Contracting in the face of an economic crisis
8 August 2023
by Isaivan Naidoo and Kayla Casillo
As the global economy grapples with instability, contracting may become a daunting thought especially when it comes to commercial and legal risk appetite. This article highlights some of the main considerations that companies should take into account when wanting to reduce commercial and legal risk exposure under existing contracts, or when intending to conclude IT contracts that have a lower risk profile, to accommodate any financial constraints the company may be experiencing as a result of the current state of the economy.
If a company is looking to tailor its existing contracts to accommodate financial demands or instability, it should review its existing contracts and consider the following contractual mechanisms for reducing its risk exposure:
- Scope of services: In a master or framework agreement, where multiple service schedules or statements of work are concluded, it may be possible for a company to terminate or reduce the scope of one service without impacting the other services being provided. Such termination or scope reduction may be for various reasons, including a change in demand or financial constraints.
- Change control procedures: A change control procedure is a mechanism generally built into contracts which makes provision for changes or amendments to the services procured (such as the pricing model, increases or reductions in charges, pricing fluctuations, the scope of services, performance metrics, and the like). Using the change control procedure pursuant to the terms of the existing contract, the company may have the flexibility to renegotiate service or commercial-related contractual terms to accommodate any changes in demand or commercial constraints experienced by the company.
- Termination provisions: Certain contracts may contain termination for convenience provisions that enable a customer to terminate the contract without cause. Such termination is usually not without liability. Typically, parties to the contract agree on an early termination fee should termination for convenience be exercised. However, the threat of termination for convenience may have the effect of bringing the supplier to the negotiating table in order to prevent the complete loss of its projected revenue under the contract in question.
- Benchmarking exercises: In outsourcing agreements that hold a lengthy contractual duration, benchmarking may be necessary to ensure that the service provider is not overcharging in comparison to the charges that would be payable to competitors in the industry. Conducting a benchmarking activity may assist in reducing the charges payable to the company’s existing supplier, although this is dependent on the terms applicable to the benchmarking exercise. For instance does the contract force the supplier to reduce the costs to align with the benchmarker’s finding.
- Waivers: Waivers can be used by the customer to relinquish or reduce service levels or certain onerous provisions which may not be required any longer. In this case, such a reduction could lead to the supplier reducing its fee based on the reduced risk such requirements posed.
- Invoicing: In most cases, you will find a customer will only pay a supplier after 90 to 120 days after receipt of an invoice. The customer could seek to reduce this time period to ensure payment within 30 to 45 days after receipt of the invoice. This may allow for alleviation of any cashflow on the supplier’s side and /or may lead to the supplier passing on some form of commercial benefit such as a reduction or discount on the service fees.
On the other hand, if an unstable economy prevents the company from entering into new contracts with IT suppliers as a means to reduce costs and risk exposure then, instead of suspending the company’s contractual plans and service goals for the financial year or future, the company should firstly conduct a thorough risk assessment, including an evaluation of the company’s financial health, and the solvency, track record and stability of the potential service provider, as well as assessing whether the service is core to the company’s requirements and needs and the risks associated with using such services. Once the company has conducted its risk assessment and selected its preferred service provider, it should consider negotiating flexible contractual terms and low-risk positions throughout its contract to allow for flexibility, including:
- Currency fluctuations: Currency conversions are directly impacted by financially unstable economies. To mitigate this risk, companies should negotiate a fixed currency conversion or a range of currency conversions to ensure stability within the contract, or alternatively, include clauses that make provision for potential currency fluctuations.
- Payment terms: For purposes of ensuring the continued fulfilment of a company’s payment obligations, shorter payment terms, advance payments, interval payments, or better yet, fixed-priced contracts, can be negotiated.
- Service levels and credits: To ensure that the quality of services the company is receiving remains consistent in the face of economic instability, the company will benefit from only negotiating the necessary service levels required for the service and not requesting “nice to haves”.
- Termination clauses: A well-drafted and clear termination clause may provide a legal way out of the contract if the supplier undergoes, or is likely to undergo, an event of insolvency. These termination clauses typically allow a customer to terminate the contract without liability where the supplier is insolvent or may provisionally be insolvent.
- Liability and insurance: Liability clauses are one of the most material legal clauses in a contract as they could serve to expose the company to risk and liability that it would not ordinarily assume under law. The liability provisions should seek to reduce the company’s liability exposure, especially where a claim arises.
- Force majeure: Force majeure clauses protect both contracting parties in the event of unforeseen or unanticipated circumstances that are beyond their control, such as an economic crisis, sanctions and embargos. This clause makes provision for the party experiencing a force majeure from under-performing, or a failure to perform, for a specified period until such time as performance is rendered impossible under the circumstances, thus generally giving rise to termination of the contract or alternative rights (such as step-in rights) being available to the other contracting party.
- Internal alignment: To ensure the successful fulfilment of a company’s contractual obligations, it is critical that the technical, operational, commercial and legal teams of the company are aligned on the company’s strategy. Internal alignment is critical to the success of negotiating a low-risk and flexible contract that accommodates the company’s business requirements and strategy under conditions of economic instability.
- Data security: Data security is a critical issue in IT contracts, and companies should ensure that their contracts impose adequate data security and protection measures regardless of the economic environment.
- Government regulations and compliance: Governments may enact new regulations or policies to accommodate the country’s financial instability. Therefore, your contractual terms must be flexible enough to allow for any changes in law, regulation or policies imposed by the government or regulatory authorities.
- Dispute resolution mechanism: Financial instability may prevent or delay performance under a contract, which increases the likelihood of disputes. Retaining a robust dispute resolution mechanism in the contract is crucial, which could include alternative dispute resolution mechanisms such as amicable settlement, arbitration, mediation, or otherwise court litigation provisions.
While the above considerations may help to mitigate the risks associated with IT contracts in an unstable economy, there is no one size fits all approach and it is more important to consider each transaction on a case-by-case basis. Our TMT law experts have assisted many clients with navigating their existing contractual rights and remedies and drafting new contracts which cater to complex and risky situations.
Executive | Technology, Media and Telecommunications
Senior Associate | Technology, Media and Telecommunications