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.
Recent research by IACCM has revealed that ‘cutting costs’ is the number one issue for both buy-side and sell-side contracts professionals. The focus is on a range of measures, but ‘internal efficiencies’ top the list.
My conversations with functional leaders suggest that the main targets for cost reduction are the traditional budgets for staff, travel, training etc. In other words, savings will be achieved by reducing capability. Yet there are many other – and much larger- impacts that the contracts / commercial function could be having and one example of this was contained in this weekend’s New York Times.
In an Opinion column, Ezekiel Emanuel highlights a study by Harvard economist David Cutler that explored waste and inefficiency in the US health provisioning system. It resulted in a conservative estimate of $32 billion in annual savings from electronic billing and credentialling.
Errors, fraud and inefficiencies in billing are endemic to many companies (a recent UK public sector survey suggests again several billion Pounds of opportunity from ‘future contract opportunities’. We also know that an insightful contracts organization can drive efficiency in many other areas, such as reducing review and approvals, simplifying contract signature processes or eliminating recurrent sources of claims and disputes.
But these improvements depend on how the contract and commercial groups see their role. If they view themselves as purely tactical, putting contracts in place and perhaps overseeing their implementation and management, then they are missing the ‘golden egg’. The internal efficiencies that can be achieved by cutting existing budgets are trivial and have the long-term effect of further reducing the function’s relevance. The opportunity here is to take an enlarged view of contracting and to recognize that it is the efficiency and effectiveness of the overall process that matters. This bigger view will not only yield dramatic cost reductions, but it will also raise the profile and relevance of the contracts function.
IACCM will discuss this issue – and also the other main pressures on Contract Management groups – in a webinar on November 16th. For details or to register, see https://www.iaccm.com/events/register/?id=1225
“In the last couple of years, things seem to have got worse.”
That sentiment about the unfairness of risk allocation in contracts is one I have encountered many times during discussions in recent weeks. There is a feeling that large corporations and major public sector bodies have become more risk averse and have used current economic conditions to exert their strength – liabilities, indemnities, IP rights, termination provisions, performance criteria and (in the corporate sector) payment terms have been areas of focus. And despite their insistence on ‘the integrity of contract’, these same organizations think nothing of using their power to force unilateral renegotiation when conditions change.
Overall, I think things have become worse. Ironically, on one hand economic conditions have forced many corporations to take added risk (new markets, more rapid product development, supplier consolidation are examples), but at the same time they have sought to clamp down further on their established suppliers, without much regard to the business consequences.
Some legal and procurement staff stick to the belief that harsh terms drive performance. Short-term and for commodity acquisitions, that may be right. But for any more complicated or long-term acquisition, all the evidence points the other way – that unfairness undermines loyalty and commitment, leading to poorer outcomes and therefore added risk.
However, while things may have become worse, I see growing light at the end of the tunnel. I have the impression that an increasing number of organizations are starting to question their approach. This is leading to a number who have renounced liquidated damages; some who are questioning how they can be more intelligent in protecting (and exploiting IP); others who are looking for shared approaches to governance through better change provisions, escalation procedures and added flexibility through mechanisms such as ‘hardship clauses’. I believe the door is opening for those suppliers who engage early and demonstrate their capabilities and commitment to deliver.
Relationships that extend beyond a few transactions will always depend on trust and cooperation. Failure to establish and sustain these characteristics will always result in degraded performance and missed opportunities. This truth is dawning on a growing number of those responsible for contracts and they are influencing their management and colleagues to think differently – to distinguish between risk allocation and risk management.
“There isn’t such a thing as an IT project, they are business projects. Virtually none fail due to the technology.”
This quote, from the UK Government CIO, reflects growing understanding that it is primarily commercial and relational issues that undermine success in IT procurement. Indeed, research by the International Association for Contract and Commercial Management (IACCM) suggests that more than 70% of ‘troubled projects’ are struggling due to non-technical factors.
What goes wrong – and how can the problems be avoided?
IACCM has discovered a series of issues that appear frequently to undermine outcomes:
– weaknesses in requirement definition
– poor alignment between business requirements and supplier selection criteria
– inappropriate allocations of risk and the wrong performance measurements / KPIs
– lack of discipline in the management of change
In a world where the pace of change continues to accelerate, it is not surprising that projects are often challenged by high levels of ambiguity, uncertainty and volatility. This is hard to manage when there is a lack of alignment between functional objectives. For example, Procurement is driven by achieving the lowest price, Legal is driven by minimizing risk, and IT is concerned about achieving good outcomes.
