What is Contract Risk Assessment
A critical component of contract management, contract risk assessment is a systematic approach to identifying, evaluating, and mitigating potential risks that could impact the successful execution of a contract. Risks can stem from a variety of sources and can have financial, legal, or operational impacts on both a buyer and a seller. The objective of a contract risk assessment is to gain a comprehensive understanding of these risks, and develop a plan to effectively manage or reduce them.
Risk assessment has become an essential function of contract management. A well-structured process enables both parties to make informed risk-based decisions, such as whether to accept a new supplier , or what trade-offs to make while developing a new product. A proactive approach to risk management can decrease the costs associated with risk response projects, insurance, claims, and litigation. Not to mention help ensure that both parties fulfill their contractual obligations.
For buyers, adopting modern contract management solutions that incorporate the contract risk assessment process, streamlines and automates contract reviews. Increased standardization of contracts leads to more efficient and insightful reviews. Contract risks, and available risk mitigation strategies, are more apparent. For the seller, an automated risk assessment process within a contract management solution ensures consistent evaluation of incoming contract opportunities, while reducing administrative overhead associated with contract review.
Typical Contract Risks
Contracts are the lifeblood of any business. They form the backbone of transactions with clients and suppliers, establish the parameters of relationships between business partners, and outline the terms of employment for employees. However, no contract is without risk. Failing to understand the various types of risks contracts can carry can place your business in jeopardy.
Financial Risks. Financial risks can be the most damaging type to businesses. Whether it’s a client failing to pay on a contract, a supplier raising costs, or an employee suing for undue dismissal, any financial loss can send ripples throughout an organization. The impact can range from small to catastrophic, depending on the specific requirements of the contract. While managing cashflow can become a full-time job, it is even more difficult when financial risks materialise. From cost-cutting to finding new revenue streams, these issues can distract from other operational requirements.
Legal Risks. Legal risks are those associated with how enforceable and applicable a contract is in a legal setting. Understanding the legal aspect of a contract can be a time-consuming and costly task. As contract law differs from jurisdiction to jurisdiction, it is vital that you ensure all clauses are worded in a manner consistent with the jurisdiction you operate in. To further mitigate legal risks, make sure your organization has sufficient legal cover. From a simple legal retainers to bespoke insurance packages, ensuring your business is fully protected from legal risks can help protect it from crippling losses.
Compliance Risks. Compliance is an increasingly important part of business. From protecting customer data to ensuring your operations don’t harm the environment, businesses are required to adhere to a number of legal requirements. If a piece of legislation changes, there can be significant impacts on your business if a contract fails to comply with it. Understanding which requirements you need to comply with can help you futureproof your contracts.
Operational Risks. Our final type of risk is operational. Operational risks can affect how your organization is run. For example, the current requirements of a supplier may not be sustainable if the business suffers due to a financial downturn. In this case, it becomes important to understand how a contract with that supplier can be renegotiated. Similarly, with an employee, it is vital to determine how their contract can be changed in order to accommodate changes to the business.
Contract Risk Assessment Steps
When embarking on the contract risk assessment process, companies must take a systematic approach or the assessment of the risk of particular suppliers could be missed. There are a variety of ways to conduct a risk assessment, but generally speaking, there are several basic steps to consider in the process.
- Identify the supplier – You will want a standardized approach for identifying suppliers to profile, but typically, you will want to identify suppliers that are high dollar volume or hold strategic importance for your company.
- Evaluate likelihood of risk – Take a look into the financial status of the supplier, regulatory issues affecting the supplier and its facilities, the technology risks, etc.
- Evaluate impact of risk – This step goes hand-in-hand with likelihood of risk and can be as easy as determining what it would cost to re-sourced if the supplier disappeared over-night, or as complex as having a cross functional group work through the impact of each risk in each department.
- Prioritize the risk – If you have 1,000 suppliers, you’re not going to be able to do a risk assessment on all of them at first. You will have to prioritize which companies offer the higher risk or greater liability to your business.
Contract Risk Assessment Tools and Techniques
With the importance of contract risk assessment firmly established, the next step is to take a look at the tools and techniques that can make the whole process much more straightforward. Depending on the complexity of the contract at hand and the nature of the risk being assessed, there are different options to consider. First, it’s important to keep in mind that, regardless of the techniques used, each risk assessment will require the same basic steps: Of these steps, the last one is arguably most vital for larger or otherwise complex contracts. This is where a comprehensive risk assessment tool can come into play. Such tools help organizations to consolidate commercial, technical, operational, financial and legal risks in one coherent document, all whilst implementing a consistent approach to risk management across the organization. This allows for greater visibility of risk across the business while also making the entire process more systematic and repeatable. Risk matrices – maybe the simplest and quickest option – are another useful technique for helping companies to assess different contract or project risks. Typically these consist of an evaluation of the severity of impact that a risk could have, paired with an estimation of the likelihood of its occurrence. For instance, it might be that an organization determines that a given risk would be quite costly, but is also considered to be unlikely to arise. In this case, the impact might be rated as ‘major’, but the probability told might be ‘unlikely’ – meaning that the overall product of the two – I x P – is 5: I = 3 P = 2 5 = Medium Risk A risk matrix such as this is fairly rudimentary in terms of the variables on which it focuses in making a determination. But when utilized correctly, it can speed up a risk assessment process and provide a decent summary of the risk involved. As such, it is recommended for use when assessing lower stakes contract risks that do not require a full evaluation and exposure assessment for legal liability purposes. There are also many software solutions available that will help organizations to assess various risks, both when it comes to contract management procedures and other major business processes. Such tools typically include features such as automated risk analysis and management report generation that will bring together critical information in a neat, easy to interpret format, positioning managers to make the right moves at the right time. Ultimately, these risk management solutions speed up the risk evaluation process and cut down on the amount of man-hours required to get the job done. In addition, holding workshops with all relevant parties can prove a great way to riskticate contract risks. As well as allowing a team to collaborate and communicate on the issue at hand effectively and efficiently, they help to ensure that the most granular and accurate assessments can be made, even where the situation is a complicated one.
