Thursday, February 18, 2016

Managing Risk

Recently I’ve seen articles posted on a number of sites about the greatest risks in contract management. I decided to share my thoughts about risk and risk management as these articles haven’t done justice to the issue. I don’t know how you can identify the “greatest risks” simply because there are so many variables. For example the risks to the Buyer are always going to be different than the risks to the supplier and depending upon which side you represent they need to be managed differently. Risks will also vary greatly depending upon the subject matter involved as different things have different inherent risks. The needs of the parties as the actual magnitude of the risk may vary greatly. The ramifications of either party not getting what was committed will vary depending upon use. Something that is nice to have will have different magnitude of risks from something that is mission critical. The one thing I do know is that management of the negotiation, contract management and risk management are all inter-twined and they are not a single point in time activities. They occur and need to be managed throughout all phases of the relationship. ·

Various risks will exist throughout life cycle of the Product or Service and the relationship. To illustrate that this is my view of the phases that exist in negotiation:

1. Conceptual Planning. For a supplier the risk is determining what features and benefits a buyer will want and will be willing to pay for.
2. Product or Service Development. For a supplier the risks here are time to market versus competitors and being able to develop a product that works.
3. Marketing and prospecting. For a Buyer one of the risks here is the supplier finding out too much about what you need, why, and when as that impact leverage in the negotiation.
4. Pre-qualification by Buyer/Supplier. This phase helps determine the potential risks in hiring specific suppliers for your work.
5. Definition of buyer’s requirements. One of the biggest risks to the buyer is purchasing something that isn’t what they need. This phase is to both identify what is needed to reduce the potential for scope change in the future and results in the creation of the specification or scope of work.
6. Bid. Quote, Proposal Stage. As part of this stage you identify the specific business requirements that will be part of the deal. Many of those business requirements are linked to specific costs and risks.
7. Review of Suppliers bid or proposal. In this stage you look for any disconnects between what you want and what the supplier is willing to offer as those disconnects represent risks that need to be managed.
8. Negotiation Planning / Preparation. In this phase you establish what you want, what you are willing to agree upon and what risks you are willing to assume. For any risks you are willing to assume you need to address how your contract may need to change to manage those assumed risks.
9. Negotiation. Agreement is reached and signed. The negotiation process establishes what risks both parties have agreed to assume and what they have agreed to manage.
10. Mobilization period. Typical risks in the mobilization period involve changes that may be required because of schedule, availability of materials etc.
11. Performance period. The performance period is when performance risks occur and when you need to use your contract tools you build in to manage performance.
12. Changes during the contract. Every change to the scope can add to the cost, but they can also introduce new or different risks or complexity.
13. Contract close out.
14. Warranty redemption.
15. Contract Claims. How well you manage and document the performance of the contract can impact the how successful you will be in dealing with claims.
16. Disposition / salvage at the end of the useful life. The biggest risk in this stage is making sure you have what is needed to maximize your return on the disposition.

From a risk management perspective how well you manage all the activities leading up to the formal negotiation (phases 1-8) will have a major impact on how successful you’ll be in the negotiation and whether your tactics will work. They will impact how successful you will be in either having contract terms that transfer the risk to the other party or provide you with what is needed to help manage risks that you agree to assume. How well you manage all the activities following the formal negotiation and contract execution (11-16) will determine how much of the value you negotiated you’ll actually keep. It will help keep intact risks that were transferred from changing or eroding. If will also allow you to use the tools you included to help manage risk and performance. Anything left un-managed will always cost more.

What’s the greatest risk? For a Buyer there are many risks. For example here’s my list of general categories of risk for a Buyer:

• Performance risks with contract deliverables, quality, schedules, on-time delivery.
• Risks from third party claims.
• Contract enforcement risks including the potential of contract lapse for failing to extend the term.
• The risk of defining and getting what you want/need.
• Risks with changes that will occur to the product or service, the relationship, your demand, the circumstances.
• Risks in pricing, payment, currency exchange, and any adjustable rate factors.
• Risks in long-term support need to use the item purchased.
• Risks in continuity of supply (if there is demand for the product or service over time).
• Legal risks associated with the product or service complying with laws.
• Risks with defective products and warranty redemption, warranty support.
• Risks with delivery performance and the need for flexibility.
• Risks dealt with by the insurance coverages and indemnities (third party liability, property damage, and infringement claims.
• Risks with the import / export
• Risks in recovery should something go wrong (limitations on the types of damages, limitations or caps on liability, limitations on tindividual amounts or types of costs recoverable, and exclusions from liability.

