Navigating Legal Uncertainty

Contracts usually create a set of rules by which people and companies deal with one another. They also usually rely on a set of agreed expectations: If I do X, you give me Y. But finding common ground for those expectations can be challenging in times of uncertainty: What if X or Y might change as the deal goes forward? 

Enter the Prescribed Adjustment Clause, or PAC, which is a contract term that establishes specific criteria, external to the agreement, that can change the terms of the contract without a separate modification agreement. These provisions allow the parties to recognize the potential for uncertainty at the time of contracting and negotiate the impact of uncertainty into the terms of the contract itself. The contracting parties also have the flexibility to pick their own triggering events, measures and thresholds so that factors affecting unique individual markets can be considered.

A standard PAC has three parts: 

1. First, the clause will establish the set of circumstances that trigger when it applies—the triggering event. This can vary depending on the type of contract and market. The impacts of commodity costs, tariffs, labor difficulties, delay and inflation are some of the more commonly considered trigger events.
2. The second part of a PAC is language that defines the impact of the trigger on the contract’s obligations. In the case of a price adjustment clause, changes in the ultimate contract price, per unit price, or offset entitlement can happen automatically. Where it is a performance adjustment clause, changes in delivery date, substantial completion, or per-unit completion, can all happen without change-orders or the need to negotiate an extension.
3. Thirdly, most PACs will include a set of limitations. Accounting for uncertainty when contracting is wise, but too many or too drastic automatic adjustments can make a contract meaningless.

Establishing limits on the number or frequency of changes helps keep the contracting parties close to their original expectations.

Recommended, but not essential, components of PACs can also include caps on the overall number of adjustments, specific notice requirements so there is no surprise when one side claims an adjustment, and event reversion language that eliminates prior adjustments if the uncertainty is temporary or did not last a specific amount of time. These can all help limit manipulation and gamesmanship when the ideas of these clauses is to help the parties be cooperative trade partners.

A few examples can help provide some context. Where raw material prices are an essential component, a PAC can set a specific percentage increase from an established market metric like the Producer Price Index that provides a corresponding adjustment to the contract price. Or, where labor uncertainties predominate, tying an adjustment to the Employment Cost Index from the U.S. Bureau of Labor and Statistics can be set for an underlying price or delivery change to the contract. Finally, where uncertainty in the overall cost of production is unknown, an adjustment based on changes to the Consumer Price Index or specific cost of business metric allows the parties to help manage those dynamics.

Properly negotiated and drafted PACs can help both sides of an agreement. It can protect profits by capping adjustments but also allows both parties to get something out of the agreement by protecting overall production costs. They also help provide some financial stability by avoiding excessive change order processes and mid-performance modifications, although these do have their place.

Further, they can improve relationships and make the performance process more efficient by avoiding ongoing renegotiation efforts.

Getting PACs into contracts is not always easy, but there are few best practices that can ease acceptance.

Start early. Getting the prospect of a PAC into the negotiation process early helps manage expectations and can overcome kneejerk rejections. Even when dealing with form agreements, raising the prospect of a PAC as a separately negotiated agreement or addendum can serve a useful place.

Research and update triggers. Knowing where embedded costs are subject to the most flexibility, and then identifying third party indexes or metrics that can be reasonably relied on to reflect market changes, allows the negotiation of PACs to be more readily accepted by both sides. Fair use of neutral data that is not subject to gray area interpretations helps build the relationships that can get these clauses into agreements.

Use technology. Whether it is using AI-generated  contract reviews to find PACs, or setting smartphone reminders for where a specific index is entering triggering territory, technology can help define where the clauses are and enforce them when in place.

Monitor and notify. PACs only work when they are used. Monitoring for potential triggering events is essential to ensuring the benefits of a PAC are maximized in a timely manner. Also, notifying the other side of a contract that a PAC is close to trigger, or was triggered, can avoid later disputes as to whether the clause is applicable and needs to be enforced.

There is always risk in setting the rules in a contract. And while the risk from market uncertainty cannot be eliminated, it can be tempered with PACs.