Contractual Risk Management

Managing contractual risk is a high value procurement activity, seriously underestimated by many organisations. The traditional approach is to have standard forms of contract, some of which are rarely reviewed or revised, despite changes in legislation and developing case law. In extreme situations the buying organisation forms contracts on the supplier’s terms and conditions.

BFL have a set of Metrics of Excellence to evaluate the existence of contractual risk. It is intended to probe the key areas where risks exist and to evaluate the likely impact on the organisation should the risk be realised. Examples of risk are not difficult to identify. A common risk is the limit of liability imposed by some suppliers. The limit of 125% of contract price is quite common. It ICT we have found risk in excess of £1 million but the contract limit has been less than £100k. The presence of Force Majeure is a very common issue. The supplier is claiming every eventuality as Force Majeure and using it to excuse their abject performance. We know of one situation where a Force Majeure situation was permitted to continue for six months with adverse impacts on the buyer’s business.

There is often a lack of co-ordination between the selling side of a business and procurement. Sales are accepting harsh conditions of contract, sometimes under offshore jurisdiction. This information is not passed to the buyers are therefore unable to flow down to the strategic suppliers the same contract terms. It has become evident that one supply chain company can miss a milestone that impacts on later events and costs large amounts of money to reschedule later activities.

Insurance is a source of poor performance in contractual risk. Not infrequently, the insurance provision is not checked post-contract award. We have encountered uninsured contractors undertaking on-site high risk activities and totally exposing the buying organisation to claims for which they may be uninsured. The absence of an insurance data base showing when insurances are due for renewal does not help the situation.

It is worth reflecting who is accountable for managing contractual risk. We would give this accountability to procurement. They do not accept this without dependencies on other functional areas, including sales, legal and through-life support. This liaison will effectively utilise the strengths of all these disciplines.

The procurement profession I soften criticised for concentrating on price. Of course, this is an unproven allegation. Price is an important component in contracts. The buying organisation needs to know if it fixed for the contract duration or is it variable on some basis or other? A common denominator is a Price Variation Formula. There are many situations where the supplier can, annually, revise the price related to an index or indices. The fact that 100% of the price fluctuates does not register with some organisations who have not heard of a fixed element.

When contracts fail and legal action ensues the cost is truly horrendous. We have known legal fees in excess of £500k. A better approach is to have a robust review, invest a relatively small amount in identifying current practice and plugging the gaps.