Contractual risk

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Contractual risk and commercial decision-making

Contract negotiation lawyers tend to be more consequence-agnostic than they need to be — both in creating and commenting on drafts. There is a decision-making aspect to this. Some risks are existential, some are mere irritations. Treat them differently when you formulate your positions. Consider three types of contractual provision:

• Credit related: Contract clauses which address what happens if your counterparty does — or looks like it imminently will — blow up. These are of mortal significance in a finance contract, where the essence of the arrangement is for the parties to take material present financial exposure to each other: if there is no counterparty, you lose all your money. In service contracts, where a party commits to provide ongoing services for ongoing payments, the “present value” of your exposure is limited, and a counterparty’s failure is less catastrophic: if your building maintenance contractor blows up, you just engage another one. In any case, whatever your exposure, if your counterparty has no assets, it doesn’t matter what the contract says. Can these consequences be ameliorated by the commercial imperative? Generally, no. They are, generally:

• Events of default/termination rights: These allow you to get out of further obligations and mitigate the incurring of forward losses, but don’t have a lot to say about existing exposures
• Credit mitigation terms: Whatever the contract says about enforceability of security and effectiveness of close-out netting, things which preserve or prefer your claims over whatever assets your counterparty still has, including its contractual claims against you. But security provisions and close-out netting formulations tend to be “verba magicae”: incontrovertible formalities which no legal eagle dares touch.

• Regulatory: Will this contract put one or other party in breach of law or regulation? Whose fault is it if it does? Who bears liability? What are the consequences? Can these consequences be ameliorated by the commercial imperative? Generally, no.
• Commercial liability: Liability outside the outright failure of your counterparty.

See also

• Decision-making
• Risk
• Magic words
• Boilerplate