Posts Tagged 'contracts'

How Are Contracts Used in Projects?

When you hire someone to do work or to deliver a product, you expect them to do it right, and they expect to be paid.  When transactions are simple, such as the purchase of fuel at a gas station, there is no confusion about whether the services were delivered or the right amount paid.

However, complex purchases (procurements) are not so easy to assess.  Contracts become necessary when there is uncertainty about who will do what (scope), by when (schedule), and for how much (cost). They are used to clarify expectations and to define mechanisms for problem resolution in the event of misunderstanding that leads to conflict.

Contracts are meant to solidify/clarify/explain commitments on both sides of an agreement. Contracts should state exactly what the seller will do or deliver, and when, as well as what consideration the buyer will provide (and when) in exchange for those goods and services.

Allocation of Risk
Contracts clarify the allocation of risk:  “If this happens, it’s your problem; if that happens, it’s my problem.”

Contracts explain what actions will be taken under various future outcomes so that there is no confusion about how problems will be resolved.

Contracts do not keep people honest. They do not prevent fraud and criminal behavior. They just provide a method of recourse (the courts) in the event of dishonest behavior or disagreement between the parties (honest or not).

Transfer of Responsibility
From a practical perspective, contracts are used in business to ensure that responsibilities are transferred in exchange for benefits. For example, if I hire someone to do work and I pay them in advance, without a contract in place, then I am taking a chance of the work not getting done and the money being lost. If the ‘contractor’ does not complete the work for which they were paid, how can I prove that they were paid or show what the payment was for if there is no contract?

On the other hand, if I hire someone to do work and commit to paying them in arrears (after the work), but there is no contract in place, they take a chance on doing the work and not getting paid.

What a contract does is document the commitments on both sides.  Agreements and commitments are written down before the work begins. If either side fails to live up to their promises, the dispute can be resolved using the courts.

Risk Transfer
Risk transfer (from a buyer’s perspective) means making someone else responsible in exchange for payment. If the buyer wanted to transfer all of the risks to a vendor (schedule, scope, and cost inflation), they would need to find a vendor willing to sign a contract for a fixed price, with clearly defined scope and a rigid completion date.

Of course, the contractor would need to be well-paid to accept all of these risks. Buyers are able to transfer risk, but it is not free.

So, if a company decides to do the work themselves (internally), they retain all the risks. However, if they choose to contract out the work, they are able to transfer some portion of the risk in exchange for financial reward. BUT, and this is a big but, risks are not effectively transferred from a buyer to a seller unless there is a legally enforceable contract in place to ensure that the right work gets done, gets done properly, and gets done on time. This is where experience and the legal department come in.

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Contracts and Contracting

Contract Definition
“A mutually binding agreement that obligates the seller to provide the specified products, services or results, and obligates the buyer to provide monetary or other valuable consideration.”
PMBOK Guide – 4th Edition, p. 315

A contract creates a “formal relationship between two organizations.”  A contract is like a marriage certificate (which is a form of contract) only with a lot of details about how exactly each party is expected to behave.

Like a marriage certificate, the terms of a business contract can be enforced through legal action if the parties involved are not able to settle their differences on a private basis.

Contracts exchange obligations and responsibilities.  One party pays the other for taking responsibility for delivering goods or services.

Terminology
Other names, such as agreement, MOU, SLA, understanding and purchase order may be used in place of the term contract. However, only a contract is a legally-binding agreement.

Documents do not need to be labeled as a contract in order to be legally binding. Whether or not a document constitutes a binding contract depends on the presence or absence of well-defined legal elements, the so-called “four corners.”

A legally binding contract typically must contain mutual consideration and legally enforceable obligations of the parties. There cannot be any barriers to the legal formation of the contract, such as fraud, duress, insufficient age or mental incapacity.

An agreement, understanding, MOU or purchase order may not have all the legally required ingredients, and therefore, is not necessarily a “legal” contract.  In other words, a contract may be a purchase order, agreement, or understanding, but the reverse may not be true.

Also, if an agreement cannot be enforced through the courts, it is not a contract.  Instead it is a “non-binding commitment,” sort of like a promise.

Essential Ingredients

  • Capacity or legal capacity: The parties entering into the agreement must have the legal authority to enter into the agreement on behalf of their organizations.
  • Consideration: Something must be given in exchange for something else.
  • Offer: There must be an invitation to make a deal, typically within a time limit.
  • Legal purpose: The deal must be legal; the contract obligations cannot violate the law.
  • Acceptance: An exchange of commitments must take place, possibly within a given time limit.  If there is a counter-offer rather than an acceptance, this condition has not been met.

Signatures
Notice that a signature is not listed as a required element to have a legal contract.  If both parties behave as if a contract is in place and meet the other requirements, then a legal contract exists between the parties and a signature is not required.

For example, when you order products over the Internet, you provide a credit card number but no signature. Nevertheless, you and the vendor have still entered into a contract where the vendor agrees to provide the product you ordered, and you agree to provide consideration by credit card payment.

Related Contract Terminology

  • Duress: Refers to a contract being signed under pressure where the signatory’s actions are constrained by threat.
  • Minors: Refers to the minimum age under which a person is not considered to be capable of signing a contract.  The courts cannot be used to force minors to live up to contract commitments.
  • Estoppel: Refers to a decision by an authoritative body that prevents someone from denying the truth of a fact that has already been settled.
  • Privity: Refers to the limitation that a contract cannot confer rights or impose obligations on any person or organization except those who have signed it.
    • If you hire a company and they hire subcontractors, you have no legal relationship (rights or controls) with the subcontractors as a consequence of having a contract with the primary contractor.

Alternative to Contracts

Not everything is a contract. In order for something to be a ‘contract’ it must have very specific ingredients.

Memorandum of Understanding (MOU or MoU)
An MOU is a document that describes a bilateral or multilateral agreement between parties.  It outlines a common understanding between parties indicating an intended course of action.
MOUs are most often is used in cases where a legal commitment is not desired or where the parties cannot create a legally enforceable agreement.

MOUs are formal versions of “gentlemen’s agreements.”  However, MOUs can be legally binding if they contain the correct wording and ingredients of a contract.  In other words, an MOU can be a “contract” if it contains all the elements of a contract, but otherwise, it is not.

Service Level Agreement (SLA)
An SLA is an agreement negotiated between a customer and service provider.  Like MOUs they can be formal (legally binding) or informal.

It is worth pointing out that contracts between service providers (vendors) and their subcontractors are often (incorrectly) called SLAs, because the “level of service” is set by the buyer and communicated to the subcontractors.

SLAs are used to document common understanding regarding services, priorities, responsibilities, guarantees, and warranties.   In theory, each area of service being delivered should have its own defined “level of service.” SLAs may specify:

  • levels of availability
  • serviceability
  • performance
  • operation
  • other attributes of the service, such as billing.

The “level of service” specified in an SLA is typically defined in terms of “target” or “minimum.”  Setting specific performance standards allows the buyer to know when corrective action is justified.

SLA contracts typically include penalties and defined corrective actions in the case of non-compliance with performance standards.

image from melodi2 at rgbstock.com


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