CSCMP's Supply Chain Quarterly
Procurement
March 23, 2019
Procurement

Legally sound procurement: how to add legal value to the purchase of goods and services

Comment
A simple but revolutionary change in the process of negotiating procurement contracts can dramatically improve a buyer's position. Getting legal experts involved right from the beginning saves time, allows for a better assessment of proposals, and may lead to more favorable contract terms. Above all, it ensures fully informed decisions.

In the 2017 film Darkest Hour, Winston Churchill scolds his war council, whose advice was to seek peace with Hitler, by saying, "You cannot reason with a tiger when your head is in its mouth.While the procurement process may not be as dangerous as World War II, pressing a supplier on contractual terms after the winning bid has already been accepted puts procurement managers in a risky position similar to the one Churchill described. As the U.K. prime minister knew, that approach rarely turns out satisfactorily.

Procurement managers typically assess suppliers and then select a winning bid based on the commercial and technical terms they offer. Only then, after this main stage of the negotiation has been completed, do the purchaser and the supplier discuss the contract. At this point, lawyers frequently have little time to negotiate the contract, because the purchase must be completed quickly, and the chosen supplier has no incentive to be accommodating. The contract negotiations can drag on for months, causing the procurement organization to lose sight of the business goal. In urgent cases, it can compel the parties to execute the purchase even though an agreement has not yet been formalized.

Article Figures
Example of the assessment matrix
Example of the assessment matrix Enlarge this image
Traditional procurement process vs. legally sound procurement process
Traditional procurement process vs. legally sound procurement process Enlarge this image

For the purchaser, leaving contract negotiations to the end is a strategic mistake because it goes from negotiating from a position of strength to negotiating from a position of weakness. Even worse, in the absence of an alternative to the traditional process, procurement professionals might decide to bypass the lawyers' intervention and seek an agreement on a purely "commercial" level. (Which is, of course, nonsense, because no contractual agreement can be purely "commercial," as opposed to "legal.") Accordingly, this kind of "corner cutting" and "avoidance of the law" generates only risks and uncertainty.

To prevent this situation from occurring, procurement managers can turn to an important but often overlooked ally: their company's legal advisors. In procurement, lawyers traditionally have been relegated to converting the outcome of a commercial and technical negotiation into contractual clauses. However, they can do much more, including (to continue the Churchill analogy) playing a major role in keeping the procurement department's head out of suppliers' mouths. Nonetheless, procurement managers often limit lawyers' involvement, either because they consider the lawyers to be insufficiently business-focused, or because they are unaware of the valuable contributions that lawyers can bring to the negotiating process.

The "legally sound procurement" (LSP) protocol proposed in this article consists of a new method that incorporates legal strategies, considerations, and tools into the process of negotiating with potential suppliers and assessing their proposals. This new approach could revolutionize the procurement process, saving time, enabling a better assessment of proposals, and possibly leading to more favorable contract terms. Above all, it ensures the purchasing company will make fully informed decisions.

Preservation of the buyer's advantage

A company in the procurement phase normally is in an extraordinarily advantageous position. It is approaching a competitive marketplace and seeking to choose the supplier that best suits its needs. Competition among potential suppliers is the key to a successful purchase. Buyers can take advantage of the fact that if, as popular wisdom says, "the client is always right," suppliers will treat a potential client with even more deference. Offerors will race to propose better conditions than their competitors and to please the future customer that has not yet made up its mind.

The cornerstone of the procurement process must therefore be the preservation of competition among potential suppliers in every aspect of a negotiation. Purchasers do follow this principle to a certain extent, as nobody would first choose a supplier on purely technical grounds and then start the commercial negotiation afterwards. Purchasing companies know that once the supplier understands it has been awarded the purchase, it will have no incentive to allow discounts on the price. Suppliers therefore have traditionally been selected on both commercial and technical grounds. Doing so, however, leaves out one critical piece: contract negotiations. Once the business has been awarded on the basis of those two factors, the supplier has no incentive to be flexible in the negotiation of the contract itself;thus,this approach cannot be the correct way to proceed.

Our legally sound procurement protocol instead calls for a different approach for establishing the legal terms of the procurement contract. It seeks to foster competition among potential suppliers on all three pillars of the proposal—economic, technical, and legal. This approach will not only lead to better contractual terms and conditions but also can reveal useful information for evaluating and understanding the economic and technical aspects of the award. Early knowledge of the contents of the contract before a winning supplier is chosen also allows the buyer to make a fully informed decision.

Indeed, contractual terms, far from being simply a formality, may alter the economic equilibrium of the deal and may even modify the technical evaluation. The length of the warranty period, for example, changes the assessment of the price being proposed. If, for the same price, one potential supplier offers a three-year warranty, and the second potential supplier offers only a one-year warranty, the second offeror isactuallycharging more because it is offering less in terms of service. Likewise, the scope of liability may change the technical assessment. If one potential supplier offers to accept liability for direct and indirect damages, while the second potential supplier offers liability for direct damages only, it may be that the latter is not as sure as the former about the quality of its products.

