A Primer On Reviewing Contracts

This article is about reading contracts carefully. Although many of the issues that arise are quite simple to spot, they are often missed. Here is my list of some of the common issues which should be considered when reviewing any contract:

1. The Names of the Parties

"Cojo Transportation Limited" is not the same as "Cojo Logistics Inc. or "Cojo Logistics". When an incorrect corporate name is used, questions arise as to whether a contract has come into existence at all. Perhaps even more importantly, if a contract has come into existence, there arises the very important question as to who is bound by it and who can enforce its terms. If a company is not properly identified as a party, the company may derive no benefit from the contract, but an affiliated company mistakenly named as a party (or whoever signed on behalf of the improperly identified company) may be liable for the responsibilities that the company was to assume. Imagine how delightful it would be for a CEO to read a Statement of Claim alleging that there is a contract, but that he should be held personally liable as a sole proprietor, or for a lease entered into with a money-losing operation to be held to be binding on a profitable sister company.

2. How Long Will the Contract Last?

If the contract is a distribution agreement, a franchise agreement or a commercial lease and the distributor, franchisee or tenant is going to make a substantial investment of time, effort and money that will be lost at the end of the term, the answer may be "the longer the better". If one party wants the right to terminate the contract "for convenience" or "in its discretion", the other party may want to obtain compensation for its capital costs or downsizing costs, etc. There are a number of provisions which impact the length of a contact, including the original term, renewal rights and termination rights. Termination provisions, particularly those governing renewal notices, termination notices, and events of default, should be reviewed quite carefully.

3. Agreements to Agree

Contracts often have various "agreements to agree" scattered throughout them, and they are not typically legally enforceable. Examples may include an agreement to agree on future price changes or quotas in a distributorship agreement or agreements to agree on rent payable during the renewal term of a lease. Sometimes the "agreements to agree" are so fundamental to the contract that they may render the entire agreement unenforceable.

4. What Does Life Look Like After the Contract is Over?

Consideration must be given to: (a) obligations which continue after, or arise upon, termination of the contract; (b) how each party will carry on their respective businesses following termination; and (c) who will benefit from investments made by each party in entering into, or carrying out the terms of, the contract. For example, if the contract is an outsourcing agreement, does the contract have to address how the outsourcing party can continue carrying on business after termination? What transitional assistance does the service provider have to provide? If the contract is a commercial lease, was the term long enough for the tenant to recoup its investment in leasehold improvements? Does the tenant have the right to remove trade-fixtures or the obligation to restore the premises to their original condition?

5. Who Stands Behind the Promises Made in the Contract?

It is important to understand the relative wherewithal of the parties to a contract. Is one a well-known real estate developer or merely a shell company incorporated for one specific project? Is it the U.S. parent company or the newly incorporated Canadian subsidiary which operates as a sales office but has no assets? Is it the company in a corporate group which holds most of the assets in the group, or a similarly named affiliate with very few? Does the company making the promises have the resources to perform its promises? If the promises are not coming from a company with adequate resources and assets, is security available or is a guarantee available from another company in the group?

6. What is Being Promised?

Is it clear what will constitute performance? We too often see clauses such as, "The Distributor shall promote the Product throughout the Territory" but what does that mean? What is the nature and extent of the efforts required? If the Territory is Ontario, does that mean maintaining full-time sales offices in Owen Sound, Thunder Bay and Elliott Lake? If obligations are not set out with sufficient clarity, the provisions purporting to create them may be found to be void due to ambiguity. Alternatively, in the case of a dispute, the parties may find themselves engaged in lengthy and costly negotiations or proceedings in an effort to sort matters out.

7. Does the Contract Allow One Party to Change the Rules?

In a recent review of a Dealer Agreement, the dealer was required to agree to comply with six different policies of the manufacturer, none of which were provided to the dealer when the dealer was asked to sign the agreement, and all of which could be changed at the discretion of the manufacturer. Depending on the circumstances and the language of the contract, this provision could be found to be unenforceable by the manufacturer, or, alternatively, the dealer could be held to onerous terms which it never contemplated. Ideally, parameters, standards of reasonableness or discretion and conditions would be included to establish a greater degree of legal and business certainty.

8. What is the Level of Commitment?

"The Purchaser shall" is different than "The Purchaser shall use its best efforts to" which is different from "The Purchaser shall use reasonable commercial efforts to" which is different from "The Purchaser shall use efforts to". There are some agreements in which the promises made by one party are always stated as mandatory obligations while the promises of the other party are always stated to require the party to attempt to do things. Questions then arise as to specifically how much effort or expense such party is required to devote and what happens if its efforts are unsuccessful.

9. What are the Remedies for Breach of the Agreement?

The default remedy is damages. In theory, this is an adequate remedy to compensate for most breaches of an agreement. On the other hand, theory can be misleading. In theory, communism works. In reality, parties who breach contracts may not have the money to pay the damages or they may have more than enough money to pay the damages and to dispute the claim of the innocent party through the courts for many years until the innocent party gives up. The innocent party may simply not have the resources to pursue its claim for damages. In real life, the right to sue for damages may be cold comfort. More creative and realistic remedies may often be fashioned.

