Dealing With Supplier Contracts
Understanding the Terms and Risks of Agreements
Imagine that you've spent weeks vetting potential materials suppliers, and that you've finally found one that meets your organization's needs.
Your next step is to review the supplier's contract. You know that a fair contract will help you ensure that both parties are satisfied with how the materials will be delivered and paid for.
But you're not a lawyer, and you're nervous about reviewing a legal contract. How do you know what needs to be included? And how can you make sure that the contract is fair?
In this article, we'll look at what contracts are. We'll explain some common legal terminology, and we'll look at why you need to know this. We'll also explore how you can review and negotiate contracts with suppliers.
This article focuses on U.S. and English & Welsh contract law. Research the laws in the area that you're doing business in, especially if your supplier is based in a different country or region.
This article is for general information only. Consult your boss, a lawyer, or a suitably qualified professional before you sign important contracts, particularly if you haven't reviewed contracts before; if the contract is of significant value or key to your business; or if the consequences of getting things wrong could be costly.
To keep things simple, we've focused this article on contracts for the supply of materials. If you're dealing with contracts for products and services, you can use this article as a guide, but bear in mind that there will be some differences.
Purchasing is a business discipline in its own right, and your organization may have a specialist team that manages it. Make sure that you're aware of your organization's purchasing policies before you engage in a supplier selection process. If people with relevant expertise are available in your organization, then seek their help, particularly if the markets or materials concerned are business-critical, or if they are specialized.
Why Contracts Matter
A contract is an agreement between two or more parties. It spells out the terms and conditions of an offer, and, once it's accepted, it shows that the offer (including its terms and conditions) has been converted into a contract.
Contracts can exist between many different kinds of parties and in many different forms – for example, a verbal exchange or an exchange of emails may be enough to make a contract.
Written and agreed contracts are essential when your organization works with suppliers. Contracts state:
- What the supplier will deliver.
- What they need from your organization.
- What will happen if there are problems.
- What each party will pay, under what circumstances.
Contracts also clarify specific terms, such as:
- Details of when and how you or the supplier can terminate the contract.
- Sanctions that either party will suffer if they fail to keep to the agreement.
- Information about after-sale services, such as maintenance, warranties, or technical support.
You can also include details of standards that are important to your organization. For example, you could include a clause to ensure that a supplier follows specific environmental guidelines.
When you agree these details in writing, you avoid confusion, you save time, and you establish clear standards that the supplier must meet. This will strengthen your relationship with the supplier in the long term.
The Elements of a Contract
Contracts are only legally binding when they contain particular elements. These will vary depending on the jurisdiction that you're in. ("Jurisdiction" refers to an area that uses a particular system of law, for example, a state, region, or country.)
If you are representing your organization in contract negotiations, make sure that you're authorized to do this, and also make sure that the value of the contract is within your sign-off limit.
Some of the elements that may (and in some cases have to) be included in a contract are listed in bold below:
- A specific offer states what the supplier agrees to provide. An offer on its own is not a legally binding contract.
- Consideration refers to the exchange of something of value between the two parties. It must be explained in the contract. For example, your organization may agree to pay a firm an agreed price in exchange for four tonnes of timber.
- Acceptance is the other party's agreement to the specific offer made in the contract. Acceptance cannot change the terms of the offer in any way. If terms are changed at any time – for example, if the firm in the example above can only offer three tonnes of timber in the time specified – then they've made a counteroffer. You'll need to negotiate on this, and put it in the proposed contract, before you accept it.
In many jurisdictions, you can accept a contract orally, in writing, or through another action that clearly meets the terms of the contract. Some contracts (for example, those relating to land) need a greater degree of formality.
However, it's always best to agree through a written contract, because it's difficult to prove that an oral agreement exists. For example, if you need to prove that a term was breached, you'll be able to refer to the signed agreement in your dealings with the supplier.
You'll also make things easier for yourself and your colleagues if you have a signed agreement in your records – that way, people know what has been agreed, even if you aren't available.
- Intention of legal consequences (sometimes referred to an intention to create legal relations) means that both parties acknowledge that they are entering into a legally binding agreement. Most of the time in a business context, this is assumed, so the contract does not state it specifically. If the contract is not intended to be legally binding, then it should state this explicitly.
- Legality of purpose refers to the fact that contracts are only legally binding when both parties' obligations are allowed by law. A court will not enforce a contract that involves activity that's illegal in the applicable jurisdiction.
- Non-disclosure relates to confidential information that your organization and the supplier must protect as part of the agreement: for example, a product specification or a manufacturing process. This applies to both parties. If included, you must ensure that the contract specifies exactly what information is confidential, and how your organization and the supplier will protect it.
- Your organization might incur financial loss or a legal challenge because of an act or omission of your supplier. The contract should include a reasonable acceptance of liability clause or, if possible, a right to indemnity. This means that the supplier will compensate your organization for certain losses that occur because of its actions up to defined limits.
Obtaining an indemnity will severely restrict the ability of your supplier to challenge a claim which falls within its scope. (This is usually covered by the supplier's insurance.)
Try to make sure that your compensation includes more than just a refund of the cost of the materials.
