Change Order Mechanisms For Good Contracts – Two Examples

Building in the right change order procedure into a contract can go a long way towards making the contractual relationship stronger and avoiding disagreements down the road.

My elevator speech (as it is now – you never know) emphasizes three attributes that I think any good business-to-business contract should have:

  1. The contract should be a win-win for both parties
  2. It should contain the necessary mechanisms so it works on a day-to-day basis
  3. The contract should last for a long time without requiring major fixes

My last blog covered why I believe contracts should be a win-win. This post focuses on one of the mechanisms.

These mechanisms “impose” policies and procedures on one or both side from which they will benefit. The best way to relate this is with a couple of examples: one from a master services contract and its equivalent from a master sales contract.

Master Service Contract Example

Every master service contract should provide for change orders. Successfully modifying a statement of work requires these documents.

I see some agreements without any provision for change orders, which invites “project creep”. People on both sides make changes, in the field and on the fly, to services and deliverables. The poor service provider may not realize what happened until the once-profitable project comes in at a very low margin or even at a loss. So, every master service agreement should have a requirement that no changes to the services or deliverables take place without a change order, signed by both parties. That’s not optimal, though.

Just saying a change order will be required ignores the issue of how it will come into being. Without a process for negotiating them, the chances that the change order will get created, regardless of the requirement in the contract to do so, decreases substantially.

For this example, let’s assume the client wants to change the services and/or deliverables. Construct the master service contract such the following occur:

  • The client provides that request in writing to the service provider
  • The service provider has time to think about the change, and to calculate a new price to address the financial impact
  • This revised proposal should be provided to the client in writing

    People Around Table Agreeing on Change Order
    © Can Stock Photo / pressmaster
  • The client should have adequate time to consider and accept or reject the proposed revision.
  • There should be mechanisms (with time limits) around negotiating the final change order, which the parties then sign
  • Finally, a procedure is needed in the event of an impasse, in which case the change order does not happen, and the parties agree not to make the change or just part ways

Master Sales Contract Example

The example here is simpler: the buyer wishes to cancel its purchase order before the product ships. The example assumes manufactured products. IP deliverables, such as software, fit the model as well.

  • Within a certain period before shipment, say 120 days, perhaps there should be no penalty for cancelling the purchase order
  • Within a much shorter period prior to shipment, the buyer should have to pay the full price or at least the cost of acquired long lead-time materials plus labor
  • For the times between the two extremes, a good solution is a table with various percentages of the purchase price the buyer must pay, depending on the period before the ship date the order is cancelled. For example:

Days Before Ship Date

Percentage Payment Required

90

25%

60

50%

30

100%

 

Both the change order and order cancellation process may tilt slightly in favor of the service provider or seller. But, if the client does not get a surprise bill for “project creep”, and the buyer does not get a demand for the entire purchase price because of cancelling six months out, they win as well.

If litigation is avoided, both parties save a lot of money.

If drafted properly,these are simple solutions for handling what could become major stumbling blocks in the contract.

3 Reasons Contracts Should Be a Win-Win

3 Reasons Contracts Should be Win-Win

In my practice I have always advocated that contracts should be a win-win, i.e., they should provide equivalent benefits to both parties. Here are three (of many) reasons why I think that’s so.

  1. Failure of Purpose. If you are doing contracts with companies, whether customer, suppliers, strategic allies, or almost any other type of contract, the aim should be so that you can work together and both benefit from the arrangement. If that is not so, why are you doing business with that other party? If you insist on “winning big” in the contract negotiation, are you showing good business sense or hubris? Good business sense says you must protect yourself, but that the contractual relationship should demonstrate good faith and the fact that you will be a good partner in the endeavor.
  2. Wasting Time. If you send out a contract that is very one-sided, with unilateral onerous provisions for the other party, it is often a waste of time and resources for both parties. The chances of the other party
    Two Business People Fighting Over Contracts
    © Can Stock Photo / AndreyPopov

    missing the harsh terms is pretty low, and the draft is going to be rejected out of hand or sent back well marked up. And the other party may have been forced to spend a lot more money to have its reply prepared. Is that going to improve the dynamics between the companies or damage the relationship?

  3. Ethics and Perceptions. Some people believe businesses should be ethical in their behavior. Actually, a lot people believe it and I am one of them. When a client of mine receives an NDA with hugely one-sided and onerous terms, I sometimes advise them not to sign and to end the relationship right there. The other party had assumed my client was stupid and would not read the document, that it might be able to “sneak” the terrible provisions through anyway, or that it is the bigger player and the smaller company has to give in, so take every advantage. Even if any of those is ethical (I obviously think not), the party being taken advantage of will be on the defensive from the outset and will not trust the other party’s ethics. That is not a recipe for a successful business relationship of any duration.

