A little understood legal principle could turn your next outsourcing exercise into an expensive headache, says David Galloway, in house lawyer for a leading super fund.

By sending out a request for submission or tender document the issuer will almost always create a side contract called a process contract, exposing it to legal action if submissions aren’t dealt with in a particular way.

Though based in common law, process contract obligations can arise because of statutory requirements such as a ban on misleading or deceptive conduct or an obligation to act in a fair, efficient and honest manner. Both of which apply in many industries, especially financial services. A process contract obligation could even arise by implication from what a trustee should do to satisfy a prudential standard, so perhaps it’s time to revisit this often overlooked problem.

What are they?

The general rule is that if a document sets out rules for assessing submissions or awarding a contract, a side contract may be created in which the issuer contracts with each competing party to act in a way consistent with the document.

One consequence of this is that if an issuer departs from a stated process, an unsuccessful competitor who suffered disadvantaged may be entitled to seek damages for losses sustained in preparing their submission and even for loss of profit.

Since terms can be implied into just about any type of contract, prudential standards and trustee duties could also affect the content of a process contract entered into by a trustee. Though the core terms are usually taken to be those stated in the document.

In the Hughes Aircraft case a document informed competitors in unqualified terms that there would be fairness between tenderers. While fairness is good, an unqualified promise of fairness is a big undertaking to live up to. And when the issuer departed from stated selection criteria for what it presumably thought were good reasons, Hughes was able to sue for substantial damages.

By contrast the State Transit Authority case concerned a document that clearly allowed the Issuer to deal with each submission differently, and so could not be successfully sued for breach of process contract. But that doesn’t mean the problem can be solved by using an open ended or vague process because the State Transit Authority operated an unusually well protected environment.

The Port Macquarie-Hastings Council case involved a breach of process contract that arose despite an open ended process, because council engaged in misleading or deceptive conduct. The misleading or deceptive conduct arose when negotiations between the preferred bidder and council ran into difficulties and council began negotiating in secret with a competitor, just in case.

When council eventually informed the preferred bidder it would proceed with its competitor, the preferred bidder sued and won because council was obliged to disclose the negotiations to the preferred bidder to avoid engaging in misleading or deceptive conduct. So what tripped council up was not its document, but a commercial law of which it was only faintly aware. It’s easy to imagine how a trustee could find itself in a similar predicament, particularly when new prudential standard and covenant obligations have transformed much of the legal background against which they operate.

Managing the risk

It may be impossible to completely remove the risk of being sued under a process contract, but the risk can be managed by applying a few principles to tendering and evaluation processes.

Some key rules to follow when drafting a document are:

• Though not always effective, exclusion clauses are often made less effective by failure to specifically exclude implied obligations. Always ensure an exclusion clause is included and that it excludes damages for breaches of both express and implied obligations.

• Explain the tendering process using words that confer options on the Issuer but not obligations. Failing to provide any description of the tendering process is probably not a realistic option for a trustee seeking to demonstrate compliance with its general law and statutory duties, but the words used to describe the process should never drag you into a dispute.

• State that the Issuer reserves the right to reject any or all tenders, amend the tender process at its discretion and enter into negotiations with one or more competitors. While that might seem to be an all-encompassing provision we know from case law that it has limitations, but some protection is better than none.

Key rules when evaluating submissions:
• Ensure the method used to evaluate submissions clearly addresses all criteria mentioned in the document.
Care should also be taken to ensure that any criteria not mentioned in the document are kept secret from all competitors. This is most direct and persuasive defence against a claim for process contract breach, but is  overlooked with surprising regularity.
• If a document gives the Issuer a right to depart from a stated process and it decides to do so, all competitors should be notified of the departure and given an opportunity to provide further relevant information.
• Recognise the importance of information symmetry in avoiding claims by providing each competitor with all additional information requested by any other competitor to the extent possible without breaching confidential information and intellectual property obligations.
• Finally and perhaps most importantly, don’t explain the reasons for the decision. While competitors will often ask for a debriefing, the fact is that clams for beach of process contract generally arise because the Issuer told a competitor it did something wrong. What you don’t communicate can be just as important as what you do.

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