Mitigating Contract Risk
Once the contract risks have been assessed, strategies should be put in place to mitigate them. This can take a number of forms. In some cases, it is possible to renegotiate the terms of the contract in order to address identified risks. For example, if the contract features a liability clause that is giving you cause for concern, you can try to negotiate a limit on the amount of damages for which you might be liable. This can also work in reverse. If the contract in question contains a liability clause that caps your damages at some patently unreasonable amount, such as a dollar figure so low as to amount to a free pass to breach the contract, you may wish to renegotiate in order to minimize your risk .
There are a number of other strategies that you can adopt in order to reduce your risk, including purchasing insurance and developing contingency plans. Your risk assessment criteria will be a wise investment only when they lead to effective mitigation of appropriately identified risks.
It is not also sufficient to merely conduct the risk assessment and, when it is complete, either act as if it does not exist, or fail to take its results into account during contract negotiations. Instead, the risk assessment must be a vital part of how the contract is drafted, negotiated, and ultimately executed.
Reviewing and Monitoring Contract Risk
Continuous review and monitoring of contract risks is essential to ensure that issues are identified before they develop, and contract terms evolve in a manner commensurate with shifts in one’s business or industry. Some of the most common issues that develop under contracts arise from misunderstandings of contract terms, which typically develop from a single event or initial communication under the contract, which are compounded over time by later events or communications under the contract. For example, if an early meeting between certain stakeholders under the contract gave one stakeholder the impression that the contract would be interpreted or performed in a certain way, it then becomes incumbent upon that stakeholder to help ensure that initial understanding pervades the further development of the contract, such that later changes including amendments, notices, performance and related communications remain consistent with the initial understanding. Likewise, if there is a disagreement over contract terms during negotiations or performance, it is critical to document the position of all stakeholders, as well as any follow-up actions taken to confirm that the positions of each party have not changed. This strategy can help to prevent issues from developing, which can be important for large, complex contracts between multinational parties where there may be sudden changes in the regulatory or legal environment or where local laws or regulations differ among jurisdictions.
For some circumstances that are less certain, a simple progress report, indicating the areas of discussion among stakeholders, whether under the formal reporting structure under contractual terms or by other means, can go a long way to help ensure that misunderstandings do not develop. When review and monitoring of contract terms include periodic audits, enforced by proper documentation of all communication under the contract, stakeholders will be able to ensure that their interpretations take into account all relevant considerations. In addition, by properly documenting discussions and related actions to confirm understanding of a contract, stakeholders may shield themselves from allegations that their positions changed if issues develop in the future regarding interpretation of contract terms or performance thereunder.
Lastly, with respect to monitoring risk under contracts, emphasis should not only be on the negotiation and performance phases, but also on the foundational relationship between contractual parties, which often arises slowly and is not contingent on the contract itself. Careful consideration of the relationship between parties under a contract can assist in understanding the motivations of stakeholders that can influence the better performance of the contract, and overall relationship management among stakeholders is critical in that regard.
Legal and Best Practice Considerations
While contract risk assessments typically happen at the beginning of a contract lifecycle or during any important renegotiations, some enterprises don’t consider the legal implications when doing so. When a contract is breached, terminated, or poorly managed, you need to know if you’re in violation of any laws, regulations, or industry standards. If you fail to do so, contract breaches could turn into even more lawsuits and fines.
You should start with your contracted obligations. For instance, certain U.S. government contracts require compliance with Federal Acquisition Regulation (FAR) cybersecurity clauses, which have strict requirements for data security requirements set by NIST. If you work with, for example, HIPAA-regulated data, you’ll find a wide variety of federal and state directives that you’ll need to comply with , as well.
The last thing you want to deal with after a contract breach is defending a breach of contract (Breach of Fiduciary Duty and Breach of Duty of Care fall under this category). The burden of proof is on you to prove that your company as a whole exercised sufficient care in formulating and upholding the terms of the contract.
One way to ensure you fulfill your obligations is to be methodical and organized. Make sure your recordkeeping is excellent and contain all of the information you’ll need down the line. Be prepared to share records with regulators as needed.
While a good contract risk assessment tool will help identify digital data risks, it can also help you check for red flags that indicate noncompliance. A vendor may not comply with the Health Insurance Portability and Accountability Act’s (HIPAA) breach disclosure requirements if it holds onto protected health information (PHI) after your business relationship is terminated, for instance.