Common Draft – A Contracts Deskbook

Common Draft – A Contracts Deskbook

Model contract clauses and checklists, in plain language, with annotations and playbook notes.

For practitioners & students. A work in progress; working draft 2016-03.1. Copyright © 2013-2016 D. C. Toedt III. Last modified Friday August 26, 2016 09:47 Houston time. See also the prior versions.

Quick links:     How to use Checklists Playbook Archive
 

Free for use in individual contracts under a Creative Commons license.
NOT A SUBSTITUTE FOR LEGAL ADVICE; see the Cautions below.

  Table of Contents

Introduction (with cautions)

1.   Front Matter of the Contract

2.   Definitions & Usages

3.   Major Business Provisions

4.   Payments & Related Provisions

5.   Supporting Provisions

6.   Standards & Restrictions in General

7.   Litigation & Alternative Dispute Resolution

8.   Termination

9.   General Provisions

Additional reading notes

About the author

Introduction (with cautions)

How to use the Common Draft materials

Use the model checklists for first-pass discussion

Both a contract drafter and a contract reviewer can save some time by first reviewing — together — the Common Draft model checklists (as well as other clause titles) and discussing just what types of provision they want in the document.

Use the clause text under a (limited) Creative Commons license

You're free to use the Common Draft materials (which are copyrighted) in accordance with the following license; all of the following permissions are given on the express condition that you agree to the Cautions below.

  • Anyone is free to use the Common Draft materials, at no charge, for educational (non-commmercial) purposes, subject to the restrictions in the Creative Commons Attribution-NonCom­mer­cial-ShareAlike 4.0 International License. Attribution should include a link to www.CommonDraft.org.
  • If you're a licensed attorney (or acting under the direction of a licensed attorney), you're free to reproduce and/or modify any or all Common Draft model clauses for use in spe­ci­fic individual contracts, and/or in your general-terms-and-conditions forms, at no charge; there's no need for attribution or sharing, although both would be certainly be welcome.
  • In case there's any doubt, the authorizations above don't extend to reproduction, distribution, display, or performance in, or as part of, an automated document-drafting or document-assembly offering (e.g., systems offered by contract-automation providers). I'd be happy to discuss that possibility; please contact me at dc@toedt.com.

Or use the clauses like the INCOTERMS®

The INCOTERMS® are "a series of pre-defined com­mer­cial terms published by the International Chamber of Commerce (ICC) [that are] widely used in international commercial transactions …. [for] the transportation and delivery of goods." (Wikipedia.com).

Imagine that a German widget manufacturer and an American customer are negotiating an order. They want to allocate responsibily for ar­ranging for ship­ping the widgets; insurance; export clearances; and customs.

The manufacturer and customer needn't bother negotiating the wording for those responsibilities. Instead, they likely will "order from the menu" of the INCOTERMS 2010 publication: By specifying a standardized three-letter abbreviation — DDP, EXW, or whatever — the parties can quickly signal which of that publication's pre-defined terms and conditions they wish to use.

In the same vein, to save time, contract drafters (and reviewers) can consider incorporating selected Common Draft model sections, or even entire model contracts, by reference and specifying any desired variations or modifications — this could be thought of as "drafting by exception" or even as like INCOTERMS on steroids.*

For clarity: The Common Draft project is not sponsored, endorsed by, or otherwise associated with the International Chamber of Commerce, which produces the INCOTERMS® 2010 rules.

Suggestion: If you incorporate one or more Common Draft provisions by reference, consider using your browser's "Save to PDF" or "Print to PDF" capability to preserve a copy of this deskbook for future reference.

Playbook symbols

Certain language is underlined in gray to indicate places where drafters or reviewers might want to make changes.

In addition, to help with incorporation by reference, some subprovision headings are marked with check marks, indicating that they will be automatically included whenever their "parent" provisions are incorporated by reference into an agreement;*

A green check mark signifies a sensible default (or at least I think it's sensible); the subprovision is incorporated by reference whenever its parent provision is incorporated.*

A smaller gray check mark likewise signifies a subprovision that's incorporated by reference together with its parent provision — but drafters and reviewers might want to verify that the subprovision and its specific terms are in fact appropriate for their particular needs.

 ? A gray question mark signifies a subprovision that's not incorporated by reference when its parent provision is incorporated,* but drafters and reviewers still might want to consider whether they do want to expressly incorporate the subprovision into their agreement.

The absence of a check mark means that the subprovision is very likely to require discussion (or even to be controversial) and therefore is not incorporated by reference when its parent provision is incorporated.*

* Unless the agreement says otherwise.

CAUTIONS

  1. Of course, you shouldn't rely on the Common Draft materials as a substitute for legal advice about your specific needs.
  2. You acknowledge that your use of the Common Draft materials doesn't establish an attorney-client relationship with the author or anyone else who might be associated, in any capacity, with the Common Draft project.
  3. Keep in mind that very-small changes in facts or in wording can sometimes make a big difference in the legal outcome.
  4. (At the risk of beating this horse to death:) The Common Draft materials are provided AS IS, WITH ALL FAULTS; use at your own risk.

Long-term goal

The long-term goal of the Common Draft project is to serve as a lasting, public repository of carefully-drafted contract provisions that cover a wide variety of business needs, with annotations, commentary, and student exercises.

Please email me with sug­ges­tions for ad­di­tions or re­vis­ions at dc@toedt.com. Un­less you say other­wise, I'll cred­it you in these mat­er­i­als for any sug­ges­tions that I in­corp­or­ate.

Also, please sign up to be notified of updates (I won't spam you).

1   Front Matter of the Contract

1.1   Preamble [of Agreement]

The parties to this [FILL IN TYPE OF AGREEMENT] (this Agreement) are:

  • ABC Corporation (ABC or Provider), a Delaware corporation, having a place of business and initial address for notice at 123 Main Street, AnyTown, AnyState 12345-6789; and
  • XYZ LLC (XYZ or Customer), a New York limited liability company, having a place of business and initial address for notice at 456 Commerce Street, OtherTown, OtherState 98765-4321.

The Agreement is effective as of the Effective Date, namely the date on which the Agreement was signed and delivered by or on behalf of the party whose signature and delivery were the final ones required for the Agreement to form a contract.

