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Risk Management Subcontracting Supply Chain Management

Subcontracting risks - must we wait for disaster?

Published: 15 Oct 2013 Average Rating: 4 / 5

This article appeared in Contracting Excellence magazine on 15 Oct 2013

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I was alarmed recently when I heard the news: Thirteen government contractors had just been shot dead. The alleged gunman worked for a subcontractor of a Navy contractor. Soon afterwards, I knew I had to change my thinking about subcontracting and consider new lessons I would face. Incidents like this should alarm anyone in subcontracting.

By Shalas Benson, Vice President, Business Management, J.D., C.C.M.E. Global Purchasing, Xerox Business Services, L.L.C.

This and other incidents like it are leading investigators to review the processes and risks associated with subcontracting. Often the risks are high. Oversights can be devastating. Do we want to proactively do everything we can to prevent them, or just wait to clean up the mess afterwards?

Reviewing the basics – we need to start here

A “prime contract” is a contract between a service provider and a customer to provide a service to the customer. The “prime” is the service provider responsible for delivering all contracted services to the customer.

When a prime contractor decides to have another company perform some of the services included in its prime contract scope of work, it enters into a services contract called a “subcontract” with the other company (subcontractor). The subcontract enables the performance of the outsourced tasks[i].

This means the prime contractor is a party to two contracts: the prime contract and the subcontract. As a result, the prime is positioned between the customer and the subcontractor. There is no direct contract between the customer and the subcontractor. If the subcontractor fails to perform, the customer will hold the prime responsible. The prime must exercise its subcontract rights to enforce subcontractor performance obligations for the benefit of the customer.

The tricky job for the prime is balancing the risks in the prime agreement with those in the subcontract. If the prime doesn't do so, it can be squeezed between the customer and the subcontractor.

Squeezing happens in many situations.

One occurs when the customer expects the prime to provide more services at lower cost than the scope of the subcontract includes.
Another occurs when the subcontractor insists on a price or additional charges for services which are higher than the prime can charge back to the customer. This happens when unit price definitions and price assumptions in the prime agreement do not match those included in the subcontract.
A third occurs when a subcontractor fails to perform and the money paid to the customer due to the subcontractor's failure (in service level credits or otherwise) is more than the amount the subcontractor pays to the prime.

When prime contractors are required to enter into international subcontracts, the level of difficulty and risk of squeezing increases significantly due to language barriers, differences in governing law, cultural differences, currency differences, time zone differences and time required to coordinate stakeholders located around the world.

Reduce Squeezing – the subcontracting phases

To reduce the risk of being squeezed, the prime must take some steps to reduce the risks of subcontractor failure. Four main steps contracting professionals take when subcontracting include:

Planning, market research and due diligence;
Competitive sourcing and strategic teaming;
Subcontract negotiation and execution;
Subcontract management planning and administration[ii].

Step 1: Planning, market research and due diligence

Planning for subcontracting occurs prior to a customer request for services. The purpose is to prequalify a group of potential service providers with whom a prime may subcontract before a subcontract is needed.

This step requires contracting professionals to work with sales leads, solution designers, solution architects, finance and procurement professionals to identify suitable subcontractors and complete pre-contract due diligence on them.

Due diligence involves

reviewing potential subcontractor capabilities,
obtaining subcontractor references and recommendations from subcontractor clients,
conducting site visits,
seeking the advice of consultants and industry researchers, and
completing financial due diligence on the subcontractors.

Due diligence also includes meeting with potential subcontractors to determine if the prime and potential subcontractor share any goals for business growth; if their services may compliment rather than compete with one-another to strengthen each other's market position, and to determine if the corporate cultures of the organizations are compatible[iii].

Primes want to work with subcontractors capable of complementing their service offerings. Generally, the more business a company has with a subcontractor, the more influence it may have over the subcontractor if any issues must be escalated to resolve contract issues amicably.

Step 2: Competitive sourcing or strategic teaming

The second step occurs once the customer has defined its requirements and requested a proposal for services from the prime. The prime will review all customer requirements including prime contract terms and conditions, statements of work, service level agreements, pricing requirements, technical requirements and associated performance data provided by the customer.

