What is a Price Adjustment Clause?

What is a price adjustment clause?

A price adjustment clause (sometimes referred to as a price escalation clause) is a contractual provision that establishes rules for adjusting the contract price in response to one or more triggering events. The contract price, in this content, includes any purchase price, fee, charge, royalty, rent, or other amounts payable as consideration under a contract. Triggering events often involve factors that are beyond the parties’ control. Perhaps the most common example of a triggering event is a change in the inflation rate over a given period (see examples 4 and 5 below); however, triggering events can be anything that the parties deem likely to have a material effect on the contract price. As shown in the examples below, other triggers include: (i) a change in exchange rates, (ii) a change in applicable law, and (iii) a change in direct input costs. The purpose of the price adjustment clause is to permit some flexibility in the contract price to account for changing circumstances over the term of the agreement.

How do you review the price adjustment clause in contracts?

When trying to determine whether a contract has a price adjustment clause, a good place to start is the pricing terms. Most agreements will have a section that sets out the main terms for the contract price, and if an agreement has a price adjustment clause, it will typically be included in this section. As the examples below illustrate, the clause may also be indicated by section headings such as “Changes to Purchase Price”, “Price Adjustments”, etc., which should make it easier to identify.

After locating all the price adjustment language in each agreement, key information to consider when reviewing these provisions includes:

1. Adjustment trigger. Understanding what events trigger the price adjustment clause is the first step in evaluating its potential impact. Not all triggering events are created equal. Many will have clear parameters that establish when the event has occurred, but some may be more ambiguous in this respect. Example 2 below, for instance, clearly defines the triggering event as any time the percentage change in the USD/Euro exchange rate exceeds the Threshold. Similarly, examples 4 and 5 below establish annual price adjustments to compensate for the increase, if any, in the rate of inflation over the preceding 12-month period. On the other hand, the triggering event in example 1 below is not so clearcut. Looking up the defined term “Key Technical Parameters” should establish what these parameters are in relation to the Specification. But what constitutes a “material increase” in the production costs of the Product? To make this determination, the parties must exercise judgment, and they may not always agree that a particular change in Key Technical Parameters results in a “material increase” in production costs, which only adds to the uncertainty. Note as well that an agreement may have more than one triggering event. Examples 4 and 5 below, for instance, each have three triggering events, and example 2 has two. It is therefore important to review the clause thoroughly to ensure all triggers have been identified.

2. Adjustment amount. The adjustment amount is usually closely related to (if not part of) the triggering event. Where the adjustment involves economic or financial factors like inflation or currency, the adjustment amount will typically be determined according to the change in value of an established price index, exchange rate or other benchmark and it may be limited (or capped) at a certain amount regardless of the overall change in the benchmark (see examples 1, 4 and 5 below). Some other bases for establishing the amount of the price adjustment are shown in example 5 below. Section 7.4(a)(ii) provides for a price adjustment equal to the annual increase in Supplier’s lease and property costs. Similarly, section 7.4(b) provides for a price adjustment equal to the increase in Supplier’s costs as a result of a change in Applicable Law. These kinds of pass-through adjustments for input costs are similar to an inflation adjustment in that they are accounting for a change in the price of goods or services that a supplier or service provider needs to generate revenue. However, an advantage of a pass-through adjustment over a more general inflation adjustment is that the pass-through adjustment accounts for the full increase in the price of particular input costs; whereas, an inflation adjustment may not provide the same benefit if the periodic change in the price of the same input costs exceeds the rate of inflation.

3. Adjustment frequency. The adjustment frequency helps the parties anticipate how often prices are likely to change. It is not uncommon for price adjustment clauses to stipulate regular periodic adjustments on, say, an annual or quarterly basis. In some cases, however, the frequency may be more dynamic. In example 2 below, for instance, price adjustments happen anytime the USD/Euro exchange rate exceeds the Threshold, meaning that price adjustments could be quite frequent when the USD/Euro exchange rate is volatile. More frequent adjustments translate into a more unstable contract price, which is typically a disadvantage for buyers.