Comments

See {PLACEHOLDER FOR BOOK MACRO}.

Be sure your "party" has the legal capacity to enter into a contract

Depending on the law of the jurisdiction, an unincorporated association or trust might not be legally capable of entering into contracts. See generally Ken Adams, Can a Trust Enter Into a Contract? (AdamsDrafting.com Dec. 2014).

If a contract is purportedly entered into by a party that doesn't have the legal capacity to do so, then conceivably the individual who signed the contract on behalf of that party might be personally liable for the party's obligations.

Be sure you're naming the correct party as "the other side" — or consider negotiating a guaranty from a solvent affiliate

Failing to name the correct corporate entity as the other party to the contract could leave the drafter's client holding the bag. This seems to have happened in Northbound Group, Inc. v. Norvax, Inc., 795 F.3d 647 (7th Cir. 2015):

  • Northbound Group was a company that generated leads for life-insurance sales. Facing financial difficulties, it agreed to sell its assets to Norvax, which generated leads for health-insurance sales.
  • The actual asset-purchase agreement, though, was not between Northbound and Norvax, but between Northbound and a newly-created subsidiary of Norvax.
  • Northbound later claimed that both the new subsidiary and its parent company Norvax breached the asset-purchase agreement in various ways.
  • When Northbound filed suit, it sued only Norvax, not the subsidiary; the latter purportedly had no assets, see id. at 650, and thus might well have been judgment-proof.

Northbound's decision to sue the parent company, and not the subsidiary that was the named party to the contract, proved fatal to Northbound's breach-of-contract case. The Seventh Circuit affirmed summary judgment in favor of the parent company, saying:

It goes without saying that a contract cannot bind a nonparty. … If appellant is entitled to damages for breach of contract, [it] can not recover them in a suit against appellee because appellee was not a party to the contract.

These are the general rules of corporate and contract law, but they come with exceptions, of course. Northbound tries to create one new exception and invokes two established ones. We find no basis for holding Norvax liable for any alleged breach of the contract between Northbound and … the Norvax subsidiary.

Id. at 650-51 (internal quotation marks and citations omitted).

Caution: Don't make affiliates "parties" to the Agreement unless they actually sign

Some agreements, in identifying the parties to the agreement on the front page, state that the parties are, say, ABC Corporation and its Affiliates. In my view that's a bad idea unless each such affiliate actually signs the agreement as a party and therefore commits on its own to the contractual obligations.

The much-better practice is to state the specific rights and obligations that affiliates have under the contract. This is sometimes done in "master" agreements that are available to the affiliates of one or more parties.

See also:

Why the corporate status is recited in the preamble (e.g., "a Delaware corporation")

Contract drafters typically include each party's type of organization and the jurisdiction in which it's organized — for example, "ABC Corporation, a Delaware corporation" — as a way of establishing diversity jurisdiction (a U.S. concept that might or might not be applicable) and personal jurisdiction as well as venue.

Including the jurisdiction can simplify a litigator's task of "proving up" the necessary facts: If a contract signed by ABC Corporation recites that ABC is a Delaware corporation, for example, an opposing party generally won't have to prove that fact, because ABC will usually be deemed to have conceded it in advance. (See also 2.2. Acknowledgement Definition and its field notes.)

Why the parties' places of business are stated in the preamble

Stipulating that a party has a place of business at a specified location can later help to establish, in a lawsuit, that the party is properly subject to personal jurisdiction and venue in that location.

(Such a stipulation might be binding on the party in question, as discussed in the commentary to 2.2. Acknowledgement Definition.)

Why the parties' initial addresses for notice are recited in the preamble

It's useful to put the parties' initial addresses for notice in the preamble. That way, if one party later wants to send notice to another, at least the initial notice address can be found right on the front page of the contract, without the reader's having to flip through the other pages.

Some countries might require specific information in the preamble

Apparently the Czech Republic and some other Central- and Eastern-European countries require contracts to include specific identifying information about the parties, e.g., the registered office, the company ID number. and the registration in the Com­mer­cial Register. See this Ken Adams blog post; also this one from 2007.

I found similar information in this apparently-Israeli contract.

How to state the effective date in the preamble

This language reflects my preferred approach to writing the effective date. Some other possibilities include:

  • "The Agreement is made December 31, 20XX, between …." DCT comment: I tend to avoid this version, because the stated date might turn out to be inaccurate, depending on when the parties actually sign the contract. CAUTION: Never backdate a contract for deceptive purposes, e.g., to be able to book a sale in an earlier fiscal period; that practice sent more than one tech-company executive to prison.
  • "The Agreement is dated December 31, 20XX, between …." DCT comment: I tend to avoid this version as well, for the same reasons stated above.
  • "The Agreement is entered into, effective December 31, 20XX, by …." DCT comment: Stating that a contract is effective as of a different date, for non-deceptive purposes, might be just fine, depending on the circumstances. EXAMPLE: Alice discloses confidential information to Bob after Bob first orally agrees to keep the information confidential; tbey agree to have the lawyers put together a written confidentiality agreement. That written agreement might state that it is effective as of the date of Alice's oral disclosure. (Alice would not want to backdate her actual signature, though.)

1.2   Master Agreement Acknowledgement

(a) The parties intend to use the Agreement as a pre-negotiated set of terms and conditions for one or more purchase orders, statements of work, or other specific agreements incorporating the Agreement by reference; the Agreement in itself does not obligate either party except to the extent indicated otherwise.

(b) Any prior master agreement between the parties concerning the subject matter of the Agreement is cancelled, on a going-forward basis only, as follows:

(1) the Agreement (along with any applicable transaction-specific agreement) will govern any transaction concerning that subject matter whose performance is begun during the term of the Agreement.

(2) Unless the Agreement expressly states otherwise, IF: Performance of a transaction has already commenced under a prior master agreement between the parties; THEN: That prior master agreement will remain in effect as to that transaction until its performance is completed.

Comments
Purpose of master-agreement acknowledgement

A pre-negotiated master agreement can be extremely useful in business. It allows parties to negotiate the "legal T&Cs" one time; the parties can re-use those T&Cs in future transactions by signing short-form contracts that (ideally) incorporate the master agreement by reference and set forth any transaction-specific terms.