The presentation of a one-sided contract engenders mistrust and creates doubts about doing business with the drafting company. Even if such a contract gets signed, the relationship is unlikely to work smoothly or be long lasting.

The Contract With a 500-Pound Gorilla

Whatever the size of your company, eventually you will be dealing with a contract with a 500-pound gorilla for the first time – a very large multinational, or just a company that is much larger than your previous clients/ customers. This is a good thing, as it means your business has grown.

The problem comes when the gorilla insists that you sign its sales or service document rather than your own. The problems that may result include:

  • The document doesn’t fit your business because it is a one size (or one type of vendor) fits all;

    500-Pound Gorilla
    © Can Stock Photo / cthoman
  • There are sections you could live with, if only they could be tweaked.
  • Some provisions are toxic and cannot possibly be agreed to.

Generalizations are risky here, as no two contracts will be alike. However, there is some advice I can share regarding the different issues, based on my experience.

  • The document doesn’t fit your business. I see this all the time with a client who prepares high-quality videos for companies to post on their websites. Very large companies send them their standard agreement for software providers, not creatives. Almost nothing fits. My favorite is when the document is rife with onerous confidentiality restrictions on the customer’s information. As the whole purpose is to make that information very public, those sections must be deleted. To address this:
    • Try getting the salespeople to have a frank discussion with the people they are dealing with at the company and explain the problem. Often, they will find that major changes are expected.
    • There are times that a section has absolutely no applicability to your business and it is safe (after taking great care to confirm your understanding with counsel) to leave it in. Sometimes in my example above, there are large sections protecting Personally Identifiable Information (PII), a requirement of the utmost importance for some companies. As there is no possible way for my client to get to PII, having no access to the company’s systems or facilities, the COO sometimes chooses to leave the requirements in.
  • The Sections You Could Live With if they Were Tweaked. If the client or customer is serious about wanting to enter into an equitable arrangement, they will expect to negotiate some points. Work with someone who can help you with corrective wording. Sometimes you will be told that modifications to some sections require lengthy legal review. Then you must consider accepting the risk versus losing the deal, which is what they are really saying – they are not going to wait.
  • The toxic provision you cannot sign. One of my clients received an NDA from a prospective strategic partner that made everything discussed between them – ever – the sole intellectual property of the prospective partner. My client, rightly, walked when the prospective partner would not give. There are several elements to this issue:
    • If there is a section that is that onerous (and ridiculous) you have to delete it. You may well find out the other side just puts it in knowing it will be deleted.
    • Their legal department may put in such provisions in the hope that someone will miss them and sign the agreement with them still in there.
    • The other party may really be insisting on onerous, one-sided terms.
500- Pound Gorilla Behind Bars
© Can Stock Photo / cthoman

If any of the three reasons immediately above is true, ask yourself “is this a company I really want to do business with?” If the legal department just wastes your time, as in the first sub-bullet, or acts like a bully and is a bit unscrupulous, as in the other two, they are not acting in a vacuum. The management team is likely to show the same behavior. Such companies do not make good customers, suppliers or allies.

Just because you are dealing with your first 500-pound gorilla does not mean you cannot negotiate a reasonable contract. If you need help, get it. But don’t just blindly accept terms that you will regret later because you don’t know what is and is not acceptable and how to negotiate for what you need.

The Escalation Procedure

An escalation procedure commits people on both sides of a contract to meet and attempt to resolve disputes without costly arbitration or litigation. If there is no procedure agreed to in the initial document, the parties may find it difficult to work out a process to resolve major problems when they are already at odds. Putting a workable escalation procedure into the contract itself establishes the framework to be used if and when it is needed.

Man Holding aprt two huge boxing gloved hands
© Can Stock Photo / focalpoint

I discussed escalation procedures with attorney Phillip Cannatti of Lehtola & Cannatti the other day. I could not understand why this kind of process isn’t used in more agreements, particularly in service contracts. Phillip agreed. He pointed out that the attorney’s focus should be on keeping their client out of litigation, and this kind of procedure could further that goal.

