For any business, contracts are the backbone of transactions. They protect your interests, secure agreements with other parties, and set expectations and obligations.
According to PricewaterhouseCoopers, companies can save up to two percent of the annual costs using a contract management system, thus avoiding risks, inaccuracies, and non-compliance.
Let’s examine contract risk, how it occurs in different aspects of commercial activities, and helpful advice on how best to manage them effectively.
What Is Contract Risk?
Contract risk refers to the potential for financial loss or legal liability resulting from breaches or failures in fulfilling contractual obligations. It happens when parties fail to meet their respective duties or circumstances prevent them from doing so.
Contract risks significantly impact the business if not mitigated early on. Here’s a list of contract risk implications.
- Firstly, failure to adhere to them can lead to litigation, financial loss, and harm to brand reputation.
- Secondly, if not resolved, contract disputes can escalate into damaging legal battles that drain vital resources, time, and energy.
- Thirdly, failure to manage and mitigate contract risk can lead to legal and regulatory sanctions that can severely impact businesses, such as the banning of products or services to a particular region or country due to unethical manufacturing processes.
In short, understanding contract risk is critical to safeguarding your reputation, assets, and prospects.
Types of Contract Risk
When you involve contracts, there’s always a chance that something could go wrong. It’s essential to understand the risks involved and how to manage them.
There are four common types of contract risk: financial, operational, legal, and reputational or brand.
1. Financial risk
Financial risk is all about money. It happens when the financial implications of a contract don’t work out as expected. Say a company signs a contract with a supplier to purchase a certain amount of goods at a specific price for a local music festival.
However, the supplier cannot fulfill the contract due to unforeseen circumstances like an accident on the way to the event’s place. The business has to pay more to find another supplier.
2. Operational risk
Operational risk is when a contract disrupts normal business operations. Say a company signs a contract with a supplier to deliver leather goods at a particular time, but the supplier needs to do so.
This delay could cause major operational issues among the production team, ultimately leading to financial losses.
3. Legal risk
Legal risk is ensuring that the contract complies with the law. This risk can arise due to ambiguous language or if a party fails to fulfill its obligations under the contract.
Legal risks can also occur if the contract is not enforceable in a court of law. For example, an agreement missing key information or having unclear clauses could be deemed unenforceable.
4. Reputational or brand risk
Finally, reputational risk is when a contract could damage a company’s reputation. This could occur due to non-compliance with ethical or social standards or if the other party does something that tarnishes the company’s reputation.
A famous example of reputational risk is the United Airlines passenger dragging incident in 2017, where a passenger was violently dragged off a flight after he refused to give up his seat to a United employee. This incident caused significant public backlash and damage to the United Airlines brand.
How to Conduct a Contract Risk Management
Here are five steps to follow when conducting contract risk management.
1. Identify potential contract risk issues
This step includes reviewing the contract terms and assessing the contract’s potential impact on the business, such as financial losses or reputational damage.
For example, a business may identify the risk of a vendor failing to meet its delivery obligations, leading to lost sales and revenue.
2. Evaluate the likelihood of occurrence
This step involves analyzing the probability that the identified risks will happen and assessing the impact if they do occur.
For instance, a business may evaluate the likelihood of a breach of contract by assessing the vendor’s track record and the potential consequences of a breach. The business can also conduct a background check of the vendor’s history and previous transactions with other companies.
3. Assess the Consequences
Once potential contract risk issues and their likelihood have been identified, you must assess the consequences.
This involves determining the financial, operational, and reputational impact of contract risk on the business.
For example, a delay in delivery by a vendor may result in lost sales, reduced profit, and damage to the business’s reputation.
4. Determine strategies to mitigate risk
This step may include renegotiating contract terms, establishing contingency plans, or seeking alternative suppliers.
For instance, if the risk of a vendor’s inability to deliver goods is high, a business may develop a contingency plan to minimize the impact of a delay.
Other appropriate strategies are:
- Conduct a thorough contract review to ensure all terms and conditions are clear and well-defined.
- Negotiate favorable terms that will protect the business from potential risks. This often involves having legal counsel review the contract to identify potential risk areas and negotiate proactive measures.
- Purchase insurance policies or risk management tools that can help offset potential losses in the event of a breach of contract or other contract-related issues.