After determining what the prime can do, the scope of work to be subcontracted will be defined. The subcontract manager will work with the solution designer, sales lead, financial modeler, procurement lead, legal counsel and other internal stakeholders to define the scope of work to be included in a request for proposal or request for quote from potential subcontractors.

After re-qualifying the potential subcontractors based on the customer's scope, the deal team stakeholders will select potential subcontractors with whom to work to build the solution design. If a strategic alliance exists with a pre-existing subcontractor, it may enter into a strategic teaming agreement and use benchmark data rather than a competitive sourcing process to negotiate pricing with the preferred subcontractor.[iv] Using competitive sourcing and benchmarking data to analyze subcontractor pricing enables the prime to achieve lower rates than it may otherwise. The arms-length processes also reduce the chances of unethical subcontract awards influenced by bribery, nepotism or other favoritism.

Step 3: Subcontract negotiation and execution

Subcontract negotiations can be complex depending to the scope of work to be performed, the timing for delivery of services, and the number of subcontractors involved. Primes often start contract negotiations by sending a subcontract agreement to a potential subcontractor for review and editing.

The subcontract agreement should not be a copy of the prime contract between the customer and prime with only the names of the parties changed[v]. Instead it should consist of the prime's terms and conditions to which flow downs from the prime Agreement are attached as exhibits. (The term flow downs means language from the prime contract that applies to the specific scope of work the subcontractor will perform.)

Subcontract Managers should carefully review the scope of services the subcontractor will provide and consult with legal teams, solution designers, and other stakeholders to include only relevant flow downs to the subcontract agreement. Otherwise, the subcontract pricing may be higher than necessary to account for the unnecessary obligations required of the subcontractor.

Customer requirements that apply to the prime and the subcontractor's performance of its obligations should be included in the subcontract. This includes background checks; drug screening; customer policies; access and use of customer facilities and data; a clear scope of work; rights to hire; approve and remove subcontractor personnel and other relevant rights and obligations[vi].

The timing of subcontract negotiations is important. If a pre-existing subcontract agreement is in place before the current opportunity, then the parties may amend the agreement and add relevant statements of work, flow downs and other exhibits that apply to the new opportunity. If it is not in place, the subcontract should be negotiated and ready for signature before the prime agreement is signed to avoid possible subcontractor squeeze .

Subcontract managers should negotiate subcontracts when the prime agreement deal teams negotiate the prime agreement. By communicating consistently with the prime deal team, the subcontract manager can receive new or changed requirements from the customer for negotiation with the subcontractor. Also, the subcontract manager can share any flow ups with the prime contract manager. Flow ups are subcontractor requirements that the prime and customer must agree to follow in order for the subcontractor to agree to provide services.

Examples for flow ups include limitations on a customer's or prime's right to use subcontractor's software, rights to audit subcontractor records, limitations on rights to hire subcontractor employees, access and use of subcontractor data and background and drug screening limitations.

Step 4: Subcontract planning management and administration²

After the subcontract has been signed, the subcontract manager should draft a subcontract management plan and share it with key stakeholders responsible for delivery to the customer. The extent of the plan will depend upon the criticality of the subcontractor's performance to the successful delivery of services by the prime.

The subcontract management plan summarizes the key components for subcontractor compliance and monitoring. It should include [vii] all action items, milestones, deliverables, service level agreements, and other key performance metrics due from the subcontractor. The subcontract manager should include the termination rights, price changes, change control procedures, service level monitoring mechanisms and other key compliance terms in the subcontract plan.

When a prime plans to subcontract more than one portion of its scope of work to another subcontractor, the planning and due diligence must include how each subcontractor will interact with the prime and the other subcontractors to ensure seamless service delivery. A prime may require its subcontractors to enter into Operating Level Agreements (OLAs). OLAs define how subcontractors will interact with each other and the prime at the operational level to deliver services to the customer. The OLA should tie into the subcontract management plan. The subcontract manager will include key components of the OLA in the subcontract management plan.

