Leaders’ Corner: How Good is a Contract? Tips to Avoid Loopholes

A good contract can prevent numerous issues—this is well established. However, detailing what this ‘good’ encompasses is trickier than it sounds. Here are some tips to avoid loopholes.

Why sign a contract? There are risks and benefits to signing a contract. The benefits are routinely associated with the legal protection offered by the bespoke wording, as well as different laws and regulations contained therein. That is, if something goes awry, remediation can be sought from the other party with a high probability of success.

The risks come from ties created among parties. These ties are tangible, that is, there is a product that must be delivered, or intangible, that is, the linking of firms in a cause–consequences chain.

From the tangible point of view, as a buyer, you essentially commit to pay for the product you receive and to respect the intellectual property associated with it.

From the intangible point of view, you link your company to the supplier’s potential misconduct, creating vulnerability in terms of reputation, image, and possible direct and indirect financial consequences (fines or loss of market share). Thus, before signing a contract, these aspects must be properly considered.

A contract has two sections: legal and commercial. External elements can be considered a part of the contract without including the whole text (e.g., readily available standards and regulations, company specific documents for which a URL is provided, etc.). We focus here on the commercial clauses, as writing or amending the legal ones calls for a highly specialized skill specific to lawyers; if your firm has no legal department, it will have to hire an external service provider.

What do commercial terms include? Identification of parties, description of goods and services as objects of the contract, and pricing and payment terms usually comprise the bare minimum. In perspective, you exchange these elements when buying donuts for your breakfast: the shop and you, a chocolate-glazed donut with a cup of coffee, and a price of $2 to be paid immediately. If they suffice for this case (usually, the server will also give you a napkin and cream with a smile), then, in a professional context, they leave greater opportunities for issues to surface.

In the commercial section of a contract, a common source of issues is the definition of the products or services being purchased. Irrespective of the detail in technical drawings, with their attached set of materials and process specifications, they rarely include information on the logistics aspect.

Without packaging, labelling, reasonable lot size, frequent deliveries, scheduling of data exchange protocols, and so on, the product, in spite of being exact to the technical specification, may still become a quagmire in your operations flow.

Paying attention to such details is also an easy source of added value; for example, specifying the use of different-colored marking on boxes to avoid confusion between similar components on your assembly line, or positioning labels to identify where the incoming goods scanners first check for them. Avoiding errors and saving time are sources of competitiveness for your company.

The same is true for services—precision in the expected outcomes, and the measurement of their attainment, is essential. If you were to contract a consultant to deliver ‘a strategic analysis of the company and recommendations for its future development,’ you are at risk of paying a hefty sum for a few (or many) general content slides that will not support the executive committee’s decision in this matter.

It is good practice to detail the description of the object of the contract in an appendix rather than in the main body of the contract. Devoid of legal content, this appendix will be more easily reviewed and understood amongst internal and external stakeholders.

Another often-overlooked element is time. The duration of the contract, independent of the performance of the object of the contract, must be practical. Many are tempted to either match the delivery target date or to mark a contract ‘in force until terminated’ (also known as ‘evergreen’). Both attitudes, even when grounded in good intent, are sources of issues. In the first case, any deviation will require an amendment to the duration of the contract itself. In the second case, the contract manager will need to track useless and unused contracts. The contract database will grow endlessly until a massive contract termination effort is undertaken.

Thus, be precise with what it is you are buying; how, when and under which form it must be delivered; and the acceptance criteria that will trigger the payment of the goods or services. This is a valuable opportunity to confirm requirements with your stakeholders and promote the service they obtain from you.

Another common source of issues is the absence of a description of the order-to-payment processes. The contract facilitates the materialization of the decision of two parties to work together. That is, the supplier will deliver to the client, who will proceed to pay. More often than not, the contract is followed by a purchase order (PO) issued by the customer. This PO informs the parties’ internal departments that an event will occur. The customer’s finance department will record a need for funds to be available at a certain date. Accounting is aware that an invoice matching the PO’s number and amount is expected. Then, logistics conducts planning and scheduling activities to obtain the object of the PO, and for the supplier to gather the materials necessary for the operations to produce it, and plan production. Next, finance will expect income, and so on.

Therefore, why not detail the information that the PO will bear, as well as the information that the matching invoice is expected to show? Why not clarify if they can be fully electronic or not? When they are sent by surface mail or email, to whom should they be addressed? Should they be acknowledged by the supplier? Is the supplier not to start any activity without a PO due to a risk of not being paid? Is the payment term triggered at the receipt of an undisputed invoice? Further, what happens when a one-line item on an invoice of 10 is rejected? Are the remaining ones paid for as they are, or should the supplier provide a new, separate invoice for them?

Many details on how parties work together can be clarified through a contract. This would enable smooth flow of information. It would help a supplier provide the best performance based on its expertise, rather than on administrative—though necessary—tasks, on which value other than issue avoidance is harder to capture. Have you thought of including a list of contacts for the most frequent interactions (sales and purchasing, logistics, quality, accounting, etc.)? This simplifies communication, and will relieve the purchasing personnel from being the mediators whenever an event occurs. They may still want to be carbon-copied without being actively involved.

In contrast, avoid being overly prescriptive at every point. The more constraints you impose on suppliers, the more difficult it is for them to perform at their best. Eventually, you create more chances of uncomfortable discussions for even marginally different requirements. Any change is a potential trigger for cost creep. The supplier will be justified in avoiding changes until a duly detailed amendment is signed, thereby reversing the power play in the negotiation.

To summarize, a contract can be a powerful foundation for a fruitful relationship among firms. One crucial criterion for a successful contract is to provide useful information on the expectations and obligations of both parties, and promote communication. Hopefully, this will keep both parties from having to refer to the legal section. Therefore, the commercial section must be a reflection of the atmosphere that will regulate daily business.

Thierry Fausten is a Procurement professional experienced in all aspects of Procurement at strategic and operational levels. He has unique international exposure to direct and indirect Procurement in the automotive and pharmaceutical industries in Fortune 500 companies. Fausten is currently working on a doctoral thesis on multitier supplier relationship management at Cranfield University School of Management.   To learn more about the author you can visit his about me page here   The opinions expressed in this article are the author's own and do not reflect the view of Beroe Inc.