Contractual obligations: What they are and how to manage them

Contractual obligations are the specific duties, responsibilities and promises that each party to a contract is expected to fulfil in order to achieve the contract’s purpose.

These obligations are the core elements of a contract, typically outlining the terms and conditions that govern the relationship between the parties.

Contractual obligations can require something to be done or not done, either continuously, on or by or from specific dates, or when circumstances dictate.

Failure of any parties to comply with contractual obligations can result in a breach of contract and may have a range of undesirable consequences up to and including contract termination.

This article provides a step-by-step approach to managing contractual obligations, covering:

• Examples of contractual obligations
• Key terms you to know 
• What might happen if contractual obligations aren’t fulfilled
• Awareness and ownership of contractual obligations
• Ranking the criticality of contractual obligations
• When and how to check contractual obligations compliance
• How to manage a contract breach
• How to report contractual obligations compliance levels
• Recalibrating contractual obligations
  
  

Examples of contractual obligations

The bulk of contractual obligations are explicit and visible, relating mainly to the operation of the contract, such as:

• Issuing invoices within 10 days of the end of the month
• Not issuing invoices later than six months following delivery of an order
• Paying invoices by the due date
• Paying late fees when invoices are paid after the due date
• Submitting requests to amend the contract via an agreed process.

Other obligations that apply are typically not party-to-party related, and may or may not be incorporated in the contract by reference only, without any accompanying details. These obligations can concern compliance with:

• Laws and regulations enacted at any level of government, such as data protection principles and export regulations. Sometimes the applicable laws and regulations will be stated in the contract by reference without any details. At other times, those laws and regulations will apply even if not explicitly stated in the contract
• The organisation’s internal directives, policies and operating practices, such as a code of conduct governing behaviour on the organisation’s premises. Compliance cannot be expected unless details are provided before contract execution
• Generally accepted domestic and international standards, such as SOC 2 Type 2 data-centre security reporting.

Key terms surrounding contractual obligations

Contractual obligations typically become legally binding and enforceable from any effective date specified in the contract, or the date it was last signed by one of its parties. That’s not always the case because the following factors can apply:

• Conditions Precedent: a contract can specify events or actions that must occur before certain contractual obligations become enforceable
• Conditions Subsequent: events or actions might be specified in a contract that, on occurrence, terminate an enforceable contractual obligation
• Force Majeure: a contract might contain clauses that excuse performance of certain contractual obligations for the duration of unforeseen circumstances beyond the applicable party’s control
• Mutual agreement: the parties may agree that certain contractual obligations will only become enforceable upon mutual agreement, to allow for adjustments based on changing circumstances
• Performance dates: a contract can specify particular dates for performance of certain contractual obligations, which may not be legally enforceable until those dates
• Phased implementation: common in long-term or complex contracts, some contractual obligations may only become enforceable at different times and durations during the contract’s operational lifetime
• Survival clauses: contracts commonly specify any clauses containing contractual obligations that will remain operational for some time following contract termination
• Termination clauses: if a contract is terminated before certain obligations are due, those obligations may no longer be enforceable
• Triggering events: some contractual obligations might be triggered by the occurrence of a contract milestone, a particular incident or the passage of a specified period, only then becoming enforceable.

What might happen if contractual obligations aren’t fulfilled?

All obligations are meant to be complied with, but the consequences of non-compliance leading to a breach of contract can range from trivial, such as interest accruing on late invoice payments, to catastrophic, such as termination of the contract, massive government fines, loss of business or failure of the non-complying party.

Some notable contract breaches reported during 2023 that resulted in significant financial penalties for the businesses responsible include:

• Boeing: delivery of defective 737 MAX aircraft, €1,000,000
• Credit Suisse: breach of non-disclosure agreement, €100,000
• Meta: unfair practices related to user privacy, €1.3 billion

Commonly, where non-compliance is an isolated event, the parties to the contract will treat the case as an aberration and attempt to ensure that causation is adequately remedied, with or without a penalty of some kind.

More serious non-compliance in respect of effect on the aggrieved party may require invocation of the contract’s dispute resolution process or a court hearing to obtain any redress.

Chronic, blatant or bullying non-compliance, often based on market power and arrogance, can be difficult to combat. The courts of law and public opinion may be the only way for any consequences to be applied for such behaviour.