Specific terms to consider in master agreements
  • Pricing terms are sometimes pre-negotiated in master agreements. When that happens, it is useful also to include an agreed mechanism for periodically adjusting the pricing, so that the supplier won't potentially be stuck with outdated pricing long after the deal was struck.
  • Evergreen term extensions and unilateral extensions can also be useful, but should be approached with caution.
  • termination-at-will clause (with suitable "fences" around it) can provide parties with a way to bail out of a master agreement that's no longer suitable.
A company can negotiate a master agreement for its corporate "family"

Companies sometimes want to negotiate pricing and other terms & conditions on behalf of their affiliates; that can help to reduce the transaction costs that would attend negotiation of individual contracts between each affiliate and the same counterparty. An easy way to do this is to pre-negotiate a "master" agreement that can be incorporated by reference into other contracts.

EXAMPLE: a company signs a master purchase agreement. It wants its affiliates to be able to make purchases from the seller, on the same negotiated terms and conditions and/or at the same negotiated pricing. By having the master agreement say just that, the company can ensure that its affiliates won't have to negotiate their own deals with the seller. (Of course, any given affiliate might want to negotiate its own deal.)

In that situation, consider doing the following:

  • The parent company signs a master agreement with stated pricing and other T&Cs.
  • The master agreement states that either party and its affiliates can utilize the master agreement by entering into a short-form agreement (for example, a purchase order) that incorporates the master agreement by reference.
  • If a buyer's subsidiary places a purchase order with the seller, then the subsidiary doesn't become a party to the master agreement per se; it's a party only to the contract formed by its own purchase order.
  • The purchasing subsidiary is a third-party beneficiary of the master agreement, but only in the limited sense that it has the right to place orders at the stated pricing and under the stated T&Cs.
  • The purchasing subsidiary's parent company avoids being liable for the subsidiary's financial obligations under the subsidiary's purchase orders (unless of course the seller negotiates a guarantee from the parent). That's something the parent company's lawyers and finance people will usually want.
  • If a lawsuit should come to pass over a particular purchase order, there's little room for satellite disputes about who has standing to sue whom and who the necessary parties are.
Pro tip: Have "subsidiary" contracts expressly state that the master agreement controls

CAUTION: When using a master agreement, it's best for any subsequent contracts to expressly state that the master agreement's terms are to control. Consider CEEG (Shanghai) Solar Science & Tech. Co. v. LUMOS LLC, No. 15-1256 (10th Cir. Jul. 19, 2016), affirming No. 14-cv-03118 (D. Colo. May 29, 2015). In that case:

A Chinese manufacturer of solar-panel products entered into a co-branding agreement with a U.S. retailer. That agreement called for the retailer to order solar-panel products from the manufacturer at stated prices. The co-branding agreement contained an arbitration provision, which expressly required that arbitration proceedings be in English.

  • The retailer also entered into specific written sales contracts with the manufacturer; the sales contract contained an arbitration provision, but that provision did not require English-language arbitration.
  • The retailer's CEO testified, and the U.S. trial court accepted, that the parties had intended for the co-branding agreement to be a "master" agreement that would govern all sales contracts.
  • Apparently, though, neither the co-branding agreement nor the sales contract in question actually said referred to the master agreement (the courts' opinions were not specific on this point).
  • The manufacturer and the retailer communicated exclusively in English.
  • One shipment of goods had quality problems; the retailer refused to pay. After negotiations went nowhere, the manufacturer filed a demand for arbitration with the Chinese arbitration institution designated in the earlier, co-branding agreement.
  • The Chinese arbitration institution sent the U.S. retailer a notice of arbitration, in Chinese. The U.S. retailer did not realize what the notice of arbitration was. Consequently, the retailer did not realize that under the agreed arbitration rules, a 15-day clock was ticking on the retailer's right to participate in selecting the members of the arbitration panel. That deadline passed, and the panel members were selected without input from the retailer.
  • The arbitration panel ruled that the so-called master agreement did not apply and that the sales contract controlled. The arbitration panel awarded damages to the manufacturer, which then sought to enforce the award against the retailer in a U.S. court.

The Colorado district court ruled that, contrary to the decision of the arbitration panel, the testimony of the retailer's CEO established that the co-branding agreement had indeed been a "master" agreement; this meant that the Chinese-language notice of arbitration had been insufficient, and that in turn meant that, under the New York Convention, the court could decline to enforce the damages award.

Citing the virtual unreviewability of arbitration awards even when grounded on errors of law, the Tenth Circuit chose not to address the master-agreement issue:

[O]ur holding does not rely on the conclusion that the [sales contract] was bound by the terms of the [co-branding agreement].

Rather, the [co-branding agreement] is one piece of evidence demonstrating that the parties understood their relationship would proceed in English,

and that [the manufacturer] suddenly deviated from that understanding and practice when providing notice.

Id., slip op. at 10 n.2 (emphasis and extra paragraphing added).

DRAFTING LESSON: It's best if purchase orders, statements of work, etc., expressly identify a "master" agreement and state that the master agreement applies.

Should a master agreement override purchase orders, etc., no matter what?

A master agreement might state that its terms apply to all transactions between the parties, even if the parties use a purchase order, statement of work, etc., that doesn't refer to the master agreement. This was suggested in a LinkedIn comment (group membership required) by attorney Michael Little.

I'm on the fence about that one:

  • In one sense, Mike's suggestion might be safer, at least in the short term, in that the parties (and thus the client) wouldn't have to remember to incorporate the master agreement by reference.
  • On the other hand, it might not be ideal for parties that did a lot of business together in different divisions, geographic territories, etc.
  • And this practice could lead to parties, long afterwards, inadvertently incorporating a forgotten "zombie" master agreement by reference, to unclear effect.

My own preference is often to be silent on this point in the master agreement, so that the parties will have to remember to expressly incorporate the master agreement by reference. My guess is that they'll be more likely to remember to do that than to research whether any previously-negotiated master agreement still applies. But this is a judgment call, to be made based on the particular circumstances and the client's desires.

Danger of a master agreement's setting the bar too high

In an Eighth Circuit case, the parties' master services agreement set the bar too high for services agreements, and as a result the master agreement was found not to apply. The master agreement prescribed the exact language that a statement of work was required to include to incorporate the master agreement by reference:

Barkley shall performfor [Gabriel Brothers] certain services which shall be agreed to by the parties on a project-by-project basis . . . . The Services agreed to for each Project shall be designated in a written Statement of Work (“Statement of Work”).