Each of these general categories of risks can be further defined. For example, risks from third party claims may involve:
• Claims for product liability that caused personal injury, property damage.
• Auto liability for personal injury or property damage
• Premises liability (for guests and business invitees), for personal injury
• Financial claims against the product or work such as security interests or liens.
• Claims of infringement of intellectual property rights. Infringement of copyright, patent, mask works, trademark, and misappropriation of a trade secret claims. These risks include the cost to defend against the claim, the damages awarded and the cost to correct the infringement to allow continuing use such as licensing fees.
• Claims from other Suppliers for things like unfair trade practices, defamation, libel, slander.
• Claims relating to Supplier employees for personal injury (as guests or business invitees) and as workers under workers compensation, employers liability, claims for employment rights, and government claims for withholding taxes
• Claims by governmental agencies for complying with laws, regulations, ordinances and licensing or permit requirements.
• Claims that impact the potential ability to import product.

When you put risk into perspective, the management of risks needs to be done in a number of ways in the relationship. First and foremost is the qualification and selection of the supplier you will do business with. That helps identify the inherent risks they will bring into the relationship and you need to identify how you will best manage those risks. Second key in managing risks is to clearly define what you require. The clearer you are in terms of what you need, the lesser the need to make changes. The clearer you are the better prepared a supplier will be in determining if they can meet your requirements and what it will take to do that. Third, in the Bid. Quote, Proposal Stage, Review of Suppliers bid or proposal stage and Negotiation Planning / Preparation stage two things must occur. One is you need to draft a contract that includes terms needed to either transfer these risks to the supplier or have the tools and controls you need to manage the risks you assumed. You also need to include tools to manage performance. The second aspect of this stage is you need to ensure that the supplier is both capable and willing to both manage and assume the risks you need them to assume. If they can’t or won’t you may need a different supplier or you may need to change your contract so you have more control over the supplier to help you manage the risks. Many suppliers want the freedom to act however they want. If they want you to assume the risks of their actions you need the ability to control what they can do as part of managing the risk.
In the negotiation stage you need to ensure that the terms you agree upon will provide you with the desired protection against the perceived risks. Upon execution of the contract you move into the contract management phase where you use the tools you built into the contract to manage against risks that arise. For a buyer one of the biggest risks that can be managed from that point forward is performance / schedule. Once again, you should have tools built into the contract to help you do both.

To manage against the risk of performance you need a number of tools:

The first is what I would call Relationship management where you build a strong relationship with the Supplier’s account team so that they know and understand what you need, want and what will impact them getting future business awards if they don’t perform. This does not need to be addressed in the contract.

The second method to manage the Supplier’s performance is Structural. In the contract you would include all the structural tools you need to manage their performance. The larger or more complex the purchase, the more you need the structural tools as part of the contract requirements that the Supplier must meet. Examples of structural tools that would be used to manage performance are:
• Having clear specifications or a statement of work that makes it clear what they must deliver.
• Establishment of a team to manage performance and Supplier contacts.
• Identify tasks required.
• Establish schedule, milestones and deliverables
• Have a clear process by which the work will be tested and accepted
• Establish a strong program review process
o Establish meeting review schedule, frequency, attendance
o Implement action item lists
o Identify content and frequency or required reposts
• Have rights to audit any on-site work being performed for quality and performance,
• Establish Senior Management involvement and reviews
• Establish formal escalation process
• Include ability to back charge management costs for significant problems, delays or resources provided.

