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Contracts face changing perceptions, changing needs

“We must think about contracts as the foundation for business operations”, observed Steve Harmon, Deputy General Counsel at Cisco. “We’ve reached the end for strategic ambiguity in contracts – there is a need for far more clarity”.

Steve, along with Paul Lippe, CEO of LegalonRamp, was a presenter on a recent IACCM webinar exploring the implications of the new ASC606 revenue recognition standard, due to be implemented in the US (a recording is available in the IACCM member library).

The standard is significant in that it is just one more step forcing organizations to have clarity and precision in their contracts, enabling unambiguous data extraction and management. The regulation forces organizations to unbundle their contract obligations and take revenue only as each obligation is fulfilled. That means contracts staff must be far more aware of the various cost elements within a contract and to ensure there is not only clarity within the terms, but that relevant commitments and obligations are then flowed into the business and actively monitored.

This requirement simply reinforces the existing pressures for better designed contracts and for robust processes supporting data extraction, dissemination and monitoring. It plays to existing trends – such as offshore centers to undertake extraction, more sophisticated contract management systems, growing focus on the role of ‘contract owners’. As Steve Harmon also observed when talking about CLM applications: “We need to publish the implications of contract terms, not just simplify their creation”.

In summary, we are looking at contracts and their management becoming a core capability for businesses, rather than a peripheral area of administration. Contracts have been obscure, yet now they must be increasingly transparent and designed for active use. These are challenging changes for all the professionals traditionally involved in their creation and management. The pervasive nature of contract terms means that many people in the business are affected. Indeed, just yesterday I was writing an article for a Sales journal, explaining the impacts on the traditional sales and account management teams.

Over the next two years, we will see a fundamental reappraisal of contract design and wording, challenging the way that traditional legal drafting has occurred. We will see fundamental changes in the software to support contract management, as artificial intelligence and machine readable data facilitate extraction and dissemination of information. We will see fundamental changes in the way that contract portfolio performance is monitored and business intelligence is generated to drive marketing and policy decisions, as well as far greater sophistication in understanding and managing risk. And this means we will without doubt see fundamental changes in the way that contract management skills are developed and deployed.


What’s the future for pricing?

As part of the mounting social debate over ethics and perceived fairness, the UKs Labour Party has announced that suppliers to the National Health Service will not be permitted to make more than 5% profit.

The intent here may be to ensure the exclusion of private business from health services, but that would seem to lead to their inevitable collapse, since there is complete dependency on the private sector for drugs and equipment. So perhaps it is simply a target number, or a way to impose price pressure at a time when current procurement practices have largely stripped the fat from supplier pricing. Most likely, it is just unattainable populist politics.

But behind the headline is a serious issue and that is around the growing questions over ‘permissible’ levels of profit. This is a complex area, since profits – and the need for them – vary dramatically. Commodity businesses, with low costs of entry, constantly struggle to make or maintain margin; many retail sectors are a case in point. Such sectors are often under public and political pressure to mimimize prices, yet often the only ways they can do this are either by cutting service levels or pressuring their own (often small) suppliers. In both cases, they are then criticized by those same people who demanded the lower price. Another example is utilities, where true competition is often difficult to achieve because of the underlying monopoly in infrastructure. Again, prices in this industry are a political football, since everyone needs access. Companies in the energy industry struggle to make profit and are then accused of failing to make investments in the infrastructure and supply network. Today, many energy companies can make more money by helping customers use less energy than they can by selling them the energy itself.

To add to the irony of the situation, recent research discovered that consumers actually accept being ‘ripped off’ by their favorite brands, so long as there is transparency in pricing! It is certainly notable how little pressure there is on a company like Apple, despite its remarkable profitability and cash pile.  This leads us to another aspect of modern pricing, which is the issue of open-book accounting. Certainly it is a focus for Governments. Yet once again, even if socially desirable, the formula is complicated. The definition of an acceptable margin must take account of circumstances. For example, price should bear a direct correlation to risk. It should also link to the potential for innovation and investment. And for a multi-project supplier, should margin be limited on each project, or across the entire portfolio?

