Imbalance and Risk in Business contracts
“Shifting risk” is an inherent function of business contracting. Accordingly, a business contract will almost always favor one side. This is true across all forms of business agreements, from loans to purchase agreements to licenses to contractor agreements. Even under a contract with terms that seem to apply equally to all parties, one of the parties will usually find itself in the position of being subject to greater contractual risk than the other parties. The disadvantages formalized in a contract can be minor, or they can be catastrophic.
Common risk shifting devices can be subtle, like removing a party’s discretion to make certain decisions, or they can seem egregious, like requiring one party to reimburse the other party for harm caused directly by the other party, or giving one party the right to declare default based on nothing more than “feelings of insecurity.”
Where do these imbalances come from?
Self-serving Terms. Companies draft contractual terms that favor themselves, and call them their “standard terms and conditions.” Contracting parties who do not or cannot negotiate more favorable terms become subject to the imbalances in contracts drafted to favor someone else.
Greater bargaining power. The weaker party to a contract is the one that needs the transaction more than the stronger party does, and is willing to accept unfavorable terms for the opportunity to do business under the contract. The stronger party takes advantage of this imbalance to shift some of the risks and costs of doing business. The ability to shift costs makes the bargain worth more to the stronger party, and can be a key inducement for the stronger party to enter into the contract at all.
Business culture. In some industries, companies simply expect to work with serious risk shifting terms as a matter of course. Construction industry and commercial leasing contracts are well-known for including some harsh contractual terms, for instance.
How can companies manage contractual imbalances?
Know what you sign. Identify the contractual imbalances that affect your company. Some of the imbalances will be negligible, either by their terms or by the nature of your transactions, but others will be significant and should be negotiated to a point where the company can manage the risk of the imbalance. Some of the imbalances will also seem favorable, and it’s good to identify where you have an advantage.
Develop standard terms. Companies that are able to propose initial contract terms in the course of conducting business should take the time to develop their own set of standard terms. Even if a company is not able to use its standard document for every transaction, the more it’s used, the more it will help mitigate the company’s overall contractual risk. Having a standard document also saves time for the company’s business development or contracting team.
Have a plan to manage contractual risk. Companies that do business under a number of agreements should develop a contractual risk plan that reviews the company’s goals and aspirations, explains the risks baked into the existing contracts, and devises ways to address the aggregate contractual risk in light of the company’s goals. A plan is an essential tool for a business development team that initially reviews the company’s business contracts. The plan can incorporate strategies from easy steps like pushing back on challenging contracts, to more structural steps, like forming subsidiary entities to isolate risks flowing from riskier business lines.
What about doing nothing? It’s okay to do nothing about contractual risk as long as your contracts pose no risk. It’s hard to think of an example, but let’s say a farmer has sold to the same customer for 20 years, a market owned by her sister. In that case, let’s assume there are so many options for handling a business dispute that the risk of either party attempting to enforce a contract in court is nil, so the contents of any contract just would never matter. Other than that, though, doing nothing simply means that you are accepting risks that you haven’t evaluated or maybe even identified.