What is Contract Risk?

Contracts are the backbone of business dealings, outlining each party's expectations and obligations. Any agreement, even the most well-crafted, can contain inherent contract risks, introducing the potential for negative consequences arising from its terms.

Understanding and effectively managing contract risk is crucial for any business seeking to safeguard its interests and ensure successful collaborations.

This article discusses contract risk, covering the following areas:

• Types of contract risk
• How contract risk occurs
• Best practices for managing contract risk
• How Gatekeeper can help mitigate contract risk.

Types of Contract Risk

There are generally two categorisations used to describe the nature of contract risk:

Cause-based:

• Direct: pertains to risks explicitly outlined within the contract terms, such as payment defaults or delivery delays. These risks have a clear and immediate impact on the parties involved. For instance, a customer failing to pay for a service would directly impact a vendor’s finances.
• Indirect: encompasses broader risks that may not be explicitly addressed in the contract but still have implications, such as changes in legislation or geopolitical events affecting the contract's performance. These risks tend to have a less obvious and potentially delayed impact. For example, a supplier facing a workforce dispute might impact a customer’s need to receive its orders on time.

Consequence-based:

• Financial: this involves the potential for monetary losses due to breaches of contract, cost overruns or unexpected expenses, or failure to comply with date-driven obligations.
• Legal: related to contracts containing ambiguous or conflicting terms, and/or lacking key legal clauses, exposing parties to litigation or regulatory penalties.
• Performance: occurs when one party fails to fulfil its obligations under the contract, leading to delays, quality issues or project failures.
• Market: involves external factors such as economic changes or shifts in market conditions that impact the viability or profitability of the contract.
• Reputational: stems from negative publicity or damage to brand image resulting from contractual disputes or failures to meet obligations.
• Security: inadequate contractual protection against unauthorised access to sensitive information, with a potentially wide range of consequences.

Note that the unmitigated or poorly mitigated occurrence of a single contract risk situation can result in multiple types of consequences, either simultaneously or over time.

How Contract Risk Occurs

A broad range of factors can lead to the potential for contract risk to occur, including:

• Assumptions or ambiguities: unclear language or differing interpretations of contract terms can lead to disputes and disagreements.
• Complexity: contracts often involve intricate legal language and numerous clauses, making them susceptible to interpretation errors or misunderstandings. The more complex a contract is, the higher the likelihood of overlooking crucial details or unintended consequences.
• Dependency on external factors: contracts often rely on external factors beyond the control of the parties involved, such as economic conditions, geopolitical stability or certain technologies. Changes in these external factors can impact the feasibility or success of the contract.
• Dynamic nature of business relationships: business relationships will evolve over time, but what may seem beneficial or reasonable at the outset of a contract may become obsolete or disadvantageous as circumstances change. This dynamic nature can introduce an urgent need to adapt to unforeseen developments or shifts in priorities.
• Force Majeure events: natural disasters, pandemics, political and economic instability or other situations beyond a party’s control can disrupt contract performance or render its obligations impossible to fulfil, temporarily or permanently.
• Hidden risks: a party might unknowingly withhold relevant information, leading to unexpected challenges or costs.
• Human error: contractual agreements involve multiple stakeholders, each with their own perspectives, priorities and potential for oversight or mistakes. Human error in drafting, reviewing or executing contracts can introduce risk, whether through typos, misinterpretations or miscommunications.
• Inadequate risk allocation: unequal allocation of risks between parties can leave one party unfairly or unreasonably more exposed to potential consequences.
• Insufficient due diligence: failure to properly assess the capabilities, reputation or financial health of counterparties can increase the risk of their non-performance.
• Malicious intent: in rare cases, a party may deliberately breach the contract or act in bad faith.
• Market fluctuations: prices, regulations and economic conditions can change unexpectedly, impacting the feasibility or profitability of the contract.
• Miscommunication: misunderstandings or communication breakdowns can lead to delays, errors or frustration.
• Technological advancements: new technologies might disrupt existing industries or make agreed-upon deliverables obsolete.
• Uncertainty: despite efforts to foresee all potential scenarios, contracts are drafted based on current circumstances and expectations, which may change over time. Unforeseen events, market fluctuations or changes in regulations can invalidate approaches taken in operational contracts.
• Unrealistic expectations: wishful thinking on deadlines, performance benchmarks or cost estimations can set the stage for failure and potential financial losses.

Watch this video below to find out more about mitigating contract risk. 

Best Practices for Managing Contract Risk

There are many moving parts to dealing with contract risk. It requires organisation, a fair bit of documentation, acceptance that the unexpected is still likely to happen, and teamwork.

Any approach to managing contract risk should have the following elements:

1. Comprehensive Guidance

Clear and detailed instructions, frameworks, and standards for locating, assessing, managing, mitigating, and preventing contract risks are essential, including:

• General risk assessment and management policies and relevant training material.
• Regularly updated watchlists of the factors that can lead to contract risk, and approaches for dealing with any occurrences.
• Clause template libraries containing approved, clear, and unambiguous language.
• Contract risk mitigation roles and responsibilities.
• Third-party due diligence methodology.
• Understanding of what the business itself does, where it does it, its contractual and regulatory compliance track record, and history of the success or otherwise of contract risk management efforts.
• Lessons learned from past contracts to help avoid contract risk.

