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Insidious Risks in Contracts: A Comprehensive Checklist for Suppliers

Reading Time: 10 minutes

In this article, we offer a thorough checklist to uncover and address subtle yet significant contract risks that (especially mid-sized suppliers) may encounter during or after delivery. Essential for suppliers working with EPC Contractors, End Users, and other professional buyers to avoid costly mistakes and manage risk effectively.

RISKS IN CONTRACTS

DEALING WITH PROFESSIONAL BUYERS

Forming partnerships with professional buyers such as EPC contractors, large end-users, or engineering firms can offer significant benefits to small and mid-size suppliers, including steady business flow, large order volumes, and more reliable payments.

Nonetheless, these smaller suppliers must exercise caution when entering into supply contracts with such entities. The contracts and their General Terms and Conditions of Purchase might contain hidden risks that could emerge during or after the fulfillment of the contract.

In industries like oil & gas, construction, and power generation, the complexity inherent in contracts can present numerous risks. Without proper management, these risks may lead to considerable financial losses, legal disputes, and reputational damage. Suppliers need to recognize and understand these risks to safeguard their interests and cultivate successful partnerships.

Among the most prevalent risks in these contracts are ambiguous language, an unclear scope of work, uncertain payment terms, inadequate mechanisms for dispute resolution, and poor allocation of risk. To mitigate these risks effectively, a thorough review of contracts is indispensable.

Although consulting with legal advisors is highly recommended when dealing with large buyers, suppliers can identify several key risks using a comprehensive checklist.

Now, let’s examine some of the critical risks in detail.

WHAT IS A CONTRACT

A contract with a major buyer is a formal agreement outlined in a document that specifies the quantities, quality, prices, and the stipulated terms for delivery and payment. This contract is augmented by the “General Terms and Conditions of Purchase” (GTC), which the buyer provides along with the contract. Additionally, any interactions that have occurred between the buyer and the supplier during the offer and negotiation phases are, by law, considered part of the contract.

Hence, the risk profile of a transaction is determined by the aggregate conditions outlined in the contract, the GTC, and the entire sequence of communications between the parties.

Upon receipt of a contract and its GTCs, it is crucial for the supplier to diligently review and identify any potentially detrimental terms before sending an order confirmation.

The order confirmation serves as the document through which the supplier agrees wholly or partially to the contract or takes the opportunity to express concerns and urges the buyer to modify the contract to alleviate the identified risks.

CONTRACT RISK MANAGEMENT BASICS – PROCESS TO FOLLOW

When you receive a new contract, follow these steps to ensure due diligence and proper risk management:

  1. Gather all communication (emails, meeting minutes, and memos) exchanged with the client during the contract negotiations.
  2. Thoroughly review the Purchase Order (PO) and/or Contract to verify it accurately captures the agreed-upon scope of work/supply, including:
    • Details of goods or services to be delivered (quality, quantity, timing, specifications).
    • What is included and what is excluded.
    • Payment terms.
    • Delivery conditions.
    • Required shipping documents.
    • Any special requirements (e.g., inspections).
    • Other significant contractual terms derived from the PO or contract.
  3. Note any discrepancies, uncertainties, or inconsistencies found in the PO and/or contract.
  4. Examine the Client’s General Terms and Conditions of Purchase (GTCs), requesting a copy if not initially provided.
  5. Identify potential risks within these GTCs, using your expertise.
  6. Utilize the provided Risk Checklist to uncover any additional risks you might have missed.
  7. Compile a “Contract Risks” document and consult with your lawyer to assess the severity of each risk and explore potential mitigation strategies.
  8. Suggest any necessary amendments before sending an Order Confirmation to the client.
  9. Officially confirm the order through an Order Confirmation only after all risks have been identified, addressed, and deemed acceptable.

Remember that it is better to reject a bad contract than to accept one and pay the legal, financial, and moral consequences at a later stage!

CONTRACTUAL RISKS CHECKLIST

IS THE SCOPE OF SUPPLY 100% CLEAR?

The first point to check is if the scope of supply (goods delivery) or the scope of work (service supply) is clearly outlined in the contract:

  • deliveries that are included in the price
  • deliveries that are not included in the price and cannot be offered
  • deliveries that are not included in the price but can be offered against additional compensation

The scope of supply/work in the contract must be thorough and clear, eliminating any potential confusion about whether a specific task or item is covered under the Purchase Order (PO) or within the contract’s price.

