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Contract negotiations and ineffective risk sharing


I’m in Australia, reading the Financial Review. An article on infrastructure projects asks the question: ‘Will this investment surge allow Australia to ride the global economic upswing? Or. amid the rush to compete, are high profile commercial disputes a sign that government and business are failing to effectively share risks for taxpayers and investors?’

A great question – and one that I am encountering everywhere I go. During the weekend, it was the subject of an online discussion with a leading academic in Denmark. Last week it was with the CEO and General Counsel of a major European outsourcing provider. The week before, it was a conversation with the Canadian government …. the list goes on, but ultimately it all comes down to the point that contracts and negotiations are overwhelmingly focused on the wrong thing.

Most negotiated versus most disputed terms

This week will see the release of IACCM’s latest annual report on ‘the most negotiated terms’. Once again (and this is the eighteenth year of reporting), it reveals that contention over risk allocation dominates the typical agenda. Contracting remains primarily driven by issues of relative power and theoretical protection of assets through the application or avoidance of onerous terms. Hence – other than price or charge – the top negotiated terms remain focused on liabilities, indemnities, intellectual property, termination rights and warranties. The only encouraging news is that scope and goals has crept into fifth place.

Why is this a cause for concern? Quite simply because these terms are in general not relevant to achieving business goals and, in fact, success in risk transfer increases the likelihood of a failed outcome.

Right diagnosis, wrong remedy

The world is volatile. It is not possible to accurately predict market and competitive conditions a few weeks from now, let alone several years ahead. This uncertainty lies at the heart of risk and business people are absolutely right in wanting to establish mechanisms that protect against those risks. Today’s business requirements or social imperatives may look very different in the future. So contracts quite naturally become a vehicle through which the parties seek to limit their exposure to possible harm. The problem is that they are going about this the wrong way – they are seeking to protect themselves at the expense of the other party, rather than working together to develop shared protection. They create contracts that are prescriptive, rather than adaptive.

Ultimately, using power to impose or resist terms and conditions leads to adversarialism. Perhaps more important, it means that contracting parties fail to deal with the issue of uncertainty. It often starts with the very things that they believe are certain – their core goals and objectives. Economics guru Professor Richard Thaler has written about this in the context of behavioral economics and the fact that people frequently think they have agreed, but actually have a very different understanding of what they have committed to do. This is one reason why the number one cause of contract dispute is disagreement over the price or charge, tightly linked to issues around scope and goals. According to Professor Thaler, a remedy for this is to have everyone document what they think has been agreed – and then make sure they deal with the differences.

The remedy for improved success is to spend time establishing and formally agreeing the mechanisms for handling uncertainty and avoiding confrontation, of which one element is having clear and understandable documentation. There will be disagreements; there will be performance shortfalls and errors; there will be times when one or both parties need to compromise. If resolving these situations is left to chance, they will frequently lead to problems. If, on the other hand, the parties have established and implemented effective methods for early identification and resolution, they will typically arrive at a successful outcome.

This isn’t just a theory

IACCM has been promoting new and better ways of contracting and negotiation for many years. Since 2011, this has been through encouraging what we term ‘relational contracting’. This well-defined approach brings increased discipline to the way that contracting parties interact. It stops leaving ‘a good relationship’ to luck and actually institutes formality into the way they will handle their day to day interactions, especially around unexpected or unanticipated events.

The important point is that it works. We have implemented this approach in a variety of major project and services agreements, both public and private sector. They come in on time, on budget and with a workforce that is energized and motivated by positive results and positive relationships. Success like this becomes self-reinforcing.

Major projects and large outsourcing relationships require similar thinking to managing and structuring a large organization. People need clarity over the processes they will use, the ways they should communicate, the shared goals and objectives they are pursuing. Imagine if the functions within an enterprise tried to operate using only an incomprehensible legal document that focused on the consequences they would face when they failed. Motivating? Productive? Clearly not.

