CHAPTER

5

Contracts

If you are an experienced buyer, then you must know the importance of the legal implications and terminologies for different types of contracts. The importance of contracts grows when such agreements or contracts are drawn up with international suppliers or contractors. It is the duty of the buyer to protect their own organization from unforeseen legal risks.

5.1 Difference Between an Agreement and a Contract

It is important for every buyer to understand the difference between an agreement and a contract. The very basic difference is that contracts are enforceable in the court of law, which means, in case of default by any of the parties, they are to be answerable in a legal trial, which further can lead to penalties, imprisonment, or both.

The world can be divided into two legal codes:

a)Civil law code: Decisions based on civil code are dependent on a compendium (which can be understood as a kind of encyclopedia), which has written defaults and decisions against each type of default.

b)Common law code: Common law code decisions are based on arguments, circumstances under which default has happened, and other unique situations. The decision of the judge is based on the trial hearing and/or earlier decisions given under similar cases.

From above, it is clear that lawyers are considered more important in common code law-based countries compared to civil code law-based countries.

Why it is important for buyers to know which country follows what type of legal code? The answer is simple: The buyer must know the risks before entering into or agreeing on a different law. For example, India is a common code law-based country, whereas countries in the Middle East are civil code based. In case buyers have limited knowledge of legal codes, it is always desirable to agree upon neutral country laws (i.e., third-country laws can be understood as laws that are neither from the buyer's country nor the seller's country). For example, if a contract is to be agreed upon between an Indian buyer and German seller, both may agree to Swiss laws (as they are considered neutral) as the applicable country for jurisdiction. Otherwise, it is desirable to have contracts agreed upon with countries having similar legal codes.

5.2 Elements of Contracts

Although there can be several opinions on elements of contracts, we shall discuss only the very pertinent ones. The important elements of contracts are:

• Offer and acceptance
• Obligations and consideration

5.3 Types of Contracts

It is of immense importance for any project buyer to know the available contract types that can be agreed upon with the subcontractor. For example, if company A is the project owner and has awarded the contract on a turnkey¹ basis (meaning from design phase to engineering, procurement, and construction projects, where the awarding organization will not participate in the completion of projects in a direct or indirect way), then contracted company B has to offload the contract in the best possible manner so that project profit margins can be enhanced due to subcontracted savings. The strategic buying team will have to decide the methodology for offloading the contracted works, either on a back-to-back basis (i.e., turnkey), a cost-reimbursable basis, and/or a mix of both, considering the potential risks by employing any particular type of contract. Therefore, the project buyer should know the following types of contracts:

• Fixed-price contracts
• Cost-reimbursable contracts
• Time and material contracts

5.3.1 Fixed-Price Contracts

This type of contract involves setting fixed prices for products, services, or results provided. Fixed-price contracts are beneficial for the buyer, as liability does not increase during the execution of work since the price is already fixed for the services, results, or product provided. However, such contracts can have incentive provisions for exceeding the contracted results. Sellers are at financial risk to complete the contracted work, and to meet the contracted requirements on time and within cost and scope. The fixed-price contracts can have the following subtypes:

• Firm fixed-price contracts
• Fixed-price incentive fee contracts
• Fixed-price with economic price adjustments

5.3.2 Cost-Reimbursable Contracts

It is helpful to understand why sellers and buyers agree to cost-reimbursable contract types. The reason is simple; whenever scope or quantity of work is not clear, it is always advised to have cost-reimbursable contracts. Let us take a simple example. The project owner of company A has awarded work on a turnkey basis to an EPC (engineering, procurement, and construction), company B, to build a power plant. The EPC company has awarded the contract to different manufacturing companies for:

• Supply of turbines from the original equipment manufacturer (OEM),
• Civil works for installation of the turbine to another civil contractor, and
• Supervision services from the OEM required during installation of turbines.

In the above scenario, the number of supervision days cannot be estimated in advance, as the installation of turbines will depend on the contractor who is installing the turbine in the turbine-hall building. Therefore, while awarding supervision of works to the OEM, it is necessary to award such contracts on a man-day charges basis. It is important to understand why any EPC company requires supervision from the OEM. The reason is simple: In order keep the warranty terms intact, it is necessary to install the equipment in the presence of the OEM's supervisor to avoid any warranty issues. (However, there might be supply contracts which may insist on getting the equipment installed by the OEM only.)