A well-defined scope is crucial for distinguishing between services or materials included in the initial fee and additional offerings not considered at the contract’s outset. Without this clarity, it becomes challenging to bill for extra services or products needed once the contract is underway.

The negative consequence of a badly defined scope of supply/work is called “Scope Creep“: this occurs when the project’s scope expands beyond what was initially agreed upon, without appropriate adjustments to time, budget, or resources. Scope creep happens too often due to vague contract terms, changes in project requirements, or inadequate change management processes. Suppliers need to ensure that contracts have clear, detailed descriptions of the scope of work and mechanisms to handle changes effectively.

⚠️ DON’T ACCEPT!

  • Any client-drafted clauses that ask you to agree (or even certify) that the scope of supply includes anything that will be “adequate to meet the project needs,” or that you will “provide any and all the services and materials necessary for the completion of the project”, “provision of ball valves and all the ancillary equipment“, or similar deceptive language
  • Contracts missing detailed lists of the specific goods and/or services to be delivered for the agreed price
  • Contracts that do not mention the procedure/approach for change orders and variation orders

ARE THE PAYMENT TERMS AND POTENTIAL FOR DISPUTES CLEAR?

The contract ought to clearly specify matters like the timing of payments, consequences for delayed payment (for instance, interest charges, costs of collection), and the supplier’s entitlements should non-payment occur (such as the suspension or cessation of services, or return of goods). It should also clearly define in which cases the buyer is entitled to withhold payments, or not.

Extended payment terms or payment delays are common issues that suppliers face. Professional buyers, leveraging their purchasing power, may insist on lengthy payment terms, which can strain the supplier’s cash flow. Furthermore, disputes over work quality or completion can lead to delayed payments, impacting the financial stability of the supplier. It’s important for suppliers to negotiate favorable payment terms and include clear criteria for payment schedules and dispute resolution.

By accurately defining payment terms, the likelihood increases that the supplier will receive timely compensation and circumvent disputes over fees. Disputes are generally unpleasant and could potentially result in the forfeiture of subsequent opportunities with the same client.

⚠️ DON’T ACCEPT!

  • Any language in the Contract or the GTCs that would permit the client to withhold payment at will
  • Clauses that may hinder the collection of the payment even in case of successful delivery (for example: payment subject to “approvals” that the buyer may control and therefore withhold)
  • Clauses that impose excessive penalties, or deductions from due payments, in case of failure to deliver the contract, in part or in full (penalties shall be set for a fair, determinable, value, and proportional to the contract value)

IS A CLAUSE FOR CONSEQUENTIAL DAMAGES PRESENT IN THE CONTRACT OR ITS GENERAL TERMS?

Your contract should contain a clause waiving consequential damages, which are indirect costs (such as lost profits) stemming from a delivery failure.

This clause should explicitly state that neither party will be liable for any consequential damages arising from any purported failures by either side.

Without such a provision, you risk being liable for damages that far exceed the contract’s value or the actual cost of rectifying the damage, potentially leading to lawsuits for disproportionally high amounts. Consider a refinery claiming consequential damages due to the failure of some equipment: the costs associated with such a claim may be gigantic and lead to bankruptcy!

⚠️ DON’T ACCEPT!

  • Any language in a client-drafted contract that would make you responsible for consequential damages.
  • If your contract remains silent about consequential damages, you can still be sued for them. Having a negotiated limit of liability does not take the place of the additional protection against liability for consequential damages. Be sure your Limitation of Liability and Consequential Damages clauses are coordinated with each other and clearly stated.

IS THE LIABILITY CLAUSE DEFINED, CLEARLY STATED, AND REASONABLE (INDEMNIFICATION)?

Limitation of Liability clause shall always be present in a contract: the clause is an agreement that sets the conditions for the supplier’s responsibility and a cap on the amount of liability that the supplier accepts in case the client files a claim regarding the delivered goods and/or services.

Accepting unlimited risk on projects can lead any supplier toward substantial losses or even financial ruin. Implementing a limitation of liability ensures that the risks associated with a project are distributed in a manner proportionate to the profits and benefits each party expects to receive. The limitation of liability sets the maximum financial exposure of the seller in case of unforeseen events and shall be capped to a reasonable value (not beyond the contract value).

Indemnification clauses can expose suppliers to disproportionate liability, requiring them to compensate the buyer for losses that may arise from the contract’s execution, including third-party claims. These clauses can sometimes hold suppliers responsible for risks beyond their control or contribution. Suppliers should carefully review these clauses to ensure liability is fairly distributed and aligned with their level of control and responsibility.

