Thursday, January 30, 2014

Onerous Contract Terms

In the NCMA LinkedIN group someone asked it there was any training on spotting and dealing with onerous contract terms. That sounded like a good topic for my 601st blog post.

When reading a contract for potential high or excessive risks, it’s just as important to be looking for the things that the agreement doesn’t say as much as what it does say. For example a document could have a limitation of liability section that only addresses limits on the supplier’s liability but not the buyer’s liability or the contractor’s liability and not the sub-contractor’s liability. In that situation they have limited their liability to you, but have left your liability to them for both the amount and the types of damages wide open. While having the same limitation of liability may not make sense, it’s important to limit your potential liability and the types of damages that may be claimed to manage your risk. Other terms that are absent from the contract could easily be the most onerous thing you are agreeing to. One thing that I always recommend is if you need to work off the other party’s agreement, always read that agreement along with your standard agreement to compare the two. That helps identify terms that are either missing and are needed or differences between their terms and your terms that will increase your risk.

A second comment that I would make is just like beauty is in the eye of the beholder, what may seem onerous to you may be considered perfectly justifiable by the other party and vice-versa. It’s important to think of the language in the context of the overall deal. Once you have identified language that you consider onerous, take the time to understand what their problem is and why they included that language. What was the risk they were trying to protect against? Demand that they to take the time to listen to your issues and the concerns that you have with the language. Many times that opens up a discussion where you can change the terms to something that meets the concerns of both parties and isn’t as onerous as first stated.

Many people look upon a term such as liquidated damages to be onerous. Before you refuse to agree to a liquidated damages provision consider the alternative. Do you want the amount of damages that may be claimed to be unlimited? Do you want the claim for the breach of on-time delivery to be potentially what has been agreed as the entire financial cap on liability? While liquidated damages will establish a fixed amount that has to be paid, it also limits recovery for that breach to only that amount. It caps you liability and one of the best ways to manage against onerous terms is to both cap the liability and the types of damages that can result from a breach of that term.

Many suppliers or subcontractors view a termination without cause provision as onerous. For the buyer or contractor it’s a necessary tool. Things change and the last thing they need is to have work continue to be performed when there is no longer a need for it. If you don’t want to have the buyer or contractor abuse the use of it, negotiate a termination for convenience that makes it costly to use it in specific situations. That will eliminate the most of the times the buyer might consider switching suppliers because they can buy something slightly cheaper.

Many suppliers consider indemnifications as onerous. There are multiple types of indemnifications and the only indemnification that I consider onerous is what’s called a broad form indemnification. A broad form indemnification requires the supplier to indemnify the buyer even if the buyer was negligent or the buyer’s actions cause an infringement of an intellectual property. For other types of indemnifications, I’ve never thought it was onerous to have the supplier be responsible for their own negligence or have the supplier be responsible for the infringement they caused. If the injured party sued them directly wouldn’t they be liable?

Always take both time and volume into consideration when considering whether something is as to onerous. Things like financial caps can be structured a number of ways and how they are structured is important. Let me give you several examples. There is a five-year contract. There are $300,000 of purchases planned for each year.

In one approach the buyer includes a one million dollar cap on liability.
In a second approach the buyer caps the liability at the value of the purchases.
In the third approach the buyer established $500,000 liability, which resets each year.

When you consider time and volume:

While the first approach had the highest initial amount, the potential liability per unit is
1,000,000 ÷ (300,000 x 5) or $.66 per unit.

The second approach has the liability grow as the volume grows and the potential liability per unit is $300,000 x 5 = $1,500,000 or $1.50 per unit.

The third approach could potentially create $2,500,000 liability but for that to occur there would need to be at least $500,000 in claims each year to reach that level. If it did, the per unit liability would be $2.50 per unit.

For many other terms that are different from your standard think of the terms from a total cost or total life cycle cost perspective and put a price tag on each. If they want 60 day payment terms versus thirty, tell them the impact that will have on the unit price to get that. For things that simply aren’t acceptable don’t be afraid to say no.

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