Yesterday I attended a ‘China Outsourcing Seminar’, sponsored by (among others) the Chinese Ministry of Commerce.
Although the audience represented a wide mix of interests and perspectives, contracts and contracting practices proved to be a major discussion point. On the one hand, people were asking some of the stock questions about intellectual property, data privacy and the like. But the more interesting discussions revolved around whether or not contracts are accepted and have purpose in China.
The point that emerged was that they have a very definite purpose, but it is not the same as the way they are typically used in the West. First, all experienced practitioners in the Chinese market have grasped the fundamental importance of building relationships. “Contracts are a milestone on the way to working together”, commented one speaker. “A true win-win is key – and it is essential to understand that contracts must be maintained, updated, a reflection of current conditions and circumstances.”
The lawyers who presented also reflected this view. “The contract process is key to getting understanding. There is a tendency (in the West) to rush to the ts&cs rather than gaining understanding on what the parties are trying to achieve and what mechanisms are in place to do it”.
Several of those presenting acknowledged that enforcement of contracts is an issue – and hence suggested that the contract is far more about creating a platform for understanding and the management of change than it is about developing a vehicle for litigation. They observed that this situation is in no way unique to China – it is in fact the norm for much international business, especially in low-cost markets.
So if the business people have grasped this point – and consequently place such high value on the contract – how much longer must it be before the contracts community itself makes the adjustment and switches the focus of its attention and negotiations to establishing effective relationships rather than theoretically water-tight legal contracts?
Last week, I commented on the weaknesses created by a focus on low-cost sourcing and the apparent absence of analysis related to the resulting supply chain risks and their cost to the business. Among the observations in my blog was: “It can be hard to get the right balance between cost and risk. But a start would be through an understanding of the ‘costs of vulnerability’ – that is, the actual cost to a business that occurs as a result of selecting low price supply. This would of course be a cumulative number over a specified period of time and would capture the costs associated with supply disruptions, crisis management etc. that were a direct result of deciding to take the risk of going with a low-cost supply option.”
In his Friday blog, Jason Busch raised similar concerns when he suggested that ‘spend analysis is broken‘.
The common strand to both of these is that contracts and commercial staff need to focus on business and market intelligence that will help steer the business towards improved decision making. This is a point that Professor Rob Handfield has made on many occasions in the past and of course, by fulfilling this role, those in the commercial contracts group would place themselves into a far more strategic business position. To do this, we need to be far more thoughtful about the nature of the data needed for analysis and how to combine this with forecasts based on likely market trends and directions. Through this combination, the quality of risk management would improve and result in increased bottom-line contribution.
Last week, I was asked to present on trends in international contracting. It was a lively session, with excellent participation from an experienced audience. One of the key points I made was that the growth of international business has not been accompanied by sufficient thought about contracts and contracting practices. In particular, I suggested that there has been an increase in disputes, but that many of these could have been avoided if we improved our approach to contracting.
A report on litigation trends by law firm Hogan Lovells, in conjunction with Legal Week, proves timely. Their survey confirms that international disputes are on the up, with commercial / contractual issues leading the list in terms of added workload. Regulatory issues are in second spot, with fraud / bribery in fourth. Not surprisingly, the research indicates that the recession has increased the workkload for in-house counsel and, with budgets remainign tight, they are under pressure to reach resolution faster.
An aspect of the report that I find especially interesting is the absence of discussion about dispute avoidance. There is focus on doing things more cheaply and on speed, but nowhere does anyone ask “Is the increase in volume avoidable?” And that brings me back to my presentation, in which I highlighted that today’s contract terms and practices contribute to disputes, rather than assisting in their reduction. To give some simple examples, we know that the biggest sources of dispute relate to disagreements over scope or over changes to the agreement. Yet these topics are not among those that top the list of most frequently negotiated terms. Lawyers and contracts professionals spend far more time debating the clauses that govern when things go wrong – liabilities, indemnities, jurisdiction. So our contracts are being designed for disputes, rather than establishing a framework to reduce their likelihood.
In addition to focusing on the wrong things, contracts are also designed for litigants, not for day-to-day users. Most contracts (especially in international transactions) are structured and written in a way that renders them almost useless to those who are charged with their implementation. We take situiations where clarity of communication is key and then offer instruments that are composed by lawyers, for lawyers.
If legal and commercial staff spent more time up-front ensuring that there was clarity of intent and process, they would spend far less time dealing with disputes and failure.
My friend Henrik Lando has referred me to some work undertaken by Gillian Hadfield, a Professor of Law at the University of Southern California.
Prof. Hadfield apparently undertook an analysis of contracting practices across a number of businesses and concluded that:
“In relatively stable industries, business partners pay little attention to formal Contracts and rely on informal means to create and adjust their relationships and resolve disputes.
In industries that are relatively innovative and heavily dependent on external relationships for successful innovation and competitive success, businesses engage in substantial formal contracting. They turn to experts to create relationships and they revisit those documents to determine their own actions and to evaluate the actions of their contracting partner. Where substantial disagreements about contract performance arise, they engage in legally-informed problem-solving that can result in formal amendment or modification of contract documents.
Innovative businesses use formal contracting, however, with little expectation of turning to the courts to enforce their formal contracts; instead, they expect their contracting partners to perform either because of an alignment of interests or, when alignment fails, because of informal enforcement threats such as the threat of terminating or limiting a relationship or the threat of harm to reputation.”
These conclusions are interesting and probably represent a framework that many will recognize. However, to what extent do they tell the whole story and to what extent, if correct, do they explain some of the problems we encounter with contracting today?
