Risk Management in Contracts

Allocation of risk is central to commercial contract negotiations. In this article, the team at Lex Moderna explains the need to and offers tips for managing risk in contracting. While risk cannot be avoided, it can be managed and minimized through careful drafting, while managing the inherent tension that risk allocation creates between contracting parties.

Before contracting, as part of the due diligence process, a party should thoroughly vet the counterparty to ensure that it possesses the capability to deliver the desired goods and/or services and to understand any specific risks associated with doing business with the counterparty.
This article discusses common types of contract risk and various provisions that firms should consider as part of their negotiating processes.

Common Types of Contract Risk

There are four principal types of contract risk that must be considered in contracting; other forms of risk may be relevant in specific kinds of transactions:

• Financial Risk—Financial risks include all contract risks associated with the loss of money. Such risks may arise by missing a key contract renewal date or inadvertently continuing a contact term in the case of an automatic rollover date.
• Legal Risk—Legal risks occur when a breach of contract results in the potential for legal accountability. Legal risks can arise from non-performance of contract obligations, noncompliance with a range of regulatory requirements, allegations of intellectual property infringement, or any number of disputes based on alleged non-compliance with contract terms.
• Security Risk—Security breaches can result in financial, legal, and other issues. Contract security risks arise when contracts are not stored securely or when confidential or other sensitive information is shared too broadly within a party’s organization or disclosed to those outside the organization.
• Brand Risk—Brand risk refers to risks associated with negative public and customer opinion, which additionally often leads to problematic employee morale and loss of talent. Brand risk is weightier than ever and can impact financial performance over time.

Common Risk Provisions

What follows is a list of some contract provisions that parties can use to protect themselves against unnecessary risk:

• Representations and Warranties—Representations and warranties allocate risk in several ways. They can apportion exposure to potential losses and shift risk between and among parties; create a direct claim for any inaccurate representation or warranty; and serve as a basis for indemnification (see below).
• Indemnification–An indemnification or hold harmless provision allows parties to customize their risk allocation by shifting the burden of loss to the party best positioned to prevent the loss. An indemnified party will be compensated for risks it did not assume and other expenses such as attorney fees that might otherwise not be recoverable.
• Guaranties—Guaranty provisions manage the risk of nonpayment or other failure to perform by a contractual party. Guaranties are often used when there is uncertainty about the financial capability or creditworthiness of a party. A guaranty shifts risk from the obligor to the guarantor, providing an added level of protection against default.
• Limitations of Liability—Limitations of liability, sometimes referred to as damages caps, seek to limit the amount payable in damages for a breach, restrict the types of loss recoverable or the remedies available, or impose a time frame within which damages are recoverable. It is common to base the cap on a percentage of the value of the contract. Limitations of liability can apply to direct and/or consequential damages arising from the contract.
• Insurance—Agreements often stipulate that the provider and any subcontractors must post and maintain specific levels and types of commercial insurance. Insurance coverage confirms that a party has the financial capacity to satisfy its liabilities under the contract by shifting risk from the insured to its insurer.
• Waiver of Subrogation—Subrogation is when an insurance company pays its insured and then sues the entity or person responsible for the loss to recover the amount paid to the insured party. Waiver of subrogation clauses are agreements in which one or both parties agree to waive subrogation rights.
• Express Contractual Remedies—A contract’s express remedial scheme can allocate risk by narrowing or expanding common law remedies or otherwise minimizing uncertainty regarding the scope of potential liability. Express contractual provisions may be unilateral or mutual and may apply to one or more specific terms or to the entire contract. While not always binding, courts give such provisions strong evidentiary weight. Examples of express contractual remedies include the following:
  • Equitable Remedies—An equitable remedies provision expresses the parties’ view that monetary relief is inadequate to fully compensate an aggrieved party and the parties’ intent to grant the injured party equitable remedies in addition to any remedies at law.
  • Cumulative Remedies—A cumulative remedies provision reflects the parties’ intention that the express remedies set out in the contract are in addition to rather than instead of any implied rights or remedies available in law or equity.
  • Exclusive Remedies—An exclusive remedies clause is the inverse of a cumulative remedies clause and reflects the parties’ intention that certain express contractual remedies are the exclusive remedy for a particular breach or under the contract more broadly.
  • Liquidated Damages—A liquidated damages provision stipulates that the breaching party pay the injured party a stated fixed amount or an amount based on a pre-determined formula.
• Payment Terms—Payment terms result in risk because any delay or acceleration of payment impacts each party’s cash flow and risk of default. Contracts can include payment term provisions that allow payments to be deferred or advanced. This can include some form of deferred payment terms in which sellers try to minimize risk by reducing the amount of time between delivery and payment; or advance payment terms that offer earlier payment and a reduced risk of nonpayment.
• Force Majeure—Force majeure provisions allow a contracting party to mitigate the risk of breach due to events or circumstances the parties did not cause and could not have anticipated.
• Termination Rights—Termination rights allow either or both parties to end the contractual relationship before its stated term under certain agreed-upon circumstances. Termination rights can permit early termination either for cause or convenience. 

In specific industries or sectors, there may be additional types of provisions to manage risk that a contracting party should consider.

Reporting Requirements

CTA imposes the following reporting requirements:

• • Identifying information about the reporting company (e.g., legal name, trade name, and “doing business as” name; address of principal place of business; jurisdiction in which the entity was formed or first registered; and tax ID number).
  • Identifying information about beneficial owners and company applicants (e.g., legal names, dates of birth, current addresses, ID number; and copy of passport or driver license).
  • FinCEN identifier.

The information provided under CTA is not publicly available and not subject to the Freedom of Information Act. Such information can be disclosed only to the following governmental entities:

• • Federal agencies engaged in national security, intelligence, and civil and criminal law enforcement;
  • The Department of Treasury in connection with its official duties, including tax administration; and
  • State and local law enforcement agencies in connection with criminal or civil investigations. FinCEN may also disclose information to financial institutions to assist in their anti-money laundering compliance activities.