4 Key Elements Supply Chain Managers Should Bear In Mind When Reviewing Commercial Contracts
Attorneys and other compliance professionals often assist in this review.
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Editor’s Note: This contributed article on commercial contracts is by corporate attorney Haydon Keitner—Partner in Nixon Peabody LLP’s M&A and Corporate Transactions Group, representing buyers and sellers in a variety of domestic and international corporate transactions.
People who are responsible for managing their company’s vendor, supplier and service provider relationships should routinely review their company’s commercial contracts. Attorneys and other compliance professionals often assist in this review. If this task is on your to-do list, or if you have asked someone else to do this and are planning to review their findings, the following four topics are worth paying special attention to:
- Termination. Ironically, once it’s clear that a valid contract exists, it is critically important to understand how the parties can get out of the contract. Contracts typically have a fixed term. However, the term can sometimes be extended. Extending the term usually requires the consent of both parties, but sometimes a party might have the right to extend the term unilaterally. By contrast, the term of some contracts might automatically renew, unless either party notifies the other party within a certain time period of its intention not to renew the contract. Contracts often give each party the right to terminate the contract under various circumstances. For example, a contract might be freely terminable by either party (i.e., for convenience). By contrast, a contract might be terminable only upon a breach by the other party. However, the breaching party might have an opportunity to remedy the breach within a certain time period.
- Economics The underlying economics of the contract are obviously essential. Terms relating to price, quantity, and quality are key. It is important to note how these terms are determined. Are the key economic terms fixed, or do they fluctuate? If the economic terms fluctuate, is the variability based upon a fixed schedule, or upon some other external source, such as the consumer price index? Can the economic terms be modified through mutual consent, or does one party have the right to change any of the economic terms unilaterally? Do any of the economic terms come with minimum requirements? For example, in a supply contract, are there minimum purchase or minimum supply commitments? Are there penalties if either party falls short of its commitment?
- Indemnification Indemnification provisions are often hotly negotiated, and for good reason; the wording of these provisions can create, mitigate, or avoid, significant liability. To “indemnify” someone means, essentially, to agree to cover them in certain situations. For example, suppose your friend who has a large van is helping you move furniture out of your apartment, and the only parking space available in front of your building is for residents only. You tell your friend, “it’s okay, park in the residents’ only space, and if you get a parking ticket, I’ll handle it.” Contractual indemnification provisions work the same way. Typically, the parties agree to cover each other for certain risks that are incidental to the work to be performed under the contract. When reviewing indemnification provisions, it is important to note whether the parties have agreed to limit their liability to a fixed amount (for example, the total fees paid under the contract, or a multiple thereof). It is also important to note whether the parties have limited the types of damages the indemnified party (i.e., the party being covered) has the right to receive. There are many different categories of damages, including, direct damages, lost profits or consequential, special or indirect damages, and punitive or exemplary damages. To the extent that a party’s liability is limited, and certain categories of damages are disclaimed, it is nevertheless important to note any carve-outs or exceptions to these limitations.
- Other Noteworthy Provisions It is also worth paying special attention to provisions that restrict either party’s freedom to operate, or that could impact either party’s business in the future. For example, a contract might prohibit a party from engaging in certain lines or business, conducting business in certain geographic areas, or soliciting customers, clients or employees of the other party. A contract might also contain restrictions on some of the key economic terms, such as the price. For example, a party might be prohibited from offering a lower price to any of its customers, without also offering the lower price to the other party (i.e., a so-called most favored nation clause). Any of the provisions described above could also be noteworthy, if it is one-sided or conveys unilateral rights to either of the parties.
The foregoing list is only a summary of certain key topics that a basic review of any commercial contract should cover. The unique aspects of a company’s business, and the reason for the review, might implicate other provisions of the contracts.
For example, a review of contracts in connection with a potential sale or acquisition will require an in-depth analysis of any change of control or assignment provisions, and the results of this analysis will depend upon the structure of the transaction. In addition, most contracts contain provisions regarding dispute resolution, and the process and venue for bringing legal claims relating to the contract. It is also important to take note of these provisions, in the event that disputes arise.
If you are reviewing contracts in connection with a potential acquisition or litigation, the sooner you involve an appropriate subject matter expert the better.
About the AuthorPatrick Burnson, Executive Editor Patrick Burnson is executive editor for Logistics Management and Supply Chain Management Review magazines and web sites. Patrick is a widely-published writer and editor who has spent most of his career covering international trade, global logistics, and supply chain management. He lives and works in San Francisco, providing readers with a Pacific Rim perspective on industry trends and forecasts. You can reach him directly at [email protected]
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