Here is how an escalation procedure might work, using a master service agreement as an example:

  • First, the project managers must meet on the issue. If you failed to name project managers on both sides with equal authority, you did not get the original agreement right. The chances are that the project managers would meet quickly on a major issue anyway, but the escalation procedure has time limits (such as five business days) that force two very busy people to address the issue quickly and personally.
    • Project managers usually have a good perspective on what has happened to date.
    • They also should have a firm understanding of any technical and/or business issues.
    • It is also probable that the project managers will have a good handle on what the costs would be to make changes to the project, through a change order process (yes, you need a change order process – I have written about it before), and can present a plan to their respective management teams.
  • If the project managers cannot resolve the issue in the allotted time, the appropriate vice presidents from each firm become involved. Note that this is not an optimal outcome for the project managers, so they will be motivated to resolve the issue before escalating it. The procedure again requires very busy people to find time to meet and sets a time limit on their deliberations, say ten business days.
    • The vice presidents should have a firm understanding of the importance of the project in question.
    • They should have the authority to make changes that will alleviate the problem without further review, increasing the probability of the dispute ending here.
  • Finally, if the other initiatives have failed, the CEOs of the companies must meet.
    • This puts tremendous pressure on the project managers and vice presidents to resolve the issue themselves. Otherwise, the CEO is forced to take a meeting he or she would rather avoid.
    • The CEOs can make the tough decisions that may be required to fix any damage or choose to part ways.
    • CEOs like to get deals done, and they will be motivated to find common ground to avoid appearing as though they
      Business People arguing at table
      © Can Stock Photo / endotune

      failed.

If the escalation procedure is unsuccessful, a mutually-agreed termination may result, or there can be a provision providing for mediation and, if necessary, arbitration. Your attorney may prefer litigation in place of mediation and arbitration.

The procedure does not have to be more detailed than that. The time limits are important to prevent things from spiraling out of control. The rest should be based on experience and common sense.

Obviously, the escalation procedure is not a panacea. If the companies just cannot agree on anything, there may be no solution. However, sometimes the escalation procedures work, avoiding costly arbitration or litigation. Particularly smaller companies should adopt this as a useful tool for placement in all its major agreements.

6 Elements of Good SOWs

Much of the work I perform for high tech enterprises deals with Statements of Work or Scopes of Work (there may be other names out there as well – I will call them SOWs.)

The SOW can be a major stumbling block in a project if it is not properly written. One reason it often is not is that the people working with the customer to develop the SOW are usually stretched thin, and producing a clear, concise SOW takes time, concentrated effort, and expertise.

Here are some of the major SOW requirements that will be discussed below:

  1. Tie every SOW to a Master Services Agreement (MSA) that includes the key provisions.
  2. Have a strictly limited, but available, method of contradicting the terms set out in the MSA through specific wording in the body of the SOW.
  3. Take care in wording the pricing sections of the SOW to prevent pricing meant for a short term to be locked in for a much longer period.
  4. Include a change order process (actually contained in the MSA but referring to the SOW) that sets out strict requirements, without which a change to the scope of work is invalid.

Consider each of the requirements in more detail:

  1. To have a workable SOW, tie the document to a Master Services Agreement or some other document that sets out the terms and conditions under which one company will provide product and/or services to the other. Include in the MSAs sufficient detail so that the parties know exactly what to expect when an SOW is executed, and work begins. General requirements for a proper MSA will be covered elsewhere. Elements of a good MSA as it relates to the SOWs include:
    • The minimum requirements for SOWs to be valid under the MSA
    • Escalation procedures to handle minor disagreements about the services before they become major ones
    • A strict change order process for adjusting the SOW during the work term. This is frequently omitted, which can be a costly error. Without a clear, step-by step procedure, changes of scope are made in the field and on the fly. Margin erosion for the service provider and disagreements about the final deliverables are potential results.
    • The clear delineation of what intellectual property will be owned by whom when work is performed. If this section is not properly drafted, the parties may have a short and stormy relationship.
  2. There are always special cases where the particular SOW does not fit the terms of the MSA. Reasons for such deviations may be as simple as extended payment terms or as complex as a different allocation of intellectual property (IP).
    • Make the MSA rule in most cases if there is a contradiction between the documents. Then add language that allows for the SOW to overrule portions of the MSA if specific sections of the MSA being modified are referenced by section number. Then make it clear the exception applies only to that one SOW.
    • An exception would be an SOW that specifies unique parameters. For example, an SOW for the production of pictures or videos may include a “style guide” that sets out the quality of the pictures, time of the videos, the number of “talent” included, etc. In the unlikely event there is a conflict between the MSA and the style guide, the latter should rule. This can be specified in the SOW.
  3. Place pricing in the SOW unless, for example, the party performing the work will charge the same hourly rate regardless of what is in the SOW. These cases are rare.
    • Serious errors can occur in the pricing section. I have handled many SOWs stating that the price for a quoted service will apply for the term of the Agreement.” The SOWs for that company defined the MSA as the “Agreement” in the opening section (to tie the documents together, as required). The writers of the SOWs meant for the price to be good for the term of the SOW, but as they dealt with SOWs and not MSAs, thinking of the SOW as “the Agreement” was an easy error to make. MSAs frequently have a term of three years or more, or are evergreen, renewing automatically unless one party objects. Locking in the price for that term could be very costly to the service provider.
  4. Absolutely define what is going to be done by the performing party in a way that is so clear that there is no room for controversy. This requires a lot of work, and it is the place where most companies get into trouble. If the SOW is inexact, inaccurate, poorly written, and full of errors of omission, or all of the above (they go hand-in-hand), the room for disputes between the parties is huge, and project delays or even cancellations are likely.
    • One test is if someone with a moderate understanding of the service to be performed (especially when they are high-tech) cannot decipher what the services and/or the products to be delivered are, then the SOW is inadequate.
    • When the SOW is going to describe complex, high-tech operations, the developers or other technical people that will perform the work should review the schedule, each deliverable, any deliverable testing and other technical concerns for correctness.
      • In one memorable case, I finally got the CTO into a conference room, only to discover that the SOW described, in every instance, services the company could never perform. It took over four hours of difficult work to rewrite the entire SOW so that it accurately described the work that would be performed.
  5. Use good grammar and concise writing for clarity. Good grammar reduces the possibility of misinterpretation. Being concise makes for a shorter cleaner document. It also forces you to understand the point you wish to make well enough that extra words are not needed to express it. Even when there are bullet points rather than paragraphs, how those bullets convey the information is critical.
  6. Include an execution block. It is best that both sides agree to the terms of the SOW in writing.