The new edition of The Most Negotiated Terms sets out a series of steps that would embed a new approach to trading relationships. But already, through the adoption of relational contracting principles, organizations could be making a dramatic shift in contract success. It’s just a question of whether we are ready to address the question posed by the Financial Review – are we willing to start sharing risks so that we can also share benefits, or are we just too invested in fighting over whose losses will be greater?

 

Negotiating skills are just the beginning


IACCM regularly conducts industry studies on the values and experiences of contract negotiators to support ‘voice of the customer’ and ‘voice of the supplier’ reports for its members. These studies are increasing understanding of the approaches used by the best-performing organizations and how they are creating a framework that increases the chances of not only reaching agreement, but also realizing long-term value from their trading relationships. It points to the fact that success is highly dependent on the organizational framework, rather than the personal skills of a specific negotiator.

Negotiation is supposed to help us reconcile perspectives and interests. A simple definition is “a formal discussion between people who are trying to reach an agreement”.

Based on this definition, a high proportion of business-to-business negotiations must be considered successful. They do indeed reach an agreement – though whether that agreement was really worth having and whether it actually delivers the benefits the parties hoped for is, of course, a different matter.

There is a massive amount of research and writing on the topic of negotiation, much of it highlighting the extent to which value is missed or lost as a result of typical approaches and behavior. IACCM research has been focused on the practical barriers and looks beyond the skills of individuals, to examine the broader challenges of organizational design.

Our findings suggest that most business-to-business negotiations suffer from some (apparently fatal) defects. Among these are:

  • a lack of coherence
  • unclear goals
  • rigid rules and standards
  • lack of confidence in capabilities and process
  • inconsistencies of culture or value which negotiators make little effort to understand

How do these manifest themselves? The findings here are interesting. For example, negotiators on both sides claim that they value a sense of partnership – yet in most cases, neither feels the counter-party offers this. Indeed, on digging further, you find that negotiators are generally not confident about the behavior or performance of their own organization, so they are understandably hesitant in what they will commit, even though they expect full commitment from the other side.

Also, each side looks for ‘responsiveness’ and hopes for a ‘single point of contact, empowered to make decisions’. Yet again, they consistently feel this is something the counter-party lacks or – ironically – if they find a counter-party with these characteristics, they don’t believe what they are being told!

Flexibility is another key value – but is once more something that each side feels is missing. They criticize each other for the use of standard agreement templates which either reflect the wrong type of relationship or introduce an adversarial focus on legal and financial risk allocation. Often this is tied to issues of culture and the different attitudes to risk – yet there is little evidence that the parties seek to explore those differences and address their respective concerns.

Ultimately, many negotiations suffer from a lack of clear ownership and leadership. The interests of competing stakeholders make coordination extremely difficult and the growth of ‘specialism’ is making that increasingly difficult. As a result, negotiations are often quite fragmented and decision-making may be inconsistent. Desired characteristics like ‘partnering’ and ‘collaboration’ are lost in the more fundamental challenges of skepticism, cynicism and absence of trust. For example, when I was presenting to a group of senior supplier relationship managers, one of them posed the question: “Hands up if you think all suppliers are evil?” Every hand was raised.

In an environment of growing complexity and increased interdependency, the need for organizations to work together in relative harmony has never been greater. Right now, the framework and approaches to negotiation are clearly not helping. Yes, we reach agreement – but at what ultimate cost and with what loss of opportunity?

 

Why do we use the wrong contracts?


Earlier this week I cited a report which observed that outsourcing contracts are failing to keep pace with the nature of the market. Smaller, more flexible agreements which focus on outcomes and use new pricing models are not compatible with the onerous terms and conditions and sheer size of the contracts in use today.

This mismatch between market reality and the quality of commercial assessment and oversight has also been evident in the audits and reviews of public sector outsourcing and franchising. It emerges time and again when construction and capital projects experience time and cost overruns. An IACCM assessment with one major organization found that over half their contracts were using the wrong template, resulting in higher prices and poor supply relationships.

