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CONTRACT RISK: UNCERTAINTY THREATENING THE ACHIEVEMENT OF OBJECTIVES

We are not aware of any standards attempting to define contract risks. Contract risks are sometimes seen as part of legal or liability risks and contractual risk management is seen as a subset of legal risk management.[1] The company may face liability if it breaches its contractual obligations. It may incur harmful consequences if it fails to implement its contracts, if its contracts are invalid, or if contract documentation is defective or lacking. False claims in contracts or related sales documentation may subject a company to liability for breach of contract, breach of warranty, fraud, or deceptive trade practices, and so on.

Contract risks can be caused by the other party—for example, its inability or unwillingness to pay or to otherwise fulfil its obligations. When a company operates in the middle of a supply chain, its sell-side and buy-side contracts may not support each other. When this happens, the contract chain may break and result in a loss. If contracts are unclear, the probability of problems developing will grow. In some contexts, certain regulations such as consumer protection laws or competition laws may also add to contract risks.

While contract risks may lead to disputes and litigation, they extend beyond legal issues, such as damages and remedies for breach. If we define risk in terms of uncertainty related to reaching objectives or as a possible negative deviation from the expected, what, then, are the objectives that may be at risk in the context of contracts?

The answer will depend on the context—for example, whether we are discussing a company, a business unit, or a project— and on whom we ask. An entrepreneur might say that business results are at risk: contracts are made to accomplish business results. An accountant might say that cash flow and assets are at risk: contracts are made so that money, products and services can predictably change hands and reliable accounts can be kept on who owns what and who owes what to whom. A project manager might say that successful project outcomes are at risk: contracts are a way to set goals and monitor results in terms of time, money and quality. A lawyer might say that a company's entire financial future may be at risk: contracts are needed to clarify commitments, exclude undesirable and unknown liability, limit excessive risk exposure, and control and resolve disputes.

It is hard to disagree with any of these answers. They represent different functions of contracts and different professions' and individuals' varying views on what matters most. Contracts are tools to reach all of the above objectives—but they can only do so if they are properly designed and a balance is found between the different (and sometimes conflicting) objectives.

Contract risks may threaten business deals and relationships, reduce margins, and prevent the parties from achieving their objectives. They may cause unexpected costs or unintended liabilities. In this book, we use the words "contract risk” for risks that can lead to a negative deviation from the expected outcomes of a contract. These may be business outcomes, legal outcomes, or both. Contract risks are about uncertainty related to reaching objectives. They threaten the success of a contract and can lead to a negative deviation from what is expected.

Contract Risks

  • • threaten the success of a contract
  • • are about uncertainty related to reaching objectives
  • • can lead to a negative deviation from what is expected
  • • can impact business objectives, legal objectives, or both.

What is viewed as success also depends on whose view we represent. What appears as a source of contract risk to one party—for example, the buyer—may appear to be contract risk management (or risk allocation) to the other party, in this case the supplier. The views of the buy-side and sell-side differ, as do those of business and legal.

In this book, we see reaching business objectives as the ultimate goal of contracts. Viewed in this way, contracts become business benefit realization tools. The objectives and benefits depend on the business and the situation at hand and may relate, for instance, to profit, cash flow, completion of work, uninterrupted service delivery, or access to resources such as funding, information, or talent. In this context, contract risk is the possibility that the contract leads to a negative deviation from the expected business outcomes, such as when objectives are not achieved at all, on time, or to cost/budget, quality, or performance expectations.

Contract risk can also lead to a negative deviation from the expected legal outcomes. For instance, the contract or some of its terms that were expected to be valid may not be legally binding and enforceable. This may lead to one party abandoning the contract and the other being left with no performance or remedy. While freedom of contract is the basic principle governing contract law, there are limits to this freedom. There also might be requirements as to form and other requirements that sometimes vary from one legal system to another, and the parties do not want to be negatively surprised. one of the legal objectives of contracts is to create clarity about the binding force of contracts and their terms. Further, contracts should pass the tests of legal accuracy and clarity.

often, the business and legal objectives of contracts are intertwined, and a negative deviation from one objective can lead to challenging the other. Negative surprises that have a commercial impact can lead to a dispute and invoke the legal dimensions of the contract. Parties who did not read the contract earlier will soon realize that even the small print may have a big impact. Different contracts and sources of contract law may provide different and unexpected results. Even the provisions related to the choice of law and settlement of disputes might have a major impact on the outcome of the dispute and whether the judgement or arbitral award can be enforced.

In addition to success and desirable outcomes that a business wants, there are outcomes that a business does not want— for instance, resources spent in excess of what is budgeted, revenue leakage, losses, delays, conflicts leading to disputes and litigation. These result in negative deviations from the expected outcomes. Whether one classifies them as contract risks, business risks, project risks, or legal risks is not important; the main point is that businesses should be aware of the opportunities offered by their contracts to manage these risks and to realize business benefits.

  • [1] See, for example, Mahler, T. (2010) Legal risk management—developing and evaluating elements of a method for proactive legal analyses, with a particular focus oncontracts. Doctoral thesis, Faculty of Law, oslo: university of oslo.
 
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