Each Statement of Work shall contain the following provision:

“This Statement of Work is incorporated into, and made a part of, that certain Master Services Agreement . . . between the parties dated [October 5,] 2012, which Agreement governs the relationship of the parties. All terms and conditions provided in the Agreement shall apply to this Statement of Work.”

Barkley Inc. v. Gabriel Bros. Inc., No. 15-2308, part I, slip op. at 3-4 (8th Cir. July 25, 2016) (extra paragraphing added, alteration marks by the court).

As to the relevant statement of work:

  • The service provider began working while the parties were negotiating the statement of work.
  • At some point the customer pulled the plug by invoking a termination-at-will provision in the master agreement — and at that point the parties had not signed the statement of work; consequently, there was no signed statement of work containing the prescribed incorporation-by-reference language.
  • The provider sued the customer; it alleged that, because the customer failed to pay for the work already started for the (unsigned) statement of work, the customer thereby breached the master agreement.

The district court granted partial summary judgment in favor of the customer, on grounds that because the statement of work was never signed, the specific requirements of the master agreement had not been met, so there was no breach of that agreement. The appeals court affirmed. See id., part II-A, slip op. at 9-10.

(A jury, though, held the customer liable for damages for breaching a subsequent [oral?] agreement that apparently wasn't "under" the master agreement; the appeals court affirmed judgment on that verdict.)

In a similar vein, a thoughtful LinkedIn group discussion comment (group membership required) by attorney Michael Little was that a master agreement should "specify" the form of purchase orders, statements of work, etc., by including the form(s) in an exhibit. My own view is different: It can be useful to include such a form as an example, but I don't like to specify that use of that form is required. That's because, in a particular transaction, the parties might thoughtlessly (or intentionally) use a different form instead of one matching the exhibit. That, in turn, might give rise to a dispute over whether the master agreement's terms applied to that transaction.

2   Definitions & Usages

2.1 Definitions Preamble

(a) The terms defined in 2.   Definitions & Usages have the meanings stated there; other terms might be defined "in line" in the provisions in which they are used.

(b) Any term in the Agreement that is linked to a Common Draft definition has the meaning stated in that definition unless the Agreement expressly states otherwise.

Comments

Overview

Defined terms can be quite useful (as long as they're not overdone); this clause refers to the three most-common ways of setting up the definitions, namely:

  1. in a separate section of the contract;
  2. as the defined terms occur in the contract text; or
  3. both 1) and 2) in the same contract.
Caution: Consistency in capitalizing defined terms can be crucial

It's a really good idea to be consistent about capitalization when drafting a contract. If you define a capitalized term but then use a similar term without capitalization, that might give rise to an ambiguity in the language — which in turn might preclude a quick, inexpensive resolution of a lawsuit.

Something like that happened in the Clinton Ass'n for a Renewed Environment case:

  • The defendant asserted that the plaintiff's claim was barred by the statute of limitations and therefore should be immediately dismissed.
  • The plaintiff, however, countered that the limitation period began to run much later than the defendant had said.
  • The court held that inconsistency of capitalization of the term "substantial completion" precluded an immediate dismissal of the plaintiff's claim.

See Clinton Ass'n for a Renewed Environment, Inc., v. Monadnock Construction, Inc., 2013 NY Slip Op 30224(U) (denying defendant's motion to dismiss on the pleadings; citations omitted, extra paragraphing added).

Put the definitions at the back of the Agreement?

A drafter can place a separate "definitions" section:

  • near the beginning of the agreement — this is perhaps the most-common practice;
  • at the back (with results that might be surprising);
  • in a separate exhibit or schedule (which can be handy if using the same definitions for multiple documents in a deal).

On his blog, IACCM founder and president Tim Cummins tells of an IACCM member whose company saved hours of negotiating time — up to a day and a half per contract — by moving the "definitions" section from the front of its contract form to an appendix at the back of the document. Cummins recounted that "by the time the parties reached 'Definitions', they were already comfortable with the substance of the agreement and had a shared context for the definitions. So effort was saved and substantive issues were resolved." Tim Cummins, Change does not have to be complicated (July 21, 2014).

Further reading about definitions and usages

See, e.g.:

2.2 Acknowledgement Definition

To acknowledge something (whether or not the term is capitalized) means to stipulate to its truth.

Comment
Caution: "Acknowledging" something in a contract could hurt the client later

A contract reviewer should be extremely careful about statements in a draft agreement in which the parties “acknowledge” something or another. Such language might preclude the reviewer's client from later disputing what was acknowleged in the contract.

As an illustration, consider Cellport Sys., Inc. v. Peiker Acustic GmbH & Co., KG, 762 F.3d 1016, 1022 (10th Cir. 2014) (reversing and remanding trial-court judgment in part). In that case:

  • A license agreement between a manufacturer of cell-phone docking stations and a patent owner required the manufacturer to pay royalties on its products that were covered by the patent.
  • The license agreement included a statement in which the manufacturer "acknowledged" that certain specific docking stations were indeed covered by the patent.
  • The manufacturer later denied that some of those specific docking stations were covered by the patent.
  • The court, though, held that the acknowledgement language in the contract precluded the manufacturer from making that denial.
Acknowledgements are an opportunity for drafters — but don't be a jerk about it

Contract drafters should give some thought to judiciously including one or more factual acknowledgements in a draft. Doing so could help to reduce the cost and burden of any future disputes, as well as make it easier for the client's future trial counsel to do their jobs.

On the other hand, nobody likes a drafter who asks the other side to “acknowledge” something that clearly is or would be in dispute.

  • EXAMPLE: Suppose that a customer's purchase-order form includes printed boilerplate language stating that "Supplier acknowledges that any failure by Supplier to deliver the goods or services required by this purchase order at the stated delivery date will cause Customer significant long-term harm." In a particular case that might be true, but in a standard form it's just obnoxious.
  • EXAMPLE: Suppose that a supplier's standard terms of sale recite that "Customer acknowledges that Supplier's products have a reputation for exceptionally-high quality and value for the money." Come on, now; few if any customers would willingly agree to such a statement.
Review questions for acknowledgements in contract language
  1. What does it mean to "acknowledge" something, and why might it be dangerous?
  2. Cite (or make up) an example of how acknowledging something in a contract might be dangerous (other than the example in the reading above).

