In 2018, a missing comma in the state's overtime laws once cost a Portland dairy company a staggering $5 million!
As an in-house legal counsel, you know that overlooking such details can have disastrous consequences for your business. But staying on top of contract risk is not easy either - and we understand that all too well.
In this post, we'll share proven tips and strategies for mastering contract risk management, saving your business' reputation, and keeping the commas (and cash) where they belong.
Read on to understand how you can reduce the likelihood of costly disputes and protect your organization's interests by effectively managing contract risk.
What is contract risk management?
Contract risk management is the process of identifying, evaluating, and limiting the exposure to risks associated with business agreements.
The process involves a strategic assessment of all potential hazards that an organization may face during operations, with the aim of mitigating the likelihood and impact of any adverse events.
While it may not be possible to manage or anticipate every risk, you can plan for different scenarios to help lessen their impact on the business. This means taking a comprehensive approach to contract risk management that includes identifying and analyzing all potential risks, developing effective mitigation strategies, and monitoring the implementation of those strategies.
Before we delve into the strategies and best practices for contract risk management, let’s explore why you should implement such a process in the first place.
6 reasons to set up a robust contract risk management process
We’ve already established that effective contract risk mitigation strategies are an indispensable part of the in-house legal counsel’s responsibilities. But let’s see in detail how contract risk management can largely benefit your organization as a whole.
#1 Protecting the organization's financial position
Contracts involve significant financial commitments, and effective risk mitigation strategies will help protect your organization's financial position and prevent losses. By identifying and addressing potential financial risks, you can ensure that you are entering into contracts that align with your financial goals and objectives.
#2 Avoiding legal and regulatory penalties
Failure to comply with laws and regulations related to contracts can result in legal and regulatory penalties, which can be costly for organizations. The Association of Corporate Counsel (ACC) found that the global average cost of a data breach is $4.35M. Data breaches can occur as a result of noncompliance with legal and regulatory requirements related to contracts, highlighting the importance of effective contract risk mitigation.
By implementing effective risk mitigation strategies, you can ensure that you are complying with all applicable laws and regulations, and avoid costly legal and regulatory penalties.
#3 Reducing operational disruptions
Contracts can impact business operations, and effective risk mitigation can help reduce the likelihood of disruptions and ensure that operations continue smoothly. By identifying and addressing potential operational risks, you can minimize the impact that contracts have on the company’s day-to-day operations.
#4 Protecting the organization's reputation
Effective risk mitigation can help prevent breaches of confidentiality, unethical behavior, or other actions that could damage the organization's reputation.
#5 Improving vendor and supplier relationships
Contract risk mitigation can help build stronger relationships with vendors and suppliers by ensuring that contractual obligations are met, and issues are addressed proactively.
#6 Maximizing the value of contracts
You can maximize the value of your contracts by identifying and addressing potential risks and issues that could impact the contract's value over time. By proactively managing risks, you can ensure that your contracts deliver the intended value and achieve their desired outcomes.
6 common types of contract risks
Contracts are a fundamental part of doing business, but they can also carry significant risks if not managed effectively. Here are some of the most common types of contract risks that you may encounter.
#1 Legal and regulatory risks
Contracts must comply with all applicable laws and regulations, and failure to do so can result in legal and financial penalties.
Example: A contract that violates antitrust laws or data protection regulations can result in significant legal liability for the company.
#2 Financial risks
Contracts often involve financial commitments, such as payment obligations or performance guarantees. Failure to manage these commitments effectively can lead to financial loss or a negative impact on cash flow.
Example: If a vendor fails to deliver goods or services as agreed, it can result in financial losses for the company.
#3 Reputation risks
Contracts can have a significant impact on a company's reputation, particularly if there are breaches of confidentiality, unethical behavior, or other actions that could damage the company's reputation.
Example: If a company is found to have engaged in unethical behavior in a contract negotiation, it can damage its reputation with customers and partners.
#4 Operational risks
Contracts can impact a company's operational processes and procedures, and failure to manage these risks effectively can lead to disruption of business operations.
Example: If a vendor fails to provide goods or services on time or at the required quality, it can impact the company's ability to meet its own obligations to its customers.
#5 Intellectual property risks
Sometimes, contracts involve the use or sharing of intellectual property, and failure to manage these risks effectively can lead to infringement claims or loss of intellectual property rights.
Example: If a company shares confidential information with a vendor without proper safeguards, it can result in the loss of trade secrets or other intellectual property.
#6 Data leakage risks
The risk increases exponentially if you use unsecured methods to communicate contractual information between parties. Confidential or sensitive information exchanged during contract negotiation, such as financial data or customer information, can be vulnerable to cyberattacks or data breaches.