One thing seems certain: debates on pricing and on the morality of profit are unlikely to go away. The digital age means that every business has to live with increased visibility and needs to accept that it will face demands for greater transparency and for justifications of its pricing policies.

Unreasonable terms

‘Just because you can doesn’t mean you should’ …. That is a principle which every organization should apply when developing its terms and conditions and underlying business policies.

It certainly seems to be the case in the recent announcement by Amazon that it will no longer require contract staff to sign non-compete agreements (at least in the UK). Many of these workers are on minimum wage and on variable hours. The inequity of such a term should surely have struck any fair-minded executive at Amazon and resulted in such a provision never being imposed. But it did not – and this calls into question the internal review process for policies and contract provisions.

According to a recent study of European CEOs, ‘honesty and integrity’ are today’s most important attributes for business. They may well be right, since public and political opinion is increasingly hostile to what is seen as unfair and manipulative behavior by many large corporations. Examples abound – for instance on issues such as payment terms, rights of termination and ownership of intellectual property. Amazon is certainly not alone in using its power to impose one-sided contracts.

It sometimes seems as though companies take the view that if there isn’t a regulation prohibiting it, any action is acceptable. But of course it is not – and this points to a key failing in many organizations today: a lack of judgment.

This issue of judgment is not new, but it is increasingly complex. Our interconnected world, the growth of specialism, the shift in public and political expectations have combined to multiply the range of stakeholder views that must be taken into account. At the same time, functional silos within business have made it increasingly difficult to reach balanced decisions on a timely basis.

It is this set of dynamics – and the need to project ‘honesty and integrity’ – that underpins growing interest in ‘commercial acumen’. Organizations need their staff to have greater awareness and sensitivity to the potential consequences of their actions. Those who prepare or draft such terms must, in particular, be a last line of defense and ready to challenge the wisdom of the policy sponsor. For those in procurement, contract management or legal, the opportunity is clear: it is time to have the courage to demonstrate capacity for judgment.

And as if things were not already complicated enough …

So Microsoft now requires its suppliers to commit that their workers in the US receive a guarantee of paid leave. This requirement will apply to all employees who do ‘substantial work’ for Microsoft.

This announcement has a number of fascinating implications – and reinforces my past blogs suggesting that the contract and commercial management community need to start taking sustainability issues far more seriously.

First, I was interested to note that it was Microsoft’s General Counsel, Brad Smith, who made this announcement. It’s not the sort of issue that would typically have been associated with the Legal function – but this is just one indication of how fast the role of in-house legal is altering.

Second, the broader rationale for this move is to enhance (or protect) Microsoft’s reputation in an environment of growing public hostility to Corporate ethics and practices, especially in matters of finance and income distribution. So expect much more of this type of initiative, as others jump onto the bandwagon and try to build their reputation. What might come next? Perhaps push-back on zero hours contracts, or demands that workers receive health coverage, or insistence on specified minimum wages? And issues around ‘ethical practices’ won’t stop there. What about caps on executive compensation, or limits on employee bonuses, or elimination of tax arrangements that are viewed as ‘unfair’?

Third, just think of the practical issues associated with implementing and managing the Microsoft requirement. Even if there is agreement on what constitutes ‘substantial work’, can suppliers really start to differentiate among their employees in this way? Issues of morale, employee relations and potentially litigation would suggest that Microsoft suppliers will have little choice but to change policy for all their US employees. And can they limit geographically? Indeed, can Microsoft justify the geographic limit to US workers?

Microsoft say that they recognize the potential cost impact of this change and are willing to negotiate with suppliers accordingly. Other customers may not be so happy to follow suit. So that leaves a supplier wanting either to pass all resultant costs onto Microsoft, or of having to accept a potential hit on margins. It will be interesting to discover how Procurement at Microsoft has been instructed to deal with these situations and in what way their measurements are being adjusted; for example, will Procurement continue to be measured on savings, or increasingly on maintaining corporate reputation?