These are two very basic examples, but they serve to explain the underlying idea. In fact, there are many contractual terms that may have an immediate economic and technical impact on the deal that are often overlooked during the core negotiation process. These include: clauses governing termination for convenience (the right to unilaterally terminate the contract for any reason or no reason at all), performance indicators and penalty clauses, insurance, confidentiality, assignment (the transfer of rights and obligations, or of the contract itself, from one of the parties to a third party), applicable law, and dispute resolution.

The value of awareness

In some cases, even though they are competing for business, potential suppliers may not be willing to offer better contractual terms than their competitors, or they may simply be unable to do so. This does not mean, however, that the LSP protocol will not be useful. In fact, LSP always provides something else that is important during every procurement negotiation: awareness. Because LSP requires a potential supplier to specify not only the technical and commercial details but also the terms of the contract that it would be willing to sign, this approach at least guarantees that the procurement department is fully aware of all aspects of each proposal. This reduces the chance that the purchaser will be surprised by the final contract terms.

This kind of awareness is even more valuable than the other benefits discussed so far. Would a reasonable businessperson sign a contract without reading it? Strange as it may seem, something like this happens when a deal is struck based on only commercial and technical grounds, postponing the determination of contractual terms. In such cases, the direction that the contract negotiation will take is unpredictable, and the exact content of the agreement is unknown at the time that the parties decide to sign it.

LSP in practice

Once everyone understands why the LSP approach is desirable, it is time to put it into practice. The first thing needed is a reliable, well-reasoned, repeatedly tested model of the contract for the intended purchase. Standard models (or templates) are by no means sufficient; each company has its own particular needs, strengths, and weaknesses, and the legal advisor has to take all of them into account, tailoring the contract to the client like a custom-made suit (or—even better given the contract's protective function—a suit of armor).

The lawyers must draft the model in collaboration with the procurement department and the "internal client" department that wants to purchase theproduct or service. To be most effective, the lawyers should gointo the field to understand, to the best of their ability, the internal client's requirements asdescribed in the technical documentation, or even to cooperate in drafting that documentation. Even if they do not have technical expertise, legal professionals can be helpful in drafting technical documentation becausethese documents often regulate some aspects of the relationship between the parties, and these are "contractual contents" in their own right. In these cases, the guidance of a professional with experience in contract drafting can be valuable.

For example, a technician may understand enough to write in the technical specification "maintenance corridors are needed and included in the scope of the purchase." A lawyer, to prevent conflicts, would then recommend specifying how many corridors, where they have to be placed, what material they have to be made of, and so on. The lawyer's detailed study is useful not only because it ensureshigher-quality technical documentation but also because it allows the lawyer to draft a contract that reflects the particulars of the product or service and ensures that the buyer's specific requirements will be met.

Once the model contract is ready, the buying company provides it to potential suppliers and informs them that it will serve as the basis of any future transactions between them. Suppliers may, and will, of course,propose amendments to the model. But the party making the investment has every right to maintain maximum control over the deal; in other words, the one "who pays the piper calls the tune." Suppliers therefore ought to be reminded that in addition to the traditional criteria, they will also be awarded the purchase on the grounds of the contract they are ready to sign.

Proposals to amend the model should be subjected to a preliminary examination by both the procurement managers and the lawyers, so that the latter can advise the former on the potential impact of any proposed amendments. Amendments that are utterly unacceptable may be brought to the attention of the supplier, thereby granting the supplier the chance to change its mind.

To sum up, with LSP there are two stages or cycles of communication about the contract terms between the buyer and potential suppliers:

  • Stage 1. The buyer sends the model contract to potential suppliers, who then submit proposed amendments. The buyer reviews the proposals and informs suppliers of any that are unacceptable (and therefore will eliminate them from consideration).
  • Stage 2. After considering the buyer's comments, the potential suppliers submit revised proposed amendments. The buyer reviews them and makes a final decision to award the contract.

This procedure is nothing like traditional contract negotiations. Examining the proposals of a handful of potential suppliers only twice is much less work than sending a draft back and forth between the chosen supplier and the buyer, again and again, as typically happens. The working environment is also much different. For example, the traditional process often is very stressful because once selected, the supplier is unwilling to be flexible during the subsequent contract negotiations. Meanwhile, internal clients often do not understand why the procurement department is "wasting time" on a formality like the contract when the price has been agreed upon and the product is satisfactory from a technical standpoint. When the LSP protocol is followed, stress is reduced because the contract terms are agreed on before the supplier is chosen and there is no long, drawn-out negotiation.

