Top 10 issues to watch out for in commercial contracts
Whether you are a customer or a supplier, ensuring that your contracts with third parties protect your business and knowing what minimum protections there should be – can sometimes be an unnerving task.
So, where do you start? Clearly, each side will have different priorities and principles that they want to protect. What is important to a customer may not be important to a supplier, and vice versa. Is it possible to reach a consensus where both sides actually get what they want? It rather depends on how each side behaves at the negotiation table and where the balance of bargaining power rests!
Without the right advice, contract negotiations can end up delving into all possible risks, without assessing the likelihood that such outcomes will, in fact, occur. It is therefore important to ensure that both sides have a clear understanding of the differences between probabilities and consequences, and that they identify, focus on and address key issues and risks.
Good legal advice at an early stage can help ensure your position is protected and the key elements and principles are concluded appropriately.Although these top 10 are based on our extensive experience of drafting and negotiating a variety of different types of commercial contracts for clients in all sectors, we recognise that each company will have their own priorities and negotiation style.
The Top 10
|Get the scope and requirements right||Be clear about what is included and what is not, and about what each party expects to gain/get out of the contract. Ensure that each requirement has a relevant measure, and ensure any constraints, dependencies and assumptions are clearly identified. As far as possible, try to include measures that mean any scope (i.e., price) creep is eradicated, or at the very least minimised.|
|Be clear about responsibilities||Ensure each party understands their responsibilities, when they need to be performed and what will happen if they are not met (including the remedies available to the other party). Wherever possible, responsibilities should be linked to requirements and include any constraints, dependencies and assumptions. Also, if you fail to fulfil one of your responsibilities, it is likely to have a knock-on effect to your other responsibilities as well as the responsibilities of the other party.|
|Manage change||Given what we have said so far about change, it would not be wise for us not to include a mechanism to formally introduce and approve changes in our top 10 list! For low value and low risk contracts, you might include a simple clause which states who can agree a change, how and on what basis any additional costs would be calculated, and that for a change to be legally binding it has to be in writing and signed by authorised persons. On the other hand, for high value and high risk contracts, a more detailed process may be required which would also include these principles but also standard form documents to be used to request and approve changes, and different people to approve changes depending on their subject matter, complexity and value.|
|Payment terms||Ensure that you are clear about what is payable and when, and how prices can be changed. As a supplier, you are going to want to ensure that your prices not only remain competitive, but can be adjusted to take into account external factors outside your control, such as increases in raw material prices and/or shipping costs. You will want to make sure you are clear about when payment is due and the consequences of failure to pay. As a customer, getting the best price with no price increases and sufficient time to pay is your best possible outcome, but an unrealistic one. Forcing a supplier to accept your terms is not only going to drive the wrong supplier behaviours but could force a supplier you depend on out of business. Conversely, a supplier expecting the right to hike prices when, and by how much, it likes and suspend performance if the customer is late in paying is also unrealistic.|
|Measure performance||This principle relates to mechanisms in the contract to ensure that performance has taken place as the contract prescribes. These will be more important to the customer as they are mechanisms to ensure that it gets the services or goods that it wants when it wants – and if it does not what “penalties” kick in. Measurement might be around delivery, acceptance and testing, implementation and/or live service provision. Also, be clear about what remedies you want (e.g., liquidated damages for failure to meet key milestones and service credits for failure to meet certain service levels) but above all you want to ensure that the supplier is incentivised to perform. Financial penalties are unlikely to incentivise a supplier sufficiently enough to get them to perform because they will (i) have already included any financial risk into their prices at the start of the contract; and (ii) argue that they have been prevented or delayed from performing because of something you have or haven’t done, or factors outside their reasonable control. Ensure you have sufficient information to enable you to measure performance. This might include management information from the supplier or internal reports your contract management team collate on a weekly basis. Suppliers don’t tend to like giving customers information on their performance and they might limit the information they give you, so ensure that you understand what information you will get, how it will be set out and, more importantly, that you can understand it and request clarification where you don’t understand or have questions.|