- Maintain open communication with the other party throughout the contract lifecycle.
5. Monitor and review risks regularly
Monitoring and reviewing contract risk involves tracking the performance of vendors, reviewing contract terms, and modifying mitigation strategies.
For instance, a business may periodically review a vendor’s performance to ensure they meet performance obligations.
Other ways to monitor and review risks are the following:
Monitoring and reviewing risks regularly is essential to manage and mitigate contractual risk effectively. Here are some ways you can do this:
- Create a database or spreadsheet to track all your business contracts. Ensure to include important information such as contract expiration date, responsibilities, and ownership.
- Schedule regular reviews of your contracts to identify potential risk issues. This could be every six months, annually, or at a frequency that makes sense for your business.
- Ensure someone within your organization has responsibility for reviewing contracts and risk management.
- Monitor changes in laws, regulations, and industry standards that may affect your business.
Strategies for Mitigating Contract Risk Through Effective Negotiation and Communication
When businesses sign a contract with another party, risks can cause financial and legal problems. However, these risks are manageable through effective negotiation and communication.
Here are some of the strategies worthy of implementation.
1. Establishing clear expectations
Before signing a contract, establish clear expectations and goals for both parties. This includes understanding the scope of work, timelines, payment terms, and any potential risks. By addressing these issues upfront, both parties can ensure they are on the same page and reduce the likelihood of disputes.
For example, a software company is hired to create a new website for its client. Before signing the contract, both parties discuss the website’s features, design elements, and desired launch date. They also clarify the payment structure, including the penalties for missed deadlines.
2. Conducting thorough risk analyses
Both parties should conduct a thorough risk analysis to identify any potential issues that may arise during the contract term. This includes assessing costs, legal compliance, intellectual property, and risks.
For instance, a construction company is hired to build a new office building. Before signing the contract, both parties assess the potential risks, such as material costs, labor disputes, zoning compliance issues, and weather-related delays.
3. Drafting clear and concise contract terms
The language of a contract should be clear and concise to avoid any misunderstandings. Both parties should ensure the contract terms are well-defined, specific, and enforceable. As such, it is vital to establish the appropriate legal framework to govern the contract terms.
A vendor is contracted to supply raw materials to a manufacturing company. The contract legally defines:
- the types and quantities of materials
- payment terms
- quality standards, and
- dispute resolution processes
4. Maintaining open communication
Open communication between the parties is key to effective contract management. Both parties must be willing to communicate openly and honestly throughout the contract term to avoid misunderstandings or potential problems.
Say an advertising agency is contracted to create a branding campaign for a new product launch. During the contract’s term, both parties maintain regular communication to ensure the campaign meets the client’s brand vision and expectations.
5. Reviewing and updating contract terms
As circumstances change, contract terms may also need to be updated. Both parties should review the contract periodically to ensure that it continues to meet their expectations and is still enforceable.
In anticipation of possible future contractual risks, both parties should be prepared to negotiate and update the contract terms.
Let’s say an insurance company updates its policy contract terms to include new regulatory requirements. Before renewing policy subscriptions, the company notifies its customers of the revised contract terms and re-negotiates as needed.
In conclusion, managing contract risk is essential to doing business effectively. The abovementioned strategies can help mitigate contract risk and ensure both parties benefit from the agreement.
How to Successfully Manage Contract Risk Using Fill
If you’re looking for a platform to help you manage contract risk, Fill is the best solution. Here are some key features and what to do with Fill in your mobile device or computer.
- Contract Template Library: Fill has a library of pre-made contract templates customizable to your specific needs. This ensures that your contracts are legally compliant and reduce the chances of missing essential clauses that could result in future risks.
- Automated Reminders: The platform sends reminders for contract renewals, deadlines, and other important dates. It reduces the likelihood of missed deadlines and potential legal disputes.
- Collaborative Review: Collaborate with other stakeholders to review contracts. All parties agree before signing, reducing the chances of legal disputes or misunderstandings.
- Secure storage: Fill app offers secure storage of contracts, ensuring that your sensitive information is protected from unauthorized access or potential breaches, thereby eliminating the risk of potential data risks.
Using the Fill app to manage your contract risk ensures smooth business operations, saving you time and money.
Sign up for a free account on Fill’s website today and see the other features in action.