The third method is Control. If you have agreed to assume a cost or risk, you simply can’t let the Supplier do its own thing, so your contract terms need to provide you with the necessary control over what the Supplier can do over the things that can impact your cost or risk. Control is a way of managing behavior or performance. Examples of control type of provisions would include:
• Control over the Supplier’s team that performs the work and any changes to that team.
• Control over where the work is performed
• Control over subcontracting of the work
• Restrictions against assignment of the work
• Control over changes to the product or service
• Control over changes to the process.

The fourth aspect of managing performance is Financial. The four main financial ways that manage performance are:
1. The remedies that you have in the event of a breach of the Contract (the types and amount of damages you may recover).
2. The costs of any remedies the Supplier is required to provide for failing to meet the specific obligation.
3. Any pre-agreed impacts to price for non-performance such as liquidated damages or price adjustments for being late with deliveries.
4. Impact to their payments and cash flow. For example, a term that would allow the Buyer to withhold progress or interim payments if the work was behind schedule would be designed have the cash flow impact to try to drive the Supplier take necessary actions to get back on schedule.

In the vast majority of cases correcting performance problems is an investment decision on the part of the Supplier. If the financial approaches that are included in your contract won’t have a significant financial impact on the Supplier, the Supplier probably won’t make the investment to correct the problem.

The fifth aspect of managing performance is to structure terms to drive the desired performance. A classic example of this is many times a Buyer will want the Supplier to help you reduce the cost of the work. Which approach will work better in meeting that goal?
A. Fixing their overhead and profit amount and sharing in the savings, or
B. Paying them a fixed percentage for both overhead and profit based on the cost of the work?
To me the answer is clear. A provides the Supplier with an incentive to perform, whereas B provides a negative incentive. How much help would you expect to get if helping you penalizes them by reducing the amount the Supplier gets paid for their overhead and profit?

The sixth aspect of managing performance is making sure that you include and negotiate express conditions for that performance.
1. Make it an express commitment in the Contract.
2. Use language that establishes it as a firm commitment.
3. Avoid any softening or qualifying language that would reduce the commitment.
Any commitment that includes “efforts” as part of it whether its Best Efforts, Reasonable Efforts or Commercially Reasonable Efforts doesn’t guarantee performance. All it does is require the Supplier to extend that level of effort in trying to perform.

A seventh and last way of managing the Supplier’s performance and your risk is Contract Administration. The amount of contract administration you need will be dependent upon the Supplier and the risks. There are three main focus to contract administration. One is to manage the delivery of any Buyer deliverables. That is to avoid claims by the Supplier. The second is managing Supplier performance with the goal of obtaining products, supplies or services, of requisite quality, on time, and within budget. For contract administration to be successful you need the structural management tools to be in place. The last focus on contract administration is maintaining the working contract file. A good contract file should consist of the following:
1. A record copy of the contract, highlighted to show any amendments made and when those amendment were made.
2. A record copy of the applicable statement or scope of work, annotated to show any changes agreed and the effective date of those changes.
3. Copies of all amendments
4. Copies of any change requests and their disposition.
5. An action item log.
6. Copies of all correspondence to and from the Supplier
7. Minutes from all meetings and calls with the Supplier
8. Copies of any inspection reports on the progress of the work, site visits, audits, etc.

Whether you win or lose on a claim may be dependent upon being able to establish who did what and when and what the requirements were at a specific point in time.

Managing risks requires you to consider the entire life cycle of the product or service as part of your strategy to manage the risk. For example, if you purchased capital equipment one of the things you want as part of managing your life cycle cost is to be able to get maximum compensation for the equipment when it becomes surplus to you and you want to sell it. If the equipment contained software, you need to secure the right to assign the license it in conjunction with the sale of the equipment. If you don’t do that when you initially negotiate the equipment purchase you are creating a risk for that point in time. If the equipment supplier is unwilling to allow the assignment, the value of the equipment would be substantially reduced as you are forced to sell it for scrap versus a working item. Alternatively the equipment supplier could require a new license that would be an added cost to your buyer, which in turn would reduce what they would be willing to pay for the equipment.