This category of contracts is based on actual costs incurred plus the profit margin to the service provider. These types of contracts are beneficial for the buyer and seller, and are considered to be a fair arrangement, as the cost will always remain on an actual basis. Hence, such contracts are clear for both sides; however, such contracts are not favorable contracts for turnkey arrangements, as costs are always uncertain and may exceed due to any unavoidable delays. Now, think of a situation where the buyer has agreed to a turnkey arrangement with the customer, and offloads the contracts on a cost-reimbursable basis to the contractor. Then, chances are high for financial cost increases or fluctuations during the execution of works. These categories of contracts further have three subtypes, as follows:

• Cost plus fixed fee
• Cost plus incentive fee
• Cost plus award fee

5.3.3 Time and Material Contracts

Time and material contracts are a hybrid type of contractual arrangement that contain both the aspects of fixed-fee and cost-reimbursable contracts. They are often used for staff augmentation, acquisition of experts, and any outside support when a precise statement of work cannot be quickly prescribed. These types of contracts resemble cost-reimbursable contracts, as they can be left open-ended and may be left open for cost increases by the buyer. The buyer can leave the full value of the contract and quantity undefined at the time of the contract. Hence, time and material contracts can increase in contract value as if they are cost-reimbursable contracts. Many organizations require value and time limits placed in time and material contracts to prevent unlimited cost growth. Therefore, time and material contracts are fixed-unit price contracts when certain parameters are specified in contracts. To understand time and material contracts better, let us take an example of contracts that are based on price variations with time. For example, an organization would like to take EHV (extra high voltage) cables, where the price of copper will vary with time. So, the buying and selling organization will agree on the current prices in the market and drive the unit price applicable as on date. These organizations will utilize the price variation formula, which will decide the unit price at any future time for the copper cables.

5.4 Important Contract Terms and Conditions

Although every written word in the contract is of great importance for the execution of work, knowing the critical terms and conditions will make life easier for the project buyer, especially in a situation where the buyer is handling more than one project. Buyers discuss terms and conditions with their suppliers day in and day out, so they have to be aware.

Contractual terms and conditions are important for the customer as well as the contractor organization.

5.4.1 Termination Clause

Why is a termination clause important? Because disputes may arise in the absence of one. Contract termination can occur in two possible ways:

a)Termination by convenience: Termination of contract with convenience is agreeable to both the parties; reasons for termination may include project cancellation, end customer issues, because of a statutory issue, or any other issue where both the involved parties agree to come out of the contract.

b)Termination of contract because of nonperformance by one party: Termination of contract can be because of nonperformance of any member of the party against the agreed upon contractual terms. Such termination is always followed by a termination schedule, which will be time based.

The following is an example of what a standard termination clause may look like:

The customer (purchaser) shall be entitled to terminate this agreement by giving three-months’ notice to the supplier in that behalf, without assigning any reason. All the obligations undertaken prior to such termination shall survive. After receipt of such a notice, the supplier shall not process the said products and forthwith hand over all the machines/tools/drawings, etc., which are in the supplier's custody, along with the product processed by the supplier and remaining in the supplier's custody.

5.4.2 Payment Terms

We need to consider engineering milestones of the works, while agreeing to the payment terms. To understand this scenario, let's consider the following situation: End customer A has awarded the contract for building the complete electric substation to EPC contractor B, and B has offloaded the works for the supply of transformers to the manufacturing company, while installation goes to a third-party contractor. Therefore, party B has to take care of their payment from A before awarding the contract to party C.

5.4.3 Defects Liability Clause

A defects liability clause should be understood as a measure in the event that defects are found in the goods and/or services provided by the selling organization. The defects liability clause covers any risks related to supplied goods and/or services for a specified period of time.

Since products manufactured by organizations are specialized products for which these selling organizations have resources to upkeep such products, the buying organizations bind the selling organization for a period of time in which the selling organization will keep the product working for the agreed upon defects liability period without any cost, expense, and risks for the buying organization.

Standard defects liability clauses are discussed in the following sections.

5.4.4 Law of the Land

As discussed earlier in this chapter, the world can be divided into two legal codes. Ones that are based on civil law, and others that are based on common law. Countries that were ruled by the United Kingdom are common law. In common law, decisions of the court are based on decisions taken earlier in similar matters, where judges can refer to precedence to pass judgment on issues, whereas civil law-based countries refer to written decisions by categorizing the disputes and passing judgment based on a written law encyclopedia. Therefore, it becomes of immense importance that buying and selling organizations agree to the law of the land applicable in contracts for sale, which will become mandatory to refer to in case disputes arise. During the execution of contracts, the agreed upon law of the land will prevail.

The following is an example of what a standard law of the land clause may look like:

All sums payable by the customer (purchaser) to the supplier, or by the supplier to the purchaser under this order shall be due and payable at the customer's office. This purchase order shall be governed by and construed in accordance with the laws of India.

5.4.5 Dispute Resolution and Arbitration Clause

An arbitration clause is important because this is the resolution taken prior to approaching a court of law to settle a dispute between the seller and buyer. However, if an arbitration decision is not acceptable to either party (i.e., the seller or the buyer), then the parties have a right to move to a court of law. This process will avoid high litigation costs and valuable time.

The following is an example of what a standard arbitration clause may look like:

All disputes arising out of or in accordance with this contract, including any question regarding its existence, validity, or termination, shall, unless amicably settled between the parties, be finally settled by arbitration. The parties shall mutually appoint a sole arbitrator who shall be a person who must have held an office of a judge in any court of law. Notwithstanding to what is stated above, if the parties cannot mutually agree upon an arbitrator within 4 (four) weeks, then the customer shall appoint a sole arbitrator who has held the office of a judge in any court of law.

Each party submits to the jurisdiction of the court of law for the purposes only of compelling compliance with the above arbitration provisions and for enforcement of any arbitration award made in accordance with the above provisions.

5.4.6 Time for Completion

This clause sets the time for delivery of obligations and/or services under the contract. This is a reference clause for having liquidated damages agreed upon (discussed in the next section). Milestone dates, as well as completion dates, can become part of time for completion.

Under civil law, the customer will not be entitled to liquidated damages if the customer has prevented the contractor from completing the works within the agreed-upon date. Hence, at large, time for completion is purely an approach for common law-based contracts, as it will not fit into civil law, where time extension is usually not a considered claim.

5.4.7 Liquidated Damages

Liquidated damages are compensation for the delays caused by the seller in delivering the goods and/or services within the time for completion. The delay damages are considered a genuine, pre-estimated lump sum for failure to comply with time for completion. Delay damages should not be confused with penalties, as penalties are fixed and do not have any basis for losses due to deliverable delays. In common law court, contracts with an agreed upon penalty clause in the sales contract will not stand, as the penalty is already agreed upon between the selling and buying organizations. Therefore, such sales contracts require no discussion, whereas liquidated damages need to be established and proved in the court of law by the buyer. When liquidated damages are established and proved in the court of law, they need to be borne by the seller.

The following is what a standard liquidated damages clause may look like:

Delivery time is the essence of this contract and must be strictly adhered to. If the supplier fails to deliver the goods in time, the customer (purchaser) may, at its sole discretion:

a)Treat the order as canceled at any time and recover any loss or damage from the supplier; or

b)Purchase the goods ordered or any part thereof from other sources on the supplier's account, in which case, the supplier shall be liable to pay the purchaser not only the difference between the price at which such goods have been actually purchased and the price calculated at the rate set out in this order, but also any other loss or damage the customer may suffer; or

c)Accept the late delivery, subject to deduction in payment of 1% of the total contract price for every week or part thereof of the delay, toward liquidated damages, subject to a maximum deduction of 10% of the contract price.

For the purpose of establishing the timeliness for deliveries involving installation, commissioning, or recertification services, the relevant point in time shall be the date of acceptance.

5.4.8 Force Majeure

A force majeure clause voids all the agreement terms especially related to time for completion, as force majeure should be understood as abnormal conditions during which the seller or buyer fails to comply with the agreed-upon terms and conditions under the contract of sale.

The following is what a standard force majeure clause may look like:

The customer (purchaser) shall be under no liability for failure to accept the deliveries of goods, if such acts of failure are due to any act of God, fire, earthquake, floods, or any natural calamities or transportation embargoes, civil commotion, riots, violent acts of terrorists, state enemies, or any other similar reasons or circumstances beyond the control of the customer.

Such occurrence shall be informed in writing by the supplier.

