Prevention beats cure - proactive contractual care for successful supply chains
HELENA HAAPIOLexpert Ltd
Main points
Proactive contractual care is increasingly important for supply chains.
Contracts and contracting processes can be used to prevent problems.
Businesses can and should use legal knowledge and contracts proactively.
Tools and techniques already exist that help implement proactive contractual care.
Through the IACCM and the recently established ProActive ThinkTank, you can get involved in initiatives that help to identify the skills, practices and tools that are required, and to share and strengthen them.
In today’s networked economy, timelines get shorter, requirements tighter, and inventories are kept to the lowest possible level. Each day, companies become more dependent on each other. If one point in the supply chain fails, everyone is likely to be affected. Personal and business relationships suffer, and the damage to reputation can be permanent. But that does not have to happen. Proactive contractual care can prevent problems from occurring, keep differences of opinion from developing into disagreements, and help manage disagreements in ways that prevent them from escalating into disputes and legal action.
From reactive to proactive, even in legal care
Lawyers are often accused of seeing contracts primarily as a potential source of breach, trouble and dispute. The view has developed through generations of contracts that have failed, disputes, litigation and case law. When discussing contracts, lawyers tend to use the language of law, risks and failure, rather than the language of business, opportunities and success. A language and culture barrier has developed, keeping lawyers out of many teams where they could have made a valuable contribution.
Traditionally, the steps in providing legal care have resembled those of medical care — diagnosis, treatment, and referral — all steps that happen after a client or a patient has a problem. Care has been reactive — you get sick, you seek treatment. You encounter a dispute, you turn to a lawyer. As lawyers and as clients, we need to move away from that model. Supply chains benefit from a proactive approach focusing on how to secure success and help everyone stay out of trouble.
Supply chains do not become stronger when the parties spend hours drafting and negotiating clauses dealing with breach and remedies — they benefit much more if those hours are spent on clauses that enhance communication, clarify tasks, and help secure successful performance.[i]
The good news is that a growing number of contract and legal professionals are beginning to adopt the proactive approach. They want to help prevent issues that can adversely impact relationships by promoting better performance and sound business practices. This is underpinned by a strong belief that legal knowledge is at its best when applied before things go wrong. To exercise proactive contractual care, consider the following.
·Whether working on the sell-side or on the buy-side, give consideration to a commercially justifiable allocation of risks.
·Encourage success by giving incentives for good performance and aim at arrangements where rights, responsibilities, risks and remedies are effectively identified, assessed and managed.
·Based on an understanding of the business critical issues, use well planned contracting processes and documents to help produce common, explicit knowledge that can be shared and understood within and between organizations.
·Contracts serve the best interests of all involved and lay the foundation for long-term trust and loyalty when theyprovide the script for successful implementation,align expectations, define desired outcomes and allocate tasks clearly.
The proactive/preventive law approach
In the context of practicing law, the idea of prevention was first introduced by Louis M Brown, a US law professor and legal practitioner. He published the treatise Preventive Law in 1950, followed by numerous other books and articles on the topic. Proactive Law is a Scandinavian approach built on Preventive Law. Both approaches have similarities with preventive medicine and its methods of preventing the occurrence of disease — here, ‘disease’ refers to legal trouble, disputes, and litigation.
The proactive/preventive law approach provides tools and techniques for the early detection and prevention of potential problems. If problems do arise, the approach offers mechanisms to resolve them quickly, before they develop into disputes. Still, the focus is not just on preventing problems or ‘legal ill-health’. The goal is to promote ‘legal well-being’: embed legal knowledge and skills in corporate culture, strategy and everyday actions to actively promote success, ensure desired outcomes, and balance risk with reward.
Proactive contractual care
Proactive contractual care refers to the use of contracting practices that merge proactive/preventive law with good contract, project, quality and risk management practices. The goals are:
first, to promote successful performance and relationships and to eliminate causes of potential problems;
second, to minimize the risk, problems and harmful effects when problems do arise; and
third, to manage conflict, avoid litigation, and minimize costs and losses where they are unavoidable.
The construction industry has used dispute prevention and resolution techniques longer than most industries. This has been a matter of necessity. Once the building process has begun, the work cannot be interrupted or delayed without serious cost consequences. Accordingly, the industry has placed a premium on quick solutions to problems. Those in charge of supply chains in other industries can learn a lot from the techniques used in the construction industry. Not surprisingly, one of the most powerful ways to prevent and control disputes has proven to be allocating risks realistically, by assigning each potential risk to the party who is best able to manage, control or insure against the particular risk.[ii]
If something is not in the contract, is it in the deal?
