I’ve heard a contract described as a “risk allocation tool” on many occasions. In other words, we use contracts to allocate the risk of certain unwanted/unforeseen events to one party or the other.
I wanted to test that concept. My basic question is this: is “risk allocation tool” the best way to characterize a contract? In order to work through this idea, I thought I would try to categorize types of risk that either: (i) surround the drafting of a contract; or (ii) that parties want to mitigate with a contract.
Below is my description of the types of risks associated with contracts. It might not be a comprehensive list, but I believe it’s pretty close to complete. Also, I will try to add some possible solutions for each category of risk.
- Sophistication Risk
This is the risk that your client is not sophisticated in the ways of business, contracts, negotiation, etc. This means the lawyer has to spend extra time and money to educate the client, learn about the business issues covered by the contract and to get solid instructions for drafting.
Solution for Client: If the client recognizes that he’s not particularly sophisticated, he should try to retain a lawyer that has a lot of experience in the type of contract being negotiated (this cuts down on Drafting Risk—see below).
- Drafting Risk
Poor Drafting. This is the risk that happens when a contract is poorly drafted for any number of reasons. First, the drafting lawyer might not have expertise in the area (or may be inexperienced, in general). Second, the client might not want to pay to have the contract carefully drafted (i.e. the client is cheap). Third, the client might not appreciate the risks of “under-drafting” a comprehensive contract (Sophistication Risk). Fourth, the client might not want to spend the time necessary to help the lawyer understand the business deal (i.e. “I’m too busy, you handle it”).
Note how these are all intertwined. A lawyer who does not have expertise in the area could be working with an unsophisticated client who doesn’t appreciate the risks of entering into a complex agreement. Because the lawyer is not an expert in the area, he or she is not capable of advocating for why the client should take the process more seriously. Thus, like many business people who are conscious of the bottom line, the client decides he doesn’t want to spend the time or money to draft a proper contract. And, because the client takes a “cheap” approach, the lawyer never gets the opportunity to dig into the business and, thus, learn about the issues that should be reflected in the contract. In other words, a lot of lawyers can do a capable job with most contracts, notwithstanding their inexperience with the area, if the client authorizes them to take the time to educate themselves. But time = money.
Solution for the Client: The client should try to make a careful assessment up front of the critical nature of the contract. For example, if the contract is not mission critical (i.e. its success or failure will not have a material impact on the business), it is less likely under-drafting the contract will cause harm to the business. Additionally, listen carefully to your professional advisors. During the course of negotiation it sometimes becomes apparent that you have not properly assessed the contract’s risk to the business. Be flexible and be prepared to change instructions to your lawyer about his/her approach to the contract if new information about other substantial risks comes to light.
Common Law/Equity/Statutes. This is the risk that the common law, equity or legislation will trump the terms of a contract or cause an unexpected outcome in the interpretation or enforcement of a contract (this could also go in Outcome Risk—see below).
Solution for the Client: Once again, clients can best mitigate this risk by using a sophisticated lawyer who understands the intersection between the language of the contract and possible effects of the common law, etc., on the interpretation or enforcement of a contract. I think it is fair to say that bigger firms, with sophisticated knowledge management practices, will be more up to date on the latest legislation/case law and their precedents will reflect best practices. Having said that, you would probably get as good of service from a boutique that specializes in the area. The biggest risk comes from a smaller, full-service firm full of contract generalists that do not focus on any specific area of law.
- Due Diligence Risk
In general, this is the risk that you do not have all the information required to make an informed decision when entering into a contract. This could arise from a lack of sophistication (i.e. “I don’t know what I should be asking”). It could also come from the counterparty manipulating information or failing to provide information. Thirdly, it would come from the client not wanting to spend the time/money to dig deep enough.
Solution for the Client. The starting point is, once again, how mission critical is the contract? If it’s mission critical, the client should seek as much relevant information as possible. We’re again faced with Sophistication Risk in that less sophisticated clients might not understand the types of information they require to make the right decisions. Additionally, it’s sometimes difficult to detect fraud or manipulation by the counterparty. Unfortunately, manipulation often has to be dealt with after the fact with lawsuits. In that regard, Drafting Risk comes into play. Did the lawyer draft effective protections so the client can get a remedy? There is also Outcome Risk (discussed below) in that sometimes remedies are ineffective (e.g. the counterparty flees the jurisdiction).
- Complexity Risk
This is the risk that comes from entering into complex contracts, especially ones that are bespoke (vs. common). As a general rule, as an agreement increases in scope and complexity, there is a greater chance of missing risks and potential negative outcomes. Additionally, highly-regulated industries may require complex provisions to deal with regulatory issues.
Solution for the Client: We’ve already discussed Sophistication Risk. As a businesses’ complexity increases, one would hope the key people also increase in sophistication and, thus, can work closely with the lawyers to understand and mitigate complexity risk as best as possible. Again, using a lawyer who has a lot of experience in the area (especially for highly-regulated industries) can help mitigate the increasing risk that growing scope and complexity can bring.
- Point in Time Risk
This is the risk that decisions you make today when negotiating a contract, and cover today’s situation, might prove to be poor decisions when a dispute happens.
