We all know risk is associated with every contract. And, if you as a prime supplier novate a customer’s third-party contract(s), you increase risk to a great extent. Simply put, novation involves transferring one party’s rights and obligations under a contract to another party.
In this article, I have highlighted the common problems a prime supplier faces during contract novation and the best practices for mitigating the risks.
According to the global IT outsourcing consultancy firm Ovum Research, around 1680 deals worth over $80 billion will be renewed in 20201 and the deal sizes in 2020 are expected to be bigger according to Peter Bendor-Samuel, founder and chief executive officer of the outsourcing advisory firm Everest Group.2
The larger the deal size, the greater the number of small to large third-party suppliers working in a customer’s outsourced IT landscape. For example, along with a prime supplier, many other providers will be involved in the deal like software license and maintenance providers, hardware license and maintenance providers, professional service providers, cloud service providers and so on.
The customer (buyer) usually forms a dedicated team to perform responsibilities like these:
- monitoring performance and suppliers’ compliance regularly;
- tracking suppliers’ contractual obligations;
- amending contracts;
- processing change requests;
- negotiating terms and conditions during contract renewal;
- resolving issues between third-party suppliers; and
- managing relationships with suppliers.
One key to success is efficient supplier coordination when implementing the project or IT operation. As third parties become increasingly involved, the challenge increases for managing many third-party suppliers and ensuring smooth delivery.
Customers today prefer that the prime suppliers novate all their existing in-scope third-party contracts, because they want to be relieved of future liabilities and they seek to mitigate the risks of managing multiple third-party contracts to simplify the contract base.
As stated above, novation involves transferring one party’s rights and obligations under a contract to another party. After that occurs, a prime supplier will be responsible for coordinating with all third-party suppliers, managing the novated contracts and taking full responsibility for end-to-end service delivery.
This will limit the customer’s interaction with the prime supplier for day-to-day status checks, escalations and so on. A prime supplier will be held responsible for any default, regardless of whether the default has been caused by the prime supplier or the third-party suppliers.
This greater control of the prime supplier on these third-party suppliers minimizes the risk of default due to non-performance or lack of coordination. And yet, although this approach appears to be a winning arrangement for both the customer and the prime supplier, the supplier still needs to overcome several potential obstacles to make this work well for both parties.
During the procurement cycle of the novation process, a prime supplier is expected to submit an all-inclusive cost estimate including the cost of in-scope, third-party contracts to be novated. But it becomes a challenge for the prime supplier when adequate information about those third-party contracts are not provided by the customer before the proposal submission.
It is important that the prime supplier not only obtains accurate values of all third-party contracts, but also obtains adequate time to perform detailed due-diligence of those in-scope contracts to identify the risks and gaps in those contracts and come up with a mitigation plan before novation. Many cases exist involving the customer sharing limited details such as only the total value of the in-scope third-party contracts, or sharing only the names of the third parties and applications whose maintenance or license contracts were to be novated.
A successful partnership cannot happen until both parties benefit from the engagement. The overall engagement will be at risk if a prime supplier novates the contracts without understanding the intrinsic risks and gaps and as a result, the partnership starts suffering losses during the service delivery. A supplier’s fee is definitely an important criteria for selecting a supplier, but it is also important to assess the bidder’s proven track record of helping its customers achieve similar objectives in large outsourcing initiatives.
In light of these challenges, I suggest prime suppliers take seriously the following essential considerations during the due-diligence contracting process before novating the third-party contracts:
Is novation permitted by the third-party contract?
Before starting any contract novation, a prime supplier should ensure that novation is specifically permitted by the terms and conditions of the third-party contract, and ensure the customer has received, at its own cost, the required consent for novation from all in-scope third parties. If the third party doesn't provide consent, novation is not possible. Before going ahead with novation, it is important for all involved parties to assess their relationship, particularly with the third parties. Due-diligence should be performed for only those contracts for which the consent has been obtained.
What is the nature of the contract?
In any large IT operation, different types of contracts exist, such as, software or hardware maintenance contracts, software or hardware license contracts, professional service agreements and so on.
It is critical to understand the type of the contract and the associated payment provision for submitting the cost for the bid. For example, the payment provision is different for a perpetual license agreement and a subscription based license agreement. If an enterprise level license is involved, a prime supplier needs to check whether it is feasible to novate such agreement for the in-scope services. Any ambiguity may lead to incorrect price submission.
Are the third-party contracts aligned with the customer’s prime supplier contract?
