Use the Contract Hierarchy for Better Results
It is time to rethink contracts and document management. Understand the contract hierarchy to improve profitability, collaboration, and risk management. The contract hierarchy unifies the legal concept of a contract, document management, and business analysis.
The contract hierarchy starts with the business deal at the top, supported by documents (including the main agreement), with requirements at the base.
The contract hierarchy organizes the network of obligations between the parties.
A contract is not a document. A contract is a lot more than a document. A contract creates a legal relationship between two parties that, if all goes according to plan, endures over time. Parties reduce agreements to writing which conflates contracts and documents.
In most common law jurisdictions the requirements for a contract between two or more parties (individuals or legal entities) are:
Those criteria only determine whether there is an enforceable agreement when the parties sign the agreement. From the parties’ perspective, life with the contract is just starting.
The heart of the agreement is the “contract” for the people who actually operate under the terms of the contract. This notion that there is an overarching “deal” is a helpful way to think about contracts for contract management.
The contract is the deal in its most basic terms. It is the umbrella for all documents and requirements.
A contract contains documents. The first document is usually, but not always, the main agreement. Ancillary documents follow the main agreement. Common contract documents include:
“Simple” contracts might include just one document: only the main agreement. It can be difficult to identify examples.
Consider the lowly Non-Disclosure Agreement (NDA). There are no ancillary documents for an NDA. However, the NDA is often an ancillary document for a larger contract. Companies do not sign NDAs for the fun of keeping another party’s information confidential. An NDA precedes discussions aimed at consummating a meaningful contract. So even the lowly NDA fits the contract hierarchy, not as a contract but as a document. But of course, you can manage an NDA as an independent contract if you want.
Here are examples of types of contracts and types of documents:
From a management perspective not all terms in a document are created equal. Most people in the organization are not even casually interested in a force majeure clause. However, the provision that allows the other party to increase prices if sales fall below a certain level captures everyone’s attention.
Documents within the contract umbrella have provisions that matter to the organization. The consequential provisions will vary by company, industry, and contract context.
Requirements or obligations flow in two directions. For example, your organization might be obligated to provide quarterly reports from a joint marketing venture. The other party could be obligated to pay commissions from sales.
With contract management software you can capture those requirements. Some requirements have due dates. The due dates might be absolute, like February 2, 2020, or relative, like 20 days before contract expiration.
It is useful to track some provisions, even when they do not pose an immediate obligation. There are two examples that can crop up in one or more contract documents: indemnification and change of control.
An indemnification clause requires that one party compensate the other for certain losses. However, it does not impose an administrative burden on the business during the ordinary course of the business. Lawyers and risk managers want to identify documents with indemnification clauses, but contract managers probably do not need to track them in the same way.
Likewise, a change of control provision is worth knowing about when there is, well, a change in ownership of the other party, but probably not germane to the business of the contract day-in and day-out.
Contract management should flag the presence of these kinds of provisions so that they are readily identifiable when needed. Flagging these provisions also allows contract management to provide reports to legal and risk management, whereas full-text searching does not support reports.
The contract hierarchy places the deal at the top. This is the “contract record.” The contract consists of one or more documents and each document consists of one or more requirements (or “terms” or “provisions”) which should be tracked.
There are two important benefits to the contract hierarchy. First, using the contract hierarchy to organize contracts provides a platform for consistent collaboration.
Second, the contract hierarchy is a useful risk management tool.
The contract hierarchy promotes collaboration across your organization in several ways. At the most practical level, there is a common organizational design so no one wastes time looking for contract information.
The hierarchy also frames discussions about contract or performance issues during the course of the contract. Your team can locate the source of the problem at the appropriate place in the hierarchy.
Calling out requirements and tags across documents and the entire contract portfolio allows insights otherwise not available. Those insights, however, need data collected consistently over time.
For example, to see which contracts require the counterparty to carry insurance, you need to add a requirement or tag to each contract. That data will allow you to understand your risk exposure across the entire contract portfolio.