Solution for the Client: It’s hard to predict the future. But, for example, companies in highly-regulated industries should be on top of the potential direction of the regulatory regime (and, where possible, be influencing it). Again, using a lawyer with expertise in the regulated area, and who also understands what the future might bring, can allow the client to build options into the contract to cover issues that may arise in the future.
- Negotiation Risk
This is the risk that you do not have negotiating leverage and, thus, get stuck with a lot of unfavourable terms.
Solution for the Client: Most importantly, how mission critical is the contract? If the contract is mission critical, you may be willing to put up with a substantial amount of Negotiation Risk. If, on the other hand, the contract is not mission critical, but could lead to substantial negative outcomes, why would you enter into it? This is tied to Sophistication Risk. The leaders of the business must understand the business, where it’s heading, and what entering into the relevant contract will mean to the business vs. what will happen to the business if the contract goes bad. Once again, an experienced lawyer can help. Because even when you have little bargaining power, small tweaks can make a big difference. An experienced lawyer may be able to help you negotiate one or two small provisions that greatly increase your protection or decrease your exposure.
- Obligation/Breach Risk
This is the risk that comes from the obligations/representations/conditions created by the contract. They can work against both sides. For example, if your client negotiates a contract the counterparty can’t fulfill, it can damage your client’s business. Maybe, for instance, a huge manufacturer jams onerous terms down the throat of a supplier. The supplier accepts the terms with best intentions (and belief that it can fulfill the terms), but finds it can’t deliver on the schedule demanded by the contract. If the manufacturer is counting on the supplier for parts that can’t be delivered on time, it can cause delays for the manufacturer. Notwithstanding there are remedies built into the contract, these may be inadequate (see Outcome Risk). In other words, running off to court may not solve the problem that the manufacturer does not have the supplies required to manufacture its products.
There are other questions that must be answered in order to properly deal with Obligation/Breach Risk. Who takes the risk when things go wrong? What level of liability will each party be held to (e.g. limitations on liability)? What level of recovery can you get if the other party breaches (i.e. is the breaching party impecunious)? Can you get specific remedies (e.g. specific performance and injunctions) and what are the costs to pursue these remedies? Is the cost of enforcement way out of line with the potential recovery, effectively leaving you with no remedy? Can you get a remedy at all (e.g. do you want to sue a Chinese counterparty in China)?
Solution for the Client: Sophistication Risk and Drafting Risk play a big part in dealing with Obligation/Breach Risk. Less sophisticated parties may not appreciate the risks associated with contract failure. At the risk of sounding repetitive, hiring the right lawyer can help the client draft effective contractual protections, and help the client understand the effects of Obligation/Breach Risk (i.e. that in some instances the lawyer may not be able to provide an effective and practical contractual remedy for certain Obligation/Breach Risks (e.g. going to China to sue a Chinese counterparty)).
- Outcome Risk
As discussed above, this includes the risk that your client might not be able to get a practical remedy for breach (e.g. the counterparty has hidden its assets offshore). It also entails the magnitude of the disaster if things go wrong (e.g. a bet-the-company contract).
Solution for the Client. As always, understanding the true risk of entering into the contract is crucial. This brings out Sophistication Risk and Drafting Risk. Hopefully, where a contact is mission critical, the client is able to comprehend the risks and instruct counsel properly. And, having an experienced lawyers drafting the contract can help to mitigate some of the Outcome Risk through contractual provisions.
We started out with the question is “risk allocation tool” the best way to describe a contract? After engaging in the above analysis, I say no. It’s better to describe a contract as the end result of a process through which risk is identified, assessed and dealt with. I would call this the “risk mitigation process”. This means both the contract—and the process of drafting a contract—are crucial to mitigating risk. One of the most important components of the risk mitigation process (maybe the most important) is who the client chooses as a lawyer, and whether or not the client allows the lawyer to do her job.
If you look at the above categories of risk, you should see some common elements: (a) Is the contract mission critical?; (b) Sophistication Risk; and (c) Drafting Risk.
The right lawyer can make a significant difference in all of those common elements. Put differently, it’s a bad combination to have an unsophisticated client entering into a mission critical contract, for the many reasons described above. Add to that an inexperienced lawyer—this is a recipe for potential disaster, in my opinion.
Where the contract is mission critical or high-value, I strongly suggest you hire an experienced contract drafter who has specific industry experience, especially for clients in heavily-regulated industries. This will probably cost more than hiring a generalist (or someone with less experience). Or maybe not. Perhaps the experienced lawyer will spend less time educating herself and can quickly and succinctly help you work through the risk mitigation process, including drafting a reasonable contract that does its best to deal with risk, given the circumstances. Thus, notwithstanding a (presumably) higher billing rate, the experienced lawyer might spend less time on the file, saving the client money.
Even if it does cost more, wouldn’t you feel much better knowing you have a talented lawyer with lots of industry-specific experience leading you through the risk mitigation process? I know if my net worth was on the line, I would want to have the right lawyer in my corner. It would certainly help me sleep better at night.