⚠️ DON’T ACCEPT!

  • Contract without a limitation of liability shall be rejected (even if some exceptions may be considered in the case of projects for public entities, which rarely agree to a limitation of liability clause)
  • Contracts with fuzzy language about limitation of liability (unclear, verbose, over or underspecified)
  • Contracts that do not state the exact type of events that may trigger supplier’s responsibility
  • Contracts that do not set a specific max. amount of liability for the supplier and that set exposure levels that are not proportional to the contract value of the damages that the buyer may claim

DOES THE CONTRACT DEFINE HOW DISPUTES WILL BE SOLVED OR MEDIATED?

Mediation is an approach to dispute resolution, typically voluntary, that helps the disputing parties reach an agreement among themselves, thus maintaining or reopening their communications. Your contract should include a clause that calls for mediation as the first step in settling disputes.

Litigation and arbitration proceedings can be both expensive and time-consuming, cutting into a firm’s billable hours, hurting morale, and lowering productivity. These adversarial processes can also destroy business relationships.

⚠️ DON’T ACCEPT!

  • A contract that doesn’t call for mediation is the first step in dispute resolution. Otherwise, you’ll have a difficult time convincing a client to use mediation when the two of you are in the middle of a dispute.
  • Mediation has a remarkable track record, especially when employed at the appropriate stage of the dispute.
  • A contract that sets dispute resolution in locations that will not be easily accessible (or costly to access)

ARE THE CAUSES FOR POSSIBLE CONTRACT TERMINATION CLEAR?

Ensure your contract encompasses a termination clause outlining the scenarios (such as nonpayment) that allow either party to dissolve their legal agreement. This clause should also detail the entitlements of each party upon termination, based on who initiates the termination.

A contract lacking a clear termination provision opens the door to potential disputes. Situations that might prompt you to terminate the contract include the client violating any significant term, failure to agree on extra services, changes among the contractual parties, or significantly altered circumstances.

Termination clauses are essential for stipulating how either party may withdraw from the agreement. Unfavorable termination conditions can expose suppliers to sudden contract termination without sufficient recompense for expenditures or resources already allocated. Suppliers must advocate for equitable termination provisions that ensure fair warning periods and proper compensation for early contract cessation.

⚠️ DON’T ACCEPT!

  • Language that permits only the client to terminate or that transfers the ownership of the contract.
  • Your firm will incur substantial shutdown costs if you are terminated prematurely from a project to which you have heavily committed your resources. You might prefer to have the option to temporarily suspend your services and keep the contract in force until the client cures the breach.

ARE THERE WARRANTIES, GUARANTEES, AND, CERTIFICATIONS THAT MAY HURT?

Your contract should never promise to assure the total accuracy of something (e.g., a subcontractor’s HVAC installation) or confirm absolute compliance with a standard (e.g., ASME compliance).

By certifying, guaranteeing, or warranting something, you are assuming a level of liability well beyond the legally required standard of care.

Your liability insurance is not intended to cover breach of contract or warranty, the assumption of someone else’s liability, or a promise to perform to a standard of care higher than legally required.

The smallest error, whether caused by you or someone else, could lead to a claim for breach of warranty.

⚠️ DON’T ACCEPT!

  • Other terms that, in effect, guarantee, such as “all,” “every,” “insure,” “ensure,” “assure,” “state” or “declare.” You can substitute contract language that reduces your risk, doesn’t jeopardize your liability insurance coverage, and answers your client’s concerns.
  • Certifications, warranties, and guarantees may also be found in the fine print of a client’s purchase orders.

IS THERE POTENTIAL FOR EXPOSURE TO THIRD-PARTY CLAIMS?

Your contract should include a provision that addresses the issue of third-party claims. If your negligence damages others who reasonably and foreseeably could have been damaged, you may be liable to them.

In most jurisdictions, they would not need a contract with you to file a claim and win.

⚠️ DON’T ACCEPT!

  • A contract that doesn’t address the issue, since, in the absence of such a clause, a Court may follow what it believes to be precedent or it may make new law based on its predilections.
  • The legal obligations towards third parties are difficult to interpret. Parties to a contract can establish many of their own rules to guide judicial interpretation. As with all contract issues, however, be sure to consult with your attorney and insurance agent or broker.

IS THE RESPONSIBILITY FOR REGULATORY COMPLIANCE CLEAR?

Suppliers must adhere to a wide range of regulations, including environmental, safety, and industry-specific standards. Contracts may shift the burden of compliance to suppliers, exposing them to risks of non-compliance penalties. Suppliers need to assess their ability to meet all regulatory requirements and negotiate terms that reflect a fair distribution of compliance responsibilities.