Finally, if you think this move will be complicated to manage, just imagine what it will be like when others start jumping on the bandwagon. There is little point in them following the Microsoft approach – it is no longer newsworthy. So each initiative needs to have originality – and imagine for a moment what that could mean for suppliers. How can they possibly manage in a world where individual customers start to set rules for personnel policies and broader business practices. For example, Oracle may now say they don’t want to deal with suppliers who avoid taxes through offshore operations (unlikely I know, but I use it simply as an example).

As the Corporate world awakens to the need to rebuild public trust, we have to anticipate a mass of sustainability initiatives – and it is hard to see how they can be achieved without significant cost and price increases.

Poor practices drive contract under-performance

Procurement, legal compliance, accounting, marketing … These are all necessary activities within a business. The problem comes when those activities become enshrined within rigid policies and practices which are not well aligned and then undermine business goals and performance.

A recent report from Deloitte illustrates this point perfectly. It is just the latest in a number of audit reports that highlight how procurement practices damage economic results, frequently overwhelming the declared ‘savings’ that are generated by today’s Procurement functions. Yet when you review the causes identified by the study, most Procurement groups would deny responsibility: the problems are associated with poorly defined objectives, unbalanced allocations of risk …. ‘Not my job’ will be the reply. ‘That’s because of senior management, engineers, lawyers ….’. And in fairness, they are right – because the real problem is that process responsibilities are not aligned and the business lacks holistic insight.

This immediately illustrates the point that we must distinguish competency to perform a task from the assumption that it will then be achieved by a specialist business function. Firstly, the job title frequently does not reflect the span of responsibility. Secondly, there is a very real danger that the specialists become a barrier to good performance because their practices become sacrosanct, rather than the quality of their output.

Output is often hard to define and measure. You need to find critical indicators. That is why IACCM promotes the idea of measuring contract performance. Contracts are, after all, tangible assets – far more so than the sales revenue forecasts or procurement savings that are such a focus today. Smart organizations take these predictions of contract performance and monitor the actual results. More importantly, they explore and analyze the reasons behind performance gaps.

Contracts represent an overall measure of business effectiveness since every activity within the business contributes to them. If looked at through the lens of the contract, almost any shortcoming – or success – can be tracked back to its origin. This analysis, when the results are considered, quickly starts to reveal the practices and processes that are out of step with business needs – or which should be promoted to ensure success.

Increasingly, analyses are pointing to issues like insufficient stakeholder engagement, selection of the wrong supplier, use of the wrong incentives, inappropriate allocations of risk, over-commitment of resources …. All of these are readily evident from analysis of contracts that fail or underperform. Yet rarely are such analyses undertaken. Why? Ironically because contracting is one area where there is rarely a defined process and even more rarely any point of accountability for overall performance. While individual contracts may have ‘owners’, these unfortunate people typically do not receive substantive guidance or support. Indeed, the contract they are handed is frequently flawed from the outset due to the various policies and practices that governed its construction .

‘Commercial excellence’ is a term that every business leader should adopt. They should see this in terms of whether their organization’s contracts are delivering intended results. They should be demanding insights to the causes of under or over-performance. Essentially, business leaders need a small team that undertakes forensic analysis into business policies and practices as they relate to performance on contracts. Their key target should be to drive incremental revenues and cost reduction through improved performance of the contract portfolio.

Is empathy a key commercial instinct?

You don’t have to search far to discover all that is being written about increased complexity in today’s business world. At the top of the list come issues such as managing interconnections and interdependencies – many of which cross traditional boundaries of language, culture and commercial norms. Networked technologies and social media mean that we cannot any longer ignore diverse stakeholder opinions. Old assumptions that power will prevail are no longer true – so is empathy the new source of strength?