10. What are the Limitations on Claims for Damages?

Contracts often cap the dollar amount of damages that may be claimed for a breach and limit the types of damages that may be claimed. Some agreements are limited in a manner which gives a party the ability to completely default without incurring any significant liability. Let's take an example. A company is hired to install some equipment. The contract price is $50,000. A deposit of $35,000 is paid. Indirect and consequential damages are excluded. There is a liability cap equal to the amount payable under the contract. The installer does a very poor job, while blaming the customer for its failings. A replacement contractor is hired. The replacement contractor is paid $70,000. By the time the equipment is up and running properly the company has lost its contract with its customer and suffered damages of $150,000. It has paid the first contractor $35,000 and the second contractor $70,000, so it is out $105,000 for a job that was supposed to cost $50,000. The $150,000 of damages for the lost profits is not recoverable at all, and the maximum that it can collect for the $105,000 that it paid to the two contractors is $50,000. The customer sues the first contractor for $50,000 and the first contractor defends and counter-claims for the balance of $15,000 owing under the original contract. The customer settles for $35,000 and pays $15,000 for legal fees, to net $20,000 on damages of $200,000. This is a very realistic scenario, but one that could be avoided by the customer negotiating to include all damages, whether direct or indirect, and perhaps include some security for performance.

11. Tricks and Traps

Contracts have tricks and traps. Here are some of them:

1. Interest stated at a monthly rate is not enforceable at more than 5% per annum in Canada unless an annual equivalent rate is stated. The annual equivalent rate of 1% per month is not 12% per annum, but 12.68% per annum.
2. Charging more interest after default than before default is enforceable in Canada, unless the contract pertains to real estate, in which case it is not enforceable.
3. Non-competition agreements are often unenforceable, but may be enforceable if carefully structured and appropriately limited both in geographic and temporal scope. Whether or not enforceable in court, their mere inclusion may persuade a party not to compete, or a third party not to deal with another for fear of incurring liability to the party in whose favour the non-compete provisions are included in the contract.
4. In commercial leases, there is often a restoration clause tucked away in fine print that requires the tenant to restore the premises to base building standards at the end of the lease. This can prove quite costly and many tenants are not aware of the obligation until the lease is terminated.
5. In commercial leases there is sometimes a hidden security interest which allows the landlord to register its security and interfere with the tenant's ability to obtain financing.
6. Penalty clauses are usually unenforceable, but if carefully structured may be enforceable.

12. Which Jurisdiction's Law Governs the Agreement?

Often this is easy to determine because the contract expressly states which law governs. Sometimes the agreement is silent and legal principles have to be applied to determine which jurisdiction's laws will apply. If it is not the laws which you are familiar with that are going to govern, you could be in for quite the nasty surprise unless you obtain counsel from a lawyer in the other jurisdiction. In one case, an Ontario resident sold property in Florida for $8,000 and then failed to defend a resulting law suit in Florida, thinking that at worse it would be responsible for the $8,000 value of the property. The judgement, including punitive damages, was for $260,000. With interest at 12%, that sum grew to $800,000 by the time that the Ontario resident lost in the Supreme Court of Canada. Ouch.

13. Where are Disputes Going to be Resolved?

Will it be in your home jurisdiction or in a jurisdiction where it will be very expensive and inconvenient for you to fight the litigation? Does the relevant jurisdiction have a reputation for giving a home court advantage to its citizens? Can arbitration in a neutral jurisdiction solve the problem?

14. How Important Will It Be to Maintain Confidentiality While Resolving a Dispute?

Should arbitration be considered for this reason?

15. What is Missing?

The most difficult part of reviewing a contract is not identifying what is present and unsatisfactory, but identifying what is missing. For example:

1. In software development contracts, often what is missing is a provision that says that the customer owns the copyright in the software and the source-code and that the developer has waived its moral rights.
2. In promissory notes, an acceleration clause on default is often missing. Consideration should also be given as to whether it is appropriate to provide for penalty-free prepayment of the balance owing, or whether or not the note is to be treated as a negotiable instrument.
3. In employment agreements, the right to change the employee's responsibilities or transfer the employee among offices is often missing, as are provisions which address ownership of intellectual property.

In order to determine what is missing from any particular contract, the best approach is to look at checklists and precedents which are readily available from many sources, including legal publishers and law firms.

16. What is the Context?

Context is everything. What is the other side's reputation for honest dealing? How much money is involved? How important is the contract to you? How important is the contract to the other side? How much do you have to invest to perform your obligations or to reap the benefits of the contract? How does the "golden rule" apply? (For those of you who are unfamiliar with the golden rule, it is "He who has the gold, rules".) It would be impossible to create a comprehensive list of all issues that should be considered in all contracts. The very subject matter of the contract will generate specific issues which have to be considered. However, there are common threads which run through different types of contracts, some of which have been highlighted above, and there are common approaches to reviewing contracts. The most common approach of all is probably the least satisfactory, which is the "looks standard; might as well sign it; let's just get this done; money can't flow until we sign; they won't change it anyway; what's the worst thing that can happen?" The worse thing that can happen – why, that would be an aggressive lawyer backed by a client who wants out or wants you out!

Before writing, reviewing or negotiating your own contract, you should speak with a knowledgeable, experienced and practical commercial lawyer who can help you navigate your way through these and other issues.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.