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Being proactive with your contract compliance program

RISK BULLETIN  | 

In many situations, vendors, distributors and licensees fail to meet their contractual obligations, with a negative impact on profitability. Unfortunately, most organizations are reactive in nature; dealing with the consequences of contract deficiencies as they arise, rather than being proactive to discover and address any concerns in advance. To avoid any potential issues, organizations should implement a contract compliance program to monitor third-party relationships with business partners.

Contract compliance issues are on the rise with vendors, distributors and licensees. Organizations that do not have a sound contract compliance program are unable to anticipate future issues and spend unnecessary time reacting to potential noncompliance items that should never have become a concern in the first place. Examples of red flags that indicate your business partner may be noncompliant include:

  • Vendors
    • Costs are increasing.
    • Supporting evidence to substantiate pass-through costs is not provided.
  • Distributors
    • Supporting evidence to substantiate “best price guarantee” is not provided.
    • Supporting evidence to substantiate rebates is not properly calculated and shared.
  • Licensees
    • Payments received are late.
    • Payments received are getting smaller or stop coming in altogether.
    • Royalty payments are not made after the agreement or patent expires.

Incorrect reporting frequently arises when the third party issues their compliance report based on the company’s internal accounting practices instead of the terms of the agreement. Additionally, high-turnover rates exist for those responsible for compiling these reports. In many cases, the institutional knowledge and methodology does not transfer to the successor, or the successor prepares the report in the same manner the predecessor did, without reading the agreement terms. 

Many other errors can occur in the reporting process, such as:

  • Excel formula errors (all agreement types) – Errors can occur where data is pulled, with some information accidentally omitted. All the necessary products, ranges or rates are not being pulled and accounted for.
  • Contract has ambiguous terms (all agreement types) – Vague terms can lead to confusion, and different personnel may interpret contract language in different ways.
  • Unallowable deductions or inclusions (all agreement types) – Typically certain costs can or cannot be included within a contract. Are your business partners going by the defined terms in the contract or by their accounting procedures?
  • Manufacturing costs overstated (vendor) – Many costs go into a product, and not all of those costs are attributable to the product being manufactured. Costs may be stated that are not in accordance with the agreement or generally accepted accounting principles if that is what is called for.
  • Rebate allocation understated (distributor) – Distributors may receive rebates from their manufacturers that should be shared with you. How do you know that you have received your correct allocation?   
  • New products are not reported (licensees) – One product may exist, and a licensee may introduce another product that incorporates the licensed technology. Unfortunately, R&D and manufacturing may not communicate with those responsible for royalty reporting to include new products on the royalty report.
  • Foreign country sales (licensees) -- These may not be reported on the royalty report, or foreign subsidiaries or affiliates of the licensee may interpret the license agreement language differently.

If you improve the effectiveness and efficiency of your contract compliance monitoring processes and controls, it will result in improved business performance across the organization. The processes your organization can implement to increase the compliance of your business partners include:

  • Templates - A standard reporting template should be developed and implemented that will allow you to effectively monitor costs, best price guarantee payments and royalties. This reporting template should be included as an exhibit to the agreement.
  • Calendars – Generate a calendar for each agreement to manage when reports and payments are due, compared to when they are actually received or paid. 
  • Standard operating procedures (SOPs) – Designate SOPs for consistency in handling situations where deviations from the agreement arise.
  • Key terms - An abstract of key terms and conditions should be in place for any agreement so that these can be used to review the reports and payments in a timely manner.   
  • Trend analysis - A trend analysis for each revenue and cost component of the agreement should be developed to identify significant increases or decreases over the course of the agreement.
  • Frequent meetings - Monthly or quarterly meetings should take place internally to discuss the reporting provided to determine if expectations are being met and if communications with the agreement partner are needed.
  • Periodic audits – Implement a process and methodology to conduct periodic internal or external audits.

Contract compliance is an often overlooked facet of doing business, but the financial impact can be significant. Oftentimes, an organization is glad that the deal has been executed, but has not adequately planned on how the terms and conditions will be monitored. Awareness of potential issues is typically triggered by a material financial impact or if the reporting process has unexpectedly changed. Being cognizant of these issues is critical as they may have an adverse impact on your profitability.

Businesses must be more attentive in monitoring the compliance of third-party contractual relationships. All companies should develop a formal contract review strategy to monitor compliance and ensure your partners are living up to the agreements. However, it is also beneficial to bring in an outside advisor to perform an investigation if you suspect any current or past contractual issues. This process evaluates each of your third-party agreements, details any noncompliance, quantifies any monetary findings and helps to induce future compliance and rectify any issues moving forward.  

Overcharges or underpayments coupled with applicable interest and penalties related to noncompliance can result in substantial dollars recovered by this review. In many contracts, audit clauses dictate that if monetary findings exceed a certain percentage, the cost of the investigation shifts to the third party.

Every business is different, and third-party contracts are often unique and complex. With the volume of third-party relationships that many businesses maintain, you must have a process and controls in place to monitor contract compliance. Implementing proactive measures and undergoing periodic contractual compliance investigations helps ensure that your business partners are in compliance, and they are meeting their financial obligations to you.