2.3 Affiliate Definition

2.3.1 Exclusive Definition of Affiliate

This section 2.3 sets forth the exclusive tests for whether, for purposes of the Agreement, an individual or organization (referred to for purposes of illustration as "ABC") is an affiliate of another organization (referred to as "XYZ").

Comment

This subdivision attempts to block attempts by counsel to argue that affiliate status can arise implicitly through a path not set forth in this.

2.3.2 Affiliate Status Through Control Relationship

(a) At any given time, a party ("ABC") is an affiliate of another party ("XYZ") (whether or not the term is capitalized) if, directly or indirectly, ABC "controls" (as defined below), or is controlled by, or is under common control with, XYZ.

(b) If XYZ is an organization, ABC is considered to control XYZ if ABC has the right to exercise at least 50% of the aggregate right to vote to select the members of XYZ's board of directors or comparable primary governing body (the Minimum Voting Percentage); this right can arise, for example:

(i) via legal, beneficial or equitable ownership of voting securities; and/or

(2) via a voting agreement.

Comments
Langauge notes

In subdivision (a):

  • The "control" language generally tracks terminology found in U.S. securities laws such as SEC Rule 405, 17 C.F.R. § 230.405, as well as in other sources. See, e.g., UBS Securities LLC v. Red Zone LLC, 77 A.D.3d 575, 578 (N.Y. App. Div. 1st Dept. 2010) (quoting Black's Law Dictionary and citing New York and Delaware statutes).
  • The "only if" language is intended to rule out other claims of affiliate status.
Minimum Voting Percentage

A Minimum Voting Percentage of 50% seems to be pretty typical, but drafters should think about why they're defining the term affiliate, because the answer might warrant changing the percentage.

Alternative definitions of voting control

Some drafters might want voting control also to arise from one or more of the following:

  1. a legally-enforceable right to select a majority of the members of the organization's board of directors or other body having comparable authority — note that this alternative does not say that control exists merely because a person has a veto over the selection of a majority of the members of the organization's board;
  2. a legally-enforceable right, held by a specific class of shares or of comparable voting interests in the organization, to approve a particular type of decision by the organization; or
  3. a legally-enforceable requirement that a relevant type of transaction or decision, by the organization, must be approved by a vote of a supermajority of the organization's board of directors, shareholders, outstanding shares, members, etc. (The required supermajority might be two-thirds, or three-fourths, or 80%, etc.)

2.3.3  ? Designated Affilates

The members of any Designated Affiliate Groups specified in the Agreement are to be considered affiliates of each other, even if they would not be considered affiliates under 2.3.2. Affiliate Status Through Control Relationship.

Comment

By designating specific affiliate groups, drafters can expand the definition of affiliate on a case-by-case basis as needed. This can be useful because voting control might not capture all of the individuals and/or orgainzations that a party wants to name as affiliates.

If it's not possible to determine in advance who all the named affiliate groups will be, the parties could consider:

  • letting one party unilaterally name additional affiliates with the other party's consent, not to be unreasonably withheld; and/or
  • designating specific "open enrollment" periods in which affiliates can be named.

2.3.4   Affiliate Status Through Management Control

For purposes of 2.3.2. Affiliate Status Through Control Relationship, ABC is considered to have control of XYZ, even in the absence of voting control, if ABC, directly or indirectly, has a legally-enforceable right and obligation, created by a written instrument (for example, a contract, a trust instrument, or a court order), to direct substantially all of XYZ's affairs.

Comments
Language notes

This provision could be relaxed somewhat by changing the end to read "… to direct substantially all of XYZ's affairs related to the Agreement."

Language origins

The notion that affiliate status can arise through management power seems to come from U.S. securities regulations such as SEC Rule 405, 17 C.F.R. § 230.405.

Danger of management-control vagueness

The vagueness of the "management power" language could lead to expensive litigation. Drafters should therefore be cautious in taking such an approach, even though it's often seen in existing contracts and templates.

It might be the case that the definition of affiliate would be relevant only to determine, say, which affiliates of a customer are entitled to the negotiated pricing, or are entitled to use licensed software. In that situation, the downside risk of a management-power definition of affiliate might be manageable.

But it's not hard to imagine how, in later litigation, the parties might have to engage in extensive – and expensive – discovery for trial of a fact-intensive dispute about who had what management power at the relevant time(s).

If a contract really needs to define Affiliate without being limited by a certain percentage of voting control, one better approach is for the contract to designate specific affiliates.

Consider the Offshore Drilling Co. case: the parties in the lawsuit hotly disputed who had had "control" of a vessel destroyed by fire, and thus which party or parties should be liable for damages. The specific facts and outcome of the case aren't important here — what matters is that the parties almost-certainly had to spend a lot of time and money fact-intensive litigation over the control issue. See Offshore Drilling Co. v. Gulf Copper & Mfg. Corp., 604 F.3d 221 (5th Cir. 2010) (affirming summary judgment in relevant part). That's the last thing parties to a contract should want.

And in the UBS v. Red Zone case, the UBS investment bank and Red Zone LLC, a private equity firm (whose managing member was Dan Snyder, owner of the Washington Redskins) entered into a contract which stated, in part, that Red Zone would pay UBS a $10 million fee if Red Zone succeeded in acquiring — or in acquiring "control" of — the amusement-park company Six Flags. Apparently Red Zone never did acquire more than 50% of Six Flags's stock, but because of other circumstances the appellate court held that:

… Red Zone clearly controlled Six Flags once its insiders and nominees constituted the majority of the board and took over the company's management.

It cannot be disputed that Red Zone had seized the power to direct Six Flags' management and policies.

We reject Red Zone's argument that it did not control Six Flags simply because it did not obtain ownership of the majority of its voting shares. The argument is at odds with the inclusive definition of "control" ….

