The Fine Art of the Fine Print
A Guide to Effective Contract Administration
In the ordinary course of business, a company will enter into many contracts. If the company is not careful, some of the commitments made in its contracts may expose it to unexpected liability. Unfortunately, there are many cases where an organization inadvertently has been forced to incur great expense or become subject to competitive disadvantage because of its failure to pay attention to the details in its contracts.
Such contracts arise in various ways. Contractual commitments are made when a company’s products or services are sold, directly or through sales networks, or when supplies and services are purchased. Contracts can be verbal or written. There are some types of agreements that can be repeatedly encountered by a company, such as nondisclosure agreements, that are intended to protect proprietary information owned by the company or by others with whom it does business, purchase orders, quotes and sales forms, and agreements with key employees. There are also non-routine contracts such as leases of commercial space; agreements for the purchase, leasing, or licensing of significant business assets; collective bargaining agreements; and insurance and financing agreements.
Contract administration is a form of risk control, no less important to a company than having appropriate insurance coverage. Companies that protect themselves through disciplined contract-management programs can also position themselves to take advantage of valuable opportunities. There are several goals of an effective contract-administration program:
- First, a company should avoid undertaking responsibility for inappropriate risks;
- Second, it should ensure that its internal policies are consistently reflected in its contracts. Some examples of this include maintaining consistent warranties, or warranty limitations, on products or services sold; maintaining consistent protection of trade secrets and other intellectual property; and having contractual provisions that support a company’s revenue-recognition policies and goals;
- Third, a company should avoid entering into conflicting contractual commitments. Examples include inconsistent exclusivity commitments in licenses, distributor or sales representative agreements, or commitments that conflict with covenants previously made in institutional financing documents;
- Fourth, a company should monitor its contracts as part of its internal controls over risk and corporate reporting; and
- Finally, management should have easy access — for reporting, transactional, and other purposes — to information concerning currently effective contracts and the contents of those contracts.
The first step is to identify, within the organization, where and by whom contractual commitments are made, and then to develop appropriate controls. In a typical organization, for example, the purchasing department may issue purchase orders or accept quotes from vendors. Sales personnel may accept purchase orders or otherwise enter into contracts to sell, lease, or license the company’s products and services, and may enter into contracts to sell through various distribution channels.
The human resources department may enter into agreements with employees. Throughout the company, managers may be asked by third parties to sign, or ask others to sign, nondisclosure agreements for various purposes.
Effective controls include:
- Identifying those significant contracts that must be reviewed and approved by persons familiar with important company policies. This may include legal review of contracts presented to the company, which may create special risk;
- Making sure that those managers in each department, who sign off on contracts, are familiar with the company’s policies affecting contractual matters and watch for inappropriate risks;
- Limiting signature authority to certain officers;
- Developing standard forms to use for routine agreements (for example, sale agreements, quotes, purchase orders) that contain terms that are friendly to the organization;
- Developing an approach to identify contract issues that need special attention, and a process to quickly resolve those issues. This is probably one of the most difficult parts of the management process because it usually requires prompt response by various team members, including legal advisors, and a constructive approach to getting to a final agreement, in order to avoid a slowdown in operations; and
- Finally, effective contract management includes keeping readily accessible records of all the organization’s contracts, and implementing a system to monitor key contract dates and other features. These dates may include deadlines to exercise options such as extension or renewal options, options for price increases, or reminders to begin renegotiations for new contracts (e.g., real estate leases) where significant work is required in advance of the contract expiration date.
What follows are some common types of contracts, and areas of concern where a company should be careful in managing such contracts:
Most organizations have trade secrets and other sensitive information to protect, whether it consists of customer details, formulae, pricing information, designs, or other intellectual property. It is important, especially in order to preserve the trade secret status of such information, for an organization to have a form of nondisclosure agreement that can be used with vendors, business partners, employees, and others who would be given access to such information.