⚠️ DON’T ACCEPT!

  • Contracts that explicitly or implicitly shift the full responsibility for Regulatory compliance to the supplier only.
  • Contracts with unclear wording about regulatory compliance

IS A “STANDARD OF CARE” CLAUSE PRESENT?

Your contract should include a clause that affirmatively defines the standard of care to which you will perform.

The standard of care for professionals requires only that you perform your services with the degree of skill and care ordinarily exercised by other members of your profession under similar circumstances, at the same time, and in the same or a similar locale.

Any contract language that seeks to raise your standard of care increases your risk.

Your professional liability insurance will not cover you for this increased exposure since it represents an assumption of additional liability for which you would not otherwise be responsible.

⚠️ DON’T ACCEPT!

  • A client’s contract language requires you to “perform to the highest standard of practice.” Nor should you accept broad or ambiguous language such as “appropriate” or “necessary,” or provisions that would have the client making a unilateral determination as to the performance of your services, such as “to the satisfaction of the Client” or “in the Client’s sole judgment
  • Nowhere in the Standard of Care doctrine or definition is there any mention of “perfection.”

IS THERE A CLAUSE TO RULE INTELLECTUAL PROPERTY RIGHTS?

Contracts might include clauses that impact the ownership and use of intellectual property created or used during the project. Suppliers risk losing control over their own innovations or facing limitations on their use of IP. It is crucial to clearly define the terms related to IP rights, including usage, ownership, and licensing, to protect the supplier’s interests.

⚠️ DON’T ACCEPT!

Contracts without clearly written conditions about IP rights, in case special technology or know-how, is leveraged or will be created due to the execution of the contract

IS FORCE MAJURE DEFINED?

The handling of unforeseeable events or force majeure situations can significantly impact contract obligations. Suppliers need to ensure that contracts include clear definitions and provisions for force majeure events, detailing the suspension of obligations and adjustments to timelines and payments.

ARE CONFIDENTIALITY CLAUSES DEFINED?

Suppliers often have access to sensitive information. Breaches of confidentiality can lead to legal action and damage to reputation. Suppliers should ensure that NDAs are reciprocal and that they have measures in place to protect confidential information effectively.

CONCLUSIONS

Navigating these contractual risks requires careful contract review, negotiation, and ongoing risk management practices. Suppliers should consider legal counsel experienced in their industry to help identify and mitigate these risks. Establishing a clear, fair, and enforceable contract is not just about protecting the supplier’s interests; it’s also about laying the groundwork for a successful and mutually beneficial partnership with the buyer.

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About the Author

Fabrizio S.

Fabrizio S.

Fabrizio is a seasoned professional in the international trading of materials for projects, including piping, steel, and metal commodities with a distinguished career spanning over two decades. He has become a pivotal figure in the industry, renowned for his expertise in bridging the gap between EPC contractors, end users, manufacturers, and stockists to facilitate the seamless delivery of complex piping product packages across the globe.Starting his journey with a strong academic background in business administration and international trade, Fabrizio quickly distinguished himself in the field through his adept negotiation skills, strategic vision, and unparalleled knowledge of the project materials market. His career trajectory has seen him collaborate with leading names in the construction, oil & gas, and petrochemical industries, earning a reputation for excellence in executing large-scale projects (EPC Contractors, Oil & Gas End Users).At the core of Fabrizio's success is his ability to understand the intricate needs of EPC contractors and end users, aligning these with the capabilities of manufacturers and stockists. He excels in orchestrating the entire supply chain process, from product specification and procurement to logistics and on-time delivery, ensuring that each project phase is executed flawlessly.Fabrizio's role involves intense coordination and communication, leveraging his extensive network within the industry to negotiate competitive prices, manage complex logistical challenges, and navigate the regulatory landscape of international trade. His strategic approach to package assembly and delivery has resulted in cost efficiencies, timely project execution, and high satisfaction levels among stakeholders.Beyond his professional achievements, Fabrizio is an active participant in industry forums and conferences, such as Adipec, Tube, and similar, where he shares insights on market trends, supply chain optimization, and the future of project materials trading. His contributions to the field are not only limited to his operational excellence but also include mentoring young professionals entering the trade. Fabrizio is one of the co-founders of Projectmaterials, a B2B marketplace targeting the above markets. https://www.linkedin.com/in/fvs20092023/

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One Response

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    Hereford limited

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