What You Need to Know About Contract Risk: Part 1

Contract Risk Management

Contract risk is something that can happen at any point, potentially resulting in outcomes that are unfavorable. Risk assessment in terms of likelihood, impact level and the chance of occurrence. It normally impacts the arrangements, operations or outcomes of everyone involved in a contract.

In business to business contracts, collateral damage can occur for employees of a business and problems are not always predictable. Of course, an important part of a contract is its ability to deal with risk and prevent it from occurring in the future, while also minimizing any associated impacts.

It is not possible to cater for all risks, nor should all risks be accommodated. Instead, the chance of the risk occurring, along with the risk appetite of the other party, needs to be determined. Or, an option to negotiate changes to a contract if either party becomes affected through various circumstances can be useful.

In this post, the most important risk areas are discussed. Specifically, direct risk.

Direct Risk in Contracts

Being one of the most important types of risk to deal with, direct risk deals with the actual content of the contract. Here are some of the biggest direct risks that could be encountered.

Hidden Contracts

A large risk occurs when personnel doesn’t even realize a contract exists, what’s contained within it, or where it is stored. Therefore, as people don’t know pertinent deadlines or obligations, it’s possible for penalties to be enforced or even termination or auto-renew.

It’s not uncommon for people who previously managed an ongoing contract to leave an organization, leaving the contract ‘orphaned’. Alternatively, someone may know of its existence, but pay little regard to the content within. Leaving contracts to luck simply isn’t an option.

Instead, companies need to have the right technology, processes, and policies in place to make all contracts visible. This paints the most accurate picture of risk.

 

Operational Events Anticipated in Contracts

Most modern contracts enable functions to flow smoothly by outlining the operational arrangements between various parties. However, if certain activities aren’t performed, this can result in risk.

If a customer order is delivered late, production can be slowed down and the milestone might even be missed. By agreeing to the delivery period, this risk can be taken away. A price discount increase could also be applied, depending on the delay.

If a supplier invoice is delayed, there’s the risk that their creditors won’t be paid. This can cause the customer order to not be processed or delivered. Thankfully, this can be mitigated pretty easily by including non-payment penalties, charging interest on the balanced owed, or simply not accepting the order until all monies owed are paid.

If confidentiality is somewhat breached, a financial penalty could be issued, reputation can be damaged and ultimately, the order could be canceled. Usually, through adequate workforce training and providing notification requirements, this can be avoided.

If a situation is judged as being highly likely to occur, or could adversely affect contract outcomes, this can be minimized by simply identifying such a situation and implementing the right approach for reducing or removing its effects.

 

These might include:

  • Providing key dates very clearly
  • Implementing systems that can monitor supplier performance
  • Providing for each party detailed obligations, and explaining the consequences of non-compliance
  • Describing parameters and operating processes like placing orders, payment, or changing a contract
  • Clauses for risk management surrounding force majeure, limited liability, dispute resolution, exchange rate management, or governing law
Contracts that don’t Comply

Compliance problems can be a particularly strong burden on a contract. Typically, parties might have to comply with:

  • Laws regarding the sale of certain goods for people in certain countries
  • How information is protected in certain regions or countries, like GDPR
  • Laws for certain industries
  • Certain ways of doing business which is accepted generally
  • International standards like SOC 2 reports that control effectiveness
  • Obligations
  • Operating policies, practices, and processes for either party in the contract

Contracts should clearly outline obligations that apply to both parties, whether they are joint or separate. This lowers the chance of arguments and therefore non-compliance risk that affects final outcomes.

General practice might govern some forms of regular compliance anyway, even if not specified in the contract. In other cases, compliance with the law might have to be included in black and white to remove any doubt. In particular, the right language needs to be used, and the other party might need to provide evidence that they can comply. For each form of deviation, responses might need to be specific.