The list goes on …. and with each wrong contract, each agreement that fails to match the terms with the commercial or pricing model, value is lost for both parties.

Why is this happening?

The issue can be framed in several ways, but ultimately it comes down to organizational ignorance and inertia. We do what we do because that is the way we do it. Ensuring that contracts and terms and conditions are matched to the goals or realities of the business is simply no one’s job. Or perhaps it is everyone’s job. Whichever, the result is that no one takes responsibility – or anyone who attempts to be responsible meets resistance.

Good contracting is very much a team sport. Multiple stakeholders have an interest in the content of a contract and multiple functions or departments rightly wish to exert influence. But this implies time and effort and, as we all know, everyone is too busy to focus on coordinating those efforts. So the pressures of getting business closed mean that it is easier to stick with standards and precedents.

Organizations are built around functional contention systems. That often works well so long as there is a clear point of ownership and accountability for delivering results or outcomes. In the case of contracts, it is generally the case that no such point exists. Legal groups may say they own contracts, but once you start talking about their oerpational performance, they soon back away. They may produce templates, but lawyers do not guarantee those templates are actually fit for purpose and they also point to the fact that many of the transactional documents are produced elsewhere.

What to do

Given the scale of evidence, it ought to be easy to gain executive support for reforming the way contracts are designed and managed. In another recent blog, I pointed out that when most people describe ‘the contracting lifecycle’, it is purely transactional. CLOC (an organization for Legal Operations staff) is among the latest to publish a high-level process overview – which fails completely to address the question: “Where do contracts and contract terms actually come from?” In my blog, I highlighted the need for someone to have responsibility for overseeing the following strategic / operational aspects of contracting:

  • Define – oversee development and define responsibilities and authorities within the contracting process
  • Develop – establish standard clauses / options and templates based on policies, practices and market strategies / requirements
  • Maintain – monitor issues, undertake research, propose improvements, update process or standards for shifts in internal or external conditions
  • Equip – ensure suitable tools, training for those performing activities within process
  • Analyze – undertake regular reporting on effectiveness of process in supporting business goals and priorities

The existence of such a role would eliminate many of today’s problems. It really is not complicated.  At IACCM, we can make the case and promote the answer – but at an organizational level someone needs to step forward or to be appointed to make it happen. Until then, ‘wrong contracts’ will continue to proliferate.

New technology not a big deal for in-house counsel


When it comes to cutting costs, spend on external counsel is the primary target for in-house legal teams. In a current IACCM survey, 74% of participants say they are using fixed fee arrangements, detailed billing reviews and panel discounts. Just over 50% have transferred some work back from outside law firms into their organization. Unlike most other business functions, a majority do not see new technology having a major impact on legal costs or resources in the short to medium term.

Law department budgets are under pressure. In common with other areas of the business, there are demands for cost reduction; but at the same time, workload in critical areas is increasing. Balancing these pressures is challenging and has led to a variety of techniques being deployed. However, their effectiveness is proving highly variable.

Is Procurement making inroads?

Legal spend is a category that many Chief Procurement Officers would like to control – but the survey shows that for most this remains a future ambition. Just under 13% of law departments say that they use Procurement on a regular basis to assist in external negotiation of fees or charges and only 6% are actively considering greater engagement.

Alternative fee arrangements – such as outcome or success-based – have likewise made little progress and only a small percentage anticipate future use.

Outsourcing, technology should offer solutions

While a significant proportion have experimented with captive or outsource centers as a source of cost reduction, satisfaction levels vary. Interviews suggest that this is frequently because the framework for success is missing. A reluctance to define procedures or to make use of technology, together with innate resistance to change, have clearly impacted results – and led to over 15% abandoning their efforts.

