Hans Bergmann

Risk Management in Procurement

A lottery ticket with a 50% chance of winning one million euros is worth 500,000 euros. Or is it? Not if there is only one ticket on sale or if you cannot afford two.

Whether or not it makes sense to take a risk depends not only on how well the risk can be calculated, but also on the ability to control the risk and cope with the consequences should things go wrong. Only after all of these aspects are established can one put a price tag on the matter. The parties to a contract are often in different positions with regard to their risks bearing capability. By allocating contractual risks reasonably, all parties can profit.

Choice of business opportunities and business partners

When seeking to take advantage of business opportunities, you will naturally wish to avoid unreasonable risks. For instance, it would be unwise to stretch your credit lines to the point where late payment by a single customer might lead to insolvency.

There is however no guarantee that your sub-suppliers are as diligent as you are. A subcontractor may even find itself in a desperate situation, leading it to make unrealistic promises in order to keep its business afloat for a while.

It is risky to take an overly optimistic view of the capacity of a subcontractor. Misjudgement can usually not be rectified by agreeing on unlimited contractual liability.

First of all, such a contract clause would have to pass the legal validity test. Finnish law gives the courts a rather wide competence to set aside provisions deemed to be unfair or unreasonable. The risk of a contractual provision being adjusted by the court is evident in case of a small enterprise which is burdened with extensive liability risks taken one-for-one from the main contract.

Reasonable risk allocation

Prior to accepting contractual risks one should:

identify risk factors;

have the capacity to control the risks; and

be able to survive failure (pass the stress test).

Where you cannot control an issue, you should try to cover the risk by other means, such as contractual provisions, control mechanisms or the use of collateral or insurance cover.

There is however no reason to shift liability onto other parties if you can control the issue yourself more easily or at lower cost than your contractual partner. For example, if you procure separate deliveries and services in order to assemble them into a single product package, only you can assess whether they will in aggregate correspond with what you have promised to your own customer.

If after due evaluation you feel comfortable to bear the risk yourself, then accepting the risk in exchange for a reasonable reward seems to be the best choice.

Contractual risk management

The allocation of contractual risks to suppliers and/or subcontractors calls for careful drafting of contractual documents. Usually, such risk allocation is achieved by means of so-called back-to-back clauses. These commonly used clauses serve as basis for application of the main agreement (or parts of it) to the sub-supply agreement.

However, due to the fact that different setups and circumstances may exist down the supply chain, the intended risk transfer may remain incomplete. Examples include the following:

Time limits for contractual obligations are often defined as a time period calculated from the ‘date of signature of the contract’ or from ‘completion of the delivery’. In sub-supply agreements, references to the main agreement for defining time limits can cause confusion as the sub supply agreement follows its own schedule.

Fixed amounts of money defined in the main agreement (for example, penalties for late delivery or late payment) may exceed the total value of the sub-contract, so that there is a high risk that the clause does not qualify as reasonable and may therefore be set aside in case of litigation.

Procedures for testing and acceptance in the main agreement are often inappropriate for partial supply.

Conflict resolution clauses may not work within the context of the sub-contract because the burden of proving faulty supply or service may differ in the case of a complete supply as compared to a partial supply.

In a supply chain, you have to make sure that what you are buying for further delivery corresponds precisely with what you have promised to deliver. This requires a thorough analysis of what can reasonably be expected from a certain sub-supplier and what role he or she has to play in the overall time line of a project.

Responsibility for supervision of subcontractors

The scope for contractual risk allocation is severely restricted where mandatory provisions apply. Typical areas in which such provisions are to be found include employment, social security and immigration law.

Finnish law establishes several obligations concerning the supervision of subcontractor compliance. As a rule, a party contracting out work is obliged to obtain certain information and certificates from its subcontractor before the contract is concluded. The objective is to verify that the contractual partner fulfils its legal obligations concerning minimum employment terms, social security, tax and other employer obligations.

Furthermore, the main contractor has certain obligations as regards work permits etc. if subcontractors employ workers from outside the EU/EEA area.

In addition, main contractors operating in a shared workplace or common construction site have a wide range of responsibilities as regards occupational safety at the site in general. These responsibilities cannot be avoided or derogated from by contractual agreements with subcontractors.