Recently our partners at Thomson Reuters arranged for me to publish an article in the ACC Arizona Chapter Newsletter on renegotiating and managing contracts when markets turn sour.  Well, things haven’t gotten much better since then and I thought it would be useful to share some of the advice with you.

Unfortunately it is now commonplace for companies to find themselves in a bind with regard to performing their obligations under a contract with a vendor, customer or other business partner. For example, a company may have agreed to sell raw materials to a customer over a two-year period at a fixed price only to find that the deal suddenly became unprofitable because of an unforeseen rise in the company’s costs of procuring the raw materials that it was obligated to sell.  At that point the company can continue to try and perform under the contract, and risk significant financial damage to its business, or can simply cease deliveries and hope for the best when the customer begins threatening litigation. A strategy of stopping deliveries is often accompanied by any attempt to find fault on the customer side that would allow the company to claim that the customer has breached its duties under the contract thus relieving the company from its obligations. Unfortunately, arguing over the words of the contract at that point will only benefit the lawyers involved and the better course for the senior management of the company is to attempt to sit down with the customer and try and work out a restructuring of the contract that makes sense for all parties. When attempting to restructure a problematic contract an attempt should be made to align the interests of both sides and offer the other party, the customer in this case, an incentive to cooperate other than the prospect of costly litigation. In the illustration above the company might offer to substitute a new pricing formula for the fixed price arrangement which offers the customer reasonable pricing under all market conditions plus assurances that the company will not seek and obtain unfair profits from the restructured relationship. For example, assume the fixed price was $1.00 per unit and at the time the contract was first entered into the company’s cost was $0.85 per unit. At that time the company’s profit was $0.15 per unit. If the market price went down to $0.50 per unit the company’s profit would increase to $0.50; however, the contract became unprofitable for the company—and advantageous for the customer—when market prices rose to $1.50 and looked like they were going to stay there for the balance of the contract term. In that situation the company might suggest that contract price be set at the market price plus 10% which means that the customer would enjoy a price that is in line with the market and the company is entitled to a modest profit at all times during the contract term. The customer waives the right to the attractive pricing in relation to the market that it would have received under the initial contract but is spared the costs of litigating the breach and finding a new vendor. The company gets to keep the customer, and stay in business, but the days of 50% profit margins are gone. The company may throw in other incentives, such as more robust customer service plans, to sweeten the deal.

Obviously there are risks in attempting to informally renegotiate a contract. The major concern is that if discussions are not successful the non-defaulting party, the customer in this case, has been given a substantial amount of information that can be used in subsequent litigation and information provided in good faith as a basis for striking a new deal can be turned into a harmful weapon in the hands of the party’s attorneys. In many cases, however, the rewards exceed the risks and companies can resolve problems by providing the other side with sufficient information to allow them to make an informed decision and understand the benefits of a proposed compromise.

Several safeguards should be used when entering into negotiations to restructure a troubled contract. First of all, any documents provided to the non-defaulting party that contain sensitive information should be marked “confidential” and only disclosed after the other party has agreed to sign and return a confidentiality and non-disclosure agreement. Second, while it is usually obvious that the reasons for the discussion are that the terms of the initial contract have become significantly unfavorable an effort should be made to avoid using language that the other party might reasonably interpret as being an admission of impending non-performance such that the other party might claim anticipatory breach. Third, try to continue complying with the terms of the contract as they stand during a limited negotiation period even if this means incurring modest losses on the contract during that time. If possible, start talking about restructuring a contract as soon as it appears that problems are on the horizon but before they reach a crisis level. Fourth, try and determine if the other party has specific problems of its own that might be solved or managed in some way during the negotiation process. For example, the other party might have an immediate need for cash that might open the door to discussing a buyout of the contract with an immediate lump sum payment that represents a substantial discount from the costs of performing for the entire term. Finally, if litigation is a real possibility and there are legitimate concerns about misuse of information disclosed in good faith consider holding the discussions through a mediator. A mediator is not only trained to get both parties to find common grown, and ignore emotions and anxieties, but it is also possible to have discussions with a mediator protected as confidential and privileged so that they do not later come back to cause harm in the event of litigation. Consideration should also be given to other contract-related issues and problems that may arise when markets turn crazy. Things that you might consider include the following:

1. Review representations, warranties and covenants in major agreements to ensure that the company remains in compliance at the current time and that anticipated changes in business and financial condition of the company will not trigger a default in the foreseeable future. If a potential issue is identified pro-active steps should be taken to contact the other party to the agreement before a crisis emerges in order to arrange for a modification to the terms or a waiver. Remember, however, that the other party may be seeking a way to exit the contract due to changes in its own situation and any communications should include a potential solution to the issue and acceptance of the fact that it may just be the first step in restructuring the entire arrangement. Dispute resolution provisions in the contract should be reviewed and preliminary litigation plans should be prepared in the event that less formal discussions are not successful. By the way, representations, warranties and covenants provided by other parties should also be reviewed to determine whether they might be heading toward a default of their own.

2. If the company’s performance under a major agreement turns on the ability of another business partner, such as a supplier, to fulfill its promises it is important to take a hard look at the contract with that business partner and conduct some basic business and financial due diligence to ensure that market problems will not cause the partner to declare a default. Hopefully the contract with the business partner calls for delivery of regular financial information. If it does and reports are delayed this may be a “red flag” of potential problems.

3. Some of the company’s customers may seek to get out from under payment obligations by making warranty claims based on purported defects in the company’s products. If elements of the company’s products are provided by third party vendors the contracts with those vendors should be checked to ensure that indemnification provisions are adequate and that the vendors are obligated to provide necessary support so that customers are not able to back away from their obligation to pay for the products.

4. Many contracts include obligations on the company to obtain and maintain various types of commercial liability insurance. Given the issues that have arisen with many major insurance carriers attention should be paid to the company’s insurance portfolio and communications should be made to the company’s insurance broker to verify that all coverage remains in effect and that the chosen carriers are financially able to meet their obligations. If required insurance is coming up for renewal it may make sense to begin shopping around well in advance of the policy expiration date. If a change is made make sure that the contract partner is given appropriate notice.

5. Review the entire roster of parties to major contracts with the company to identify any business partners that are known to be experiencing financial difficulties and make sure that any potential contract claims against them are documented and asserted as quickly as possible. One of the goals is certainly to perfect any legal rights against the partner in the event that it goes into bankruptcy; however, every effort should be made to have the complaint accompanied by ideas to resolve the problem without forcing the partner into bankruptcy where the company may find that its rights are diluted or completed overwhelmed by the claims of other parties. Even if the company cannot assert any contract claims it may be a good time to use a bit of leverage to force the other party to negotiate pricing and other terms in a way that is more favorable to the company.

6. If the company itself is having business or financial difficulties make sure that there is an effective communications policy for sharing information with contract partners to minimize the risk that customer, suppliers and other strategic alliance partners do not begin looking for ways to void their contractual obligations to the company. Major contracts should be carefully scrutinized to identify all important ongoing obligations to make sure the company does not inadvertently let something slip that can be used as an excuse to trigger a relationship crisis around the contract.