This post discusses contract risk and contract risk management. In this post, you will understand the meaning of contract risk and the management of contract risks.

THE MEANING AND ESSENTIAL COMPONENTS OF A VALID CONTRACT

Contracts may be verbal or written to create or expand the relationship between two or more parties. The contract agreement should highlight how each party will interact within a given set of circumstances.

Valid and enforceable contracts must have the following essential components:

1) CONSIDERATION: Each party to the contract must provide something of value to the other, such as a product, service, or payment.

2) OFFER AND ACCEPTANCE: An offer made by one party, such as to provide a good or service, is accepted by the other, often for payment.

3) INTENTION TO CREATE LEGAL RELATIONS: The parties to the contract must intend for the agreement to be legally binding, and if such intent is not the case, it should be stated in the contract documents.

4) CONSISTENT WITH THE LAW: The contract must not be against public policy or the law. This is to ensure that the contract is valid and enforceable by law.

5) CAPACITY TO ENTER INTO A CONTRACT: The parties entering into the contract must be capable of making the contract and understanding what they are doing.

CONTRACT RISKS

Contract risks affect the operations, arrangements and outcomes of, and the participants in, a contract. Contract risk entails potential losses due to a buyer’s inability to pay or failure to abide by the contract agreement. There may also be collateral damage for affected business employees in business-to-business contracts.

Contract management can manage team friction, and a lack of velocity can harm a company’s ability to close deals. Poor lifecycle management can result in missing important dates, leading to expensive renewal costs. A key aim of contract management is to establish a record system to mitigate this risk.

CLASSIFICATION OF CONTRACT RISKS

There are several risks associated with commercial contracts. Risks associated with commercial contracts may be classified into five categories: financial, legal, security, brand, and operational risks. 

1. FINANCIAL RISKS: Financial risks are contract risks associated with losing money, regardless of whether it impacts the contracting parties’ top or bottom line. Contract financial risks include credit, liquidity, asset-backed, revenue leakage and cost overruns, and equity risk. Financial risks may arise during contracts when third-party bankruptcy occurs, missing key renewal dates, and renewal of contracts without cost evaluation and analysis. 

2. LEGAL RISKS: There are several legal risks, including regulatory, compliance, and dispute risks. Legal risks arise due to a breach of contract with legal accountability or litigation potential. For instance, regulatory risks may occur during contracts when location legislation is ignored, parties are unprepared for regulation changes, or documentation needs to be updated. 

3. SECURITY RISKS: Security risks can be attached to some of an organisation’s highest-profile and most severe consequences. For instance, security risks may arise during agreements when confidential or contact information is shared with the wrong parties, accessed by unauthorised individuals, or lost or stolen. 

4. BRAND RISK: Brand risk, also known as damage to business risk, is associated with hostile public and customer opinion and poor employee morale and is part of the aftermath of financial, legal, and security issues. 

5. OPERATIONAL RISKS: Operational risk is the risk of loss resulting from inadequate or failed internal or outsourced processes, people, infrastructure and technology, or external events.

CHALLENGES OF CONTRACT RISKS AND HOW TO MITIGATE THEM

There are several challenges regarding commercial contracts through which contract risks arise. Let us consider four core challenges of contract risks.

1) TRANSPARENCY ISSUES: Lack of transparency is a significant challenge of contracts. This could be frustrating scope creep, revenue loss, contract clause errors, and increased costs. Errors are never deliberate, but eschew a system that promotes transparency and minimises mistakes. 

2) COMPLIANCE AND CONTRACT RISK: Compliance goes beyond adhering to legal rules. It is a core function of maintaining or increasing savings, establishing a good reputation, and ensuring a well-respected brand. 

3) INSUFFICIENT SPEED: Time-to-signature is essential, especially for sales teams. Contract creation takes several weeks or months, and several professionals are involved. Inefficiencies and slow operations can impact contract creation, negotiation, and approvals. 

4) VISIBILITY AND ACCESS RIGHTS: Visibility is a significant challenge in contract creation. Yet this goes beyond just actual contract creation. Having the proper visibility into a contract helps the entire lifecycle. 

5) PROCESS INEFFICIENCIES: Practical contract management involves being aware of and mitigating any contract risks that come with the process. Communication across a company and a well-planned, written strategy is necessary to ensure efficient operations.

FINANCIAL LIMITATIONS OF AGGRAVATED RISKS

Contracts aggravated risks refer to the above-average consequences of contractual risks. Impacts of financial limitations of heightened risks include:

• Inferior or substandard contract works, 

• Death.

• Bodily injury.

• Breach of security.

• Breach of confidentiality.

• Infringement of intellectual property. and

• Data loss and inadequate data storage.

CONTRACT RISK MANAGEMENT

Risk management entails identifying, assessing, and controlling threats to an organisation’s capital and earnings. Contract risk management entails identifying, assessing, mitigating, transferring, monitoring, and reviewing contract risks. Hence, effective contract risk management means attempting to proactively manage contracts to ensure the success of the contract work.

Here are the five steps involved in a contract risk management process, which are:

1. Identify Contract Risks.

2. Assess Contract Risks.

3. Mitigating Contract Risks.

4. Transfer Contract Risks. and

5. Monitor and Review the Contract Risk Management Lifecycle.

TRANSFER OF CONTRACT RISKS

The essence of contract risk transfer is to offset all responsibilities to limit liability and loss of revenue. Contracts should be structured to allocate responsibility for risk to the party that creates it well-positioned to mitigate resultant contract risks. Three (3) broad ways of transferring contracts risk exposures are indemnification, liability limitation, and subrogation waiver.

Let us discuss the three ways of sharing contracts risk exposures.

1. INDEMNIFICATION OR HOLD HARMLESS: Hold harmless agreement protects a business against lawsuits by requiring the parties you are doing business with to refrain from suing you under certain circumstances. An indemnification clause obligates a party (known as the Indemnitor) to compensate the other party (known as the indemnitee) for losses or damages (physical injury or monetary) caused by that other party. Indemnification clauses are often closely tied to representations or warranties, promises that specific things are a certain way. 

2. LIMITATION OF LIABILITY:Limitation of liability sometimes referred to as a damages cap, seeks to limit the amount payable in damages on a breach, restrict the types of loss recoverable or the remedies available, or impose a short time frame in which damages are recoverable. Liability terms guard an organisation against risk, thereby limiting the firm’s liability. It is common to base the cap on a percentage of the value of the contract.

3. SUBROGATION WAIVERS: A Subrogation waiver is an agreement between two parties whereby one party agrees to waive subrogation rights against another in the event of a loss. The waiver prevents a party’s insurer from pursuing subrogation against the other party. Insurance is the primary way of waiving subrogation rights in any loss. Subrogation occurs when an insurance company pays the insured and then sues the entity or person responsible for failing to recover the amounts paid to their insured.

CONTRACTS INSURANCE POLICIES

Several insurances are suitable for managing contract risks, including engineering insurance, goods-in-transit, professional indemnity insurance, and fidelity guarantee insurance.

See my video on Contract Risk and Contract Risk Management: https://youtu.be/r-WABBBC_u8