PROCUREMENT
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| Understanding Contracts - The Basics | |
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Because
contracts are a necessary part of business transactions, (e.g. for use of
consultants or for hardware and software purchase or lease), Information
Technology (IT) managers must understand contract terms, provisions and
implications. This article reviews the general terms of all contracts and
explains terms specific to hardware and software agreements. INTRODUCTION At one time or another, all IT managers have reviewed contracts for hardware and software and may not have understood what they were reading or what they should be looking for. Contracts are a necessary part of business transactions, and all managers are expected to understand their implications (though corporate lawyers are usually available to assist them with the maze of legal jargon.) Negotiating contracts is like any other form of negotiation. IT managers must fully understand the desired objectives as well as the points of contention (and their implications for both parties) that must be addressed as part of the contract negotiations. This article reviews the various contract terms and discusses how to finalize a contract. FUNDAMENTALS OF CONTRACT TERMS The terms that are specifically written in a contract are included not to enable the contracting parties to fulfill the requirements of a typical business relationship but to help the contracting parties settle their differences if the business relationship does not work out as envisioned. Hence, the contract becomes important in times of dispute; therefore, no contract negotiation or agreement should be conducted on the basis of so-called good working relationship. A corollary to this maxim is that the hard-line terms should be negotiated at the beginning of the relationship, not at the end: if a dispute causes the end of the business relationship, neither party will be willing to acquiesce to the other's requirements. Although courts of law can ensure that the contractual terms agreed to by the parties are generally legal (e.g., one party cannot require the other party to do something illegal just because the other party agreed in the contract), the terms that are agreed on by the parties will govern the settlement of differences. Therefore, it is important for contracting parties to include all agreements in the contract rather than imply them during negotiation. For example, many contracts include in their warranty section a statement that "this warranty supercedes all other warranties express or implied." All contracts - for hardware purchase or rental or for software - include some terms to protect each party. In addition, some clauses are included to provide a mechanism to fulfill the requirements of the contract. GENERAL TERMS The preamble identifies the parties in the contract. This clause usually refers to the businesses that are contracting with each other as vendor and buyer (or something similar), which is how they will be referenced in the main body of the contract. This section also provides the addresses for each party and the usual places of business (if different than the address of the contract administration site).Although it is not customary, this section may also identify the principal parties by name if that is relevant to the execution or fulfillment of the contract. For example, in a consulting agreement, it is important for the IT manager to know by name exactly with whom the organization is contracting and therefore who will be doing the actual work.Contractual RelationshipsThis section, which is usually located wither in the beginning or at the end of the contract, identifies the relationship between the two parties. Legally, it is important for the IT manager to define and know whether the relationship with the other party is that of a supplier, consultant, or employee, for example. Such identification usually determines the scope of liability and responsibility for the relationship between the two parties. For example, if the relationship is with a consultant, the IT manager may not be liable in any way but may have to provide the IRS with the appropriate records of earnings for the other party. This is not necessary or relevant if the relationship is with a supplier of services.The GlossaryThis section, usually found in the beginning of the contract, defines the terms as they are used in the body of the contract or if they are not mentioned but are materially important to the execution and fulfillment of the contract. The glossary of terms also defines the condition for acceptance of each term. For example, in a software contract, there should be a definition of the software (e.g., whether it consists of object code only or both object and source code) and a statement of the condition of the software (e.g., "tested to the best ability of the provider"). If these definitions are not acceptable to both parties, they become points of negotiation. DeliverablesThis is the section that is of most importance to IT managers. In this section, the scope of deliverables - such as delivery of goods (i.e., products) or services - is defined. Payment This section describes in detail the price and payment terms and schedules (e.g., monthly payments or payment on submission of invoice). Any additional payment requirements agreed to by the parties are also described here. One key term associated with this section is Acceptance - that is, the date when payment terms begin. AcceptanceAcceptance terms directly relate to what type of product or service (i.e., hardware or software) is being purchased.Term - Duration of the Contract and Renewal ProvisionsThis section defines the life of the contract as agreed on by the parties: whether it is meant to last