Saturday, June 21, 2014

Contract Term – when do you include a contract term and how to negotiate it.

In a linkedIN group an individual stated that contracts may only be ended by completion or by termination. This is not the case as there are a number of situations where a party is excused from performing under a contract.
•Subsequently illegality such as a change in the law that makes the performance illegal,
•Impossibility, where the work cannot be done.
•Impracticability, where it 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
•Rescission, where the parties have agreed to stop it.
•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.

It is this last item (lapse) that excuses performance that I want to talk about.

In contracting for a specific deliverable, you traditionally do not include a specific contract term as to when it starts and when it ends. What you instead have are required milestones and completion dates. Failing to meet those dates does not excuse performance and those type of contracts do not expire. To end those types of contracts they must be either completed, terminated, or performance must be excused by law.

In many other contracts such as agreements to purchase goods or service there is normally a specific contract term. In those, once the term has expired, both parties obligations to perform are limited to only those obligations that they have agreed will survive the expiration of the agreement. All terms and obligations that aren't specified to survive the expiration of of the contract term can no longer be enforced. For example, you could have language that requires the supplier to accept and delivery all orders placed within the term and obligations for delivery, compliance with the contract terms will apply to those orders. You would also usually have a
“survival” provision where specific terms and obligation will remain in effect after either the expiration of termination of the contract.

When you do intend to include a contract term for your agreement here are my thoughts on negotiating the term.

If you will be dependent upon the Supplier for the products, service or support for a long period, such as occurs when you design a Supplier’s product into your product, you will always want either an extended term, or a combination of other terms, to help you manage the risk of continuity supply in supporting your production or service needs.

Once the term has ended, if you still need to make purchases, the Supplier may have substantial leverage. You always need to think about protecting against potential abuse where they feel you are locked in. That applies to both the price they can charge or the terms they sell under. If you can’t quickly switch sources of supply, you either need a longer term or need to include things in the contract to protect against those risks. End of the term buy options are one way to manage that risk. Another way to provide protection is to include an option to extend the agreement. Options for extensions of the terms should be subject to mutually agreed terms. I would push to establish pre-agreed parameters on what of the agreement is subject to re-negotiation and have parameters on changes to the price.

A lot of negotiating the term of the agreement is common sense. Always think about when is it best for you to have the contract end. For example, if you were dependent on a Product to meet revenue, you would never want the contract to end during a critical revenue period. If there could be any possible interruption in supply or services, always think about when is the best time for that interruption to occur as you transition Suppliers. If they are on-going services always consider the impact of any Supplier transition on the Business the service supports. For example when I negotiated a Debit Card processing agreement for a Major Bank the term was tied to when a transition would have the least impact. That meant that the major shopping period prior to the Christmas holidays could never have and transition occur as there was to much potential business at risk, whereas if you had the contract end in a time like mid February it made more sense. You also would not want a contract term to expire when you had major commitments you needed to fulfill for a customer and were dependent on that Supplier to fulfill those commitments.

A better way would be negotiate an extension of the contract to cover that term or get agreement from the Supplier that the terms of the current agreement will apply on that program until the program is complete.

Your term also needs to take into account the fact that there is a natural lag caused by lead-time that should be taken into account in establishing the term. For example, if you were buying a product with a 16-week lead-time, the first four months of your term would be consumed by lead-time. If you had a one-year contract term from the date you signed the contract, you wouldn’t get delivery for four months, and you would have to stop ordering four months prior to the end of the term because deliveries after that would then extend beyond the term. If you need time to evaluate the Supplier’s performance prior to any extension of another term or before deciding to change Suppliers, make sure the initial term is long enough. If you have a Supplier with the 16-week lead-time and it would take four months to qualify a replacement, you would have only four months of actual performance before you were forced to make a decision.

Your term should take into account the time you need to negotiate a renewal with an eye on how long it would take to source from an alternative source if needed. If it will take you six months to quality an alternative source, you need a term that is long enough so you can both conduct negotiations with the current Supplier and if your aren’t successful still have the six months needed to source from an alternate source, or you need to have the ability to make a last time buy to cover the interim period before you can bring the other Supplier up. If you have ways in which to manage competitiveness of the Supplier and are not obligated to make purchases, a longer term may make sense.

Suppliers will look at the length of the term from several perspectives. If they are making an investment to win the business, or are discounting substantially to win the business they will want a term that is long enough so they get a return on their investment or to protect them from competition. Supplier’s main concerns with the length of the term are either financial risk (e.g. how long do they have to offer the product at the price) or business strategy (e.g. how long are they required to continue to produce the product). The longer the term, the more the Supplier may look for ways to either be able to adjust pricing to cover their exposure for changing costs, or be able to end of life the Product if it no longer is consistent with their business strategy.