The problems are reflected in a series of recent quotes by CIOs:
“Weaknesses in change management are typically a key factor in project failures and overruns.”
“We operate a procurement process that takes too long and prevents the interactions with suppliers that would support innovation.”
“We generally prefer to drive down the price from the supplier, rather than tackle the costs associated with waste and inefficiency. We rarely ask which would yield more, nor the extent to which our inefficiency is adding to the supplier’s costs.”
Achieving Improved Outcomes
The IACCM research has concluded that most organizations lack a strategy for contracting and commercial management. As a result, the CIO rarely has the necessary contracting tools at his or her disposal. This includes the timing of involvement by the people who are key to both negotiation and delivery; it extends to having the right contract structures and service levels; and it is evident in the weakness and indiscipline of change management.
To improve the quality of outcomes, the CIO community must demand more from the organization. There is a pressing need for either increased support or greater empowerment to negotiate and manage the right contracts and relationships for the type of project to be undertaken.
Rapid changes in business conditions, the volatility of market demands and the speed of innovation in technology have combined to make the life of the CIO and their staff more complicated. Adding to these factors is the growing dependence on global supply networks where cultural tradition and business practices may differ substantially from those of the domestic market. To manage this complexity demands different skills and tools from those of the past; it has placed strong emphasis on communications, transparency, negotiation skills and business acumen that have not been traditional strengths. It also requires contractual frameworks that are less about risk allocation and more about governance and management standards for handling the on-going project.
IACCM believes that the answer to these challenges is to equip IT and project staff with greater understanding of the commercial and contractual issues and solutions. With this in mind, it has coordinated the compilation of a worldwide ‘body of knowledge’ – an Operational Guide to Contract and Commercial Management.
It is perhaps surprising that this is the first work of its kind; yet its previous absence maybe explains why so many IT projects have struggled to meet their goals.
It may not be an issue today, but at some point, most contracts and commercial groups face the question “What value are you bringing to the business?” And when that question arises – whether it is to justify headcount or to support a business case for more investment – most contract management groups struggle to describe their value in financial terms.
Without that ability to justify (or even better, having proactively provided management with the data), many groups find themselves subject to the ups and downs of the market, or the whims of management sentiment.
Ironically, it is in Government and public sector that the value of contract management is often most evident. This is because the audit process results in far greater visibility of losses – and with increasing regularity, the auditors are highlighting the weakness of contract management or failures in commercial expertise as key reasons for these losses. Recent examples can be found in many countries and they amount to many billions of dollars (see separate blogs or recent articles at the IACCM website).
To support its members in developing the business case for improved contract and commercial management (both sell-side and buy-side), IACCM is conducting a study to discover the extent of corporate financial losses that result from weaknesses in contracting. Its goal is to support members of the Association in their efforts to gain management support or provide strong rationale for budget and headcount.
Given the nature of the survey, the individual inputs will of course remain confidential (and can be submitted anonymously), but consolidated results will be issued to all identified participants. I hope readers of this blog will take a few minutes to share their experiences at https://www.surveymonkey.com/s/CMvalue
There is an interesting discussion underway on the IACCM Forum. It relates to relatively frequent question (and frustration) over the ability to move between industries.
We are often told that organizations should hire for skills, not knowledge. Indeed, one of the top issues raised by functional management is around the skills gap that they face. I hear relatively little about ‘the knowledge gap’. Is this because they see the two as interchangeable?
Based on the experience of many job applicants, specific industry knowledge and experience often seems to trump the value placed on demonstrated skills. There remains a tendency to hire people who fit our existing employee profile – even though we are at the same time saying that profile is not quite right for the future!
I understand that we are often hiring as a matter of urgency and want people who can ‘hit the ground running’. But firstly that assumes there is only one way of doing things and secondly it means we never start to address our more deep-seated problem, which is a lack of diversity and new ideas and knowledge.
So how do job applicants best oversome this narrow-minded approach to selecting interview candidates and hiring? I would love to hear your thoughts, either because you have succeeded in breaking down the barrier, or because you are a manager who deals with hiring.
And just a comment for those who are giving up hope. I managed to move from banking, to automotive, to aerospace, to technology. I recall overhearing my line manager the day I joined automotive saying to my supervisor ‘He comes from banking, I don’t know why they hired him, but we’ll find a way to move him on very soon’. Fortunately, he changed his mind. Now I must give some thought as to why that was, and maybe it will help me answer the question!
Coming soon! Have you applied for your licence yet?
Click for a preview of IACCM’s exciting innovation program licence[3] – and contact info@iaccm.com for more details.
Commitment Matters 