4. Direction of the adjustment. Many price adjustment clauses address price increases only, which is generally good for the seller but not so good for the buyer. Examples 1, 3, 4 and 5 below, for instance, are all cases of this. Example 3, in particular, explicitly precludes the possibility of a price decrease. Sometimes, however, the clause may provide for both increases and decreases in the contract price, as is the case in example 2 below, where the exchange rate adjustment could be positive or negative. A more interesting illustration of a negative adjustment is the second sentence of example 2. It essentially states that, should the Manufacturer sell products in the same geographic region that are identical to the Product (but intended for a different use) at a lower price, the Minimum Transfer Price will be reduced to match that lower price. Thus, the price adjustment in that context operates almost like a most favoured nation clause, which is good for the buyer but not so good for the seller.

5. Process for adjusting the price. Some price adjustment clauses may include procedural details or requirements for effecting a price adjustment. Example 1 below, for instance, requires the parties to “negotiate in good faith” to agree on a “mutually acceptable” increase in the Purchase Price. Similarly, example 3 below states that the fees in that agreement “shall be revised by the Company Board of Directors annually”, implying that a formal meeting and/or resolution may be required to change the price. Incidentally, the “Company Board of Directors” in this agreement refers to the buyer’s board, which at first glance may seem like a raw deal for the Manager (i.e., the seller). The Board’s discretion is, however, tempered by the requirement that fees be subject to increase only. Also, the language “shall be revised” suggests that the fees will be increased each year, meaning the Board also cannot effectively nullify the clause by deferring adjustments indefinitely. Finally, if a price adjustment clause stipulates that notice of any increase must be provided (see example 5 below), be sure to confirm the deadline for giving notice and check the notice section of the agreement to determine the requirements for effective notice.

As with the review of any contractual provision, it’s also important to be aware of other provisions that may affect the interpretation of price adjustment clauses. The notice clause, for example, was mentioned in point 5 above. The definitions section of the agreement may contain important defined terms that are necessary for understanding the clause. The pricing terms of commercial agreements or the rent terms of commercial leases should provide additional details of the contract price that is subject to the adjustment. The term section provides useful information about when the term begins and how long it lasts, which may be relevant if the timing of the adjustment is tied to the term of the agreement. Finally, when considering terminating a contract with an unfavourable price adjustment clause, check the termination section for termination for convenience language as well as any information about the consequences of termination (e.g., termination fees, ongoing obligations after termination, etc.).

Software that uses AI to identify and extract price adjustment clauses (as well as other terms that may affect their interpretation) can accelerate the work of finding these provisions and enable a more comprehensive review than can otherwise be done manually.

Examples of the Price Adjustment Clause

Below are some examples of price adjustment clauses from different kinds of agreements. While these examples do not necessarily cover the full range of price adjustment clauses one may encounter, they are meant to illustrate the degree to which these provisions can vary from contract to contract. Where an example includes broader contextual language, the price adjustment clause is highlighted in bold.

Example 1: From a Supply Agreement

2.4 Changes to Purchase Price. The Purchase Price shall not be subject to change as the Parties change the Specification unless changes are made to the Key Technical Parameters that materially increase the production costs of the Product. In such situations requiring an increase in pricing, the Parties shall negotiate in good faith to agree on a mutually acceptable change to the Purchase Price, and the Specification shall be amended to reflect such change.

Example 2: From a Distribution Agreement

(d) Price Adjustments. The Minimum Transfer Price and the Base Transfer Price shall be adjusted on an on-going basis should the USD/Euro exchange rate change by more than [X] from the base exchange rate of 1 Euro = 1.25 USD (the “Threshold”), provided that such adjustment shall be made only by [Y] of the difference between the Threshold and the USD/Euro exchange rate then in effect. In addition to the above and subject to Section 2.3 above, in the event that Manufacturer sells, supplies or otherwise distributes any other products which are identical to the Product in their components, concentration, and composition for use outside the Field, in the Territory, at a price that is lower than the Minimum Transfer Price, then the Minimum Transfer Price shall be reduced on an on-going basis to such lower price.