2. Broad Investigation

Thorough due diligence, research and analysis, with strong record-keeping, must be conducted to detect the presence of any of the drivers of contract risk, covering at least:

• Vendor backgrounds, including risk profile, service delivery performance, compliance track record and extended supply chain visibility.
• Market conditions where the business and its active and potential vendors operate.
• Regulatory compliance requirements, both active and prospective.
• Industry trends applicable to the business’s operations.
• Correctness, fairness, and completeness of contract terms and risk allocations in new contracts and selected existing contracts.

3. Proactive Mitigation

Set up pre-emptive, preventive measures to address potential risks before they materialise into problems, in areas including:

• Negotiating strategies.
• Risk-ranking approach.
• Risk-sharing arrangements.
• Internal controls and safeguards.
• Contract management plans.
• Vendor relationship meetings.
• Insurance coverage.
• Issue escalation pathways.
• Contingency, disaster recovery, and business continuity planning.
• Proactive training.
• Useful technology.

Again, these measures should be carefully documented, kept updated, and readily accessible.

4. Continuous Monitoring

Closely track contract performance and risk exposure over time, to enable timely intervention and adjustment as needed, including:

• Establish KPIs, set performance benchmark targets, regularly measure performance, and periodically adjust settings to maintain relevance and foster increased performance.
• Set and follow schedules for conducting relevance reviews of preferred contract terms and established risk mitigation approaches.
• Maintain a watch on the growth of general cybersecurity risk and the applicability of regulatory change in terms of risk potential.
• Set up escalation pathways for responding rapidly to the unexpected in terms of risk likelihood/impact growth.
• Establish a risk occurrence post-mortem procedure to identify root causes and recommend enhanced mitigative measures.

5. Team Approach

Effective ongoing management of contract risk is usually achieved as a team effort, where a broad range of the necessary expertise is available. Such expertise is commonly provided by the following operational teams, one of which may be assigned ownership of the contract risk management capability:

• Contract Management
• Finance
• Governance, Risk and Compliance
• Human Resources
• Internal Audit
• IT
• Legal
• Procurement
• Quality
• Sales.

Various key stakeholders in the business’s most important contracts may also contribute based on their experiences with those contracts from an operational risks perspective.

How Gatekeeper Helps Mitigate Contract Risk

Gatekeeper's Vendor and Contract Lifecycle Management (VCLM) platform can contribute to effective contract risk management through its focus on three key pillars:

Restoring Visibility

• Centralised repository: Gatekeeper stores all agreements, supporting documents and communication records in one secure and accessible contract repository. This provides a complete picture of all contract-related information, aiding in risk identification and mitigation, eliminating the risk of missing contracts or crucial information scattered across different individuals, locations, media types or systems. Increased visibility allows for:
  
  
  • Easy identification of potential risks: by readily accessing past contracts and associated issues, businesses can identify patterns and anticipate potential risks in new contracts.
  • Improved due diligence: easier access to historical data and counterparty information helps conduct thorough due diligence and assess their potential risks.
• Contract summaries: utilising AI-powered technology, Gatekeeper can condense long and complex contracts into easily understandable summaries. This allows for quick comprehension of key terms and risk factors, facilitating informed decision-making.
• Dashboards: Gatekeeper's platform provides dedicated dashboards so you can identify patterns and trends that might reveal hidden contract risks. Access insights into spending patterns, contract performance and areas for improvement in risk management strategies.

Taking Control

• Automated notifications and alerts: the platform sends automated reminders and alerts for upcoming deadlines, renewal dates or potential compliance issues. This proactive approach helps avoid missed deadlines, unwanted auto-renewals, non-compliance penalties and potential risks that could arise due to delayed action.
• Collaboration features: Gatekeeper facilitates collaboration between different departments and individuals involved in the contracting process. Automated workflows, assigned ownership and a centralised messaging centre allow for shared ownership and accountability in managing contract risks.
• Risk assessment tools: Gatekeeper’s Risk Module allows businesses to categorise and prioritise risks based on their likelihood and impact. This empowers businesses to focus resources on mitigating the most significant risks associated with specific contracts.
• Best Practice Workflows: Gatekeeper offers best practice, automated contract workflows for various contract stages, guiding users through essential steps while ensuring consistency. This reduces the risk of overlooking crucial steps or inconsistencies in different contracts.
• Vendor Portal: The self-service portal allows vendors to submit information, track contract status, and complete tasks independently. This streamlines the process, reduces manual workload for internal teams, and minimises the risk of delays due to miscommunication.

Safeguarding Compliance

• Audit trails: Gatekeeper maintains comprehensive audit trails that track all user activity and modifications made to contracts. This ensures transparency and provides a record for regulatory inquiries or legal disputes.
• Integrated risk profiling: Gatekeeper integrates with various data sources including SecurityScorecard to provide risk profiles of potential vendors, considering factors like financial health and legal history. Our Market IQ Suite helps assess potential financial, performance, and legal risks associated with different vendors.

Wrap-up

Contract risk encompasses various uncertainties and potential pitfalls inherent in contracts and their operation, spanning financial, legal, performance, market, and reputational domains.

Businesses must differentiate between direct and indirect contract risks, and adopt proactive risk management practices to identify, assess, mitigate, and resolve potential issues effectively.

By implementing robust contract risk management strategies, businesses can safeguard their interests, minimise losses, and enhance their overall resilience in a dynamic business environment.

To learn more about how Gatekeeper can help in the management of your contract risk, don't hesitate to get in touch with us.