UBS Securities LLC v. Red Zone LLC, 77 A.D.3d 575, 578, 910 N.Y.S.2d 55 (N.Y. App. Div. 1st Dept. 2010) (reversing denial of UBS's motion for summary judgment). After losing its case with UBS, Red Zone successfully sued its law firm for malpractice in contract drafting, winning a $17.2 million judgment. See Red Zone LLC v. Cadwalader, Wickersham & Taft LLP, 45 Misc.3d 672, 994 N.Y.S.2d 764 (N.Y. Sup. Ct. 2013), aff'd, 2014 NY Slip Op 4570, 118 A.D.3d 581 988 N.Y.S.2d 588 (App. Div. 1st Dept. 2014). (Hat tip: Ken Adams.)

Additional notes: Affiliate status

Business context

Affiliate status can be important in a contract because the contract might give rights to — and/or (purport to) impose obligations on — the "affiliates" of one or both of the parties.

For example, a software license agreement might grant the right to use the software not only to the named licensee company, but also to affiliates of the licensee company. Such an agreement will almost certainly impose corresponding obligations on any affiliate that exercises the right to use the software.

Or, a customer will sometimes want its non-owned "affiliated" companies to be allowed to take advantage of the contract terms that the customer negotiates with a supplier.

A supplier, though, might not be enthused about an expansive definition of affiliate. The supplier will often not want to limit its own freedom to negotiate more-favorable terms with the customer's affiliates.

Pro tip: Plan for changes in affiliate status

Contract drafters and reviewers should plan for changes in affiliate status, in case one or more of the following things happens:

  • A party acquires a new affiliate, e.g., because its parent company makes an acquisition;
  • Two companies cease to be affiliates of one another, e.g., because one of them is sold off or taken private;
  • A third party – perhaps an unwanted competitor – becomes an affiliate of "the other side."
The timing of affiliate status can be important

In some circumstances, affiliate status might exist at some times and not exist at others. That could be material to a dispute. Compare, for example:

• "Absent explicit language demonstrating the parties' intent to bind future affiliates of the contracting parties, the term 'affiliate' includes only those affiliates in existence at the time that the contract was executed." Ellington v. EMI Music Inc., 24 N.Y.3d 239, 246, 21 N.E.3d 1000, 997 N.Y.S.2d 339, 2014 NY Slip Op 07197 (affirming dismissal of complaint).

• In GTE Wireless, Inc. v. Cellexis Intern., Inc., 341 F.3d 1 (1st Cir. 2003), the appeals court held that Cellexis breached a settlement agreement not to sue GTE or its affiliates when it sued a company that, at the time of the settlement agreement, had not been a GTE affiliate, but that later became an affiliate. Reversing a summary judgment, the appeals court reasoned that the contract language as a whole clearly contemplated that future affiliates would be shielded by the covenant not to sue. See id. at 5.

(Hat tip: Ken Adams.)

2.4 "Agreement" definitions

2.4.1 "The Agreement" Definition

The Agreement refers, collectively, to the following:

(1) the agreement document signed by the parties;

(2) any exhibit, schedule, appendix, or addendum attached to or forming part of the document referred to in sub­div­i­sion (1); and

(3) any document, or portion thereof, that is expressly incorporated by reference in any document referred to in one or more of subdivisions (1) and (2).

Comment

This is a lengthy but still-conventional definition.

2.4.2 Agreement-Related Dispute Definition

Agreement-Related Dispute refers to any claim, controversy, or other dispute between the parties — whether based on the law of contract; tort; strict liability; statute; or otherwise — that: (i) is brought before any Tribunal; and (ii) is based upon, arises out of, or relates to any of the following:

(1) the Agreement;

(2) a document executed in conjunction with the Agreement;

(3) a transaction or relationship memorialized by, or resulting from, the Agreement (each, a "Transaction" or "Relationship", respectively);

(4) a service provided pursuant to, or incidentally to, the Agreement or a Transaction or Relationship;

(5) insurance coverage for, or relating to, the Agreement or a Transaction or Relationship;

(6) a document that documents or otherwise contains information about any of the items listed in subdivisions (2) through (5);

(7) an application for, or an advertisement, solicitation, processing, closing, or servicing of, a Transaction or Relationship; and

(8) any representation or warranty made:

(A) in or in connection with any document listed in subdivisions (6) or (7); or

(B) to induce anyone to enter into, agree to, or accept any such document.

Comment

This "laundry list" borrows concepts from the second of two arbitration agreements in suit in Porter Capital Corp. v. Roberts, 101 So. 1209, 1218-19 (Ala. App. 2012) (affirming denial of plaintiffs' motions to compel arbitration of defendant's counterclaims).

Some of the language is adapted from a suggestion in Glenn D. West & W. Benton Lewis, Jr., Contracting to Avoid Extra-Contractual Liability — Can Your Contractual Deal Ever Really Be the "Entire" Deal?, 64 Bus. Law. 999, 1036, text accompanying n.232.

Concerning the transaction or relationship term in sub­div­i­sion (3), see the arbitration-clause commentary.

2.5 And/Or Definition

The term and/or, whether or not capitalized, means the inclusive or. EXAMPLE: "The parties expect to meet on Tuesday, Wednesday, and/or Thursday" means that they expect to meet on one or more of those days, not on one and only one of them.

Comments
Why use "and/or"?

And/or helps remedy a deficiency in the English language, namely the lack of an inclusive-or term. (Mathematicians and computer programmers use XOR for that purpose.)

Alternatives

Ken Adams, author of A Manual of Style for Contract Drafting, helpfully suggests that, when dealing with a list of three or more items, use "one or more of A, B, and C." That might well work in many cases. See Kenneth A. Adams, "A, B, and/or C", Dec. 2, 2012, at http://goo.gl/m9U3p (adamsdrafting.com).

Is "and/or" proper English?

Opinions vary (to put it mildly) as to whether and/or is "proper" English. For example, one appellate judge excoriated the use of and/or as "indolent." That judge — evidently not a slave to brevity — proclaimed that instead a drafter "could express a series of items as, A, B, C, and D together, or any combination together, or any one of them alone." See Carley Foundry, Inc. v. CBIZ BVKT, LLC, No. 62-CV-08-9791, final paragraph (Minn. Ct. App., Apr. 6, 2010) (italics added). Um, sure, your honor. See also Ted Tjaden, Do Not Use "and/or" in Legal Writing, Jul. 27, 2011, at http://goo.gl/7d74L (slaw.ca).