Last week I attended a conference run by the Wharton School in Philadelphia. Its focus was on megaprojects – and this name alone conjures up an image of complexity. Time and again, presenters emphasized the importance of stakeholder management and engagement. We discussed the many challenges of understanding and reconciling diverse perspectives, especially since most megaprojects  are focused on infrastructure development, which is often contentious. Developing mines or oilfields, building rail networks, roads, power stations … these are the types of initiatives that seem good in concept, but may meet violent opposition from local communities, environmentalists, religious groups or political opposition.

If we fail to address those stakeholders, our project is at risk. Modern media means that no voice goes unheard. Campaigns can arise from the smallest beginnings.

While it may not be possible to address every stakeholder’s wishes, we can – and must – bring them to a point of reconciliation and acceptance. And I would argue that this goes to the heart of good commercial and contract management. The job of a commercial / contract manager should be to avoid disputes – and to do this, they have to understand diverse perspectives and anticipate likely reactions, both within and outside their organization. Such considerations are already having major impact on contract and negotiation practices. For example, the growth of local content or offset arrangements are no longer simply about keeping Governments happy, they are increasingly focused on bringing direct benefits to affected communities. In addition, there is growing need to consider not just the impact of the construction itself, but also the entire aftermath of commissioning or decommissioning – people want to know these things in advance. And even when it comes to negotiating or contracting with local communities, there are many lessons to be learned. One speaker explained how they provided a community with negotiation training so they would be equipped to have effective discussions on the issues to be resolved. Another spoke about the need to have highly adaptive approaches to contract content, wording and terms – for many markets, large corporate contracts appear very threatening and undermine trust. They also contain many terms or assumptions that simply cannot work – such as the need to link to an ERP system or to take substantial insurance.

Good contracts and commercial relationships have always depended on a readiness to listen and understand the perspectives of others. I think this used to be a skill that many contracts, commercial and legal staff possessed. Unfortunately, the imposition of rules, standards and compliance have transformed the discipline to one of imposition, rather than understanding. And this regularly undermines the value we can offer. It is time for commercial staff to develop their skills in empathy. And then we would be welcome members of every project team.

Contracts and technology

Technology has reshaped business capabilities and business relationships on a global scale. Yet somehow, the process and instruments through which those capabilities are expressed and by which those relationships are managed (that is, contracts) have largely managed to escape untouched.

The lawyers and contract managers responsible for contracting have (mostly) accepted the need to use email and some are very proficient with a variety of applications; many companies have implemented some rudimentary contract management software, though rarely is it enterprise wide and in most cases it covers elements of the process only. For example, the most recent IACCM benchmark data tells us that 77% of respondents have a repository. But that drops to only 52% who use software to support internal review and approval and other functionality falls away rapidly.

Much of this seems to be because senior management fails to take contracting seriously. It does not understand the cost to the business of the inefficiencies and value erosion associated with a fragmented approach to contracting. In most organizations, contracting remains activity- based, spread across multiple stakeholders, lacking clear authority and ownership. In such a situation, it is enormously difficult to build consensus for a solution, let alone gain funding.

But unfortunately, those within legal and contracts functions who could be leading the charge for new and better approaches in general do not do so. In some cases they may be technophobes; in others they lack confidence in the available technologies; and some who should be leaders simply do not lead.

Contract management technology should be transforming the way that the world does business. And before long, I am convinced we will see a true revolution, where software is not simply about raising internal efficiency, but is about creating more sustainable and higher-yielding relationships. Already a few encouraging signs are emerging. Two recent examples are of a system that oversees performance management – at a shared level, with both parties having direct access. This has resulted in a strengthened relationship and revenue growth for the supplier. Another is around the use of artificial intelligence that can remove the pain of dealing with individually negotiated agreements.

I am convinced that we will soon grasp the point that contract management software is not an extension of ERP – it is the application that helps business overcome the fundamental weakness of ERP in enabling or managing external relationships. And I also believe that advanced systems will drive us to adopt more industry standard agreements that avoid the time-wasting battle of the forms. Negotiation will be focused on true value trade-offs and this will be supported by powerful analytics. The contract management or legal group of the future will be targeted towards revenue and profit maximization through intelligent term selection.

And the technology that delivers this really will be something worth having!


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