If you’ve ever read any of our blogs, or seen our videos, you’ve probably heard me talk about the importance of contracts. I think contracts are a critical tool for protecting business relationships. They provide the rules of the relationship. They align critical expectations so there aren’t disconnects between the parties. They create a plan, and consistent, repeatable process. Process is key to scaling your business. What’s not to love about contracts?
Besides creating a plan, contracts serve another important purpose. They answer the question “What happens when things don’t go according to plan?” “What happens if something goes wrong? Or as we lawyers refer to it, “Who bears the Risk of Loss?”
What Is Risk of Loss?
The risk of loss in business transactions refers to potential financial losses, damages, or other negative outcomes that can occur during business dealings.
This includes risks like:
In a contract relating to goods: Physical loss or damage to goods during transit or storage, Payment defaults or delays, Quality issues with products or services, Supply chain disruptions, Market price fluctuations, Force majeure events (natural disasters, etc.) among others.
In a contract relating to services: Change in scope needed, Professional errors, Service outages, Work requiring remediation, Notice delivered to the wrong person, Compliance with industry standards or regulations, among others (including some of the goods related ones)
In a contract to buy a business: unknown or undisclosed liabilities, inaccurate financial statements, loss of key customers, competitive threats or market changes, working capital differing from expectations, and more.
How Do We Control Risk?
In any relationship, there are several things that can go wrong. But we can control what happens next in a few different ways.
First, we can structure the relationship so that the relationship includes important checks on risks. These can be done as foundational elements of the relationship embodied within the agreement, rather than contract terms alone. For these, we’re looking at creating something that happens outside of the four corners of the contract. These can include elements like:
- Payment Security (payment in advance, letters of credit, performance bonds)
- Inspection rights and quality control procedures
- Dispute resolution processes
- Requirements to maintain insurance coverage
While each of these will be memorialized in the agreement, they also feature something that happens more broadly during the relationship and outside of the contract itself. For example, that promise to maintain insurance is in the agreement, but the insurance policy is something that exists outside of the contract as well.
Next, we can create express risk allocation in the agreement. This is exactly what it sounds like. We identify a risk, and our contract explicitly states which party bears specific risks. We can accomplish this through mechanisms like:
- Risk of loss provisions that specify when risk transfers from seller to buyer
- Warranties and representations about product quality/performance
- Insurance requirements and indemnification clauses
- Force majeure clauses defining how unexpected events are handled
And finally, when all else fails a default rule may apply. When contracts are silent on risk allocation, legal default rules can apply to insert risk allocations. For example:
- Under the UCC, risk generally passes to the buyer upon tender of delivery
- Common law places risk with the party in possession of goods
- Industry customs may determine standard risk allocation practices
A Quick Note of “Default” Risk Allocations
Default rules are NEVER your first line of defense though. They are purely last resort. Why? The default rules are written by our legislatures to work for “most” people. But you are not like most people. Your business is unique. The risks that it is capable of bearing, and the opportunities it is prepared to exploit are NOT the same as those of “most” people. As much as possible the risk you bear needs to align with the risk your business model is prepared to bear, not that of some hypothetical “average” business.
How Does a Contract Manage Risk?
The conversation over who bears the risk is an important one!
A great contract will clearly state:
- Which specific risks each party assumes
- When risk transfers between parties
- How damages will be calculated and compensated
- What insurance or other protections are required
- Procedures for handling disputes over losses
This creates certainty and allows you to price risk into your agreements appropriately. From there you can use various risk management procedures based on your contractual obligations.
Who Should Bear the Risk?
We have a few different methods for answering this question. Consider these helpful guidelines.
Risk Management Capabilities
This is my starting point and foundational rule on risk. The party that controls the risk should bear the risk. Always consider who has the better control over the events that create the risk. The party that is better positioned to prevent, control, or absorb specific risks is usually the better one to bear the risk. For example, a manufacturer typically assumes product defect risks because they control quality processes, while a buyer might assume market price risks since they’re closer to end customers.
This is critical for small businesses to understand. Sometimes there can be an urge to accept a risk because of financial need (“we need to get this deal done”) or from the influence of the other methods I describe below. Before you accept a risk, whether from negotiations or industry standards, or otherwise, ask yourself whether you can control it.
Industry Standards
We don’t always need to reinvent the wheel. Many industries have established practices for risk allocation. Shipping terms like FOB (Free on Board) or CIF (Cost, Insurance, and Freight) represent standardized risk allocation patterns.
Insurance and Financial Capacity
Risk can go to the party that can obtain insurance coverage more easily or cheaply, or who has greater financial resources to handle losses. A larger enterprise may accept risks that would devastate a small business. If a party has the resources to deal with a risk, it can afford to behave more riskily.
Negotiating Power and Leverage
Ultimately, this is the one that matters most. Notwithstanding the previous guidelines, risk allocation like all other parts of a deal is negotiable.
Often, the party with a stronger bargaining position can push risk onto the other party. This depends on factors like market competition, uniqueness of goods/services, and each party’s alternatives. To have the best chance of protecting yourself you need to establish your leverage.
At Way Law, we help your business maximize return and minimize risk, including creating your leverage to get the terms you need. Give us a call and we’ll show you how!