Granted, it's possible to use and/or inappropriately. See, e.g., the examples collected by Wayne Scheiss, director of the legal-writing program at the University of Texas School of Law, in In the Land of Andorians (Jan. 2013).

But let's face it: Trying to ban and/or might be an exercise in frustration, because many drafters will use the term anyway. And properly used, the term and/or can be a serviceable shorthand expression.

So the better practice might well be just to define the term and be done with it.

See also 2.59. Or Definition.

2.6 Applicable Law Definition

Applicable Law (whether or not capitalized) refers to any applicable provision of a constitution, statute, regulation, rule, administrative- or judicial order, industry code, or the common law, when legally enforceable in the relevant jurisdiction.

Comment

In some jurisdictions, an industry code might be enacted into law — which has raised the question whether the "owner" of the copyright in the code (if any) might be able to sue others for unauthorized copying, etc. See, e.g., Trey Barrineau, Who “Owns” Legally Binding Construction Codes? (DWMMag.com 2015).

2.7 Articles and Sections

(a) Defining terms by example, this is section 2.7, which is part of section 2 (which might be referred to as article 2).

(b) Unless the Agreement clearly indicates otherwise, the terms article and section (whether or not capitalized) refer to Common Draft articles and sections.

Comment

This is a very-conventional usage definition.

2.8 Associated Individuals Definition

The Associated Individuals of an organization, if any are the following:

(1) Each individual who at the relevant time is an employee, officer, director, shareholder, general- and limited partner, member, or manager of that organization; and

(2) any other individuals specified in the Agreement, if any.

Comment

Parties sometimes want to extend a contract's limitations of liability to individuals who might be brought in as defendants in their personal capacities. For example, a plaintiff might believe that a defendant company had few assets that could be seized to satisfy a judgment, but that the officers of the company personally owned substantial assets. In that case, the plaintiff's counsel might be tempted to name the company officers as defendants in their personal capacities; among other advantages, that would increase the pressure on the company to settle the case before trial.

Basket Definition (cross-reference)

2.9 Best Efforts Definition

(a) Best efforts, whether or not capitalized, refers to the diligent making of reasonable efforts.

(b) For the avoidance of doubt, a party required to use best efforts:

(1) is not required to take every conceivable action to achieve the stated objective;

(2) is not required to materially harm its own interests; and

(3) is not required to take any unreasonable action.

2.9.0.1 Comments
Introduction; language notes

Best-efforts clauses can be (quite) problematic, but are often used anyway because many business people like them. Providing a definition can at least reduce some of the associated uncertainty.

The "diligence" requirement comes from the Restatement (Second) of Contracts.

Sub­div­i­sion (b)(1) recognizes that with the benefit of hindsight, a motivated opposing counsel can almost always find something that the a party conceivably could have done, but in fact didn't do, to achieve the stated objective.

Sub­div­i­sion (b)(2) attempts to resolve the division of opinion among various courts.

Diligence as the touchstone of "best efforts"

The "diligence" term comes from the Restatement (Second) of Agency: "Best efforts is a standard that has diligence at its essence." Restatement (Second) of Agency § 13, comment a (1957), quoted in Corporate Lodging Consultants, Inc. v. Bombardier Aerospace Corp., No. 6:03-cv-01467-WEB, slip op. at 9 (D. Kan. May 11, 2005) (finding that CLC had not failed to use its best efforts to obtain lowest and most-competitive hotel rates for Bombardier) (citation and alteration marks omitted).

Business context of best-efforts requests

Best-efforts obligations are especially common when one party grants another party exclusive rights, for example exclusive distribution rights or an exclusive license under a patent, trademark, or copyright. That was the situation in the Kevin Ehringer Enterprises case, for example.

To many business people, it may seem self-evident that when a contract uses the term best efforts, it calls for "something more" than mere reasonable efforts — otherwise, why bother even saying best efforts? That is, reasonable efforts will cover a range of possibilities, while best efforts refers to somewhere near the top of that range. I have no formal research to support this view, but I've negotiated more than a few contracts with best-efforts clauses in them, so I'd like to think I have at least some sense of what many business people are after.

A sports analogy

By analogy, to many business people:

  • "C" is a passing grade in (U.S.) schools, and is equivalent to reasonable efforts.
  • In contrast, best efforts means an "A" effort — or in basketball slang, bring your "A" game, buddy, not your "C" game.

Another analogy:

  • On major U.S. highways, the speed-limit signs often include both maximum and minimum speeds of (say) 60 mph and 45 mph. Those two speeds establish the upper- and lower bounds of reasonableness.
  • Now, suppose that a trucking company were to agree that its driver would use her "best efforts" to drive a shipment of goods from Point a to Point B on such a highway, where drivers must drive between 45 mph and 60 mph.
  • In good weather with light traffic, driving at 45 mph might qualify as reasonable efforts. But driving at that speed likely wouldn't cut it as best efforts.
Possible variation: "All reasonable efforts" instead of "best efforts"
  • A drafter could specify that best efforts requires the diligent making of all reasonable efforts. Reportedly, that's a common formulation in the UK; see the Helms et al. article cited below.
  • A drafter could also add, at the end of sub­div­i­sion (a), the phrase, leaving no stone unturned in seeking to achieve the stated objective. This language is from an opinion by the supreme court of British Columbia. See Atmospheric Diving Systems Inc. v. International Hard Suits Inc., 89 B.C.L.R. (2d) 356 (1994). I've not been able to find the full text of this opinion freely available online. It's extensively excerpted by Ken Adams in his posting "Best Efforts" Under Canadian Law. (Warning: I strongly disagree with Ken's view that "best efforts" means simply "reasonable efforts.")
Does "reasonable efforts" necessarily mean all reasonable efforts?

In an extended LinkedIn group discussion (membership required), a commenter opined that anything less than all reasonable efforts was, by definition, unreasonable. I responded that many people would disagree: Reasonable efforts can encompass a range of efforts; it doesn't have to be a binary, yes-no dichotomy.

Consider Scenario 1, in which Alice's contract with Bob requires Alice to make reasonable efforts to advise Bob in writing if some (non-emergency) Event X occurs. If Event X were to occur, then Alice might send Bob an email to that effect, using the email address that Bob has consistently used in his dealings with Alice. In that scenario, many business people would think that Alice had complied with her contractual obligation to advise Bob, even if for some reason Bob never got the email.

