Insight letter on Contracting in the New Economy – Risk aversion

In an economy characterised by increasing volatility, uncertainty, complexity and ambiguity (VUCA), new approaches to contracts are needed in many of the strategically most important commercial relationships. In Cirio’s Insight Letter on Contracting in the New Economy, we share ideas and insights based on years of experience from assisting our clients in establishing contractual rules of the game to face this challenge. We hope you find it valuable.

Is this the reason why contracting lawyers are so risk averse?

A better understanding of risks, and not least the psychology of risks, is of great importance when drafting and negotiating complex contracts in today’s economy. A good starting point is to ask why lawyers, and in particular contracting lawyers, are perceived as being so risk averse.

Contracting lawyers are indeed often considered a risk averse species which one is wise to involve as late and as little as possible in contract negotiations. Many lawyers are no doubt seen as important allies and contributors in deal negotiations. But (too) many are instead viewed as being a danger to the good commercial relationship established between the contracting parties, focusing on the most unlikely risk scenarios, always working under the assumption that the other party will do whatever it can to hurt the lawyer’s organisation or client.

An important reason for this risk averseness may be what is called probability neglect. This is a term coined by Cass Sunstein, among other things law professor at Harvard University and author of the best-selling book “Nudge, a book about decision making and behavioural economics”.

Risk is, rationally speaking, a function of probability and negative impact. The probability of a tsunami is typically low, but the negative impact can be severe. The probability of tomorrow being (yet another) cloudy day may be high, but the negative impact is probably low.

As Sunstein and other experts in behavioural economics have shown, we – including lawyers – are often not assessing risks in this way. In a 2001 article, Sunstein writes that “When strong emotions are triggered by a risk, people show a remarkable tendency to neglect a small probability that the risk will actually come to fruition.” Typically, people do not assess risks as a function of probability and negative impact but based on how they feel when thinking about the risk being realized – i.e. the tsunami occurring, the supplier not delivering on time, the customer not providing enough information and so on. If that feeling is strong (and frightening) enough, we neglect the probability and assess the risk as being high (hence: probability neglect).

Now, think about the contracting lawyer being given the task of drafting and negotiating a contract. In most contractual relationships, there are many things that can go wrong. There are typically many risks. Some of them high risks, rationally speaking (e.g. both high probability and high negative impact), and many and most of them low to medium.

But the lawyer must envision a scenario where also the low probability risks are realised and that its or its client’s organisation suffers some kind of loss or damage. The lawyer will then know that people will come running to the contract and look for remedies. And if there are no remedies to be found, someone will be blamed. Who? Well, probably the lawyer who wrote such a lousy contract…

For the lawyer, the risk assessment is often not about the deal’s equivalent to a tsunami, but about being blamed for missing to deal with the tsunami in the contract. Due to probability neglect, the lawyer will feel an urge to mitigate this risk by writing a “tsunami clause”. And since there are many risks in the deal, there are good reasons – psychologically, not rationally, speaking – to write many of those clauses.

The consequences are predictable and known. The contracting lawyer falling into this trap is perceived as a burden to, instead of enabler of, the deal and may damage the commercial relationship due to the signals of mistrust sent via the “tsunami clauses”. Probability neglect is thus often a greater commercial risk than the actual risks which probabilities are neglected.

What is the cure against probability neglect? It is not only, or even primarily, that lawyers become more aware of their own irrationalities. The primary cure, at least in more complex and long-term deals such as outsourcing, construction, alliances etc, should be for the parties to sit down together and make a joint scanning of relevant risks, which are then assessed in both the probability and impact dimensions and allocated to the party being in the best position to mitigate them. And then to include a shared risk management process as part of governance of the relationship, where this scanning and risk exercise is continued.

Questions for you to think about

• How do you assess risks in contract drafting and negotiations?
• Does your organisation have a process for ensuring that contract risks are rationally assessed and, thereafter, adequately catered for in the contract?
• Do you typically include a joint risk management process in your more complex and long-term contracts? If not, why?

For further advice or questions, please contact the team: