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26 April 2018
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Contract killers

In an uncertain economic climate, nervy companies are using indemnities to cut their risk. But Nick Martindale finds the customer-supplier relationship is often the
first casualty.

Contract killers 1

Say the words “security contract” and people, unfortunately, think “G4S”.

The unseemly mud-slinging match between the government and G4S over exactly what proportion of the £236 million Olympic security contract it should receive – on top of
the £90 million already paid up to the point when its inability to deliver became clear in July – has brought the issue of FM contracts firmly into focus.

The precise details of that contract remain confidential, but one issue that is doubtless being pored over by lawyers on both sides is that of indemnity clauses contained within the document.

These clauses are designed to protect customers against financial or other losses incurred as a result of the suppliers’ negligence.

In recent years, there has been a marked move towards more draconian and broader indemnity clauses, says Paul O’Hare, a partner at Kemp Little LLP and legal director at the National Outsourcing Association. “It’s been a trend in outsourcing contracts for the past six or seven years, emanating from a number of the really large public sector contracts,” he says.

“The national programme for IT contracts contained what most suppliers viewed as very draconian indemnities. Many felt that they were effectively becoming an insurer of last resort. It’s very common now in the financial services sector and it’s spilling into the outsourcing market more generally.”

This is certainly something that resonates with Chris Dodd, company secretary and head of the legal team at OCS, and himself a trained lawyer. “The general theme would be that suppliers are now required to take a lot more risk,” he says. “Any contractor who knows what they’re talking about would say that an indemnity, in principle, is not unreasonable, but that it should be focused on specific fundamental risks rather than a very broad, general indemnity that covers any breach of contract.

What you often see now is a limitation that excludes the indemnity, which becomes very problematic if the indemnity itself is too wide,” he explains. “We very frequently see contracts where the indemnity is so wide that it effectively leaves suppliers in a position where liability is unlimited.”

Wrong tool for the job?

Traditionally, indemnities would be used in limited circumstances to deal with particular issues, says O’Hare, where customers have no control over their impact. “The sorts of liability that it has traditionally been used for are claims that a piece of software or technology infringes a third party’s intellectual property rights, or tax liabilities,” he says.

“You sometimes see them in cases relating to death or personal injury that are caused by negligence. But a lot of the drafts that are put forward by customers now start off on the premises that every type of liability should be backed up on an indemnity basis.”

There are other specific measures that could legitimately be covered by indemnities. Protection against TUPE claims from employees in the event of contract termination is one, suggests Nigel Draper, director of procurement consultancy Sorsco and former procurement director of Allied Bakeries.

“You clearly want that because otherwise the law says it doesn’t matter how bad the supplier is or whether you like them or not, you have a legal liability to take on those people’s employment benefits,” he says. “But with other things that mitigate against risk, you have to be more pragmatic. With poor performance, if a supplier breaches, you don’t pay them. It’s inconvenient, but it’s less inconvenient than trying to hold a supplier to some issue resolution process.”

The question as to who is driving this trend is something of a moot point. O’Hare lays the blame at the door of “over-zealous lawyers”, chiefly in failing to highlight to clients the risks associated with such clauses. “It’s probably been a case of lawyers explaining the benefits of indemnities and then asking their customer if they would like to extend it beyond intellectual property infringement to data protection and then breach of confidentiality claims,” he says.

“What lawyers should be doing is managing the expectation and saying that there are certain things that indemnities are appropriate for, but that it’s not realistic to expect an indemnity for everything.”

But Phil Walton, a partner in the commercial department of Mundays LLP, says customers must take their share of the blame too. “Anything like this must be customer-driven,” he says.

“We lawyers can suggest changes to contracts, but the customer instructs the lawyer, not the other way round. I’ve been in meetings with companies where they have said they’re not willing to go that far because it’s too aggressive and others who say they want the best protection possible because they’re not willing to take a risk. Who is to say either is wrong? But I do advise clients that there has to be something in it for both sides, otherwise the contract is doomed to fail.”