When documenting deals, it is quite common to use words or omit items that appear self-evident to the document creators (but not necessarily to others). Prior to outsourcing becoming common practice, and when contracts often involved two companies only, it was simpler to resolve an issue, even when questions about omitted items arose. If lawyers got involved, they looked for the answers in the contract, such as whether it contained an exclusion of implied warranties for fitness for purpose. Today, with companies often relying on long chains of suppliers, it is not so simple when contracts and work scope are not explicit. There can be complicating factors when the supply chain members reside in different countries. In some countries, to be valid, contracts need to be in writing — in others, they do not. A number of different laws may apply and fill the gaps in the contracts. The question of which supplier (if any) has to do what was left out, and who is to pay, may cause a major chain reaction. In such circumstances, the outcome of a dispute is difficult to predict.
While lean contracting and shorter contracts certainly have advantages, they should be used with caution. Leaving important items unaddressed can be dangerous: Who knows what will be passed on in the supply chain if rights, responsibilities and remedies are not itemized in the documents (and are thereby left to the default rules of the applicable law).
Will all relevant tasks be recognized, resourced and priced?
Do the people involved know what obligations, liabilities and remedies exist in case these have not been specified?
Whose warranties and laws apply?
How do the people who are completing the orders, performing the services, invoicing, or instructing third parties know what is expected, where and when, or what the acceptance criteria will be?
Finding the answers after the fact can be costly. Knowledgeable organizations use well thought-out contracting processes and documents to provide the required clarity.
Is back-to-back the answer?
Best practice corporations have addressed the integration of buy-side and sell-side contracting. Yet many companies are still struggling with weak interfaces between sales and procurement. They acquire third-party software under licence terms that fail to reflect the onward offerings they make to their customers, or procure products that lack the appropriate warranty or service terms. As a result, they are left with a range of exposures.
In theory, ‘back-to-back’ sounds simple. The philosophy is that in a supply chain, the sub-supply contract should, as far as possible, be consistent with the supplier’s obligations under the main supply contract. The supplier’s obligations and risks relating to the main contract should pass through to the sub-supplier. In theory, it should work well in both long-term supply arrangements and in one-time supplies for major projects. Yet there is truth in the saying (attributed to Yogi Berra): ‘In theory, there is no difference between theory and practice. But in practice, there is’.
‘Back-to-back’, when used carelessly, may create more problems than it solves. Not everybody understands what ‘back-to-back’ means. For example, a supplier may be asked for a price, and give one. Then when the work is about to start, the buyer may say that they are looking for a back-to-back contract. What the buyer is requesting may sound reasonable: the supplier should accept the same terms and conditions the buyer has accepted towards its customer. Yet if ‘back-to-back’ was not discussed when the price was set and if the supplier does not know the end customer’s terms and conditions, the supplier may be in for a surprise.
‘Back to back’ means different things to different people. The buyer may have referred to it meaning ‘pay when paid’ (or ‘pay if paid’). The buyer may want the supplier to accept the same (unlimited) liabilities and remedies it has accepted. There may a be general reference under ‘definitions’, where ‘the Agreement’ is defined to include not only the agreement between the parties but also the buyer’s agreement with the end customer (as it may be amended from time to time). To know what it is agreeing to, the supplier would need to see the entire end-customer agreement, which takes time and adds to the cost of contracting. It may not be possible to pass those provisions on to the supplier’s suppliers. The process may take so long that it is tempting to commence work without a signed contract — which adds to the risk. If a dispute arises, a myriad of legal, technical, financial and factual issues become involved.[iii] Again, the outcome is hard to predict.
Existing contract management solutions can help a great deal in aligning sell-side and buy-side contracts. They can be designed to notify of impending problems in a supply chain before they become a disaster. When getting the early warning signal, people can do the right thing at the right time. Not all tools need to be high-tech. Let's use task allocation as an example: if it is unclear, problems will follow. Our hand tool is designed to prevent them. It lists (on each finger of each hand for both buyer and seller) the trivial-sounding but crucial questions that must be answered when creating or reviewing obligations: who/which party shall do — what — where — when — how — and, last but not least, what if / what if not.
This simple hand tool has proven to work in practice, both on the sell-side and on the buy-side. If the parties in a supply chain remember to go through the questions and address them when creating, amending or passing on contractual obligations, a number of potential pitfalls can be avoided. Much more sophisticated tools and checklists exist — yet few are as easy to remember and carry around.
