This article is written by Manasi Sheth pursuing a Diploma in Advanced Contract Drafting, Negotiation, and Dispute Resolution from Lawsikho.

Introduction

In our day-to-day life, we constantly enter into agreements. It can be as simple as travelling in an autorickshaw. The first party agrees to pay the fare for the travel and the second party agrees to take him to an agreed destination. With this exchange, both the parties accept the rights and obligations arising out of the non-written contract. However, these are very simple types of contracts and the stakes in such types of contracts are relatively low. Likewise, businesses enter into contracts for performing their regular day-to-day activities where the stakes are relatively higher and greater risks are involved but by applying correct management strategies such risks can either be avoided or minimised. Let us dive further into this topic to get a better understanding of what exactly is a contract risk and understand how it can be managed.

What is contract risk?

Typically, contract risk is defined as one of the two things:

• The chance of facing losses because the other party to the contract is unable to fulfil the terms, or
• The deal performs badly and hence the risk of losses arisesIt is of the most common knowledge to people that the more the chances of earning profits from a deal, the more the risks are involved.

Contract risks

All business endeavours involve taking certain risks, however; the level of risk is decided to depend on the project. With proper management, the risks involved in these projects can be reduced to a certain extent and ensure that the company makes the most out of the project deal.

For most parts, the most common types of risks involved are:

• Financial risks such as monetary profits or losses. 
• Legal risks such as breach of contracts or infringement, etc
• Security risks involved in the business.
• Risks surrounding the public image of the company such as negative publicity, poor staff morale.

• Financial risks

Financial risks are the risks involving money risks regardless of how it results in changes in the top line and bottom-line figures of the financial statement of the company. Money loss can be a result of anything ranging from missing out on important contract dates, missed delivery dates, compensation on behalf of termination of contracts. For example, let’s say your company was supposed to introduce country related goods on 15th of August and the client fails to deliver them on time and because of that the launch was unsuccessful thus, resulting in huge financial loss for the company.

• Legal risks 

Legal risks arise when one fails to comply with any of the clauses in a contract. Legal Accountability helps to control the limit of legal risks. Legal risks may also arise on account of missing out on using the right legal clauses such as confidentiality clauses, disclosures, etc. Let’s try to understand this better, say the contract does not include a confidentiality clause and the companies freely discuss the terms and context of the contract with everyone and the information gets leaked to the general public, in such a case there will be little to nothing that the company can do because of non-inclusion of the confidentiality clause in the contract.

• Security risks 

Security risks exist when the contracts are stored in insecure locations, there are certain security risks when all the information regarding a contract is shared with all the employees of the company. There is certain high-risk information that should be kept only between the high authority employees of the company or if and when necessary, only to be shared with the required departments and after making them sign an NDA, so that sensitive information is not shared with the public or competitors. 

• Brand risks

Brand risks are the risks associated with how the public sees the company. Negative branding relates to negative consumer reactions, low employee morale. A brand’s reputation is directly related to its financial statements. Word, these days spread quickly. Negative reviews impact the reputation of the brand. One of the latest examples of this that we saw recently was Ronaldo asking for Coca-Cola’s bottles to be replaced with water in front of the media and the huge negative impact that it had on the brand.

How to identify and assess risks in your contract?

Reviewing a contract and negotiating terms are crucial steps in risk management but sometimes we are forced to accept terms we do not like, maybe because the contract is too important for the company to lose out on and the client is adamant on his terms and you are willing to take on those risks. Whatever the reason, but it definitely shouldn’t be because of your own company’s fault and because no proper risk reviewing procedure was followed by them as identifying and assessing risks in every contract is of utmost importance 

The risk review team can follow certain steps to mitigate the level of risk involved, such as:

• Evaluate the technical aspect of the contract

Consider whether the scope of services mentioned in the contract is within the company’s technical expertise to ensure the smooth execution of the contract. The team will also need to review the scope to make sure that it is clearly defined and reasonable and it is within the company’s power to perform them. If there are any gray area matters in the contract then proper evaluation can help the company discuss and clarify such matters with the client.

• Term of the contract

Review whether the schedule of the contract is reasonable. If there is any delay in fulfilling the terms of the contract, does the contract provide for the damages of such delay. Studying such concerns will help the team draft a reasonable schedule and address any possible contract risk.

• Pricing policy and payment terms

Reviewing the pricing policy and payment terms of the contract can help the team analyse whether the contract with the client will be a profitable gain or loss or whether such losses are acceptable or not.

• Location of contract 

Reviewing the cost of the location of where the contract is to be executed is important as well. The risks associated with laws and regulations of a particular location where the contract is to be executed have to be assessed beforehand

• Assessment of the potential client

Before entering into any type of contract with a potential client, the risks of such contracts are to be evaluated such as, whether the clients have a good standing with respect to financial, reputation in the market, their behaviour with their previous clients, did they complete their contracts within stipulated time etc. Such a type of analysing helps a company make thoughtful decisions before entering into any type of contract.

• Review the mandatory provisions of a contract

Mandatory provisions of a contract are those provisions which a company considers very important while reviewing and negotiating contracts with potential clients and cannot do away with under any circumstances. A few of those provisions are:

1. “Standard of care” the standard of care mentioned in a contract should be reasonable, where the highest standard of care induces a lot of risk on the company therefore the company should review such provision carefully before entering into a contract. 
2. Limitation of liability: The company should review the scope under the limitation of liability clause induced by the client whether such provision probably increases the risk of your company and if it does how your company can mitigate it.
3. Mutual indemnification: Both the company and the client should agree to indemnify each other for their own negligence. The Company should consider how likely it is that the client shall behave negligently and cause damage to the company.

• “Nice to have” provisions in a contract

Nice to have provisions are terms which are not necessary to be included in a contract but if included helps both your company and the client to reduce the risks associated with the contract. Provisions such as “notice of error” and “Opportunity to care” fall under this ambit. Many clients do not provide for termination or suspension of contract in case of breach by the client. You should be ready with the ways you would deal with the client in case of such a breach.

• Heightened risk provisions in a contract

There are certain high-risk provisions in a contract that can increase the risk to your company. For example, guaranteed service provisions such provisions are generally of high risk for companies providing services. Here the risk management team can assess if it is viable for your company to agree to such terms. Here’s another one, the provision related to liquidated damages which are usually related to scheduling issues. If the client is unable to deliver the product/service on time then, is there any provision for payment of liquidated damages to be payable by the client till the day the mistake is rectified by them.

Conclusion

Let’s be honest, we cannot avoid these risks associated with contracts but we can definitely evaluate and mitigate the risks associated with such contracts. There needs to be a team dedicated to managing such risks. These risks that the team identifies during the preliminary review will not act as deal-breakers but will bring great value to the negotiating table with the client. The risk management team will bring about good value to contract review and will help identify and reduce the risks. Ultimately, it is not about avoiding risks but about providing solutions regarding mitigating the risks for your clients while also giving reasonable protection to your own company from such risks. 

References

• https://www.upcounsel.com/contract-risk-definition
• https://planergy.com/blog/contract-management-risks/
• http://www.rmmagazine.com/home/2019/08/01/-Eight-Steps-for-Evaluating-Contract-Risks

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