Contracting in turbulent times
It appears as if 2023 could be quite rocky from an economic perspective. In such circumstances, both customers and suppliers of technology and business process related services will be looking at both their existing and proposed contracts, and considering what they might need to do to safeguard their interests. The lessons of the Global Financial Crisis may help us to navigate through some of the possibilities here (as we are already seeing playing out in many of our client engagements)
Just because your contract is already signed and in place does not mean that you are out of options.
From a customer/buyer perspective, the most likely scenario as we proceed through 2023 is that they will be looking to reduce costs. In the ideal world, the pricing methodology for their contract may already provide flexibility for decreases in demand (e.g if it is an outsourcing agreement, the pricing may be based on a unit or transaction based model), but if it does not, then some level of renegotiation may be required. If that is the case, it is worth considering what additional levers may be used:
Change Control Procedure – the contract may contain a formal process for dealing with change. Whilst this may ultimately still require mutual agreement of the changes proposed, there may be obligations or limitations which are of help to the customer (e.g in terms of obliging the service provider to respond to the proposed changes, or imposing pre-agreed rate cards for any effort that may then be required)
Extensions/Renewals – there will likely be value to the service provider in terms of an early extension or renewal of the agreement. If the customer is otherwise happy with the services being provided, bringing the renewal forward in time or extending the existing term may enable the service provider to apply reduced pricing as from now
Termination for Convenience – many contracts for ongoing/long term service provision (such as outsourcing) will contain provisions enabling the customer to bring the contract to an earlier than originally planned end, albeit usually on the basis that the customer will then make some form of payment to the service provider (the quantum of which may be the subject of much negotiation). Even though such an exit will therefore be unlikely to be cost free for the customer, it will likely still be unpalatable for the service provider too, such that the threat of such an exit may be sufficient to entice the service provider back to the negotiation table
Audits – many forms of technology contract will contain audit provisions in favour of the customer. They will often “gather dust” in the sense of not ever being exercised, but they can also serve a useful role in terms of creating bargaining leverage. For example, the threat of an audit may in itself be sufficiently awkward for the service provider (in terms of its likely effort in having to accomodate it) to encourage the service provider to instead offer up some contract or commercial concessions. Alternatively, the audit may go ahead and may then throw up examples of contractual commitments which the service provider has not been living up to, and which the customer can then use as ammunition in subsequent renegotiations
Benchmarking – larger scale outsourcing agreements in particular will often contain formal benchmarking provisions, i.e whereby an independent third party can be engaged to compare the pricing and/or service levels of the service provider with those offered in the market by comparable suppliers and for comparable services. Key in such contracts is the question of what happens if the benchmarker concludes that the pricing of the service provider is not in line with the required threshold (which may variously have been agreed as being the mean price in the comparison group, the median price or potentially such price as would place the service provider in the upper quartile). From a customer perspective, the preferred position would be that the service provider is simply then obliged to reduce its charges accordingly, but service providers will usually negotiate to seek to water down such provisions so as to simply trigger a “commercial discussion” as to what happens next
Relaxing Contractual Requirements – another tool available to the customer is a relaxation of some of the existing contract requirements. For example, if the customer is willing to reduce some of the contractually committed service levels or lower the limits of liability, this reduces the overall risk exposure of the service provider, and as such may result in the removal of an element of risk premium applied previously to its pricing
Optimizing Scope – are ALL of the services really required? There may be some functions or activities which can be done without or truncated, or some inflight projects which can be closed down or mothballed
Commercial Adjustments – some of the financial terms agreed with the service provider previously may be amenable to change in a way that would bring a benefit to the service provider and in turn enable it to pass some measure of commercial benefit back in turn to the customer. An obvious example would be time for payment of invoices; we have seen some customers push for payment periods as long as 120 days, but clearly there would be cashflow advantages for the service provider if the customer was actually capable of paying in a shorter period (say within 30 days), and then committed to do so
The parties to technology contracts must also take into account the likely challenges when finalising any new contracts which they may look to enter into during 2023.
A lot of negotiation will inevitably focus upon pure cost, and as an adjunct to that will be a focus upon the treatment of inflation. We have been fortunate that for quite a long time, inflation has not really been much of contentious topic when it comes to technology contracts. However, with inflation rates running at levels not seen in Europe for a long time and with much uncertainty as to how soon they may start coming down (if indeed they do at all), attention has been focussed on the associated contract provisions to deal with this.
Fewer service providers are now willing or able to simply take on the inflation related risk and include it within their pricing, at least for multi year arrangements. Instead, negotiations look to focus on:
(a) whether there is a minimum threshold of inflation that the service provider or customer will bear in the first instance
(b) whether there is any maximum cap on the inflationary increases that can be passed on to the customer
(c) which inflationary indices to use in the first place
(d) which aspects of the overall costs the inflationary calculations should be applied to
Both customers and service providers are also increasingly wary of the potential for the other party to suffer some form of financial distress, leading up to or even including actual insolvency. From a customer perspective, having a right to terminate the contract in the event of a service provider insolvency is of very little comfort; at that point in time, the disruption will be inevitable. Instead, the customer may look for anticipatory protection, e.g by requiring regular reporting by the service provider as to its financial position, deferring payments by reference to actual progress made, and by seeking parental guarantees in relation to arrangements entered into by susidiaries/affiliates. We also now increasingly see termination rights tied to “financial distress” triggers which fall short of actual insolvency (with the logic being that this allows the customer to be “the first out of the door” and to ensure the cooperation of the service provider with such exit whilst it still has the means to provide it).
Service providers obviously also have concerns of their own in this regard, not the least being what will happen vis a vis their investments and yet to be paid fees in the event that a customer entity were to go bust. As a result, we find service providers being less willing to agree lengthy periods for invoice payments and/or requiring more upfront payments (eg as opposed to being willing to amortise costs over multiple years of a longer contract term), and in some cases also requiring parent company guarantees and/or payment of some amounts “on account” (potentially to be held in escrow accounts).
All in all and to quote the well known Chinese proverb, we are living in interesting times and no doubt the contracting process for technology and outsourcing contracts will continue to develop and adapt as we navigate our way through them.