is to further erase the disk. Unfortunately a cloud hosting business can't do that.

I think that:
1) The host service needs to make the customer responsible to identify the type of data involved as that could require hosting it on different servers with different levels of security. While you are simply holding it, customers will consider you responsible for managing its security.
2) You need to make it clear where it will be held so customers can determine if they will accept risks associated with having data stored in those locations. The simple fact is not all locations provide the same protection.

When it comes to liability of the cloud host I would argue that there is a precedence that is established for a similar activity that is escrow agent services. There the Custodian is liable only for willful failure to comply with the terms of the agreement, for negligence, misconduct or fraud in performance of its duties. This would require that the agreement describe how the cloud data will be managed and protected. Then as long as you don't willfully fail to comply with those commitments and you are not negligent, and have not committed fraud or misconduct you wouldn't be liable for the data. Where the cloud host could still be potentially liable is if you made specific service level commitments for the hosting activity and failed to meet them.

I read a good article called Five Secrets your cloud provider won't tell you about multi-tenancy. The URL is:

Using Deductibles or Thresholds In Contracts

In negotiations of terms that have a cost or liability impact, the party that is being asked to assume the cost, risk or liability may resist having those start at the first indication of a problem one. Contracts are not black or white, there are a lot of shades of grey in between. Nothing has to be all or none. Things that make sense for one period may not need to remain intact for the duration of the contract. Deductibles or thresholds are tools that can be used to trigger actions to apply the rights of the party to change. Here are a few examples:

With insurance and indemnity a party may want you to provide a waiver of subrogation rights so you or your insurance company cannot make a claim against them for their negligence. You could use an deductible or threshold to modify the waiver of subrogation commitment. For example, “the waiver of subrogation shall apply only for claims that are less than One Million Dollars.If the claim exceeds that amount, the waiver of subrogation no longer applies.

In negotiation of epidemic defect liability where you want to recover more of your costs than just having the item be repaired or replaced under warranty, you may need to agree upon a threshold that must be met before the defects are considered “epidemic”. The threshold could be a percentage of the total quantity, a minimum quantity amount. or a mix of both percentage and quantity that must be met such as 2% and a minimum or a hundred units so both thresholds must be met. When you negotiate a threshold that is creating a deductible to the other party’s liability.

Band-width currency provision may be used for payments made to a supplier in a foreign currency. Band width provisions have both upper and lower thresholds. As long as exchange rate stays between the lower and upper threshold the price remains the same.

If you make a commitment to purchase a specific quantity you cold have a deductible or threshold provide relief from that commitment. For example, if you placed orders for quantities and the supplier could not deliver and you needed to purchase your needs from another supplier, your language in the commitment could have those quantities be counted toward meeting that commitment.

In negotiations when you are at an impasse, unless you absolutely can’t change and are prepared to walk away from the deal, always think about whether you can use a deductible or threshold. As a Rolling Stones lyric once said “you can’t always get what you want, but if you try sometimes you might find you get what you need.” Many times less is better than nothing.

Tuesday, June 5, 2012

Hold Harmless – What is the impact of a hold harmless?

Frequently indemnifications have three requirements, 1) defend 2) indemnify and 3) hold-harmless. What is the impact of agreeing to hold the other party harmless?

The first impact is if there is any negligence that gives rise to a third party claim, by agreeing to hold the other party harmless, what you are doing is agreeing to be the only party that will be liable to the third party if there is joint negligence. What this also mean is since you have given up the right to make a claim against the party that you agreed to hold harmless, and as such your insurance company would not have any subrogation rights against that party. In some instances agreeing to a hold harmless without getting a contractual endorsement by the insurance company could also void your Commercial General Liability insurance or other insurances that protect against third party claims. This would leave you (if the contract was written individually) or your company to pay any damages that are awarded to the third party. In asking you to provide a hold harmless what a company is really doing is asking you to insure them against what could be their partial negligence in the injury or damage rather than have the comparative negligence (amount attributable to each party) be determined by a court.

A second impact is you (if the contract was written individually) or your company are effectively giving up a right to sue that party if they were partially negligent in an injury caused to you, an employee, or damage to your property. You could be 1% at fault, and the other party could be 99% at fault, and with a hold harmless you would have 100% of the responsibility. Without a hold harmless, the courts would determine both the damages to be paid and the percentage of those damages that each party has responsibility to pay. In that case you might be found to be only 1% liable.

A factor that can impact the amount that you have to pay is what party was sued by the injured party?
There are three scenarios. 1) Injured party sues you and you enjoin the other party in the suit. 2) Injured party sues the other party and they enjoin you. 3) Injured party sues both parties. In the first scenario you would have to pay the damages and then collect amount determined from the other party, which means if you were unable to collect their portion of the damage awarded you would wind up paying all the damages. In the second scenario the other party would have to pay the damages and then collect amount determined that was applicable to you. In the third scenario the suit would most likely claim that both parties were jointly and severally liable. What this means is that either party could be liable to pay the full amount of the damages if the other party was unable to pay. In injury lawsuits the vast majority of suits will be brought against all possible parties that could be negligent, looking to involve companies that have “deep pockets” who have the funds and insurances that can pay if others can’t.

Can you agree to hold the other party harmless as part of an indemnity? My opinion is that if you limited the hold harmless strictly to damages or injuries caused by your sole negligence and not be assuming liability for the other party’s negligence that is something you could provide. It’s probably something insurance companies could support (although it’s always best to check with them). Where insurance companies have significant concerns is when you are assuming liability for negligent actions of another party and they do not have the right to make a claim against that party because you contractually held the other party harmless. They wrote the insurance policy and established the rates based upon the risks with your company, not others.

Friday, June 1, 2012

Insurance – Difference between Commercial General Liability and Third Party Liability

In a LinkedIn forum an individual asked what the difference was between Commercial General Liability insurance and Third Party liability insurance. While I believed I knew the answer I went to the IMRI Risk Management and Insurance website that contains definitions of insurance terms.

After verifying it there, my response was the difference is in the scope of the coverage. IRMI defines Commercial General Liability (CGL) as “a standard insurance policy issued to business organizations to protect them against liability claims for bodily injury (BI) and property damage (PD) arising out of premises, operations, products, and completed operations; and advertising and personal injury (PI) liability.” This means that it would cover negligence by the party that causes either personal injury or property damage. Most insurance like CGL all provide some degree of third-party liability coverage for personal injury or property damage. Third party liability insurance is an option to provide coverage against third party claims that do not involve negligence resulting on personal injury or property damage.

Third party insurance protect against other tortious acts other than negligence that could occur by one of the parties. A “tort” is a civil wrong, not a criminal wrong. Libel, slander and intentional infliction of emotional distress are torts where there is no physical injury to the person. Third party insurance would cover claims made by non-employees for these and other wrongs.

For example, a form or third party insurance is employment practices liability (EPL) insurance. It is an optional insurance that would cover claims made by non-employees (e.g., customers, vendors, clients) against the insured company that arise from acts committed by that company’s employees. In employment liability two of the tortious acts would include claims of discrimination or harassment. Both of those are forms of intentional infliction of emotional distress.

The internet has a vast wealth of information available for the user. If you ever deal with insurance issues in contracts, I would suggest you go to IRMI.com and bookmark it for future use.