So perhaps technology will represent the great break-through? Certainly external commentators such as Richard Susskind believe this to be the case. So what about the in-house lawyers? Just over 10% consider there will be an impact in the next 12 months and almost 30% acknowledge that technology will affect internal resources and ways of working in the next 3 years. But for most, significnat change is felt to be at least 5 years away.

And when it happens, where do in-house lawyers believe the biggest impact will fall? That’s simple – it will be on the external law firms.

To participate in this confidential survey and receive the full results, click here. The report will be issued to participants on June 12th and will include insight to the most successful cost reduction techniques currently being used.

Commercial Update: a need for innovative terms


A weekly update on contract and commercial news and trends.

Outsourcing needs new contracts:  Greater leveraging of technology (i.e. Robotic Process Automation [RPA], Artificial Intelligence [AI], and Blockchain), plus a shift to DevOps/ Agile Development approaches, and greater use of output/ outcome based pricing models is forcing a change from traditional (people based) outsourcing agreements, reports Edward Caso, equity analyst at Wells Fargo. However, he observes that contracts are not adjusting fast enough to accommodate these new models.

A new form of Most Favored Customer? The availability of ‘voluntary administration’ as an alternative to bankruptcy is resulting in new contract clauses to protect healthy companies from competitive disadvantage. A feature of administration is that existing supply contracts are frequently renegotiated to generate better terms. Some companies are now inserting clauses requiring equivalence in the event a competitor benefits from this type of renegotiation.

Invoicing errors carry heavy cost: the latest IACCM research report reveals average errors equivalent to 4.3% of invoice value. While buyers increasingly focus on reducing overpayment, to what extent do suppliers undercharge? With new and more sophisticated technologies emerging, invoice accuracy is high on the list of areas for improvement.

Evaluating relationships: A research paper published in the MIT Sloan Review suggests four parameters for reviewing the strength of a supplier or customer relationship. The dimensions to be tested are trust, commitment, dependency and norms (e.g. of behavior). IACCM research has reached similar conclusions and also the extent to which selecting the right commercial model and terms influence these factors.

Learning from Carillion: the collapse of one of the UK’s largest construction and public sector outsourcing companies has inevitably led to many questions. The parliamentary report published last week sheds some light onto the overall lack of commercial insight and judgment by multiple parties. The warning signs were clear – and ignored. The critical need for enhanced skills is obvious, but also the importance of improved systems to automate reporting in today’s complex businesses. And a big question – what role should commercial staff have in challenging management when there is a clear lack of business integrity?

 

 

Invoice accuracy: problem or opportunity?


Organizations that institute greater controls over invoice payment achieve, on average, a benefit of around 4.3% of invoice value. That represents a lot of money – so it is worth reading on!

IACCM, in partnership with Zen Enterprise, recently undertook a survey to explore current levels of sophistication in billing and invoicing systems and procedures. 43% of those responding admitted that verification of invoice accuracy is somewhat ‘ad-hoc’ and lacks systems support. Only 13% are “utilising technology to automate and standardise the invoice verification process, including integration to provide independent verification”.

What causes inaccuracy?

The survey indicates that a variety of factors impact the scale of invoicing errors. Not surprisingly, overall business complexity is significant and manifests itself in a variety of ways:

  • Can people understand the contract? Almost 59% of respondents recognize that this is a problem. The structure and the wording often lead to confusion and possible misinterpretation and / or disagreement.
  • In situations where the contract is negotiated, 26% feel that disconnects between those who negotiate and those who implement and manage often creates downstream problems, especially when non-standard prices or charges are involved.
  • 29% say that there is often a lack of clarity over roles and responsibilities for contract management, leading to poor data flows and information exchange.
  • Just over 57% indicate that their organization lacks a sufficient number of people with the right skills to perform effective contract management.

The lack of integrated technology to support invoice generation and validation (just 12.5% have such software) obviously increases the reliance on human skills and accuracy. It would seem that buyers should be asking their suppliers to describe their invoicing methods, to gain understanding of the likely level of inaccuracy.

