Are your contracts doing enough to protect your company from unforeseen circumstances like inflation?
In January 2022 the U.S. inflation rate climbed to its highest level in 40 years1, with prices rising by 7.5% from a year ago. It has had a significant impact on many, including the companies (both buyers and vendors) that have been trying to survive the past two years of the COVID-19 pandemic. Inflation brings risk and uncertainty along with it, and it might be doing more harm to your business than you’re aware of.
Using Zuva’s DocAI contract analysis technology, we found that the vast majority of contracts we reviewed didn’t have an inflation adjustment clause.
An inflation (or cost of living) adjustment clause is a contractual provision that requires prices or other monetary amounts to be adjusted periodically based on the relative change in the value of one or more established price indices. The purpose of the inflation adjustment clause is to safeguard, as much as possible, certain prices, fees, rents, expenses, and more from the value-eroding effects of inflation over a contract’s term through a prescribed adjustment mechanism.
We reviewed 150 contracts dated between 2000 and 2021, all governed by U.S. law. There were 64 supply contracts, 44 service contracts and 42 intellectual property (IP) contracts2. Of those 150 contracts, only 13%3 were identified as having an inflation adjustment clause.
16 of the clauses we found addressed the price being adjusted annually, with six clauses setting out a specific percentage (ranging from two and a half to six percent). Consumer Price Index (CPI) and the Producer Price Index (PPI) were the two indices that were referenced in the clauses we found. Seven clauses referenced a potential price decrease.
With contract analysis technology, it’s possible to extract buried but critical information from your documents.
DocAI enabled our team to find out if the contracts were protected from inflation and how they could be further improved.
For vendors (companies supplying goods or services), the inflation adjustment clause helps preserve the purchasing power of the money they earn from sales during periods when input costs are rising. On the other hand, for buyers (companies buying goods or services), the opposite is true. And buyers - especially those who have limited ability to pass cost increases on to their customers - may find that the purchasing power of the money they earn from sales deteriorates during periods when input costs are rising.
In reality, very few companies are exclusively buyers or vendors. Most occupy both positions. Companies, therefore, need to have an understanding of how inflation is addressed in all their contracts to assess their net exposure. This will allow them to make informed decisions about managing overall inflation risk, including, where possible, terminating existing contracts with unfavourable inflation terms and negotiating appropriate safeguards into the inflation terms of new contracts.
The vast majority of the contracts we reviewed did not contain an inflation adjustment clause.
The absence of such a clause can cause cost uncertainty for companies at a time when inflation is the highest it has been in forty years.
Buyers that did not budget for such a steep increase could find themselves unable to satisfy existing contract obligations which could potentially lead to costly disputes or litigation. On the other hand, vendors face a number of potential challenges, including if there is no inflation adjustment clause, buyers may dispute with vendors on whether prices can increase pursuant to the contract and may not be able to fulfill their contractual obligations.
Additionally, existing contracts that include an inflation adjustment clause may have an insufficient cap. It is therefore important for companies to review existing contracts and evaluate how inflation is addressed and if there is an ability to renegotiate. Where a contract contains unfavourable inflation terms, a buyer or vendor may consider terminating the contract if there is a termination for convenience clause.
Finally, companies can consider how they should draft and negotiate inflation adjustment clauses in future contracts.
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2 For a review like this, an experienced lawyer would spend about 20–30 minutes for each contract, meaning this project would take between 50 to 75 hours to complete. Thanks to Zuva’s DocAI, we were able to speed up our review and complete the task in under 25 minutes.
3 15 supply contracts, six service contracts and one IP contract.