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CONTRACTUAL RISK ALLOCATION LEADING TO THE ILLUSION OF CONTROL WHERE NONE EXISTS

Some companies seem to believe that contract risk management involves using contract templates and terms that transfer all risks to the other party. This is especially true for large companies with strong bargaining power. Many are eager to transfer risk mechanically through onerous contracts. Some contractors accept such contracts trusting that they can transfer all risk down the procurement chain through back- to-back contracts with subcontractors and suppliers. This

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practice is risky because, contrary to the company's intentions, it may become a source of risk and lead to negative surprises. The better suppliers may have a choice and, as a result of the onerous contract terms, may walk away and do business with the competition. other companies may accept such terms trusting that they, in turn, can transfer them, along with the associated risk, to their business partners. So those onerous terms pass down the procurement chain until they reach a party with no bargaining power or will to fight.

While making other contract parties accept onerous terms might create a feeling of control and of having the risks addressed, the party down the supply chain may not be able to keep its promise. This, in turn, might cause everyone in the supply chain to suffer. If the breaching party is ultimately unable to carry the resulting losses, the risk may fall back on the shoulders of the company that thought others had assumed the risk. Effective contract risk management clearly requires a different approach.

in the context of today's networked businesses and contracts, a loss caused to a company, its contracting partner, or someone down the supply chain can impact all companies involved and their future collaboration. Expensive contractual disputes endanger relationships. Contract risk management must start with a realistic approach to risk, which often also requires a willingness to accept and share some risks. Making other parties over-promise or accept any terms may create an illusion of control where actually none exists. Everyone's fortunes in a project are ultimately linked, and one party can never fully transfer risk to others in a supply chain.[1]

The problems of attempted risk allocation through one-sided contract terms is, of course, not limited to subcontractor situations and procurement chains. In some industries, suppliers still have the upper hand and will try to force their one-sided terms on their customers. Whether working on the sell-side or the buy-side, the truth remains that using contracts that attempt to transfer all risks to the other party does not make the risk go away and is no substitute for good risk management.

  • [1] Loosemore, M., Raftery, J., Reilly, C. and ffiggon, D. (2006) Risk Management in Projects, 2nd edn. Abingdon: Taylor & Francis, p. 162. See also Loosemore, M. andMcCarthy, C.S. (2008) Perceptions of contractual risk allocation in construction supplychains. Journal of Professional Issues in Engineering Education and Practice, 134(1), 95-105.
 
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