The company’s attorney can help develop an appropriate form. If a company manager is presented with a nondisclosure agreement from a third party with whom the company does business, the manager should be sensitive to avoid signing any agreement that is overly broad in identifying what information must be restricted or that contains non-competition, non-solicitation, or other restrictions that are excessive, inappropriate, or irrelevant to the purpose of the nondisclosure agreement.
Agreements with Employees
Many organizations enter into employment agreements with key management and sales personnel, not only to avoid misunderstandings about duties, compensation, benefits, and other terms of employment, but also to protect against misuse of important company information to which the employee would have access, or to ensure that the company gets the benefit of any intellectual property developed by the employee.
Agreements with employees to consider in this regard include, where appropriate, agreements:
- not to disclose or misuse company confidential or proprietary information, or such information received from others with whom the company does business;
- not to solicit a company’s customers or employees, or not to compete; and
- to assign to the company any intellectual property created during the course of employment.
Under Massachusetts law, covenants not to compete are recognized to the extent they are necessary to protect legitimate company interests such as trade secrets. If an employee in Massachusetts has a covenant not to compete, it is important to consider executing a new non-competition agreement if the employee is promoted or changes job functions.
Note that the laws of other states, regarding covenants not to compete, are not always the same as in Massachusetts. In some states, noncompetition agreements with employees are unenforceable, or are enforceable only under certain conditions that need to be considered in preparing the agreement. Therefore, it is worth checking the status of the applicable laws for employees outside of Massachusetts.
Agreements for the Sale and Purchase of Products and Services
These agreements frequently arise from an exchange of preprinted forms such as requests for quotation, quotations, purchase orders and acknowledgments of purchase orders. These forms may be exchanged when an organization sells, leases, or licenses its products and services, or when it purchases products or services from vendors.
The documents that are exchanged often are not signed, contain conflicting terms between the seller’s document and the purchaser’s document, or are not reviewed by the receiving party before the contract is performed.
Under the Uniform Commercial Code provisions that have been enacted in Massachusetts and in other states, a contract for the sale or purchase of products can arise even if the forms exchanged by the parties differ from one another. What terms becomes part of the contract depends on timing and the language of the parties’ respective forms. Problems can arise, for example, when goods or services are not timely delivered, are defective, or cause injury or damage.
This is an area where an organization can be proactive and develop the most advantageous forms, and impose process controls, to ensure that its terms become part of the final contract. In significant situations, it may be better to have a master sale agreement, signed by both parties, that applies to all sales to an important customer, or purchases from an important vendor, over a particular term. Such an agreement would address price, delivery, volume commitment, warranty, liability limitation, intellectual property, and other sale issues.
Well-drawn warranties, and related limitations on a seller’s obligations for claims relating to defective products and services, will help control the company’s exposure to potentially unlimited consequences from the sale of its products or services.
The matters that must be included in a warranty, those persons who have the benefit of the warranty, and the extent to which a seller can limit its liabilities are largely addressed by various state and federal laws. In particular, these include the Uniform Commercial Code provisions in effect in Massachusetts and other states, and the Federal Magnuson-Moss Warranty Act, which governs the contents of consumer product warranties.
Companies that contract to use distribution and sales networks may have several sales representative and distributor agreements in place, some of which may offer exclusivity arrangements to representatives or distributors. Any exclusivity commitments should be well-defined and consistent with the company’s plans to sell its products or services directly or through all sales channels. There are also limits imposed by the antitrust and other laws that affect permissible arrangements that can be made relating to exclusivity and pricing.
Many states, including Massachusetts, also have statutes that address agreements with sales representatives and their termination. Many countries outside of the U.S. have strict dealer protection laws that make it more difficult or expensive to terminate a dealer or distributor than might be the case in the U.S., even if the contract provides otherwise. Experienced business counsel can advise about the applicable limitations in any particular situation.
In conclusion, an effective contract administration program will minimize the risk of expensive and inadvertent contractual commitments. Such a program can ensure that a company’s policies and best interests are consistently reflected in its contractual positions, and that unusual risks are considered and addressed before a contract is signed.
David Parke is a partner with the law firm of Bulkley, Richardson and Gelinas, LLP, specializing in business and corporate matters; (413) 781-2820.