By identifying and understanding these common contract risk types, you can develop effective risk mitigation strategies to manage these risks effectively and protect your business interests.
4 ways to identify risks in contracts
“Over the past five or so years, one of the key responsibilities businesses are placing on in-house lawyers is spotting and managing risk. The business wants its in-house lawyers to be the ones who sniff through virtually every situation looking for risk (legal or otherwise). What this means is that in-house counsel need to be masters of the company’s business operations and strategy (both short and long term), because you cannot successfully spot and manage risk unless you understand how the company operates and where it wants to go.”
~ Sterling Miller, CEO and Senior Counsel, Hilgers Graben PLLC
Ten Things: Spotting, Analyzing, and Managing “Risk”
#1 Evaluate the risk exposure of each contract
Start by identifying which contracts have a higher exposure to risk. Consider the value, duration, and complexity of each contract and assess the potential risks associated with it. This can help prioritize contracts that require more attention and a more detailed risk management plan.
#2 Assess the contract management process
Look for any gaps or inefficiencies in the contract management process that may introduce risks. This could include a lack of standardization, gaps in the approval workflow, or insufficient controls for reviewing and approving contracts.
#3 Consider vertical-specific regulatory compliance risks
If your organization operates in a specific industry or sector, there may be vertical-specific regulatory compliance risks that need to be managed in your contracts. For example, healthcare organizations need to comply with HIPAA regulations, and government contractors need to comply with DFARs. Ensure that your contracts contain provisions that address these regulations and that they are updated as regulations change.
#4 Consider geographic regulatory compliance risks
If your organization does business in different states, countries, or legal jurisdictions, there may be geographic regulatory compliance risks that need to be managed in your contracts. Also, consider any political or economic risks associated with certain jurisdictions that need to be taken into account when drafting contracts.
“Once you have spotted and analyzed risk, you will likely want to estimate the “cost” or “value” of the risk, depending on whether the risk is negative or positive in nature. There is a relatively simple and standard formula for this:
Risk Value = Probability of Event x Cost/Value of Event if it Occurs
For example, you are faced with a large breach of contract claim. While the dollar value claimed is high ($1M), you estimate the probability of losing to be low (25%). The Risk Value is then: .25 (probability) x $1M (cost) = $250,000. On the positive side, if you have a merger worth $25M in incremental operating income every year if consummated and you think the odds that regulators approve the merger is high (80%), the Risk Value is: .80 (probability) x $25M (value to company) = $20M. ”
~ Sterling Miller, CEO and Senior Counsel, Hilgers Graben PLLC
Ten Things: Spotting, Analyzing, and Managing “Risk”
6 ways to mitigate contract risks
“Because lawyers are trained issue-spotters, the analysis of risk in commercial agreements and the process of minimizing that risk usually falls in the lap of the in-house legal department. Unfortunately, the process of spotting and analyzing risk is rarely black and white. It’s generally highly subjective and it’s not always right.”
~ Sterling Miller, CEO and Senior Counsel, Hilgers Graben PLLC
Ten Things: Minimizing Risk in Commercial Contracts
The following strategies can help minimize the risks associated with contracts:
#1 Review and negotiate contract terms to ensure they align with your business needs
Before signing any contract, it's essential to review the terms and conditions carefully. Ensure that they align with your business needs and risk tolerance. Consider negotiating terms that can minimize risks, such as indemnification, limitation of liability, termination clauses, and dispute resolution mechanisms. Consider using a clause and template library to ensure consistency in contract terms and minimize the risk of errors or omissions.
Also read: 5 Most Negotiated Terms and Clauses in a Contract
#2 Implement a contract management process to ensure mistake-free reviews
Implementing robust contract management processes can help minimize contract risks. Establish a contract review and approval workflow to ensure that all contracts are reviewed and approved by the appropriate parties. Create a centralized repository to store all contracts and related documents. Ensure that all contracts are easily accessible and searchable by the relevant stakeholders.
Also read: Contract Lifecycle Management Process: The A-Z Guide
#3 Create contingency plans to mitigate the effects of unforeseen circumstances
It's essential to develop contingency plans to minimize the impact of unexpected events such as a vendor going out of business or a breach of contract. Develop procedures for identifying and addressing potential issues before they become significant problems. Establish a process for quickly responding to incidents to minimize the impact on the organization.
#4 Implement security controls to protect confidential information
Access controls are necessary to ensure that only authorized personnel can view and access contracts. Implement role-based access control to ensure that only those with a need to know can access sensitive information. Consider using encryption to protect confidential information in contracts.
#5 Enable alerts and notifications to never miss an important event
Ensure that your contract management system provides alerts and notifications for important events such as contract renewals, terminations, and critical dates. This helps you never miss an essential event and enables you to respond quickly to any issues that may arise.
