UNDERSTANDING CONTRACT DRAFTING – PART II

Aspects of a Commercial Contract

Now that we've reviewed the basic aspects of contract drafting with a simple example of contract involving the sale of used car, let’s look at the more complex aspects of understanding a contract.

1. Establishing the law of the contract:

A unique feature of contract law is that it sets out a ‘private law’ between the parties. This means that the parties to a contract can choose which law they wish to be governed by, regardless of the local law of the place where they reside.

For example: in case of a contract regarding the sale of a used car, the buyer and seller could resort to arbitration as a mechanism of dispute resolution instead of approaching the courts.

For example, if an American company wishes to sell a factory that it owns in China, to an Australian company, the parties could choose to have the contract governed by the laws of a California where the Australian company has a local office. This ensures that the governing law and forum are neutral towards both parties, and provides both parties with a certain degree of comfort in structuring the transaction.

2. Establishing complex transaction structures:

Commercial contracts are usually complex documents which lay out the structure and organization of the transaction. Commercial contracts are also often futuristic.

Consider the example of the sale of a business by Sam to Sally. The contract could be signed on Day 1, and then the parties could provide for a 20 day time-period where Sally has the right to inspect the financial and operational documents of the business before they take a decision on finalizing the sale. During this period, the parties will usually negotiate the purchase price, based upon the inspection of the documents and understanding of the business. At the end of this 20 day period, if Sally is not satisfied with the results of the inspection, she would have the right to walk-away. Alternatively, the contract could provide both parties the right to walk-away if they are unable to finalize the purchase price.

3. Reducing risk:

One of the most important jobs of a lawyer is to structure a transaction in a way that minimizes the risk of his client. Lawyers are becoming increasingly creative in drafting clauses that reduce risk and/or transfer the risk from their client to the other party. The most common risk that is encountered in all contracts is the financial risk. This could be mitigated in a number of ways – establishing an escrow account for the funds during the period between signing of the contract and finalizing the sale; ensuring that the buyer provides a guarantee from his bank regarding the availability of funds, providing that a third person would step in to guarantee payment of the purchase price, etc.

4. Providing waiver rights:

Waiver rights are provided to parties to permit them to go ahead with the transaction, even if some of the contract obligations have not been met.

For example, in the used car contract, the parties could include a covenant to say that: "The Seller shall ensure that the car contains a full tank of gas on the day of the sale." However, the closing conditions to the contract could provide the Buyer with the right to waive this obligation and still purchase the car, if he so wishes.

Waiver rights are important because they permit parties to go ahead with transactions, if the party feels that the risk incurred by him because of the other party’s non-fulfillment of a certain obligation is less than the risk that would be incurred if he concluded the transaction.

Contract drafting has traditionally been a lawyer’s domain. However, websites offering customizable forms have become popular, especially for the contracts that we use almost every day. Examples include: lease agreements, agreements for the sale of a used car, etc. A quick read would seem to suggest that the contract contains fairly standard terms, but a single seeminingly unimportant word, phrase, or even punctuation mark could change the meaning of an entire clause. Therefore, each party should have proposed contracts reviewed by a lawyer who understands their company, their goals, and the laws governing the transaction. This ensures that the party receives the benefits they are contracting for and prevents costly future litigation.

UNDERSTANDING CONTRACT DRAFTING – PART I

Basic Aspects of a Contract

A well-drafted contract sets out the relationship between the parties, and lays down their agreement regarding the rules that will govern their relationship. A contract should accurately memorialize the business deal, in clear and unambiguous terms. Ideally, it should be fluidly drafted, so it is flexible enough to deal with changes that occur, while at the same time tying down the parties to their obligations. As an example, let’s use a simple contract involving the sale and purchase of a used car to explain key contract concepts.

A standard contract will always contain the following clauses:

1. A statement of facts made by each party that induced the other party to enter into the Contract:

These are technically referred to as ‘Representations and Warranties’. Representations and warranties are always made as of a moment in time, and do not provide futuristic guarantees. For example: The Seller represents and warrants to the Buyer that the car was purchased in 2000.

2. The rights and obligations of each party to the contract: 

These are technically referred to as ‘Covenants’. Covenants are present and futuristic obligations that each party owes to the other.

For example: The Seller shall maintain the car in good condition, until the date of sale. The Buyer shall have the right to inspect the car, prior to the date of sale.

3. The events/sequence of events that must occur before a party to the contract is required to perform its obligation:

Contracts are always reciprocal arrangements and require one party to comply with a certain obligation, before triggering the obligation of the other party.

For example: The Buyer shall pay the Seller an amount of $10,000 in cash for the purchase of the car.

As per this example, the Seller is not obligated to sell the car to the Buyer until he has received this amount. A subsequent clause would provide that upon receipt of this amount, the Seller will execute a bill of sale for the car in favor of the Buyer.

4. Discretionary rights:

Contracts could often provide a party with a discretionary right that he could use under certain circumstances. Discretionary rights can usually be identified by the use of the term ‘may’ in the drafting of the clause. A discretionary right does not obligate the party to make use of it.

For example: If, upon inspection, the Buyer is not satisfied with the condition of the car, he may terminate the agreement.

If a situation arises where a member of Seller’s immediate family is in need of the car, then the Seller may terminate the agreement.

5. How the contract will end – the rights of parties to terminate the contract:

This includes details of when and how a party can terminate, as well as a list of specific situations under which a party can terminate. These are technically referred to the ‘Termination Clause’. Termination clauses are very important because they give the parties the right to walk away from a transaction under specified and negotiated circumstances. Clearly specifying the conditions under which the parties can walk-away, and the consequences of the parties walking away avoids a messy court battle.

For example: The Buyer shall have the right to terminate the contract if the car is not in good condition on the date of the sale.

Or, the Seller shall have the right to terminate the contract in the event that Buyer fails to pay the purchase price on the date of the sale.