Example 3: From an Accounting Agreement

5. Fee. In consideration of its services hereunder, Manager shall be paid as follows:

a) In consideration of the financial accounting services provided hereunder, a Financial Accounting Service Fee of Euro 250.000 (two hundred and fifty thousand euros) per annum, paid quarterly in arrears on the last business day of each quarter, commencing with the first payment on the 30 th of September 2012.

b) In consideration of the financial reporting services provided hereunder, a Financial Reporting Fee of US$30,000 (thirty thousand US Dollars) per Vessel per annum, paid quarterly in arrears on the last business day of each quarter, commencing with the first payment on the 30th September 2012.

The Financial Accounting Service Fee and the Financial Reporting Fee shall be revised by the Company Board of Directors annually and shall be subject to increase, but not decrease.

Example 4: From a License and Service Agreement

5.6 Unless explicitly stated otherwise in an Exhibit 1n, the initial Maintenance Fee, specified in each Exhibit 1n, is subject to annual increases on the anniversary date of the Maintenance Start Date. Annual increases shall be limited to the lesser of 7.5% or the change in the U.S. Department of Labor, Consumer Price Index (CPI) for the Urban Wage Earners and Clerical Workers, All Cities, (1982 = 100) for the 12 month period preceding the anniversary date. Maintenance Fees shall also be subject to increase following delivery of, modifications or additions to the Software or changes in the numbers of accounts processed, user seats, or other fee determinant. Company may also increase Maintenance Fees in the event that Company implements major system enhancements to comply with changes in law, government regulation, or industry practices.

Example 5: From a Service Level Agreement

7.4 The Supplier may, however, increase the Operational Service Charges:

(a) on an annual basis with effect from 1 January each year in line with:

(i) the higher of the percentage increase in the Retail Prices Index or the Average Earnings Index in the preceding 12-month period and the Supplier shall notify the Customer of all such increases (based on such index data available at the time of notification) by 31 December of the year prior to the increase taking effect. Promptly upon the Retail Prices Index and Average Earnings Index data being publicly available for each month of the proceeding 12-month period, the Supplier shall affirm or adjust in writing the price increase as previously notified and to the extent an adjustment is made this adjustment shall be back-dated to apply from 1 January and any over- payments or under-payments shall be addressed in the next invoice; and

(ii) any increase in costs to the Supplier due to increases in lease and property costs relating to any premises or site used by the Supplier in the performance of the Operational Services; and

(b) notwithstanding Clause 22, upon not less than 30 days’ prior written notice in line with any increase in costs to the Supplier in performing the Operational Services as a result of any change to Applicable Laws.

Example 6: From a Business Development Services Agreement

3. The calculation of Service Provider’s aforesaid estimated Costs and Expenses may be adjusted from time to time by agreement between the parties, and the Service Fee payable by Parent shall be re-calculated accordingly.

Example 7: From a Supply Agreement

11.2 The Supplier shall be entitled to increase the price per meter for the Stock Shape once in the year 2003 and once in each subsequent calendar year during the term of this Agreement, provided however no single annual increase shall be by more than [***]% The Supplier shall give the Buyer not less than 60 days’ written notice of any change in the Price.

Example 8: From a Distribution Agreement

7.2 The price payable by the Distributor for the Products (the “Price”) shall be no more than the price paid by Distributor for such Products in the 12 month period immediately preceding the Effective Date. Any change to the Price shall be effective only if mutually agreed between the parties, each acting in good faith, no less than 6 months in advance. Unless otherwise expressly agreed between the parties in writing as set forth in Section 7.4 below, Supplier may invoice Distributor for Products ordered upon collection of such Products by Distributor or its authorized agent from Supplier’s collection point in Edinburgh, Texas, and Distributor shall pay Supplier’s undisputed invoices within 60 days of the date of invoice. Notwithstanding any provision herein to the contrary, all prices and payments for the Products shall be in US dollars.

Example 9: From a Service Agreement

These Prices are valid for Batches commenced between 1st January 2013 until 31st December 2019, subject only to an annual increase based on PPI, with the first increase on 1 January 2014. Company reserves the right to increase the prices if there is any exceptional raw material or energy price increases.

