Every contract negotiation aims at proper risk allocation. But what is proper to one party may not be so proper to the other. At that point proper may no longer be objectively proper at all. So, how might we get it right? What does “proper” risk allocation look like?
At a recent IACCM conference I joined a panel discussion on risk allocation and its influence on performance and consequently my view of contract negotiations broadened. We all recognized a considerable gap in the available research in this area and it is definitely worth exploring. Most clauses, if not all of them, in commercial contracts apply to risk and this gap in research potentially affects how these clauses are negotiated and the risk allocated.
Risk basics – identify the risk
Risk can be defined as exposure to possible loss, injury, or other adverse circumstance and uncertainty of desired outcome. Owning the risk means taking responsibility for anything that results from it.
There are obviously different sources of risk, some more or less manageable (e.g. performance of own staff), others impossible to control or even foresee (e.g. weather, force majeure).
To be able to properly allocate risk the first step is to identify and critically asses the risk and then develop suitable risk mitigation measures and strategies. From there you can monitor the probability of risk occurrence and the effectiveness of your mitigations.
Based on this the parties of a commercial contract can make an informed decision on how to optimally allocate the risk, rather than simply push most of the contractual risks away and to the other partner.
Risk allocation means deciding who bears a specific risk, who has management responsibility and accountability for risk.
Poor practice of risk allocation in commercial contracts
Risk allocation can be done in various ways, the most popular and seemingly the optimal one would be to transfer the risk to the counterpart. In practice the risks tend to be allocated to the party with a weaker position in negotiation rather than the party that has greater ability to manage risks. It happens also when contracts are negotiated solely by lawyers who are not involved in later performance under a contract and their only goal is to maximize reward and minimize risk.
Contract professionals traditionally use several key provisions as risk allocation tools such as representations and warranties, indemnification, liability limitation and exclusions, payment terms, force majeure, etc. (uk.practicallaw).1
There is however a concern that shifting the risk onto one party to a commercial contract could jeopardize performance under the contract plus the long-term relationship of the parties. When risk is allocated poorly, either the party responsible for it cannot manage the risk or the party who should be in charge does not have such responsibility. We would like to know if and how it influences performance under a commercial contract.
The effects of risk allocation on performance can be especially relevant, where more than one party is responsible for the performance of a contract and no party’s only obligation under a contract is solely monetary. This is probably the reason why considerable research is conducted on risk allocation in major construction projects, which involve several parties with non-monetary obligations. This research provides valuable insights.
Research on risk allocation in construction contracts
Risk in a construction project is defined mostly as uncertainty about performance (duration and quality) and cost (Hartman, 2000)2. Available research on construction contracts shows that risk allocation can substantially change conduct of project participants and influence project performance. The owners in construction projects are shown to gain value from efficient allocation of risk, which reduces the overall risks and improves project performance. By contrast, the effects of poor risk allocation might include:
- Shifting risks to parties, who cannot manage or control them leads to increased costs;
- Accepting a non-manageable risk by a contractor could justify higher bid prices;
- Shifting too much risk on one party also hurts a relationship of the parties, which is highly relevant in the context of long-term construction projects;
- Strained relationships, blame culture and more likely claims increase the overall risk of poor performance, delays and rising costs of a construction project.
Conversely, wherever a trust relationship between the owner and contractor(s) is created and maintained, the parties are much better positioned to allocate risks efficiently. As a result, a party responsible for a specific risk is best placed to manage it or monitor its probability (Zaghloul et al. 2002).3
What we learn about risk allocation in commercial contracts
I believe the conclusions from the above mentioned research on construction contracts can be applied to understand risk allocation and its effects for commercial contracts as well. Specifically:
- A trusted relationship between the parties is a condition for proper risk allocation and efficient performance.
- Trust can also be created between new contract partners through accurate and honest risk management: identify all risks; assess and develop mitigation response.
Building trust logically requires more effort in the beginning of a working relationship between parties of a contract and certain degree of technical expertise and experience. It means that delivery teams -- as opposed to solely bidding teams, or sales/purchasing departments or legal representatives -- should be involved in risk allocation in contracts.
So to summarize. Proper risk allocation starts with identifying and allocating the risk and evaluating mitigation strategies needed. I believe it can improve performance under any contract. And when it is undertaken in the atmosphere of mutual trust and respect, the chances of successful management of risks, performance improvement and overall success are skyrocketing. With growing numbers of positive examples of modern contracting in the market we can hope that risk allocation in commercial contracts will become more reasonable, even if requiring more courage at the beginning. If we put to practice the points made in this article, we can keep going, take on more responsibility, and climb to higher ground!
- uk.practicallaw.thomsonreuters.com, Using Contractual Risk Allocation Provisions to Minimize Risk and Maximize Reward, 10-Jul-2013
- Hartman, Francis. 2000. Don't Park Your Brain Outside—A Practical Guide to Improving Shareholder Value With SMART Management. Newtown Square, PA: Project Management Institute.
- Zaghloul, R. & Hartman, F. T. (2002). Construction contracts and risk allocation. Paper presented at Project Management Institute Annual Seminars & Symposium, San Antonio, TX. Newtown Square, PA: Project Management Institute.
ABOUT THE AUTHOR
Natalia Ombach is an experienced legal and commercial risk manager, having worked across multiple professional settings as an in-house lawyer, freelance consultant and currently is in charge of managing risks from clients’ and suppliers’ relationships at Turner & Townsend (Europe).
She leads, reviews, and negotiates contracts of European T&T businesses, agrees mitigations strategies and monitors their performance. Her core strength is the ability to strike a balance between compliance with risk avoidance policies without creating barriers to operations – this allows top performance for business. She is innovation-driven, challenges and improves policies, processes and tools; and she researches new technologies, e.g. use of AI in contract review. She holds law degrees from Wroclaw University (PL) and Wuerzburg University (G), as well as MBA from Open University Business School (UK).
ABOUT TURNER & TOWNSEND
Turner & Townsend is a multinational professional services consulting business in Leeds, United Kingdom specializing in program management, project management, cost management and consulting.