For instance, if a supplier's mistake causes your organization a significant loss of revenue, a basic refund won't cover the loss. (Suppliers often specifically limit or exclude this, and this is often a point of contention – make sure that you have, at least, considered it.)
- Law and jurisdiction tells you which state or country's law will apply to the contract, and the courts (or alternative dispute resolution or arbitration procedure) that will decide any dispute. Make sure that these are "respectable," and be aware that it may be difficult to resolve a dispute in an unfamiliar jurisdiction, particularly if proceedings will take place in a foreign language.
When to Get Legal Advice
You may not think that it will always be cost-effective to get legal advice for minor contracts, and you may be right. However, a "minor" contract could have major consequences. Ask yourself the following questions to decide whether you need professional help:
- Do I fully understand all of the terms? Do the terms use legal jargon? Am I comfortable with them?
- Do any of the terms seem unenforceable or unreasonable?
- Do any of the terms contradict one another or "the deal," as you understand it?
- Is this a long-term contract, or are there significant risks within it?
- Does this contract have a major influence on profits or market share? For example, it could be financially devastating to your organization if the supplier is providing material for your organization's most profitable product, and it doesn't deliver these materials on time.
In any of these cases, if you answer "yes," it may be sensible to get legal advice.
It's also wise to get legal advice if you're working with suppliers in different jurisdictions, if it's a new supplier, if the contract is on the supplier terms, if it's a valuable or key contract, or if your contract involves intellectual property rights.
How to Review a Contract
A contract is a two-way agreement, so it's vital that it clearly states your organization's needs, as well as those of the supplier. Review the contract carefully to assess your organization's needs. Specify how you want the supplier to meet these, and ensure that you understand what you are agreeing to.
To do this, work through the steps below:
1. Identify What You Need
Which terms are most important to your organization? Before you start reading the contract, think carefully about what really matters to you, and what you're willing to compromise on. Then make sure that these things are properly covered in the contract.
For example, if it's essential that you have a readily available supply of stock, then you might consider compromising on price to guarantee regular delivery.
2. Understand the Risks
Conduct a Risk Analysis to explore potential problems with the project, and to establish how you and the supplier will address these issues if they occur. For example, what should happen if the supplier is unable to meet a deadline?
3. Analyze Contract Terms
Terms should be clear and defined. This avoids misinterpretation, which can lead to avoidable friction, or to a product not meeting your expectations.
First, look at the wording. Words that are absolute, such as "final," "every," "all," and "none" might refer to a standard that's unreasonably high. It's sensible to use measurable terms instead, such as numbers, dates, or items with agreed definitions.
Next, consider the liability provisions. What will the supplier accept liability for if things go wrong, and up to what amount? Also, what liability does the supplier exclude?
Also, look for wording or phrasing that's vague or imprecise, such as "a reasonable price," or "suitable quality." These terms aren't specific, and they're open to interpretation. Ask to replace these words with measurable or defined terms.
If relevant, make sure that the contract allows your organization to terminate it if the supplier doesn't meet your expectations. For example, your organization might want the right to terminate the agreement if three deliveries are late, or if a certain deadline is missed.
You should also include a general right to end the contract without having to give a reason, within a specified notice period and without liability.
Do not agree to a contract if you're unhappy with the terms, or with the way that a potential supplier is behaving, or if you are pressurized to concede key points without a fair trade-off.
Many contracts will require at least some negotiation. This can take days, weeks, or even months.
When you negotiate with suppliers, don't focus entirely on getting the lowest price (unless, of course, your boss or organization has specifically asked you to focus on cost). Instead, aim to meet the specific needs that you've identified. You may want to create a blueprint of the objectives you must achieve in the contract.
For example, your supplier may charge more when it uses better quality materials, but it may be worth paying for these if they are essential to your business. (See our article on the 10 Cs of Supplier Evaluation for more points that you should consider.)
Aim to get all of your negotiations in writing, including any important verbal discussions. These won't necessarily form part of the contract, but they're useful to have on record if a dispute arises later. It's also helpful to have a note of your discussions as a guide, so that you can refer to this when you negotiate another contract. (An exchange of emails will often be sufficient.)
File these notes with other documentation and correspondence connected to the contract. If there's a dispute later, you'll be able to find relevant information quickly, so that you can resolve the issue in good time.
Be suspicious if the person who you're negotiating with puts you under a lot of pressure for an early acceptance. (He may be interested in booking the contract by a set deadline and earning commission on the deal.) Never accept a contract until you fully understand what's contained in it, and what its consequences are. If in doubt, take advice.
A contract is an agreement between two or more parties that outlines the terms of an offer, and the acceptance of that offer. Contracts are an important part of supplier relationships, because they clarify the details of both sides' responsibilities and rights. They also allocate risk between parties.
Contract law differs widely in different jurisdictions. Research the law in your area to better understand the elements that must be included for a contract to be legally binding.
Get specific further legal advice if you need to, and don't agree to a contract if you're unclear about it, or if you're not comfortable with the supplier.
This article is only intended as a general guide to contractual issues from the perspective of non-lawyers, and it is not a substitute for specific legal advice. You must not rely on this article, and we accept no liability for its contents.