Companies often 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.