for a fixed time period (such as in a service agreement), in perpetuity (such as when licensing software) or until the conclusion of the event contracted for (such as delivery of hardware). The parties also agree in this section on the method of renewing the contract and how notification of renewal will be handled.Handling of Modifications to the ContractMany contracts are revised even after they are finalized and signed by the parties. This may be necessary for such simple things as a change of address as well as for contractually important revisions to change the terms of the agreements that were made when the contract was signed.The contract usually provides a section where the parties agree how these modifications will be handled. For example, they agree to send notifications of changes (proposed at this stage) to the other party through certified mail to a specific person. The mailing of the changes cannot be considered acceptance by the other party unless they are countersigned and sent back to the party that proposed the changes. The method of proposing and acceptance would be defined in this section of the contract.Termination ProvisionsThis section does not conflict with the section that defines the normal conclusion of the contract length. Instead, this section defines how one or both parties can find justifiable cause for terminating the agreement before the term that was agreed on. This may result from non fulfillment of contract terms or may even be as a means of convenience for the parties involved.If the termination os due to non fulfillment of contract terms, an elaborate notification process is usually required and defined in this section. The terms of this process are usually referred to as default provisions. If one party defaults on the agreement (e.g., through nonpayment of lease money), the contract terms may define a period of no action. This is generally referred to as the curing period, in which a party is given the opportunity to correct the issue raised by the other party (e.g., it can pay the lease money owed). If the defaulted term is corrected, the parties would agree to continue the contract according to the agreement, and termination provisions would not apply. This section is usually one of the most difficult to negotiate because each party wants to ensure that the other does not terminate the agreement without good reason.This section could also include a special addition stating whether the parties will or will not use a court-generated restraining order during the curing period. A restraining order would prevent the party that initiates the default action from taking any other steps that may be injurious to the other party (e.g., in a lease agreement, repossession of the equipment by lessor).Patent IndemnificationBecause most contracts in IT involve the purchase, lease or licensing of property (i.e., hardware equipment or software), the acquiring party wants some assurance that there are no outstanding claims against the property. These claims could result from infringement of patents, copyrights or other intellectual property rights.This section of a contract provides a mechanism for disposition should it be found later that some other party has a claim on that property. For example, if the software acquired is later found to be copyrighted by another firm, and if that firm chooses to bring action against the organization that acquired the software, a contract provision might specify that the software supplier must defend such a lawsuit and pay all costs incurred (including court and attorney's costs) plus any damages assessed. In the current business climate, where many such lawsuits are filed - for example, Apple corp's lawsuit against Hewlett-Packard and Microsoft for copying the "look and feel" of its products - this type of contract provision is essential to protecting the buyer's interests.Assignment of ContractThis section of the contract allows (or does not allow) either party to assign the contract to a third party. Assignment may be made either with or without the approval of the other party, depending on the contract. This is very common for lease agreements, in which the lessor may assign the contract (and therefore the collection of the lease fees) to a financial institution without affecting any terms of the agreement.This clause becomes crucial, however, if the contract is made with a specific firm for its expertise in the area contracted for. For example, in a contract to buy custom made software, it is important to the buyer who develops the software (presumably, that party is the most competent to develop such software); this contract may restrict assignment to any other firm unless the buyer is given the opportunity to evaluate the new firm's expertise in that area. In that case, the assignment clause of the contract would require that both parties agree to such assignment before it can be executed.Governing LawsThis section would identify the state, province, country, territory or even world court whose laws would govern the terms of agreement. It is not necessary to file in the location where one or both parties do business (and it is often not done). For example, many US lawyers believe that New York laws are much better than those of other states in the defining and handling software agreements. The choice of governing laws becomes important if litigation occurs later. One party could also gain a home field advantage over the other party if it is not located in the same state.This section can also define how the litigation may occur. For example, both parties may agree to try arbitration before initiating legal actions or might even agree that all disputes will be handled through arbitration (or define in the contract the method by which the arbitrator will be chosen) and the method