Risk Identification

One of the most important functions of any contract is identifying and managing risk. Most people prefer to avoid confrontation. With conflict avoidance comes a reluctance to address what could go wrong that could possibly ruin a relationship. But, identifying and managing the risk is an important piece of avoiding problems in the future. Most litigation results from one of two fundamental problems—bad contract drafting and lack of imagination. Lack imagination means that the parties did not spend adequate time thinking about what could go wrong with a transaction or with the relationship.

There are two types of risks that I like to make sure are addressed in any contract.  The first type is the transactional risk. Each contract is a document about some sort of transaction. That transaction always carries with it some risks. The easiest risk to think about and imagine is non-performance. In a simple contract that may be the only substantial risk to consider. In more complex transactions, more chances exist for something to go wrong. The parties need to spend time thinking about what could go wrong. The best place to start when thinking about transactional risks is to have a detailed, step-by-step listing of the transaction steps. For each step, think about what could go wrong in a worst-case, middle-case, and best-case scenario.

The second level of risk is relationship risks. Relationship risks are those risks that involve the parties, but do not touch directly on the transaction themselves. As I have said, a contract is a written description of a business relationship. But in a contractual relationship, not everything that transpires between the parties relates directly to the transaction. Some types of relationship risks might be a miscommunication problem, expectation problems, interactions with third parties outside of the contract, or promises of future actions or activities.

The core of the contract is the transaction. Around that core is the relationship between the parties. Think of the transaction as the core of a ball and think of the relationship as a sphere around the ball. In a one-off transaction or short-term contract, the relationship sphere might be small. But, if you have a relationship with a client or a customer and there are many ongoing or multiple transactions, the relationship sphere might be quite large, which means there might be room for something to go wrong.

Both transactional risks and relationship risks have to be assessed and addressed when drafting or reviewing a contract. Remember when I said that many litigations result from a lack of imagination? There was a case in Maryland where a farm owner was selling the property to a university to build a large facility. The farm owner wanted to maintain a certain amount of green space on the property and so he required the university buyer to not cover more than a certain square footage of the property with buildings, sidewalks, and parking lots. The university agreed.

Once the university started building, it expanded their useable space by building taller buildings, several stories higher than surrounding buildings. The farmer sued saying the university violated the square footage limit. The university ultimately won the lawsuit. But the fact is that the farmer did not imagine that the university would build up. The farmer’s lawyers didn’t imagine 3D vertical construction and were focused on 2D ground construction.

Ironically, this is something that lawyers are particularly good at. We can envision the worst case scenario quite well. So, maybe have a lawyer or trusted advisor help you see what could go wrong. Literally list out these potential happenings, whether they are a transactional or a relationship risk. Having this discrete list will then enable you to analyze whether the scenario is likely, what is the potential cost, who is going to be responsible for making sure that risk doesn’t happen. This is one place where you can start to take control of how you are going to address risk in your contract.

What happens what something does go wrong? Check out these posts on how to effectively problem solve and how to utilize your management team in times of need.

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