A prime contract supplier carries a high risk if the third-party contracts are not aligned with the customer’s prime supplier contract. For example if the service level agreement (SLA) for a priority 1 incident resolution is two hours in accordance with the customer’s prime supplier contract, but the incident resolution SLA is 2.5 hours in accordance with the prime supplier’s third-party contract, the SLA could slide into “default” if the third-party supplier takes more than two hours to resolve the incident. In such a case, the prime supplier will have to pay an associated service credit to the customer.
Or, if the credit period is 90 days per the customer’s prime supplier contract, but 30 days per the prime supplier’s third-party contract, then the prime supplier may face a cash flow issue. Therefore, to achieve successful delivery, all the key technical, legal and financial clauses should flow down from the customer’s prime supplier contract to the prime supplier’s third-party contract.
Specifically, here are a few of the most important clauses applicable:
- technical clauses:
- scope of services including deliverables
- SLA hours/support windows
- standards and data security
- financial clauses:
- Payment mechanism (e.g. monthly payment, milestone-based payment and so on)
- Credit period
- Scope of termination assistance and fees
- Service credits
- legal clauses:
- Background check
- Step-In right
It is important to understand exactly what liabilities are being transferred to the prime supplier before giving any commitment to the customer.
To ensure competitive bidding and offer value to the customer, a prime supplier may replace the customer’s third parties with its preferred vendors to reduce cost and obtain reliable service, and also to propose a transformation road map by decommissioning the customer’s legacy applications. Therefore, a prime supplier should be allowed to terminate the third-party contracts for convenience any time after novation and third-party contracts should include a provision for termination for convenience.
Third parties are not bound contractually to offer the same price to the prime supplier as provided to the customer. Therefore, a potential risk of price increase does exist during novation. Since potential risk remains unknown during proposal submission, the prime supplier’s profit and loss (P&L) may be affected by novation due to price escalation at a later time. The customer should be the price guardian to ensure that third-party vendors offer the same value as provided to the customer. Any price escalation should be compensated by the customer.
Cost of Novation
The greater the volume and complexity of third-party contracts, the greater the cost will be for pre-novation activities. These include, but are not limited to:
- detailed due-diligence of the contracts;
- risk mitigation via contract amendment and;
- contract signature.
Both parties should agree as to who will bear this additional expense. Generally, the customer pays the prime supplier’s fees for pre-novation work. If the amount of the fees cannot be agreed before pre-novation work begins, it would be prudent to at least state in the customer’s prime supplier contract that the prime supplier can claim any reasonable fees or related entitlements for pre-novation work.
Release of obligations and liabilities
Both the customer and its third parties relinquish one another from any obligations from the effective date of the novation agreement. Prior to that effective date, the customer should indemnify the prime supplier against any losses or damages incurred by the prime supplier due to the customer’s failure to perform obligations under the contract. However, after the effective date has passed, the roles are reversed. Novation agreements should be drafted accordingly to protect both parties.
The contract novation may take a couple of months depending on the volume and complexity of the contracts to be novated. It is a good practice to sign the contract with the customer after all risks associated with the third-party contracts are mitigated. But a prime supplier does not always get adequate time to perform these activities before the contract with the customer is signed.
The third-party contracts are usually novated after the customer’s prime supplier contract is signed. Therefore, a prime supplier’s contract manager (CM) has a significant role to play. The CM should not only ensure that the customer’s prime supplier’s contract contains the relevant clauses to protect the prime supplier if any gaps are found during contract’s due-diligence phase, but should also ensure the right stakeholders participate from various departments of the prime supplier’s organization (like legal, finance, delivery, sales and so on).
Preparation of all parties is the key to a successful contract novation. The customer’s prime supplier contract should allow the prime supplier to seek relief from the customer if all gaps cannot be closed through the third-party contract amendment.
ABOUT THE AUTHOR
Anirban Majumdar is a Contract Manager in Tata Consultancy Services (TCS) in India. He has more than 16 years of experience in contract management, pricing and commercials for large deals and project delivery throughout the USA, UK, Europe and India.
As an IACCM certified contract manager, he is responsible for performing business risk focused review, redlining, drafting and negotiating contracts, authoring response for large and strategic IT outsourcing deals, tracking contractual obligations, reviewing the contracts of sub-contractors during procurement cycles, performing due-diligence of third-party contracts for novation, leading contractual discussions with sub-contractors and coordinating with the legal team for contract signature.
1. SmartInvestor.in article titled $80-bn IT sector contracts up for rebid in 2020; TCS, HCL may clinch deals Debasis Mohapatra/Bengaluru published 23 Dec 19
2. Peter Bender-Samual, CEO and Founder of Everest Group, a consultancy firm. See also IEI article.