What is contractual risk?

March 15, 2023

Contracts are the foundation of business relationships. They establish the components of business deals and vendor relationships, providing certainty, accountability, and legal protection for both parties. However, various risks are frequently associated with agreements organizations enter into.

Let’s explore what a contract risk is, the types of contract risks, and how an organization can mitigate them during the contract lifecycle.

What is contract risk?

A contract risk is a potential issue that arises from an agreement an organization has executed. These issues can be many things — potential lawsuits, financial losses, regulatory fines, and reputational damage. Ultimately, contract risks can affect the desired outcome of the contract, the parties’ relationship, and business operations.

What is contract risk management?

Contract risk management is the process of accurately assessing the potential risks within a business’s contracts and taking steps to mitigate them. Although it’s not possible to eliminate all risks in legal agreements, there are effective ways an organization can minimize future issues both during contract negotiations and after, when the focus is on contract compliance and enforcement.

Types of contract risks

A key component of contract management is assessing and reducing contract risks. Agreements can carry many potential hazards, and an organization must understand them to reduce the chance of something going wrong.

Businesses should consider:

Financial risk

A financial contract risk involves losing money, whether through an additional cost or lost revenue. Some examples include:

  • Value leakage: Value leakage means the contract’s potential value is more than the actual value realized during the contract lifecycle. This can happen if an organization focuses too much time and resources on low-value, standardized contracts. Value leakage might also occur if an organization uses unapproved pricing models or an unsuccessful approach to contract negotiations. Over time, value leakage can deplete an organization’s realized revenue.
  • Missing key contract dates: If an organization misses a key contract date, like a contract renewal, it may lose business or continue an unwanted contract due to an automatic rollover.

Legal risk

A legal risk happens when an organization is exposed to potential litigation. Examples include:

  • Breach of contract: This occurs when one party breaks the terms established in an agreement, such as making a late payment or by failing to deliver goods by a specific date. Along with litigation, a breach of contract could also result in a fractured business relationship and a damaged reputation.
  • Failure to comply with regulations: If an organization agrees to a contract without legal oversight, it might be susceptible to noncompliance with state or federal regulations, resulting in potential audits, fines, and litigation.
  • Other causes of action: Depending on the contents of an agreement and the parties’ actions, a business could face lawsuits over intellectual property infringement, confidentiality disclosure, and other causes of action.

Security risk

A security risk is when unauthorized parties access or inadvertently receive contract data. Weak information security is one of the biggest contract management mistakes an organization can make, often resulting in further financial, legal, and reputational issues. Some examples of how these security breaches can occur:

  • Weak security measures: Leaving confidential contract data unencrypted, communicating sensitive information via email, and providing even levels of contract access within an organization can all trigger security risks, resulting in a potential data breach.
  • Poor contract storage: A security risk can occur if contracts are lost or displaced due to poor contract storage methods. It’s common for organizations to keep contracts stored across multiple locations that lack security — filing cabinets, shared drives, email chains, etc. These methods aren’t the safest or most organized way to store documents. To mitigate this risk, businesses should consider contract management software to keep contracts in a central repository.

Reputational risk

Reputational risk occurs when an organization is portrayed poorly or discussed in a negative light, either in public or among industry professionals. Often the fallout of a financial, security, or legal issue, reputational risk can drive away business partners, vendors, and employees, affecting an organization’s ability to generate revenue and hire talent.

Operational risk

Operational risk arises from inefficient internal or outsourced processes. For example, if an organization uses outdated contract management processes, the contract process will likely be slower, and the organization may have to wait for a needed product or service. Additionally, a contract’s value can diminish due to poor planning and demand management, ill-informed buying, deliberate contract manipulation, and miscommunication.

What is contractual risk transfer?

Contractual risk transfer involves using a contract provision to shift liability to the party that might be in the best position to control or prevent damages. This method is commonly used in subcontracting, lease agreements, sales agreements, and other similar situations.

Some of the ways an organization can shift contract risk:

  • Indemnity agreement: This agreement is a legal document or contractual provision in which one party agrees to pay the other party’s losses or damages no matter who was at fault.
  • Limitation of liability: This contract clause helps limit the number of damages or losses a contracting party can claim from the other party.
  • Waiver of subrogation: A waiver of subrogation is a provision that prevents an insurer from recouping money they paid on a claim from a negligent third party.

3 ways to navigate contract risk management

Negotiate realistic contract terms

When negotiating contracts, an organization should not overpromise or demand unrealistic contract terms. Businesses should have relevant stakeholders involved in the negotiation process to ensure the promises align with the organization’s resources and demands meet market expectations.

Along with realistic contract terms, businesses can focus on using consistent, on-market terms for many common provisions. These steps can help streamline a business’s enforcement and compliance efforts.

Identify and assess contract risks

Businesses should review their contracts, identify risks by their type (financial, legal, security, etc.), and rank the risks as either low, moderate, or high according to how often they may occur. Keeping a scorecard of contract risks may help a business prioritize where it needs to focus its mitigation efforts.

An organization may also want to analyze its current contract lifecycle management process to discover where risks enter the workflow, such as during negotiations or after execution, so it can set up additional controls.

Create processes to mitigate risk

Once an organization identifies and prioritizes the risks it may face, it must take proactive steps to mitigate them.

These processes might include securing contract data with encryption, setting reminders for contract milestones, creating or updating contract templates, and streamlining the approval process.

How can contract management software help?

Contract management software can help an organization identify, assess, reduce, and monitor contractual risks that arise during negotiations and compliance. Depending on a business’s needs, it might use a contract solution to improve negotiations and ensure it agrees to consistent, on-market terms with its business partners, vendors, employees, and other parties. Businesses might also use a contract lifecycle management solution to carefully track compliance and critical dates, such as renewals and expirations.

Contract management with Ontra

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