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Hyper-risk environment requires precise contract design
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Hyper-risk environment requires precise contract design

The effectiveness of an enterprise in managing and identifying risks is often the key to success in business. Risk can be defined as any factor, event or occurrence that could have the potential to affect a desired outcome. Business lawyers assist their clients in identifying, quantifying, and pricing each risk according to the likelihood and potential consequences. Risk cannot be eliminated, no matter how Wall Street tries hard to convince the market. There is no inherently good or negative risk. There are only mispriced ones. 

The dynamics of dealmaking continue to evolve. Each technological breakthrough or geopolitical event brings new risks that need to be quickly assessed, priced, and allocated among the parties or off boarded by insurers or any other third parties. These risks must be properly documented in order to ensure enforcement. It is more essential than ever for the business lawyer to understand his or her client’s business model, industry dynamics and transaction objectives to develop a true appreciation of that client’s true risk profile. 

Clients adapt to and feel comfortable dealing with a variety of traditional risks, including compliance, reputation, competition and operational. Due diligence is used to extract information and disclosures are made by counterparties in the form of representations or warranties. Schedules will include exceptions. Deal terms could be modified to address the disclosed risks. This was a cumbersome process, but it was possible in a world that was static and slow changing. The result is that parties can become complacent and forget to address the formal contract until it expires.      

Today’s new hyper-risk environment demands more nimble contracts designed for timely administration and action. Cyber-hacking can cause production facilities to be shut down; trade restrictions and unchecked inflation can unexpectedly increase the cost of critical inputs; travel restrictions which limit access to foreign-based engineers to repair machinery can all pose new risks that could quickly threaten core operations. Further complicating matters, the interconnectivity within a business’s own operations and with its customers and suppliers add an additional level of complexity in spotting, containing and resolving risk factors.      

The solution is to first build a dynamic negotiating framework that clearly identifies known risks, that if were to occur, could materially impact a business’s model and pricing assumptions. 

In the worst-case scenario, is that likely to be temporary or permanent? You should identify the counterparty that is most likely to prevent the risk from happening and should pay any additional cost or loss. Sometimes, the parties might be able to transfer the risk to an outside party such as an insurer. The negotiation will focus on how much coverage they want and who will pay the premium. 

Two things are often overlooked when dealing with traditional or new risks. 

• Any issues that went wrong must be fixed immediately. Assigning blame and financial responsibility can wait, but a business’s customers and limiting the harm to its name and reputation cannot. This principle must be established in the agreement. It is also important to define the process that will be followed in dealing with escalated issues. Negotiations are worth the effort to find a solution. It doesn’t matter if it doesn’t matter. 

• The ability to properly evaluate and price various risks depends on timely access to accurate information. Decide what information is required and which party has it. Your contract should give you immediate access to the information if your counterparty has it, especially in a crisis situation. 

Due to the dynamic and changing nature of commercial contracts, it is important to adopt business protocols that move signed contracts from one side to the other. This improves predictability and reliability between counterparties. 

It is important to ensure that contract provisions are consistent with reality and provide clear economic incentives and disincentives to reduce the severity or risk of disruptions. By having a good working relationship with your counterparty, you can reduce the risk of a costly outcome. Failure to communicate with your counterparty quickly when there is a change in the horizon could be the biggest risk to your business. 

Craig Owen White, Esq., is the partner-in-charge of Hahn Loeser & Parks LLP’s Cleveland Office. Caleb P. Ohrn is an associate at Hahn Loeser & Parks LLP. They both are members of the firm’s Corporate Practice Area.  Contact Craig at [email protected]Caleb can be reached by [email protected]

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