Whether you manage a construction project or commercial relationship, contract provisions for risk allocation represent an integral component of conducting business. For instance, changing site conditions, authority disruptions, and weather can threaten the contract timeline—not to mention the pervasive supply chain issues arising from the pandemic.

Market fluctuations can likewise alter project costs. And unanticipated hindrances like theft, property damage, or worker strikes will increase the risk that one or more parties cannot meet the contract requirements. Further, the need for permits, licenses, or government approval amid shifting regulations can make it difficult—or even impossible—to fulfill contractual obligations.

Contract reviewers and negotiators must exercise due diligence to avoid errors, vague language, and omissions that could lead to misunderstandings or even litigation. Artificial intelligence (AI) contract review enables legal departments to mitigate many common risk concerns without requiring excessive and expensive staff training or review time.

Contract Provisions for Risk Allocation

Standard contract provisions for risk allocation include:

Indemnification

This provision allows parties to shift the burden of loss, minimize the uncertainty of future liabilities, and transfer the cost of defending third-party claims. Parties can reduce risk by reducing the scope of the provision.  

Limitation of Liability 

Parties can tailor a limitation of liability clause to meet their needs by capping compensatory damages and excluding liability for indirect or consequential damages. 

Express Contractual Remedies

Allocation of risk occurs by narrowing or expanding available common law remedies and reducing uncertainty in the scope of potential liability. Clauses may pertain to equitable, cumulative, or exclusive remedies. A liquidated damages provision may spell out the precise formula for calculating damages. 

Payment Terms

Most commercial agreements outline a deferred payment obligation. Sellers often attempt to minimize the time between delivery and payment to decrease the risk of nonpayment. Buyers, on the other hand, seek to maximize the deferred payment period. 

Product Warranties 

Risk allocation occurs by expanding or limiting the scope of warranty coverage, including its duration, invalidation conditions, remedies for breach, and cover-all provisions affecting unspecified matters. 

Force Majeure

Unexpected events occur. The force majeure provision allows a contracting party to manage the risk of breach due to events or circumstances beyond control. 

Termination Rights

The addition of a clause for termination rights allows one or both parties to dissolve their relationship before the end of the contract term under certain circumstances. Termination rights may be granted with cause or for convenience. 

Insurance Coverage

Maintaining specific levels of insurance coverage can defer some or all risk to a third-party insurer. The policy should specify that the party has sufficient insurance to satisfy all liabilities. 

Guaranties

When financial capacity or creditworthiness are unknown, a guaranty provision shifts the risk to a guarantor who provides an added level of protection against default. 

Common Errors in Risk Allocation Contract Provisions

Contractual risk allocation provisions are powerful and strategic tools that can protect parties from unknowns and defaults. However, these provisions are commonly subject to intense negotiations. 

Contract attorneys typically spend considerable time negotiating indemnification and limitation of liability provisions. Common risk allocation errors include failures to:

• Include clear, thorough termination conditions - Negotiators may need to define notice requirements, suitable termination conditions, termination fees, and confidentiality rights when transitioning to a new supplier. 
  
  
• Establish predictable recourse for indemnification procedures - When can a claim be initiated? How long does the claim have to settle? Who pays for the defense and settlement? Reviewers should address these questions to assure recourse predictability.
  
• Draft an appropriate consequential damages waiver - Waivers can be one-way or reciprocal. They can exclude specific damages like punitive damages, lost profits, or diminution in value.
   
• Set a liability cap - Is there a cap on liabilities? Is the cap proportionate to the contract price and, therefore, enforceable? Is the cap mutual? Exceptions may be included for gross negligence, breaches of confidentiality, or intellectual property violations.
   
• Address all price and payment risks - Periodic price adjustments should be enumerated if the parties are subject to volatility in transportation or raw material markets. Prices may also require tailoring to quantity or frequency of purchase to reflect supply-and-demand, although some contracts will benefit from a stable, fixed price for the contract term. 

Mistakes often result from human error, poor clause analysis, failure to adhere to company playbook standards, over-reliance on boilerplate language and templating, and the inability to update negotiating practices to modern best practices.

AI Contract Review Reduces Errors and Risk

AI has emerged as a comprehensive contract risk analysis technology used by leading corporate legal departments. The best platforms combine AI, Natural Language Processing (NLP), and an AI Digital Playbook to create a comprehensive, automated solution for reducing errors, understanding provisions, negotiating stronger positions, and minimizing risk.

AI contract negotiation platforms can:

• Review an entire contract in less than five minutes.
• Compare current drafts to digital playbooks, past agreements, and best practices.
• Redline outlying, overly broad, inaccurate, or risky provisions.
• Assess contract language according to the degree of risk
• Provide context-based suggestions for revision.
• Integrate seamlessly with your current workflow.

By implementing an AI-powered contract negotiation solution, legal departments and procurement teams can eliminate unnecessary rounds of legal review, reduce escalations, and allow senior attorneys to focus on higher-level, strategic matters to the business.