|Be careful what you warrant||Most contracts will contain statements or assurances about factual matters that are true or will happen – these are commonly referred to as ‘warranties’. If a warranty is breached it only entitles the non-defaulting party to claim for damages for any loss suffered – there is no right to terminate. Depending on the type of contract there will usually be limited warranties from the customer compared to the supplier. As a minimum, both parties will want an assurance from the other that it has a right to enter into the contract. The customer will want assurances from the supplier around the quality of the goods and/or services being provided, that it has/will obtain any necessary licences and consents, that it does/will not infringement any third party IPR and where the subject matter of the contract is software, warranties around fitness for purpose, conformity with specifications, and free from viruses etc.|
|Limit your financial exposure||Each side is going to want to ensure that not only is its liability limited, but also that any limit of liability placed on the other party is adequate. For further information see our blog Managing liability in commercial contracts.|
|Protect your IP||Just as your IP is likely to be one of your most valuable assets, so this will be true for the other party. Most commercial contracts involve some use of the other party’s IP– whether it is confidential information or software – and it is therefore important to ensure that obligations and restrictions on its use are included. In addition, IP may be created as a result of performance of the contract and the contract would need to make it clear who owns what. Agreeing on who owns IP created or developed under a contract is usually the most contentious part. The customer has paid for something to be developed and therefore wants to retain all rights, including the right to commercially exploit or, conversely, restrict others from using/knowing so that it retains a competitive edge. On the other hand, the supplier may have developed something that enhances, or can only be used in combination with, its proprietary IP and which it therefore wants to control and commercially exploit. If you cannot get, or are not prepared to transfer, ownership of the IP, appropriate licensing (e.g., perpetual licence to use and modify) and financial incentives (e.g., royalties, reduced development costs) are the best solution. For further information on IP, see our blog What are Intellectual Property Rights?|
|Put in place a remedial plan process||Termination should not be your first or only port of call when things go wrong. Most of the time, when there is an issue both sides want to resolve it and continue with the contract. Only in extreme circumstances, or where the relationship has irretrievably broken down, would (or should) you look to terminate. Your first option should be to give the other party sufficient time to remedy their breach – the length of time will clearly depend on the seriousness of the breach, and whether this is the first or a persistent breach. Although a remediable breach termination clause will have a period to remedy before termination can occur, the clause is usually about material breaches and so it could not be used to get the other party to remedy a more minor or trivial breach. Contract drafters and negotiators often do not appreciate this and so contracts frequently omit to include a process for remedying such breaches.|
|Withdrawing service and termination||There will likely come a point in time where you want to apply greater pressure to the defaulting party. If the defaulting party has not remedied its failure in accordance with the alternate remedy provisions of the contract, your next option will be to consider exercising the harsher remedies in the contract. In terms of service withdrawal, this will only be available to the supplier to exercise. Clearly, a supplier cannot be expected to continue to perform if the customer is in breach of its payment obligations (assuming payment is not disputed, of course). There may be other customer breaches which the supplier will want to rely on to trigger a service withdrawal but these should be limited to events which actually affect the supplier’s ability to perform its obligations, as opposed to being used to force the customer to remedy an unrelated issue. The customer will want to ensure that any suspension is clearly notified to it as a possible option when the supplier exercises any of its alternative remedy provisions and that the suspension is lifted immediately the customer stops being in breach, or if the matter is disputed, that the supplier continues to provide the services pending resolution of the dispute. Before exercising a right to terminate for cause (as opposed to for convenience), it is important to ensure that the event(s) giving rise to the right to terminate have in fact arisen. All too often, termination rights are exercised without sufficient consideration being given and result in the party giving notice to terminate being in breach of contract itself.|
How we can help
Our experienced commercial lawyers can advise you on what minimum legal and commercial protections you should include in your commercial contracts. Although these top 10 are based on our extensive experience of drafting and negotiating a variety of different types of commercial contracts for clients in all sectors, we recognise that each company will have their own priorities and negotiation style. For further information, please contact us.
Disclaimer: This article is provided for information purposes only and does not constitute legal advice. Professional legal advice should be obtained before taking or refraining from taking any action as a result of the contents of this article.