5.4.9 Subcontracting

Major issues in the contractual agreement are related to product quality or workmanship of the works executed by the supplier. To avoid any use of contaminated services and/or goods, buying organizations have an exhaustive contractor qualification process where they audit the contractor's works for the existing product manufacturing and quality processes followed by the selling organization. On the other hand, it is impossible in projects that the single-selling organization can execute the complete works themselves; and hence, they offload partial or complete works. Such offloading will jeopardize the supplier qualification process and the customer may have issues during project executions. Hence, it is important to bind the seller contractually so that they may not be offloading the works. And in case they have to offload, they should receive prior approval from the customer, where the customer has the right to audit the subcontractor also.

The following is what a standard subcontractor clause may look like:

Subcontracting to third parties shall not take place without the prior written consent of the customer (purchaser) and therefore, entitles the customer to cancel the contract in whole or in part and claim damages.

5.4.10 Code of Conduct

The code of conduct clause is of immense importance, as it binds the selling organization to their behavior during the pre-award, execution, and warranty period under the sales contract. Such a clause will cover topics related to binding under the labor laws, bribery, and prohibition of child labor.

The following is an example of what a standard code of conduct clause may look like:

This code of conduct defines the basic requirements placed on the customer's suppliers of goods and services concerning their responsibilities to their stakeholders and the environment. The customer reserves the right to reasonably change the requirements of this code of conduct due to changes of the customer compliance program. In such an event, the customer expects the supplier to accept such reasonable changes.

The supplier declares herewith:

• Legal compliance

• To comply with the laws of the applicable legal system(s).

• Prohibition of corruption and bribery

• To tolerate no form of, and not engage in, any type of corruption or bribery, including any payment or other form of benefit conferred upon any government official for the purpose of influencing decision making in violation of law.

• Respect for the basic human rights of employees

• To promote equal opportunities for, and treatment of, its employees irrespective of skin color, race, nationality, social background, disabilities, sexual orientation, political or religious conviction, sex, or age;
• To respect the personal dignity, privacy, and rights of each individual;
• To refuse to employ or make anyone work against their will;
• To refuse to tolerate any unacceptable treatment of employees, such as mental cruelty, sexual harassment, or discrimination;
• To prohibit behavior including gestures, language, and physical contact that is sexual, coercive, threatening, abusive, or exploitative;
• To provide fair remuneration and to guarantee the applicable national statutory minimum wage;
• To comply with the maximum number of working hours laid down in the applicable laws; and
• To recognize, as far as legally possible, the right of free association of employees and to neither favor nor discriminate against members of employee organizations or trade unions.

• Prohibition of child labor

• To employ no workers under the age of 15 or, in those countries subject to the developing country exception of the ILO Convention 138, to employ no workers under the age of 14.

• Health and safety of employees

• To take responsibility for the health and safety of its employees;
• To control hazards and take the best reasonably possible precautionary measures against accidents and occupational diseases;
• To provide training and ensure that employees are educated in health and safety issues; and
• To set up or use a reasonable occupational health and safety management system.

• Environmental protection

• To act in accordance with the applicable statutory and international standards regarding environmental protection;
• To minimize environmental pollution and make continuous improvements in environmental protection; and
• To set up or use a reasonable environmental management system.

• Supply chain

• To use reasonable efforts to promote among its supplier's compliance with this code of conduct; and
• To comply with the principles of nondiscrimination with regard to supplier selection and treatment.

5.4.11 Order Acknowledgment

Once the seller and buyer agree on the contract terms and conditions, including obligations and consideration for each party under the contract, then it is important to agree upon and acknowledge the sales contract in writing by both parties.

The following is an example of what a standard order acknowledgment clause may look like:

The customer may cancel the order if the supplier has not confirmed acceptance of the order (confirmation) in writing within (2) two weeks of receipt of the purchase order. If the terms of the confirmation vary from the terms of the order, the purchaser is bound by the general terms and conditions of the supplier only to the extent that these are in accordance with the purchaser's own general terms and conditions or if the customer (purchaser) agrees to such in writing. The acceptance of deliveries or services, as well as payment, does not constitute such agreement.

Any amendments or additions to the order shall only be effective if the customer (purchaser) confirms in writing.

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1 Turnkey refers to complete works, which may include but are not limited to design, engineering, supply, installation, testing, and commissioning of materials at project sites.