The Basics of Contract Risk Management

By PracticeLeague, January 14, 2022   |   8 Min Read

What is Contracting Risk?

In its simplest format, the risk is the probability of a negative or deleterious happening. In organizational terms, the risk is defined with respect to the organization. Contracting risk, or contractual risk, is specifically the risk that emanates from the contract, its creation, execution including documentation, its terms or performance. It has a significant potential of impact on all the parties to a contract, the underlying task or objectives, as well as business relationships. All contracts have both benefits as well as risks associated, which need to be understood.

To keep it simple, this means that the contract should be negotiated properly and executed by authorized people on both sides; worded accurately from policy and regulatory perspective; should cover the entire grounds being discussed; cover clearly & identify all terms and deliverables; and the contract performance should be trackable. Lastly, it should be a legally enforceable contract.

Types of Contract Risks

Contractual risks can be classified into many different sub-classes, depending on your approach. Firstly, you can classify them as per pre-contract, contract execution, & post-contract risks as one approach at a very basic level. The pre-contract phase refers to the people involved in the contract negotiation & discussions, the setup of the clauses, terms and the specifics of the obligations. In this phase, care is to be given that the clauses are as per the regulations and organizational policies, and that all the mutual contracting compliance & obligations etc are properly captured.

Contract execution phase refers to the signing, the documentation of the contract – here, the sources of risk emanating from the signing authorities and their approval status within their organizations, the proper capture of documents relating to the contract, and correct registration of the same. The terms & performance phase deals with contract tracking: the phase where the contract is operational and deals with the obligation management & performance against the aspects of the agreed term

Another way to classify risks is more along functional lines: financial risk, legal risk, security risk and brand risk. Financial risk is associated with the risk of monetary, revenue loss or penalties/damages; legal risk deals with the contract clauses and their legal-regulatory aspects as well as compliance management and dispute or conflict issues. Security risk refers to the proper secure access and storage of documents and contracts, whereas brand risk refers to the risk of damage to the brand name or company reputation as a result of contractual risks or non-performance.

Contract Risk Assessment

Given the nature of contract risk as indicated above, it becomes exceedingly important for any organization to be on-hand with the range of contractual risk that confronts them. This is more so since there are hundreds, maybe thousands of contracts, each with its own risk profile. Thus, collating and viewing the risks that confront an organization on this front becomes critical.

A contract risk assessment does not start after the contract is executed; a proper assessment process runs concurrent to the contract formalization process and feeds into it and supports it. It begins with a judgement of internal capacities to execute the contract by both or all parties to a contract. For example – a company takes on a contract to produce products that are beyond its capacity to manufacture, or a trader signs on a contract to purchase products far in excess of his sales capacity. Once codified into a contract, it can become binding – hence, assessment has to be a concurrent phase in Contract Management.

The key sources of contract risks are all originating in the pre-contract or execution phase – overcommitment of deliverables, improperly worded contracts, contracts that are not legally enforceable because a key clause is missing or improperly worded etc, commitments beyond approved limits, incorrect information running up to a contractual negotiation. The key to managing and mitigating contract risk is the understanding that a fundamental aspect of risk management is judging future or potential risks, and ensuring their probability is minimized.

Post contract risk assessment is more of a question of contract management and contract compliance, that is a management and tracking of the agreed terms of the contracts in terms of deliverables by all the involved parties to a contract; their deadlines and renewal dates, and their ongoing conformity with regulations, policies and laws of the land in which they operate.

From the above, we get a basic handle on the nature of risk itself, the nature of contractual risk, and some basics on the way to handle that risk using a Contract Lifecycle Management software like Razor365. Risk, to put it very simply, it just the likelihood of any damage or loss to the organization. Contract risk is that risk which is based in the contract or in some way caused by it. Risk assessment is a simple ongoing activity driven by organizational processes, methods and policies, which is also guided by regulations and laws of the land. Further in the series, we shall go deeper into both the specific sources of contract risk, and the deeper granular aspects of risk assessment, as well as how to mitigate contract risk.. Do stay connected with our blog!