Contracts are fraught with potential pitfalls that can undermine a company’s financial stability and legal standing. But what exactly are these risks, and more importantly, how can they be effectively managed?
Whether you’re a business owner or part of a legal team forging new partnerships, understanding the types of risks associated with contracts is fundamental. This guide covers the key concepts of contract risks, along with strategies to manage and reduce these risks using tools like AI contract review software.
What is contract risk?
Contract risk refers to the potential for loss or negative outcomes resulting from the terms and conditions within a contract, or from the failure of parties to comply with these terms. This risk can arise from a variety of sources—financial obligations, performance stipulations, or legal compliance issues.
When a contract is not thoroughly vetted or if its terms are not clearly understood and managed, businesses can face significant liabilities. For example, if a supplier fails to meet delivery deadlines, it disrupts the supply chain and leads to breach of contract claims and financial penalties.
Poorly defined terms can also lead to disputes over contract interpretations.
The impact of contractual risks on businesses can be profound.
- Financially, these risks can drain resources through fines, legal fees, and settlement costs.
- Operationally, they can disrupt regular business functions and damage partnerships.
- Strategically, unmanaged risks can hinder a company’s ability to expand or innovate.
As you can guess, risk assessment becomes a critical part of contract management. Therefore, effective risk assessment assisted with AI helps identify areas of concern faster before they become real problems.
4 Types of contractual obligations and associated risks
Contracts outline specific duties that each party is expected to fulfill. These duties, or obligations, typically come in about four forms and carry their own set of contractual risks.
- Explicit obligations. These specify the exact duties each party must perform. Risks associated with explicit obligations often stem from non-compliance or partial compliance with terms. For example, failing to deliver services or products by a stipulated deadline might result in disputes and penalties.
- Implicit obligations. Not always written down, implicit obligations are assumed under the contract based on industry standards or common business practices. The risk here lies in the ambiguity—different parties may have different interpretations, which can lead to misunderstandings and legal challenges.
- Performance obligations. These require one or more parties to perform certain tasks as part of the agreement. The risk arises when the performance is not up to the agreed standard or is disputed by the other party, potentially triggering to claims of non-performance and the need for remedial action.
- Payment obligations. Critical for the financial operations of any business, these obligations compel parties to make payments as outlined in the contract. Delays or failures in fulfilling payment obligations might disrupt cash flow, provoke legal disputes, and damage business relationships.
Given the complexity of these contractual obligations, conducting a thorough contract review is essential.
Examples of contractual risks
Below are some examples demonstrating common scenarios of contractual risks.
- Unforeseen termination costs. A small business engaged in a long-term lease agreement without a clear understanding of the termination clause. When they attempted to terminate the lease early, they were surprised by the hefty termination fees, which had not been clearly outlined.
- The case of delayed deliveries. In a high-profile incident, a major electronics retailer faced severe repercussions due to delayed shipments from suppliers. The contract stipulated specific delivery dates that were critical for a new product launch. The suppliers’ failure to meet these deadlines led to significant stock shortages, tarnished the retailer’s reputation, and resulted in lost sales.
- Intellectual property dispute. A software company entered into a partnership agreement without explicitly stating the ownership rights for the developed software. Post-project completion, a dispute arose over intellectual property rights, leading to prolonged legal battles and substantial legal expenses.
All these 3 instances show that contractual risks affect a business’s financial health and operational stability. They stress the importance of conducting comprehensive contract reviews to identify and address potential risks, ideally, before they result in dramatic and unnecessary disputes.
How contractual risks occur
Contractual risks emerge from various sources in business dealings, often resulting in disputes and financial losses. Identifying these sources is key to preemptively addressing potential issues.
| Origin of Risk | Description |
| Ambiguous Language | Contracts that use vague or non-specific language can create confusion and differing interpretations among the parties involved. It can often result in disputes over the intent and scope of the contract terms, requiring legal intervention to resolve. |
| Incomplete Terms | When contracts fail to cover all necessary aspects of the agreement or leave certain terms undefined, gaps can emerge that complicate enforcement and compliance. These omissions often lead to unmet expectations and conflicts between parties. |
| Changing Circumstances | Contracts can be affected by changes in economic conditions, laws, or business environments. Such shifts may render the terms of a contract impractical or obsolete, complicating fulfillment and increasing the risk of breaches. |
| Non-compliance | Risks also emerge when parties fail to adhere to the terms of the contract, whether due to oversight, misunderstanding, or deliberate non-fulfillment. Non-compliance can disrupt business operations and result in legal penalties or damages. |
AI contract review software plays a role in mitigating these risks by analyzing contract terms with precision and speed, such tools can highlight ambiguous phrases, detect incomplete terms, anticipate problems arising from changing circumstances, and alert parties to potential non-compliance issues. To learn more about how AI can safeguard your contracts, visit Superlegal’s AI contract review software.
Managing contractual risks
Properly managing contract risks protects your business and ensures compliance. Implementing some of these strategies and tools can enhance the identification, assessment, and mitigation of these risks.
Risk identification techniques
- Contract audits. Pinpoint ambiguous language, incomplete terms, or unenforceable provisions early.
- Internal and external stakeholder consultations. Engage with all parties involved in the contract.
Risk mitigation strategies
- Clear contractual language. Using clear and precise language can prevent misunderstandings.
- Flexible contract terms. Including clauses that allow for adjustments under changing circumstances.
- Regular updates and revisions. Keeping contracts updated in line with new laws and business practices.
Risk assessment methodologies
- SWOT analysis. Applying a SWOT (Strengths, Weaknesses, Opportunities, Threats) analysis.
- Scenario planning. Anticipate scenarios to determine the potential outcomes of contract failures.
Tech in risk management
Advanced technology like AI-powered contract review software can revolutionize risk management in contract drafting and execution. These tools analyze contracts for risky clauses and suggest optimizations based on learned data from numerous legal documents. You can also consult Superlegal’s contract review checklist which helps businesses risk mitigation best practices across all contracts.
Proactive contract risk management
As we’ve seen, the landscape of contractual risks is varied and complex, but with the right tools and strategies, it’s fully manageable. The stories of unforeseen termination costs, delayed deliveries, and intellectual property disputes illustrate not just the potential consequences of neglected contractual management but also the critical importance of proactive measures.
Whether you’re drafting a new contract or navigating existing agreements, remember that the key to managing contractual risks lies in the combination of advanced technology like Superlegal’s AI contract review software, comprehensive reviews, and continuous adaptation to legal and economic developments. Embrace these practices, and you’ll set your business on a path to stability and success.