It is important for the service provider to locate and utilize someone who can create an SOW that will serve both parties as an accurate guide for the term of the project. This will speed the process and avoid disagreements along the way.

 

Strict Data Protection Policies

Large companies are tightening up contractual data protection policies for vendors. I am seeing tough requirements in agreements that one might expect:

  • Limits on the personnel that could access the data
  • Prohibitions around the data’s storage on portable devices (including laptops as well as thumb drives)
  • Strict encryption requirements
  • Security audits by the customer

None of this is bad per se. The problem is that the large companies are not limiting the restrictive provisions to what is called personally identifiable information (PII). The definitions of “confidential information” are very broad.

The requirements can be illogical in some cases. Consider my clients who produce videos for their customers. Information about customer products is “confidential”. But “information” in this case is in the form of videos (or at least creative content) provided by the customer for the sole purpose of making it very public indeed. The data protection policies fail to take this into account.

I fear three results from this:

  1. The additional protective measures are expensive, and the consumer will end up footing the bill.
  2. The broader the definition of “confidential information” the larger the impact on the small company’s productivity and the higher the cost.
  3. The small company is put at a disadvantage. I have not researched this issue in any scientific way, but a start-up where every member of the team wears multiple hats must find these policies more difficult to implement than their larger competitors.

The need for increased data protection will cost the economy. Limiting the damage by allowing leeway for the smaller companies where the protection is superfluous could help.

Contract Terms – Do the Math

This is about saying what you really mean in a contract, not almost what you mean. Contract terms (including the Statement of Work) must be clear and concise to create an effective working relationship.

The document that brought this topic to mind was a Statement of Work (SOW) for a service company client that sells its services in units of filming time. When I took a look at the SOW, I found language that could have caused unnecessary complications.

The salesperson stated in his draft of the SOW that my client had budgeted an average of (say) 20 units/product for product preparation prior to shooting. There are two problems here:

  1. You do not say what you budgeted. You say what the Contract-Terms-Math-Calculatorend-user customer will get for the initial fee and that anything over will incur additional charges.
  2. The math problem arose from the use of the word “average.”
    1. The wording creates a situation where someone must calculate an “average”. Who? When is it calculated? Does someone have to track the time and calculate an average after every product prep?
    2. The logical answer is that the average would be calculated at the end of the project. That is where the math comes in. Saying the end-user client would receive an average of 20 free minutes per product over the life of the project could be detrimental to my client. Assume the 20 minutes was exceeded by five minutes on five out of twenty products. Does my client charge a fee tied to the amount of excess time in total, 25 minutes, or the average  overrun, 25/400 minutes?  The contract should clearly provide for the former by stipulating a maximum of 20 minutes of prep per product, after which additional fees are assessed.

All Statement of Work terms should be clear and concise. When they are concerned with a calculation or accounting issues, particular care should be taken.