There are five steps to implement the contract hierarchy:
These steps lay the groundwork for a contract management process that improves profitability for years to come.
The first step to implement the contract hierarchy does not relate to contracts per se. Contracts are necessarily with other parties. Over time, organizations unintentionally create duplicate vendor, supplier, or customer records:
Full-text search is inadequate because the data is still distinct from a reporting perspective. So it is useful to consolidate and standardize on a single party name.
Standardizing counterparty names will allow us to link contracts with each counterparty over time so that the entire contract history is readily accessible.
The contract hierarchy approach requires that you ask how many deals your organization has. The less formal word “deal” focuses attention on the primary contract and away from the individual documents.
While it is not possible to provide a comprehensive list of every type of contract record, here is a diverse list of examples that will get developed in the next section:
Notice that these examples do not reference a specific document. Instead, they are short descriptions that are meaningful to the business people that work with these agreements.
There are common data elements across these examples, even though they are distinct. Each contract has a title, contract type, effective date, and expiration date. Some of these deals might have auto-renewal provisions as well.
Now that you have established contract records, you can easily organize documents within each record.
The lease for the facility at 123 Main St. might contain the following documents: lease agreement, floor plan exhibit, certificate of insurance, utilities and triple net schedule, indemnification agreement, and maintenance services agreement.
The equipment purchase and maintenance agreement for the X9000 might have the following documents: equipment purchase agreement, supplies pricing to schedule, product warranty, and training services agreement.
A professional services agreement with multiple statements of work (SOWs) might be included in the professional services engagement for long-term consulting.
Construction deals often include many documents related to the contract. For example, there is the primary agreement for construction, an exhibit with plans and designs, change orders over the life of the construction project, performance bonds and/or certificates of insurance. And there are often many more documents.
Contracting with another party for a patent license will require the licensing agreement itself along with the patent as an exhibit. Such deals often include a separate nondisclosure or trade secrets agreement.
In each of these examples, there is a one-to-many relationship between the contract record and documents. In other words, there is an umbrella contract record that contains many documents. One of those documents is the principal agreement. The other documents are also important because they reflect the allocation of risk between the parties and clarify terms left open in the main agreement.
Each document also serves a unique purpose the course of the agreement. A document can have an expiration date that is independent of the underlying contract. If the professional services agreement covers three years of work, there might be a separate statement of work for each year. This gives business people the flexibility to alter the content of the services over the agreement which is normal. In this example each SOW expires after one year. The second and third SOW only start when the prior SOW ends. So there are four sets of effective and expiration dates: the contract, SOW 1, SOW 2, and SOW 3.
Contract management software must notify us not only of the contract expiration but also of each document expiration.
In the contract hierarchy context, a contract requirement is an obligation or a provision of the contract from one or more of the documents. In the patent license deal, for example, the licensee might be obligated to provide a quarterly sales report for purposes of calculating a fee based on revenue.
You also might want to tag contracts or documents based on the presence of certain terms. If you want to run a report on all contracts that have change of control provisions, then you need to tag each contract that has a change of control provision. A full-text search would not be adequate because the report requires structured data regardless of the wording of the provision. You are focused on the presence or absence of the legal term. Someone that might use slightly different terms with each search. The report is based on consistent Boolean (or Yes/No) data. Does this contract have a change of control provision? Yes or no.
The contract hierarchy approach enables powerful and detailed analysis of the entire contract repository. You can now analyze contracts from many perspectives that are not accessible when contracts are simply filed as part of a document management system.
Example reports might include:
The structured data behind the contract hierarchy make these kinds of reports possible for the first time.
Organizing and analyzing your contract portfolio in terms of the contract hierarchy can improve profitability, collaboration, and risk management for your organization. This technique promotes consistency across the organization, transforming contracts from a pile of documents into a collection of information about the organization’s obligations and opportunities.
Yes, oral agreements are enforceable in many, but not all circumstances, but most businesses reduce agreements to writing and sign the documents. ↩︎