When contracting in supply chains, a balance needs to be struck between the different (often conflicting) requirements, such as the need for lean contracting on one hand, and clearly articulated responsibilities and remedies on the other; and the need for certainty on one hand, and flexibility on the other. A commercially and legally sound solution needs to be found so that inbound and outbound obligations, liabilities and remedies become aligned and the risks as well as the cost of contracting remain within acceptable limits.
Proactive contract and legal professionals know how to work together to strike the required balance. They know how to use the contracting processes and documents to clarify requirements and to avoid negative surprises. Using the good old rules of risk management and dispute prevention, you can begin the process by identifying the risks: what, why, and how problems may arise. Be mindful that implied (invisible) obligations are not easy to fulfill. To be able to perform, supply chain participants need to know what is expected. By asking the right questions, you can clarify goals and task allocation and be better prepared — not only for contingencies or legal problems, but also for successful performance.[iv]
Helena Haapio, LL.M., MQ (Master of Laws, Master of Quality), International Contract Counsel, Lexpert Ltd, Helsinki, Finland.
Helena supports corporate clients in succeeding in cross-border contractual (ad)ventures, helping them use contracts to get better business results and stay out of legal trouble. She is a member of the IACCM Advisory Council and the founder and coordinator of IACCM Finland. She is actively involved in the development of the ProActive ThinkTank and the Nordic School of Proactive Law. She also acts as arbitrator.
Further information: proactive / preventive law and ProActive ThinkTank
In respect of proactive/preventive law and proactive contracting, a body of practice and literature already exists; see the Nordic School of Proactive Law (NSPL), www.proactivelaw.org, and the National Center for Preventive Law, www.preventivelawyer.com. The work of the NSPL has chiefly been carried out through periodic international conferences. The 2005 Conference, Fusing Best Business Practices with Legal Information Management and Technology, was organized in Stockholm, Sweden. Conference papers were published in Volume 49 of the Scandinavian Studies of Law Series, ‘A Proactive Approach’, sisl.juridicum.su.se. The most recent conference, Commercial Contracting for Strategic Advantage was held in Turku, Finland in June 2007. IACCM Finland was one of the organizers, and the proceedings will be co-published by the IACCM and Turku University of Applied Sciences. As an outgrowth of that conference, various leaders in proactive/preventive law, together with a number of practitioners who seek to expand the field beyond legal concerns met to form the ProActive ThinkTank (www.proactivethinktank.com; web site under construction). The mission of the ThinkTank is to provide ‘a forum for business leaders, lawyers, academics and educators to discuss, develop and promote the proactive management of relationships, contracts and risks, and the prevention of legal uncertainties and disputes’. The website will provide a venue of collecting and sharing such information as best practice tools and techniques, case studies, articles, and reports on ongoing research. If you wish to join the ProActive ThinkTank or obtain additional information, please contact the author.
[i]. In the ‘Top Ten Most Frequently Negotiated Terms’, the yearly survey of the IACCM, limitation of liability has retained its Number 1 status each year. The list is dominated by risk containment clauses, and the survey shows little evidence of time being spent on defining parameters that increase the likelihood of success. See IACCM 2006 Top 10 Negotiated Terms. www.iaccm.com//library/full.php?linkid=1458.
[ii]. Groton, James: The “Up Front” Prevention, Control and Early Resolution of Disputes: Dispute Prevention and Management Lessons that Businesses Can Learn From the Construction Industry, from the proceedings of the conference ‘Commercial Contracting for Strategic Advantage — Potentials and Prospects’, Turku, Finland, June 13–16, 2007.
[iii]. For the legal and commercial complexities of back-to-back clauses in international construction contracts, see Bergmann, Hans: International Industrial Plant Construction Contracts in Finland. Back-to-back Clauses and Compulsory Law. http://bjl-legal.com/forum/pdf/FinIndustrialConstructionE.pdf. For governing law and dispute resolution procedures, see also Brown, Nicholas: When in China, Watch Your Back ... -to-Back, Pinsent Masons Press Article April 2006. http://www.pinsentmasons.com/media/904729527.htm.
[iv]. For empirical research supporting this view, see Argyres, Nicholas S; Bercovitz, Janet; & Mayer, Kyle J.: Complementarity and Evolution of Contractual Provisions: an Empirical Study of IT Services Contracts. Organization Science, Vol. 18, No. 1, January-February 2007, p 3–19.
Helena