Example 10: From a Master Services Agreement

3.8 Long Term Studies. In cases where the project duration exceeds twelve (12) months, Service Provider reserves the right on each anniversary of a project’s starting point to increase its applicable fees by up to five percent (5%) to reflect the changes in the salaries paid to its employees and other cost increases. This potential increase shall be applied to all invoices and subsequent payments occurring after the notice of the increase.

Example 11: From a Supply of Goods Agreement

9.3 If increases in the input and principal manufacturing costs of raw materials, labour and energy for the Products in any year of this agreement exceed 3%, the Supplier shall have the right to adjust the Product Prices to reflect such increase (“Product Price Adjustment”). The Supplier shall give the Customer not less than six month’s prior notice in writing of proposed changes (“Product Price Adjustment Notice”). In the event that the total of these input and principal manufacturing costs adjusts downward, the Supplier must adjust or eliminate any prior Product Price Adjustment.

Example 12: From an Offtake Contract

6.1 Price

(a) In consideration for the provision of the Material by the Seller, the Buyer shall pay the Seller the price in US dollars set out in the applicable Specification and in accordance with this Clause 6.

(b) The price agreed is based on the Incoterms and delivery place agreed in the applicable Specification.

(c) The price may only be changed or adjusted in accordance with price adjustments for quality and quantity as defined in the applicable Specification.

Example 13: From an Employment Agreement

(a) SALARY. For all services provided by Executive hereunder, Executive shall receive during the Term a base annual salary of $400,000.00, payable semi-monthly in arrears. The base annual salary shall be reviewed by the Supervisory Board as of each anniversary of the Effective Date and may be increased upon the written recommendation of the Supervisory Board with the Company’s approval, which approval will not unreasonably be withheld. The base salary as so increased may not be decreased.

Example 14: From a Manufacturing Agreement

5.2 Pricing

The price of Products will be determined by both parties at the beginning of each calendar year.

The Manufacturer shall have the right to make modifications to Product pricing during a given year when the prices of raw materials, within the order cycle, experience massive variations in prices (massive variations in prices refer to the monthly average price changes of five main raw materials: steel, aluminum, copper, composite materials, engineering plastics exceed 5% from window query of Chinese futures trading), upon providing Company with not less than sixty (60) days’ notice of such price change, provided that no such price changes will apply to any Purchase Order already submitted by Company at such time, or within such sixty (60) day period.

Example 15: From a Manufacturing and Supply Agreement

2.8.4 Pricing Adjustment Events. The parties shall review and agree to new pricing at the request of either party in the event the party making such request can reasonably demonstrate (a) changes to Products, Specifications, Testing Criteria, or additional Company requirements have directly impacted Product manufacturing or Material costs, or (b) market-driven Material cost fluctuations exceeding [X] of the aggregate Materials cost line item of the current price have persisted for at least [Y] despite Manufacturer’ commercially reasonable efforts to reduce or eliminate such price fluctuations (each, a “Pricing Adjustment Event”). Upon any such request by Manufacturer, Manufacturer shall promptly deliver to Company such documentation as reasonably requested by Company, consistent with past practice, to verify any purported cost increase related to the particular Pricing Adjustment Event. Within *** of such request and the parties’ receipt of reasonably sufficient verification demonstrating an actual associated price increase has been incurred in respect of the particular Pricing Adjustment Event, the parties shall in good faith review the impact of such unforeseen circumstances and, if appropriate, agree on updated pricing solely to reflect the allocation of any agreed upon price increases resulting directly from the particular Pricing Adjustment Event, which shall be implemented on the date agreed by the parties. On the day any new pricing is implemented, Manufacturer will also write-down or write-up, as applicable, existing Materials on hand or on order held by Manufacturer to reflect the new agreed pricing and invoice or credit Company for such adjustment, as applicable. The parties agree to close any financial claims within [Z] of the effective date of any pricing adjustment implemented pursuant to this Section 2.8.4.