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Home arrow Sociology arrow A short guide to contract risk


When asked about contract terms that deal with risk or are helpful in managing risk, people tend to think about limitations of liabilities, indemnities, and the like—or clauses that specifically mention the word "risk,” such as clauses dealing with owner's or contractor's risk in construction contracts or the risk of loss of or damage to the goods in sales contracts. Many seem to think that these are the only contract terms that deal with risk. Such a view is too narrow.

in truth, all contract terms deal with risk. Contracts are made to reach business and project objectives, and the success in reaching these objectives is dependent on issues such as price, scope, performance undertakings, acceptance criteria, and the management of change. on the sell-side, future profitability depends on these issues. The risk of not getting paid at all or on time, the risk to cash flow, and the risk of diminishing margin all depend on contracts. on the buy-side, contracts are the foundation achieving the expected benefits. The right contract structure and terms can make all the difference between success and failure, profit and loss, margin improvement and margin erosion—even customer/supplier satisfaction and disappointment, the latter possibly leading to claims and disputes.

So risk is not dealt with only in what some might call the "legal parts” of contracts addressing liabilities, remedies, and contingencies. Nor is risk addressed only in the boilerplate provisions, standard terms and conditions, or the small print. Apart from these clauses, technical specifications, work scope definitions, service descriptions, and other deal-specific provisions and attachments deal with risk. Dealing with risk is also embedded in decisions related to contract type, structure, and model, which in turn are determined by the industry and business at hand. For example, when choosing their contract pricing model, such as the choice between fixed price and time and materials, businesses deal with risk. They also deal with risk when agreeing on each party's obligations, roles, and responsibilities and how these are timed. Who has to bear what risks also depends on what role a company takes and where it is located in a supply chain, which at the same time is a contract chain.

in many cases, the "non-legal parts” dealing with scope, requirements, key performance indicators, acceptance criteria, completion, acceptance, warranties, availability, performance, and payment (whether advance payments are made, whether bonds or guarantees are involved, what their terms are, and so on) contain the true sources of risk—and risk control mechanisms. For example, as we will see later in this chapter, a major difference in the risks of both parties depends on whether a service provider agrees to provide a specific result or only to make certain resources available.

While certain "risky” clauses dealing with, for instance, liability or remedies are quite easy to spot, as we will see later, the risks embedded in the absence of certain clauses need to be recognized as well. Apart from the express, "visible” terms of a contract, the default rules also deal with risk. They enter the picture if the parties do not provide a different solution in their contract. if the parties want to limit liabilities or remedies, they can do so in their contract. if they don't, they need to be aware of "invisible” terms that do not provide limitations. The lack of express contractual limitations can lead to unlimited liability for the breaching party. it can even open the door to liability for consequential loss. So the invisible terms need to be noted among the high-risk terms.

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