Points to consider

It is not surprising that the frequency of errors increases when services are involved, although product sales are not immune from error. Discount arrangements often result in mistakes, though any form of ‘custom pricing’ requires added vigilance. Market segmentation leads to extensive granularity in pricing and, unless the supplier has extremely sophisticated software, results in a high likelihood of incorrect billing.

Services inevitably involve variable factors such as use rates, billable hours and differentiated charging levels. These demand robust internal systems within the supplier to capture and record the relevant metrics; they create challenges for customers with regard to undertaking tests to validate invoices. This is the area where the greatest inaccuracies occur – on average, around 6% of invoice value, according to the research results.

Call to action

A significant percentage of respondents do not have consistent and defined operating procedures for billing and invoicing production or checking on complex contracts. Since this is an obvious area of exposure, it clearly merits immediate attention.

As highlighted above, organizational structure often results in poor information flows and unreliable data capture. This is another area for review and improvement, applicable to over 85% of those who responded.

Finally, given the growing complexity of business operations, investment in software support is an obvious step. Digital systems and robotic process automation (RPA) are already leading to rapid improvement in some organizations, but these are a small minority. For the majority of organizations there is a clear business case to invest in technology that will deliver significant productivity gains, eliminate cost leakage, and improve transparency to support informed decision making.

Contracts: developing a quality index


During a recent webinar, a participant asked whether there is such a thing as a ‘contract quality index’ – some method or algorithm by which an organization might judge its contracts.

A typical definition of ‘quality’ goes something like this: it is “the standard of something as measured against other things of a similar kind; the degree of excellence of something”. But of course for this to be meaningful or measurable, we must decide what represents excellence. And that is where the problem comes from.

Defining purpose

If I buy a car, or call a help center, I am quite clear about my purpose in doing so and can judge whether that purpose has been met. I will also be able to compare the experience with other cars or help centers. But what about a contract – what is its purpose? A recent IACCM survey illustrated the dilemma which is that contracts have multiple purposes and their relative importance depends a lot on who you ask.

However, top of the list – and therefore perhaps a good place to begin – is that the purpose of a contract is to ‘provide a record of the rights, responsibilities and obligations of the parties’. So if we use this as the indicator of quality, what measures might we use to determine success? The most obvious would be whether or not there are subsequent disagreements due to different interpretations of those rights, responsibilities and obligations. On that measure, a relatively high proportion of agreements fail the quality test and by understanding the causes of that failure, we could take steps to improve quality (e.g. was it poor drafting, poor negotiation, failure to involve the right people?). Such improvements could then be monitored, allowing a benchmark against both the outside world and against one’s own past performance.

Feature versus Function

But is a contract’s purpose really to provide a record of rights, responsibilities and obligations? On this measure, I could have thousands of perfect contracts and still go out of business. Contracts (certainly those related to sales of goods or services) are core business assets. The mark of a good contract – its function – is whether or not it generates profit. In that context, things like clarity of intent are indicators, not core purpose. Many would argue that the contract is just one contributor to profitability and they would of course be right, but there is increasing evidence that ‘good’ contracts (i.e. those of high quality) are actually major contributors. Contracts often set the tone (e.g. are they fair?) and the context (i.e. are they clear?). They set the framework for operations (i.e. are they understood?) and for managing change (e.g. are they adaptive?).

As these examples indicate, it is certainly possible to create a ‘contract quality index’ so long as you are first clear about the purpose your contract is beig designed to fulfil. Sometimes, this will require healthy internal debate – for example, over the relative importance of a contract being clear and easily understood, versus following traditional structure and wording; or (even more significant) over which terms and conditions really need to be negotiated to support the defined purpose. Such debates are held too rarely – and that, of course, is why very few organizations have any real idea whether their contracts meet any form of quality standard.