Contract kilers 3

A victim of FMs own success

There are sound reasons why customers might want to seek as much protection as possible, whether this is driven by in-house or external lawyers, procurement departments or in-house FM practitioners. Helena Ohlsson, former global facility manager at IKEA and now director of ohlssonglobal, suggests more stringent contract terms are simply a sign of a maturing industry. “It’s a natural progression as facility management is becoming recognised as crucial to the success and sustainability of the core business,” she says.

“Many organisations put critical services into their FM scope, such as IT, energy, risk and security, and failure to deliver those services successfully can cause the organisation great harm. Indemnity clauses are a way for the client to make clear to the supplier the potential risks, and make the relationship more equal. In a partnership, both parties must be in it together. This could perhaps be seen as an attempt, for good or bad, to put a price on trust.”

Others, though, argue that shifting the balance too far towards the customer can not only jeopardise effective relationships, but even deter suppliers from seeking to add value in other ways. “As contractors, we yearn for the ability to add value to the contract negotiation process and by that I mean generating additional benefits for both sides,” says Dodd. “Our favourite contracts revolve around things like gain-share where we can really help the customer. Very onerous contract terms are a very crude tool for trying to drive best value.”

Eventually, such a situation can be damaging to customers, argues Draper, in that it stifles an atmosphere where innovation can thrive. “If you build all that risk mitigation into a contract, you take no risk, so there is no reward,” he says. “It wasn’t that long ago that there were a number of organisations that were proud they had no contracts with suppliers. It would be almost blasphemous to say that now.”

The irony is that the use of tough indemnity clauses only gives a false sense of security anyway, he adds, as many customers will be reluctant to take on potentially expensive legal cases.

Suppliers do, of course, have the right – in theory – to negotiate contracts with customers, and often what are presented as “standard” terms and conditions are expected to be challenged. “We have detailed discussions around what particular contracts mean for us in terms of risk,” says Dodd. “It’s fairly rare for us to say that the risk is so large that we’re not going to accept the contract, but if you have an open-ended indemnity without a limitation that’s very disadvantageous.

If you then compound that with liability for consequential loss, and your customer is in the pharmaceutical production business, so the numbers could be telephone numbers, it’s that perfect storm that would cause contractors to step away.”

But while the larger suppliers with in-house legal teams or sizeable resources may be in a position to challenge contract terms or even reject opportunities, this is not always the case for smaller suppliers. “The trouble is that the less sophisticated, smaller suppliers, who maybe haven’t been in the industry for as long, don’t have in-house legal teams and are trying to gain market share, generally take a more relaxed view on risk because they’re keener to meet customer requirements,” says O’Hare. “So a number of smaller suppliers are taking on much greater risk in terms of the scope of the indemnity they sign up to.”

Contract killers 2

More than one way to skin a cat
The current economic climate only makes such circumstances more likely, says Walton. But there are other ways of handling risk without having to resort to all-encompassing indemnity clauses. “You do need indemnity clauses as a fallback,” he says.

“But if the customer can be persuaded that a more appropriate way to deal with these issues is through service level agreements, and that is the first area that is looked at when something comes up, then you have a much more sensible way of going about things. I don’t like the attitude taken by some people that the only way to cover something off is an indemnity – it’s not. It’s actually quite lazy.”

Ultimately, the risk for customers is either they stifle the ability of the supplier to perform to the best of their ability once the contract has started or, even more significantly, deter them from putting themselves forward for the job in the first place.

“It’s a classic supply-demand equation,” says Lionel Prodgers, director of FM advisory body Agents4RM International. “Most companies will go through a bid/no-bid evaluation and the terms of the contract and the ability to negotiate will be one of the assessments that the supply-side makes when deciding whether to bid or not. It’s not uncommon for them nowadays to decide not to bid. In that case the procurers are the losers because they’re restricting themselves to less-capable suppliers that are prepared to accept more draconian contract terms, to no actual benefit in the end.”