Awareness and ownership of contractual obligations

The legalese used in contracts, the often confidential nature of a contract’s content, and the generally limited need-to-know about a contract outside the Legal and Contract Management teams, all work to restrict general knowledge about the workings of any particular contract.

However, many stakeholders in a contract need to know certain things about it in order to do their jobs. This is particularly the case when it comes to ensuring compliance with the obligations associated with that contract.

In an earlier article we advocated the use of a contract summary for providing a good plain language overview of the features of a contract, including obligations.

One outcome of the summarisation process is the allocation of ownership to certain aspects of the contract, like obligations.

Contractual obligation management needs to be internal to the organisation, regardless of which party is the obligation holder with compliance responsibility.

This allows proactive steps to be taken by the organisation to detect any drift towards non-compliance by itself or the vendor, and take or request remedial action sooner rather than later.

While the contract summary does a good job of increasing obligation awareness, successful obligations management requires a detailed compliance specification for each obligation.

The information needed can be recorded in our free contract template if you don’t use dedicated vendor and contract management software, or if your contract tracker doesn’t have an obligations management capability.

Also required is a standardised process for checking compliance and tracking contractual obligations. This will not only simplify any training needed across the organisation, but also increase the pool of people who may need to participate in a compliance check without much prior notice when circumstances dictate.

Ranking the criticality of contractual obligations

The criticality of an obligation is directly related to the implications of the worst-case response to its non-compliance.

Consider invoice payment after the due date as an example. In many contracts, when late payment occurs, the vendor may or will charge interest at a particular rate on the amount outstanding until that amount is paid in full.

Any accrued interest will appear on the next invoice after full payment is received for the outstanding amount. Obligation criticality here is likely to be low or very low.

However, if the payment is outstanding for say more than 60 days, the supplier might withhold the contracted services until all amounts then due are paid in full within say five days. Depending on the nature of those services, the payment obligation criticality might range from low to very high.

It’s important then that each obligation is assigned a criticality level, to heighten awareness that what might superficially appear to be a minor, relatively low-risk commitment actually isn’t.

When and how to check contractual obligation compliance

Obligation criticality usually drives compliance check frequency: the more critical the obligation, the more frequent the check.

However, other factors may need to be considered in setting the check frequency for any particular contractual obligation, such as a poor compliance performance history.

A date for each check should be established initially, say for the first 12 months of the contract’s life.

A calendar of check events should be set up, catering for any necessary preparatory activities like information gathering and discussions with stakeholders, plus any follow-up activities that might be needed, say to rank, address and report any non-compliance discovered."

The calendar should be regularly reviewed and updated as circumstances require. The obligation owner should be the person designated to receive the ‘check due’ alert.

The scope of activities required for any particular compliance check may vary for each check occurrence, depending on the complexity of the obligation and the number of aspects that need to be examined. Accordingly, the number of people required to assist with each check may also vary.

A generalised compliance checking approach for the obligation owner to use could involve activities like:

• Determine the scope, timing and people needed to conduct the approaching check
• Advise the people involved about the scope and timing of the check, and their roles
• Collect and distribute any information necessary for conducting the check
• Review the collected information and score the level of obligation compliance achieved.

Our free template can also be used to capture the details of each compliance checking event, from the contractual obligations to be checked to the compliance scores assigned, the issues detected and any remediation activities needed.

It doesn’t matter if the scale used to indicate the level of compliance achieved is simple (eg none, low, medium, high) or complex (eg 0-10).

It’s important that the same scale is used everywhere, and that it is based on the notion that the higher the compliance level, the lower the risk to the organisation.

 An important aspect to watch for over time is evidence of a downward trend in the compliance score for any specific checking activity. This needs to be treated as a rising non-compliance potential.

How to manage a contract breach

A contract breach can occur for many reasons, despite best intentions. Some breaches might be first detected by the organisation without the vendor being aware that there was a problem until advised so by the organisation, or vice versa.

Alternatively, it may be a rising non-compliance potential that gets noticed and the details passed on as a pre-emptive action.

Irrespective of how any actual or potential contract breach is detected, again there is value in adopting a standardised approach to dealing with it, such as:

1. Advise the obligation holder about their actual or potential contract breach
2. Estimate the effect of actual contract breach on the affected party
3. Investigate and determine the causes of the actual or potential contract breach
4. Decide on and then quickly apply a method to remediate and prevent such contract breach
5. Negotiate and deliver an acceptable compensatory response for the affected party as needed
6. Update the contract as needed to restate an obligation or its compliance method
7. Revise the detailed compliance specification as needed
8. Inform all interested stakeholders about how the contract breach was dealt with.

