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What Is Contractual Risk? Learn the Basics

man assessing potential for risk in a contract

Contracts allow you to take advantage of business opportunities and set the framework for profitable business relationships. However, there are contractual risks associated with every contract your business enters.

Contractual risks are issues or problems arising from a contract you entered. Contract risk hurts the operations and outcomes of a contract, and a key part of contract management is managing and minimizing these risks. In this article, we’ll explore:

  • how to assess contractual risk
  • what contractual risk transfer does
  • how you can manage contractual risks

Types of contract risk

Before you can assess contractual risk, you need to understand the various risks in a contract:

  • Financial risk: Financial risk is the loss of money, whether it affects your top or bottom line. The monetary loss can be caused by third-party bankruptcy, missing key contract dates, and auto-renewal of contracts without cost evaluation and analysis.
  • Legal risk: These are risks that expose you to litigation. It could be from breach of contract, infringing on intellectual property, failing to include key legal clauses, or missing compliance and regulatory requirements.
  • Security risks: This can happen when contract data is accessed or disclosed to unauthorized parties. If your data management practices are not compliant with privacy laws,you risk data breaches, which can cause further legal and financial losses and reputational damage.
  • Operational risk: Operational risk is any form of loss caused by inefficient internal or outsourced processes.
  • Brand risk: Brand risk is often a fallout of financial, security, and legal risk. Any negative public image will, directly and indirectly, affect your bottom line.

How do you assess contractual risk?

Contract risk analysis should start during the contract negotiation stage before you sign the contract. Every contract has an inherent risk. For example, the risk that the buyer may default in payment runs in most purchase agreements.

You can assess your contractual risk by doing the following:

Assess the counterparty

When contracting with new partners, it’s important you research and scrutinize their reputation, policies, ethics, and principles. What is their contracting history? Do they perform their contractual obligations, or is there a trail of litigation against them? What is their financial health?

Also, check their compliance with privacy regulations, especially if security is critical in the transaction. What are the security protocols they’ve put in place to secure data? Do they conduct background checks on their employees?

Review your obligation under the contract

Evaluate your contractual obligations and your ability to meet them. Are there some obligations that may be a hassle to meet? How much will it cost to meet the obligation? Are there unclear obligations?

Evaluate timelines and milestones

Check contract deadlines, such as the delivery date and payment date, and confirm that they are favorable for you. If the transaction has milestones, check that you can meet them. It’s also good to consider penalties for missing any timeline.

Review contract terms

Analyze your contract terms, especially the risky ones. Are they drafted in clear language? Are the terms fair to both parties? Inherently risky terms, such as indemnification clause and limitation of liability, should get special attention.

Note risks specific to a location

If you’re contracting with a party in a different legal jurisdiction, especially if they’re in a different country, consider the risk you may face. Countries have local regulations and legislations you may be unaware of and risk defaulting. Also, consider additional risks like exchange rate fluctuation if you’re paying in a different currency.

Ensure regulatory compliance

Your contract may need to comply with different regulatory and industry standards. Some, like privacy regulations, can expose you to penalties and erode customers’ trust if you default. Also, confirm that performing your responsibility under the contract won’t make you break any law or regulation.

What is contractual risk transfer?

Contract risk transfer is a way to shift contract risk from one party to another legally. The reasoning behind contract risk transfer is that the party in the best position to control or prevent losses or damages should bear the responsibility when they occur. Contract risk transfer is common in subcontracting, lease agreements, and sales agreements.

There are different ways to transfer contract risk:

  • Indemnity agreement: Parties can use an indemnification clause to compensate a party for losses caused by the other party’s action.
  • Limitation of liability: You can use a limitation of liability clause to cap the amount of damages a contracting party can claim from you.
  • Waiver of subrogation:A waiver of subrogation is when an insurer waives their right to recover damages that the insured party did not cause.

Contract risk management

Use the following tips to manage your business’ contractual risk:

Identify contract risk

Before you can manage your organization’s contract risks, you’ll have to discover where they exist in your contract and your contract process. Identify the contracts with higher risk exposure, specific regulatory compliance risks, geographical regulatory compliance risks, and any contract management process that puts your organization at risk.

Assess contract risk

In assessing contract risk, evaluate the different types of risk using the following measure:

  • Low, moderate, high, extreme:Rank the risks according to how often they occur in your organization’s contract.
  • The probability of occurring:Here, you are determining the chances of the risk occurring.
  • Possible consequences:What will be the fallout if the risk does happen?
  • Risk appetite:Can your organization afford the risk if it does happen?

Reduce contract risk

You can take these proactive steps to mitigate contract risk:

  • Use encryption to safeguard contract data
  • Set reminders for contract milestones
  • Assign role-based access to contracts
  • Create templates for contracts and clauses
  • Use automated workflows to streamline business processes
  • Automate contract process with contract management software

Transfer contract risk

Transfer contract risk to insurance companies and third parties whenever it’s possible. We’ve discussed this earlier.

Monitor your contract risk management lifecycle

Monitor and review your contract risk management framework to clarify misunderstandings and ensure that rights and responsibilities are clearly defined. Contract lifecycle management software like the kind Ironclad offers will help you by providing a clear audit trail of all activities in each contract lifecycle.

Use contract management software to manage contractual risk

Ironclad’s contract management software has contract risk management tools that can help you proactively manage and minimize your organization’s contractual risk. Risks are part of almost every contract, but you can take steps to reduce yours and avoid revenue loss and other negative outcomes.

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