of settlement, including who will pay for the arbitration costs. There is an increasing trend toward arbitration instead of litigation because, in general, arbitration is faster and less expensive.Force MajeureWebster's New Collegiate Dictionary defines the term force majeure as "an event that cannot be reasonably anticipated or controlled". This clause states that some or all contract terms associated with non performance by one or both parties are not affected such events as natural calamities (e.g., flood, fire or earthquake) or other unforeseen events (e.g., war, local disturbances or an employee strike). The terms affected usually pertain to delivery of equipment or service. The importance of this clause depends on the type of contract and the product or service under contract.DamagesThis section of the contract defines how damages for other than indemnified actions will be calculated and assessed against the contracting parties. It can also include liquidated damages for late delivery or installation of hardware or software. For example, if a vendor fails to deliver the contracted software for a specified time period, the buyer could assess liquidated damages, such as additional staffing needed to handle the work load during the period of non performance. Usually, the vendor tries to disclaim responsibility for such damages in its version of the contract (usually in the section addressing the limits of liability).This is another contract section that becomes a major point of negotiation, especially when the scope of damages becomes far greater than expected. For example, use of specific software can lead an organization to a business decision or act that is severely damaging. In that case, the question arises whether the software developer could be sued for actual damages (e.g., lost revenue and expenses incurred) or actual plus consequential damages (such as loss of potential revenue). A court of law or the arbitrators would have to decide the damages, based on the agreement between the parties. In addition, this section may or may not specify punitive damages (i.e., a multiple of the actual damages assessed as punishment against the provider of the product or service.Limits of LiabilityThis section usually defines the limits of liability for the provider of the product or service and bounds the scope of responsibility in the event of settlement of damages assessed by the court or arbitrator. For example, a software vendor selling a software license that was purchased with the express purpose of reselling may want to ensure that it's limit of liability for errors would result only in replacing the original tape (or other media) on which the software was provided and not all copies made for reselling. This is another section of the contract that can be a point of negotiation.UCC Reference (applicable in USA)UCC (Uniform Commercial Code, the set of codes drafted by the National Conference of Commissioners on Uniform State LAws) is generally accepted as the baseline of contractual terms for the sale of goods, governing issues that are not specifically mentioned in the contract. By reference to UCC, the contracting parties can accept these codes as the basis for conducting business. In general, UCC does not apply to software development agreements and services contracts.Other Documents or ExhibitsAs a matter of the normal course of business, it may be necessary to change the description or conditions of the contract. It would be rather tedious and cumbersome if each minor change in the description and conditions outlined in the contract required a formal change to the body of the entire contract. Therefore, the contract could define these changes in a category and include attachments as exhibits that are considered part of the contract - for example - addenda to a lease contract describing leased equipment. Order of PrecedenceThere may be clauses within a contract that appear contradictory in their interpretation. For example, one section of a hardware contract might decline the acceptance of the system as a conditional event, whereas another clause might specify that the term of the lease begin on a fixed date. If it is important to incorporate both clauses in the contract, the contract could specify a predefined order of preference governing which clause would supercede others. This would eliminate confusion and a potential area of conflict.Publicity and ReferenceMost vendors desire that they be allowed to use the contract and the relationship (i.e., the identity of the customer and application) in their publicity or as a reference for future prospects. It is not unusual to find contracts that either specifically address how this would be handled in the future or prohibit the the use of the customer's name or application in its publicity or before using the customer as a reference.This clause becomes especially important when the vendor has been involved in developing or providing a system that the customer could claim as its competitive advantage. In these circumstances, the customer may reserve the right to be notified and give specific permission to the vendor on a case-by-case basis.Especially in a large software contract, it can be important to the vendor or buyer that the terms of the contract remain private. For example, if the contract terms are extremely favorable to one party, it would not be in that party's interest to have other customers find out those terms and demand them as part of their own standard contracts. In these cases, the contract could include a clause specifically prohibiting either party from disclosing the terms to a third party without prior approval. Note: Edited version of the article;Understanding Contracts by Jagdish R. Dalal Auerbach Publishers © 1990 |
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