Note that steps 3-6 above may be undertaken jointly with the vendor as necessary.

To the extent possible, measures to address any actual or potential contract breach should be implemented without undue delay. This action helps to minimise risk and shows the commitment of both parties to the smooth running of the relationship.

How to report contractual obligations compliance levels

Visibility of contractual obligations is incomplete without some understanding of how well both parties to the contract are meeting their individual and joint commitments.

Obligation compliance levels should be a major reporting item for risk management purposes, as many stakeholders have a vested interest in the achievement of high levels of compliance, both personally and organisationally.

To provide useful information, the contractual obligations compliance report could show details like:

• Contract numbers: total contracts; important contracts; important contracts compliance-checked this year; other contracts; other contracts compliance-checked this year
• Contracts checked this period: vendor name; contract name; contract importance; contract purpose; # critical contractual obligations; a list of critical contractual obligations checked showing the obligation holder and owner details, the assigned compliance level and comments about any non-compliance detected plus planned remediation date and approach if known, and a rolled-up overall compliance level
• Overall totals: for important and other contracts, separately and together: contracts checked, contractual obligations checked, compliance by level; rolled-up overall compliance level.

The format of the compliance information reporting, its presentation timing and distribution arrangements all need to be agreed within the organisation.

A contract may oblige one or both parties to self-report on their compliance with some or all of their contractual obligations, and provide that information to the other party.

The content and format of the self-reporting and its presentation timing should be specified in the contract or otherwise agreed between the parties.

Since vendors self-reporting is likely to be incorporated into the organisation’s internal reporting on compliance levels, a measure of confidence in the self-reported numbers is required.

A policy of ‘trust but verify’ using internally-sourced information is a good way to establish that measure.

It will also reveal any mistakes, misconceptions, miscalculations or misinterpretations made by one or both parties if the numbers don’t agree. The discussion about any differences can be:

• Enlightening: didn’t know that
• Worrying: should’ve known that
• Damning: should have known better
• Incriminating: shouldn’t have done that.

‘Trust but verify’ can probably be done on a random, spot-check basis rather than for every reporting cycle. The ‘trusting’ party should deal with undesirable outcomes as it sees fit.

The ‘trusted’ party should willingly and rapidly address any issues which can or have eroded that trust.

Further analysis of the reported compliance levels might be conducted to suit specific needs such as non-compliance by organisational unit, contract type, vendor, country and so on.

Recalibrating contractual obligations

In today’s highly dynamic regulatory and political environment, yesterday’s dead certainty can disappear, change unrecognisably, just need a light refresh or remain acceptable just as it is.

Change may be forced or planned, and may need to be achieved overnight or over the longer term. Expecting and being prepared for this is a good risk management strategy.

Considering this environment, many aspects of a contract should be regularly reviewed for ongoing relevance. For contractual obligations, the focus should be on the most critical commitments and those that are most difficult or tedious to check for compliance."

Over time though, every contractual obligation should be assessed for ongoing relevance at least once.

Discussions with the vendor will always be needed, to highlight relevance-related concerns about the need for, nature or current settings of any contractual obligations, and jointly decide on any achievable recalibration.

Where a change to contractual obligations is possible and desirable in some respect, amendments to the following should be expected:

• The contract
• Some of the data measurement requirements supporting compliance checking
• Some of the compliance check specifications
• The compliance checking timetable
• The compliance reporting regime.

Details of any such changes must be relayed to all interested stakeholders, regular participants in contractual obligation compliance checking activities, and recipients of contractual obligations compliance reports, as and when appropriate.

Summary

Managing compliance with contract, regulatory, policy, process and other obligations is a good risk minimisation practice.The key to success here is increased visibility of obligations, their ownership and criticality.

A solid understanding of the pitfalls of non-compliance, a strong commitment to complying with their obligations by all parties, and a structured compliance checking program supported by appropriate alerting technologies are evidence of that visibility.

Achievement and maintenance of a high level of obligations compliance in at least all important contracts is a reasonable and worthwhile target.

It shows that, while individual contracts may have more compliance issues than others, at a portfolio level, obligation risk is being managed within acceptable bounds.

If you would like more information on how to manage your obligations compliance then contact us today for a free consultation.