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Contractual Tools to Manage Risk

Posted by Ryan M. Newburn | Mar 01, 2021 | 0 Comments

 

At Newburn Law, our focus is managing risk for clients. Operating a business means taking on risk, but our experienced business lawyers understand the many contractual tools for managing risk. Whether you run a small business or manage a large corporate entity, you should consider speaking with a transactional lawyer to identify areas where you can use your contracts to manage your business's risks. Contact our business lawyers today to set up a consultation and tell us more about your business.

Contract Risk Management

There are many ways to manage risk. One way is to try to avoid or reduce risk in the first place, including by performing due diligence before entering into a transaction. This may involve inspecting the financial and legal records of a business to determine whether they will be a reliable business partner before deciding to contract with them. Another option is to retain the risk, which means accept the risk and try to mitigate it (through insurance, process management, etc.). For example, if you know there is a risk that a transaction will fall through and your company will lose out on the profit, it may be a small enough risk that mitigating it would be more expensive than the loss itself. However, sometimes the best way to manage risk is to transfer it or share it by contract.

Common Types of Risks

There are several types of risks that may occur in business, including the following:

Legal Risks

As business lawyers, we are always on the lookout for potential legal risks. Legal risks encompass a broad swath of issues, ranging from regulatory requirements, breach of contract concerns, and personal and property injury risks, among many others. By working with an experienced business attorney to review contracts, we may be able to identify these legal risks in advance and assist you in developing a mitigation strategy.

Business and Financial Risks

At the end of the day, when your business enters into a contract, it is intended to advance the interests of your business. Whether you are entering into a lease, a sale of goods, a distributor agreement, or any other type of contract, there is always the risk that one of the parties will fail to perform. Your contracts - and contract management system - should account for all of the areas where a transaction could end up costing your company money, time or reputational capital. You should understand key delivery dates, warranties, and other provisions that could result in a cost to your business.

Reputation Risk

There are also certain risks that are harder to quantify. When conducting business, you have to be sure to protect the image of your company, since the goodwill of your customers and clients is often one of your most important assets. Ensuring your contracts restrict counterparties from disparaging you or your business can help to minimize these risks.

Types of Contractual Tools for Managing Risk

There are several different types of contractual tools that are available to manage risk in your business.

Indemnity Provisions

One common way to manage risk by contract is to include an indemnity provision. An indemnity, or “hold harmless” clause, determines who will bear certain risks under and contract. Indemnities can be extremely powerful, and they are often disguised in difficult-to-read legalese. Generally, the clause has one party to the contract, the Indemnifying Party, agree to hold the other party, the Indemnified Party, harmless for any loss incurred under the contract, and to defend and pay costs on the Indemnified Party's behalf.

In practical terms, this means that one party agrees to take on specified liabilities or risks in a contract and defend the other party if sued. For example, if you sign a lease agreement to use an office space, the contract likely contains an indemnity clause that would require your business to agree to hold the rental company harmless under certain circumstances. Some indemnity provisions are narrow, indemnifying the rental company only for harm caused by the tenant, while some may be broader, requiring the tenant to indemnify the rental company for any losses at all. Make sure to speak with an experienced contract attorney to review your contracts' indemnity provisions to ensure you are not taking on more risk than you should by indemnifying partners. Your business may also be able to leverage these type of indemnity clauses manage risk.

Limitation of Liability

In many cases, a contract will set forth a limit on liability, sometimes referred to as a damages cap. When a loss does arise under a contract, the parties may want to agree on a maximum amount of compensation that either party can recover. This limitation may be a flat amount, or it may be based on a percentage of the value of the contract.

Waiver

Another contractual tool to manage risk is a waiver of damages. This clause may set forth circumstances where either party can hold each other liable for damages. For example, the contract may specify that absent gross negligence or willful misconduct, neither party will be responsible for losses arising under the contract, such as personal injury, property damage, or lost profits.

Consequential Damages Waiver

Generally speaking, a party breaching a contract is only liable to the other party for damages that directly flow from such breach. Such damages are termed “direct damages.” For example, if a contract driver fails to pick up you package, the cost of hiring another driver to do so, would be direct damages.

Consequential damages, or special damages, are damages suffered by a party because of their particular circumstances. For example, if the package the first driver failed to pick up and deliver resulted in you paying additional fees (e.g., because you had promised the package would be delivered at a specific time and agreed to pay a fee if it was late). Courts will typically only award consequential damages if both parties were aware of or contemplated such particular circumstances when they entered the contract.

Waivers of consequential damages are common in contracts but it is crucial they are appropriately tailored not to include potential damages the parties thought would be included.

Insurance

One of the most important contracts your business will enter is your corporate insurance policy. Commercial insurance provides you the financial resources necessary to cover financial losses.  Not only should you evaluate your own insurance policy, but you may also want to require your contractual partners to carry insurance as well. This is one contractual tool that ensures that you will be able to recover from the other parties should they cause a loss to occur under the contract.

Acceptance Criteria

One other way to manage risk via contract is to be very clear up-front about what constitutes acceptable performance. You do not want to risk litigation over an ambiguous clause in a contract. Make sure your business and the other parties to the contract are clear on the standards for acceptance.

Stay on Top of Contract Management

The best-drafted contract is only as good as its administration. If your business has a lot of active contracts, your business should be sure to invest in a contract management system to ensure that you are complying with all of your contracts' terms. Similarly, you want to ensure that your partners are holding up their end of the bargain, otherwise, they may be costing your company money. Below are a few tips for contract risk management:

  • Review the scope of the contract with the team who will be responsible for performing it to ensure it is feasible
  • Know the pricing and payment terms
  • Monitor milestones and delivery deadlines
  • Conduct due diligence on new and existing business partners, such as reviewing any past or pending litigation
  • Implement software with search functionality to store and manage contracts
  • Manage the security and access to the contracts

Our Experienced Business Lawyers Can Help

The business lawyers at Newburn Law deal with contract risk management every day. We have reviewed, negotiated, and drafted many different types of contracts across various industries. Talk to our lawyers today about the many contractual tools for managing your business's risk. Contact us for a free consultation.

About the Author

Ryan M. Newburn

Ryan Newburn is a business and legal expert trusted by Executive Teams and Boards of Directors to apply sound business principals to solve legal and financial problems. Ryan's practice focuses on mergers and acquisitions, financings, corporate formations and corporate governance in a broad range of industries including energy, distribution services, healthcare, medical devices, and technology. Leveraging his formal business training and years of practical experience, including as an executive at public and private companies, Ryan has advised hundreds of companies in dozens of industries of unique legal and financial issues.

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