#6 Implement contract version control to ensure correct versions are signed
Maintain an audit trail of all changes made to a contract, including who made the changes, when they were made, and why. Implement version control to ensure that all parties are working from the same version of the contract. This helps minimize the risk of disputes and ensures that everyone is working with the most up-to-date information.
Also read: The Perfect Contract Risk Assessment Checklist
How to measure the effectiveness of your contract risk management process
After you’ve implemented the above best practices for contract risk management, you need to ensure the effectiveness of your process by introducing a risk-scoring system and measuring litigation and enforcement actions against the company.
A risk scoring system for contract risk should be based on a comprehensive analysis of various factors that can impact the likelihood of a contract dispute and the potential financial and reputational harm to the organization.
- Contract complexity: The more complex a contract, the higher the risk of misunderstandings, misinterpretations, and disputes
- Contract value: Contracts with higher values have a higher potential for disputes, and the financial impact of such disputes can be significant
- Contract scope: Contracts that involve more parties or more extensive obligations may have a higher risk of disputes.
- Jurisdiction: Contracts involving parties in different jurisdictions may have legal complexities and pose a higher risk of disputes
- Contract language: Ambiguous or vague contract language may lead to disputes
- The reputation of the counterparty: Contracts with parties that have a history of disputes or legal issues may have a higher risk of disputes
- Compliance with laws and regulations: Contracts that violate laws or regulations can lead to enforcement actions against the company
The above factors can be used to assign a risk score to each contract. For example, each factor could be given a score of 1 to 5, and the total score could be calculated by adding up the scores for each factor.
The performance of the risk scoring system and the system for escalating high-risk issues can be measured by tracking the number and severity of contract disputes and the costs associated with defending against those disputes. By implementing a robust risk scoring system and escalation process, you can proactively identify and manage contract risk, minimizing the potential for litigation and enforcement actions and reducing the associated costs.
Also read: Contract Security: Hacks and Tips for Safeguarding Your Contracts
How does Contract Management Software help mitigate contract risks?
“A simple way to reduce risk in commercial agreements is to use a contract management tool. Using technology over a manual process almost always reduces risk. There are two types of tools here. The first stores all your contract templates and executed contracts (including amendments) in a central repository where the legal team (or anyone else with access) can locate them through a simple search.”
~ Sterling Miller, CEO and Senior Counsel, Hilgers Graben PLLC
Ten Things: Minimizing Risk in Commercial Contracts
The truth is, contract risk management is crucial for any organization. Without it, businesses can lose a significant portion of their value.
According to analysts at KPMG and World Commerce and Contracting, organizations can leak up to 9% of their value without an adequate risk mitigation strategy. The good news is that with a comprehensive contract lifecycle management (CLM) system, you can identify, assess, and mitigate risks collaboratively, putting their CLM at the heartyourheir digital transformation.
SpotDraft is a CLM software designed by lawyers for lawyers. Not only do you get a comprehensive dashboard to get all the information about your contracts, but there’s a host of features that you can significantly benefit from when it comes to mitigating risks in your contracts.
#1 Contract review
When a new contract is imported into the system, SpotDraft pulls out key terms and clauses using powerful machine-learning models. This enables contract reviews and due diligence processes to happen a lot faster.
#2 Access controls
SpotDraft provides you complete visibility over your contracts, allowing you to encrypt contracts, maintain audit trails, and establish access control over all contracts. This way, you can make sure that individuals only have access to data and contracts that they need to do their jobs.
#3 Auto reminders
SpotDraft sends you reminders on the dashboard about an upcoming renewal date. You can track various important dates, details, and deadlines automatically. Moreover, reminders are proactively sent to the relevant stakeholders to notify them whenever a contract is expiring or due for renewal.
#4 Version control
SpotDraft creates automated naming and versions upon edits or when a new version of a contract is imported. It lets you track changes and compare different versions to see what changes the other party has made. With SpotDraft’s audit trail feature, you can tamper-proof your entire contract process with a detailed script of what changed, when, and who changed any part of it.
#5 Custom tagging
SpotDraft has the custom tags feature through which you can add tags to your contracts depending upon how risky they are.
Conclusion
By implementing best practices for contract risk management and using the right technology, legal teams can stay ahead of the curve and ensure that your contracts are always up-to-date and in compliance with legal requirements.
Don’t forget to conduct legal research, engage in continuing legal education (CLEs), consult outside counsel, subscribe to industry newsletters, and follow current events impacting your business to stay up-to-date with changes in laws and regulations that may affect contract risk management
Meanwhile, try a SpotDraft demo, maybe?