For subcontract governance, the plan defines, by role, who on the supplier management team does what; when it is done; how issues are managed, escalated and resolved; how and when subcontractors will be evaluated[viii] for performance. It also summarizes contract close out action items. The subcontract manager works with operations, finance, legal, prime contract managers and the subcontractor to administer the plan.

If we apply lessons learned and effective subcontract management, violent incidents -- like those in the news recently -- may be less likely to occur. When managing subcontracts, we can do our part to make a positive difference for our customers, the prime, the subcontractor and the employees of the subcontractor. We do this by confirming that each party to the subcontract meets its contractual commitments. We focus on important details that may otherwise be overlooked.

Make sure to request and review documentation provided by subcontractors to validate compliance with subcontract requirements. If they do not meet requirements, promptly follow up with the subcontractor to require compliance. Do not allow the subcontractor to start work until the subcontractor produces proof of compliance. Documents to review include:
- Certifications establishing successful completion of background checks and drug screenings;
- Certificates establishing completion of all required training;
- Certificates of insurance establishing insurance is consistent with subcontract requirements and is current;
- Acceptance certificates for completion of transition milestones and other projects requiring deliverables;
- Transition plans and project plans (confirm they are completed on time before approving release of payment); and
- OLAs - confirm they are complete and the subcontractors are abiding by them.
Communicate consistently with prime account team members and the subcontractor to make sure the subcontractor is aware of new or changed policies or other requirements.
Communicate with the contract manager responsible for administration of the prime agreement to make sure new prime agreement work orders and subcontract work orders align when work is subcontracted.
Review statements of work, work orders, change orders and amendments proposed to ensure:

Consistency with the prime agreement;
The subcontractor proposed pricing is market competitive and consistent with previously-negotiated pricing; and
Confirm proposed services to be performed are not already in scope.

By focusing on these details, we can help prevent mistakes, mishaps and devastating incidents from occurring.

The opinions included in this article are the author's own and do not represent the views of IACCM nor Xerox Business Services, L.L.C.

[i] Quentin W. Fleming, Quentin J. Fleming, Subcontract Planning and Organization (Tustin, California: McGraw-Hill Publishing, 1993), 14.

[ii] Depending on the source, contract lifecycle phases vary. See Fleming 1-14 as compared to global Phase I planning, Phase II sourcing and contracting, and Phase III contract administration commonly included in global purchasing contracting models.

[iii] For more information on pre-contract due diligence listen to the International Association for Contract and Commercial Management (“IACCM”) podcast by Tim Cummins and Richard Cellini, “Ask the Expert: International Contracting 3 - due diligence methods for validating / monitoring – Recording by Tim Cummins”, https://www.iaccm.com/members/library.

[iv] Teaming agreements normally provide for the parties to the agreement to work together exclusively to bid on, win and negotiate a subcontract. Carefully consider the proper use of teaming agreements before executing them. For more on teaming agreements see Fleming, 65-98.

[v] George Sammet Jr., Clifton G. Kelley, Subcontract Management Handbook (New York, New York: AMACOM Publishing, 1981), 46-69.

[vi] Prime contractors should obtain details regarding the exact background checks and drug screenings requested by customers, especially when international subcontracting will be necessary. There are many different types of background checks and drug screenings possible. Prime contractors must consult with legal and human resources before agreeing to background check and drug screening requirements. Privacy regulations in the United Kingdom and Europe often restrict the extent to which background checks and drug screening is permitted by employers. Subcontract managers should request subcontractors agree to the customer's requirements before the prime contractor agrees to them.

[vii] Fleming, 187-216.

[viii] Sammet, 190-199.

About the Author

Shalas Benson has over twenty years of contract negotiation and contract administration experience. Currently Vice President, Business Management for Xerox Business Services, L.L.C., she leads a diverse team focused on new business support, supplier relationship management, subcontract negotiation and subcontract administration. Ms. Benson earned her undergraduate degree in political science and speech communication from Portland State University, Portland Oregon and her J.D. from the Northwestern School of Law, Lewis and Clark College, Portland, Oregon. She is an IACCM Certified Contract Management Expert. Her husband and two cats live with her in Aloha Oregon where they enjoy playing together in the great outdoors.