Once all of the required information from the potential suppliers have been gathered, it is time for what can be referred to as a "360-degree" assessment of the offers; that is, the assessment is based on all three considerations: technical, commercial, and legal. The legal advisor should provide the negotiation team with the necessary information to understand the practical effects of the legal terms. Negotiators need to understand how each supplier's proposal is different from the company'smodel andhow each proposal is different from the others. To make it clear, a simple report in the form of a table would be prepared for each potential supplier's offer.

In the first column, there could be anindication of the amended article, and in the second column, there could be a description of each amendment.In the third column, the risks associated with each amendment would be assigned a severity level according to an agreed-upon scale (for example, from 1 to 4 or from red to green). These risks would then be described in the fourth column. The last columnwould indicate how commonly the proposed amendment appears within the proposals being considered. (This last column would be filled in after comparing all of the proposals.) Figure 1 provides an example of the proposed table.

The first and second columns of the report help to explain how far from the optimum, which is represented by the company's model contract, each offeror is and to compare offerors on a "quantitative" basis; that is, the number and type of amendments. The third column is the core of the assessment, whichallowsusers to appreciatehow risky each offer is, taking into consideration both the probability of and the potential harm from a risk event. Judging the offers on the basis of the third and fourth columns provides a "qualitative" comparison of them. Both the quantitative and qualitative aspects should be considered together in order to gain a complete picture.

In addition to facilitating a comparison of offerors' proposals, this kind of report can provide feedback to the drafters of the model. For example, looking at the fourth ("risk") and last ("recurrence") columns, if a certain risk appears in every proposal, then that risk is probably intrinsic to the operation. Thus, it should be managed differently than simply insisting on the model clause, with ad hoc insurance, for example.

Here is another example involving the "recurrence" column. If a term is unanimously refused or framed differently, it is probably because of a certain feature of the suppliers' industry or trade sector. Insisting on the original formulation of the clause to maximize protection for the buyer does not make any sense in such cases and risks hindering the company's activity. Suppliers usually have more expertise in regard to their own products and services than purchasers do. As both examples suggest, "purchasing" lawyers ought to be humble and smart and learn from the suppliers' proposals, using them to bend the contract model to their company's benefit rather than inflexibly insisting on their initial ideas.

Based on the information in the tables, the final step in the evaluation of the contract proposals is to issue an overall judgment, in the form of a ranking, for each proposal. This analysis will allow the negotiators to easily assess the legal aspects of the offers and compare them, together with the technical and commercial elements, against each other. However, between the previous matrix and this last assessment,a more sophisticated analysis may be needed, for example, an ad hoc comparison table for a particular clause.

The final decision may be preceded by a last attempt to finalize the contract. If only a single clause separates an offeror from being awarded the contract, the procurement department may insist on changing it. It is very likely that the offeror will grant this last modification. To be sure that the potential supplier, once it is about to become the true supplier, does not try to renegotiate the terms, one can adopt a juridical formula (there are many solutions, some universal, others peculiar to different jurisdictions) to bind the offeror to its proposal. In any case, once the decision has been made, all that remains to do is sign the contract and uncork a celebratory bottle.

Why LSP is better

The adoption of a legally sound procurement protocol leads to many changes within a company. It is one way, but not the only way, to transform the legal department from a supporting function (that is, a cost) to a producer of economic value for a company. For the procurement department, the LSP approach represents a change in philosophy and culture, because it introduces a focus on planning rather than on managing emergencies—a change that produces further economic benefits.

It is worthwhile mentioning again the main benefits of adopting the legally sound procurement approach. First, it reduces the tension that arises during traditional contract negotiations after the supplier has been chosen and has no incentive to be flexible and the buyer is running out of time for the purchase. In other words, it allows the company to avoid a common trap: being forced to accept an unsatisfactory contract because the chosen supplier has no intention of accepting the contractual terms and it is unfeasible to start over and choose another supplier. Second, because LSP awards contracts only to suppliers that have agreed to mutually acceptable contract terms, it incentivizes them to offer better legal terms. Third, LSP gives buyers control over the timing and length of negotiations. Fourth, as shown in Figure 2, it accelerates the procurement process to such a degree that the actual signing of the contract becomes a formality, requiring only time for signatures.

All of these advantages outweigh the drawback of having to conduct two rounds of review and revisions to multiple proposed contracts. In fact, LSP negotiations are easier than negotiating with a single supplier that has a monopolist, "take it or leave it" mindset after it has been selected. LSP does not generate more work than the traditional process, which may involve dozens of revisions during an unpredictably long time frame. In addition, the effort required to negotiate and finalize a contract at the last minute—a situation that LSP eliminates—is by no means negligible. In any case, the amount of work required would be known in advance. This kind of control and awareness is the greatest and most indisputable benefit of adopting LSP—a process that allows for a 360-degree decision and ultimately makes the purchasing company the full owner of its destiny.

Vincenzo Viglione, LL.M. is an avvocato (Italian qualified lawyer) and a legal advisor in the procurement department of Acciai Speciali Terni S.P.A., a manufacuturer of flat-rolled stainless steel products.

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