First, I would suggest that ‘stable’ industries are frequently those that also face the strongest price competition and have therefore been forced to pursue supply from low-cost markets. In such cases, contracts are indeed viewed as being of limited importance, though commercial strategy is very important (for example, to protect IP, to limit obligations to enable switching, to establish an approach that protects against supply chain risk). In these industries, the power of the supplier is typically limited and therefore they have limited strength in negotiations – they are often forced to accept onerous risks, but these are deemed acceptable because of the relative stability of the industry.
Second, it is true that more innovative industries tend to rely more heavily on contracts (and, in the case of the technology sector, on litigation, at least in the area of patents and copyright). Sometimes those contracts are to achieve increased partnering; sometimes, they seem more designed to contain risk or establish competitive advantage (the current case between Microsoft and Novell is a good example). In this ‘innovative’ category we must also place business concepts, such as outsourcing or private- public partnerships – in other words, innovation today may actually be more focused on the structuring of the business relationship itself rather than any specific goods.
I think a number of factors have intruded to make this neat analysis more complicated. One of these is globalization and the fact that many relationships today cross cultural and business practice boundaries. The potential for misunderstanding (unintended or deliberate) frequently drives a need for greater clarity and more formality than would be the case in a ‘stable’ industry with ‘stable’ and long-term relationships. The discipline applied to traditional contracts is therefore important in order to ensure there is mutual understanding of goals and responsibilities.
Another factor that many businesses overlook is that few of them are absolutely ‘stable’ or ‘innovative’. This varies depending on the range of activities being undertaken – and therefore calls for a contracting strategy that reflects the portfolio of relationship needs. But in many cases those responsible for contracts may fail to grasp this need and thus design contracting process and structures that are sufficiently adaptive to the market in which they compete.
Overall, I think this simple perspective offered by Professor Hadfield is helpful and something we could use to good effect when considering the role and importance of contracting within our business.
Contract discovery is not just something you should do when things have gone wrong; it is also (perhaps even more) something that should be done to avoid problems and bring added value to the business.
Most organizations have hundreds, perhaps thousands, of contracts. As Seal Software points out in a recent blog, these are often “spread across countries, divisions and departments. It’s not hard to imagine the scale of the challenge in pulling together the relevant contract information that proactive business planning requires.”
What is meant by proactive business planning? Seal poses three questions as an example:
Can you answer the following questions?
- Do you have visibility of all contracted costs?
- Which customers have the right to terminate their contracts this year?
- Which supplier contracts are due for renewal; can you terminate or re-negotiate?
These are just some of the questions we should be asking (and highlighting to management). As we know, the need for research into terms often goes deeper. For instance, many companies have times when they must discover assignment rights, or what happens when there is a merger or acquisition, or what variations there may be between contracts with respect to data protection duties or disaster recovery. A recent example related to in-depth understanding of what constituted ‘a default’ and the generic right of customers to terminate. Another was around the valid causes of force majeure.
For many organizations, budgets are tight and the pressure on resources is at unprecedented levels. That means it is an ideal time to push for the automation that we all need. Many may be shocked by this statement – if reources are tight, surely this is a really bad time to look for funding?
I suggest you refer to the findings of a study that IACCM recently undertook on the impacts of current market conditions. This featured in a webinar that was undertaken with Emptoris last week and revealed the following as key priorities for business:
FOR BUYERS – cutting costs, increasing innovation, making decisions faster.
FOR SELLERS – closing new business, cutting costs, being more competitive.
The analysis led to the following conclusion: “When it comes to cutting costs, internal efficiencies are high on the agenda for all contracts groups. For buyers, ensuring contract pricing agreements are met and consolidating the supply chain and distribution / logistics are also priorities.”
Contracts groups will not be able to achieve any of these business goals with less resources. Instead, they must emphasize how much more they could deliver if they were equipped with the right insights – in fact, with the ability to perform effective ‘contract discovery’.
Should suppliers be allowed to claim force majeure and if so, in what circumstances?
Whenever there is a major incident, this question re-surfaces. Over the years, the list of incidents that constitute force majeure has altered, but the basic principles remain unchanged. Today, however, there seems to be reducing tolerance for this blanket provision that excuses all performance. A refinery fire at a Shell facility in Singapore, the Brisbane floods and the Libyan revolution have been recent examples that created debate and contention.
In part, these questions are fuelled by the rise of globalization. Increased exposure to less stable or predictable markets has increased the potential for force majeure. But there are other factors. For example, the pressure for constantly lower prices has impacted the relative risk and quality of supply sources; many crops today are grown on previously marginal or inaccessible land. It was marginal and inaccessible for a reason. Similarly, there has been consolidation of supply, resulting in limited ability to switch in times of crisis.
Those who disagree with force majeure mostly seem to be buyers. They argue that a good supplier should have back-up plans (even though they do not want to pay the price premium that such plans would involve). And they also tend to overlook the mutuality of force majeure – when invoked by a customer, it is reasonable; when invoked by a supplier, it is unreasonable.
Mature organizations have a sensible discussion about force majeure incidents and consider the actions that can be taken to avoid them, or to avoid their severity. For example, do I want to select a higher price supplier who has fall-back facilities and proven disaster recovery plans, or do I want to multi-source, or am I prepared to take a lower price and self-insure? Increasingly, there are also possibilities to insure against force majeure risk (for example, Zurich Insurance). But again, this involves a cost – and, ironically, the insurer then wants to determine whether the buyer is taking intelligent risk decisions.
Another area of growing interest is to replace some or all of the force majeure clause with a more general ‘hardship clause’, under which the parties commit to a renegotiation if and when there is a major change to supply conditions.
It seems to me that this is another area of contract where there is room for increased discussion and differentiation. It also demands a term that is sensitive to the nature and sources of risk and which party is willing to pay to cover them.
Please add your thoughts and experiences.
Commitment Matters 