Contracts and Inflation – Challenges, Learnings and Opportunities to Consider

August 3, 2022 Bernadette Bulacan

This blog is part of a series looking at how companies can build economic resilience with contract intelligence. Access our free guide here.

Inflation hit a 40-year high in June. Once considered a short-term anomaly, inflation now presents a serious and ongoing risk to margins.

As we've seen with other recent disruptions (COVID-19 and the war in Ukraine come to mind), companies are using contract management and turning to their contracts to see what risk and recourse these critical documents may contain.

Certain contracts, especially long-term contracts, often include price-adjustment clauses that allow sellers to ensure their prices keep up with inflation rates. These clauses are critical to understanding, no matter what side of the transaction you're on. Sellers need to know what they're entitled to; buyers need to know what to expect.

Yet, as with so many things in business, what sounds obvious on paper can prove quite complicated in practice. In our conversations with contract managers and CxOs across the world, it's clear that the enterprise-wide scale of inflation is leading to a scramble to understand what's in companies' contracts and how they can respond.

Here are the biggest challenges, learnings, and opportunities we are seeing in the contracting world as we work with customers to stay out in front of inflation:

Inflation clauses come in many flavors

The first step in leveraging contract language to respond to inflation is understanding what language exists in your contract portfolio. This task is made difficult by the fact that inflation clauses are often not standardized across contracts.

Rather, inflation clauses may vary by the index used or the adjustment schedule they follow.

So across a body of contracts, you might have some contracts tied to CPI, some to ECA, some to COLA, and some to the Foreign Exchange Market (Forex). Some might allow for bi-annual price adjustments, and some for annual ones. Some contracts have no inflation clause at all.

This kind of variation makes it impossible for companies to take bulk actions across their commercial operations – e.g., a 3% price increase across the board.

Instead, companies need to look at every contract individually and take bespoke action on it. Done manually, this amounts to an enormous effort, though one that most companies will find worth the investment, given current inflation rates.

There are also technological options that can help. Icertis has been working with customers across the globe to surface inflation-related clauses in their contracts. With contract AI trained to identify price-adjustment clauses, these companies have been able to surface contracts containing clear inflation clauses, contracts that refer to inflation but do not identify specific indexes, and those with no mention of inflation at all. With the contract data so structured, the organizations have been to quickly form a plan of action to address areas where the contract value is being left on the table and take concrete steps to address it.

This capability is valuable on both the sell side and the buy side. While buyers might wish any and all price adjustment clauses in their supplier contracts go unnoticed, this isn't a sound strategy (or realistic hope). Price adjustments will happen, and by knowing what's in their contracts, procurement teams can plan accordingly—including by flowing price increases on the buy-side down to price increases on the sell side if and when appropriate.

This brings us to the next challenge…

Finding clauses is just the beginning

Once companies find inflation clauses, the next step is to take action.

Especially in cases where the price adjustment clause leaves room for interpretation, it's likely that you have to open up a matter with your legal department, which may have to rely on dispute resolution clauses to ensure the company gets a fair deal.

Rory Partridge of Charles Russell Speechlys explains it well:

"Many contracts contain clauses governing the procedure to be followed by the parties where any dispute arises, which may include pricing disputes or reliance/interpretation of clauses, including those [price increase terms] mentioned above. That may confer duties on the parties to enter negotiations or dispute resolution in a good faith effort to resolve the subject of the dispute throughout the process and to avoid proceedings, granting an avenue for the parties to put forward their position for and against a price increase or the mechanism and sum thereof."

Again, the question for large enterprises is: how do you manage hundreds or thousands of these matters as inflation triggers potential conflicts across the board?

Continuing on the example above, the ideal state is to have a single source of truth of which contracts have the most financial value, the most exposure to price pressures, and the most room for interpretation (because there is no operationalizing language for such price adjustment language).

With this centralized information, teams can assign resources to contract adjustments to maximize return on effort. And because contract data is already extracted and associated with each matter, contracting teams have a head start in understanding what recourse they can pursue.

On the buy-side, organizations should also look at how they can pass increases on to the end customers. In retail, for example, it's critical for grocers to keep close track of commodity price increases to protect their margins. You can read more on this from my colleague Phil Barry.

What happens if there is no inflation clause?

Not all contracts have inflation clauses. Before the recent surge, inflation had been hovering around 1% annually; for short-term contracts, they simply seemed unnecessary.

For those on the sell-side of the equation, a lack of inflation clauses doesn't necessarily mean nothing can be done. Some lawyers suggest that companies could claim force majeure and/or commercial impracticability to get out of contracts.

We won't weigh in on that debate, but once again, the very first step is understanding what's in these contracts. If companies can identify which of their contracts don't have inflation clauses and how much revenue they are associated with—that alone gives them a strong view of the risk they face, so they can manage it.

Furthermore, they can calendar out when the contracts expire/renew, so they can be sure to exit or renegotiation contracts as soon as possible.

How do you negotiate better contracts moving forward?

When COVID struck, it's no exaggeration to say every company in the world took another look at their force majeure clauses to ensure they protected against pandemics moving forward. This bout of inflation will no doubt have the same impact on price adjustment clauses.

Once a company determines what it wants its contracts to say about inflation moving forward, the question becomes how they ensure those clauses get used. In scenarios where contract negotiations are straightforward and rarely involve redlines, it might just be a matter of sharing a new standard template with the teams (though this approach leaves to chance of whether the teams actually use them).

But where negotiations are common or third-party paper is used, contracting teams should create playbooks that help them quickly respond to redlines so they can protect the business without throwing negotiations off track. Some of this work can even be automated or supported with AI.

Conclusion

The last few years have been a crash course in crisis response for companies worldwide. As we've gone from pandemic to war to inflation, what's emerged is the importance of understanding who you're buying from, who you're selling to, and what the rules governing those transactions are. In other words, your contracts. Contracts are the foundation of commerce. By using contract intelligence and focusing on the foundation, companies can stay grounded in even the most turbulent storms.

To learn more, please access our free eBook: Building Economic Resilience with Contract Intelligence.