Now consider Scenario 2, in which the contract requires Alice to make all reasonable efforts to advise Bob in writing that Event X has occurred. In that scenario, if Event X were to occur, then Alice might have to try every available means of written communication — email, FAX, certified mail, FedEx, UPS, showing up at Bob's house, etc. — until she received positive confirmation that Bob had in fact received the message.

Best efforts means different things to different courts

Depending on the jurisdiction, a court might not share the view of best efforts just described.

• As one court explained, "[c]ontracting parties ordinarily use best efforts language when they are uncertain about what can be achieved, given their limited resources." See CKB & Assoc., Inc. v. Moore McCormack Petroleum, Inc., 809 S.W.2d 577, 581-82 (Tex. App. – Dallas 1990) (affirming summary judgment that defendant had failed to use its best efforts).

On the facts of the case, the court affirmed summary judgment that an oil refiner had failed to use its best efforts to produce specified volumes of refined petroleum products. The refiner had focused its efforts on high-priced products, while making no effort to produce the specific products that it was contractually obligated to produce. The court remarked that "[a]s a matter of law, no efforts cannot be best efforts."

• Some — but not all — U.S. courts have seemingly equated best efforts with mere reasonable efforts, contrary to what business people are likely to think they're getting in a best-efforts clause.

As one 2005 review of case law puts it, "For years U.S. courts have used the phrases 'reasonable efforts' and 'best efforts' interchangeably within and between opinions. Where only one of the terms is used, the best-efforts obligation frequently appears indistinguishable from a reasonable-efforts obligation. Some recent cases have gone so far as to equate best efforts and reasonable efforts." See Scott-Macon Securities, Inc. v. Zoltek Cos., Nos. 04 Civ. 2124 (MBM), 04 Civ. 4896 (MBM), part II-C (S.D.N.Y. May 11, 2005) (citing cases).

(Some of those cases, though, might be interpreted more narrowly as holding merely that a best-efforts obligation does not require the obligated party to make unreasonable efforts, while still requiring diligence in the making of reasonable efforts.)

• Fortunately, still other U.S. courts seem to have recognized that best efforts means something more than merely reasonable efforts.

For example, in the Tigg Corp. v. Dow Corning Corp. case, the Third Circuit held that, at least where the contract involved an exclusive-dealing arrangement, "[t]he obligation of best efforts forces the buyer/reseller to consider the best interests of the seller and itself as if they were one firm." the appellate court affirmed a trial court's judgment, based on a jury verdict, holding Dow Corning liable for breaching a best-efforts obligation in an exclusive-dealing agreement. The appellate court agreed with Dow Corning, however, that the trial court had erred in entering judgment on the amount of monetary damages Dow Corning should pay, and remanded the case for a new trial on that issue. Tigg Corp. v. Dow Corning Corp., 962 F.2d 1119 (3d Cir. 1992).

Likewise, in Macksey v. Egan, a Massachusetts appeals court construed the term best efforts "in the natural sense of the words as requiring that the party put its muscles to work to perform with full energy and fairness the relevant express promises and reasonable implications therefrom." Macksey v. Egan, 36 Mass. App. Ct. 463, 472, 633 N.E.2d 408 (1994) (reversing judgment on jury verdict that defendant had breached best-efforts obligation; extensive citations omitted).

• Some UK and Canadian courts have defined the standard of performance for best efforts as, in essence, all reasonable efforts. For a survey of such cases, see Shawn C. Helms, David Harding, and John R. Phillips, Best Efforts and Endeavours – Case Analysis and Practical Guidance Under U.S. and U.K. Law, July 2007.

For example, in its Atmospheric Diving Systems opinion (1994), the supreme court of British Columbia held that best efforts requires "taking, in good faith, all reasonable steps to achieve the objective, carrying the process to its logical conclusion and leaving no stone unturned. … doing everything known to be usual, necessary and proper for ensuring the success of the endeavour."

Similarly, in Australia, the term best endeavours seems to be treated as synonymous with all reasonable endeavours; in its Hospital Products opinion (1984), that country's highest court held that "an obligation to use 'best endeavours' does not require the person who undertakes the obligation to go beyond the bounds of reason; he is required to do all he reasonably can in the circumstances to achieve the contractual object, but no more … [A] person who had given such an undertaking … in effect promised to do all he reasonably could …." Hospital Prods. Ltd v. United States Surgical Corp., 1984 HCA 64, 156 CLR 41, paras. 24, 25.

Adding to the difficulty, some U.S. courts have held that the term best efforts is too vague to be enforceable unless the parties agree to some sort of objective standard of performance, "some kind of goal or guideline against which best efforts may be measured," in a case quoted by the court in the Kevin Ehringer Enterprises case.

One court held that "as promptly as practicable" and "in the most expeditious manner possible" were sufficient to meet that requirement. See Herrmann Holdings Ltd. v. Lucent Technologies Inc., 302 F.3d 552, 559-61 (5th Cir. 2002) (reversing dismissal under Rule 12(b)(6); citing cases).

With all of this in mind, the definition of best efforts in this clause attempts to draw at least a somewhat-bright line that provides an objective standard of performance (albeit one that might require a trial to determine whether it had been met).

[TO DO: Look up California law – all efforts even if bankruptcy? https://www.linkedin.com/grp/post/4036673-6027114806685810691]

"Best efforts" might be held to be unenforceably vague

According to some U.S. courts, the term best efforts is too vague to be enforceable unless the parties agree to some sort of objective standard of performance. In the Kevin Ehringer Enterprises case, the Fifth Circuit, quoting a Texas appellate court, held that under state law, "to be enforceable, a best efforts contract must set some kind of goal or guideline against which best efforts may be measured."

"Every effort" clauses and the like are often interpreted similarly

"When confronted with idiosyncratic contractual language expressing sentiments akin to doing all that one can or 'all that is necessary' to complete a task, Texas courts often interpret such language as requiring 'best efforts'–an expression with a more clearly established meaning and history." Hoffman v. L & M Arts, 774 F. Supp. 2d 826, 833 (N.D. Tex. 2011) (citing cases).

"[C]ourts and arbitrators interpreting similar phrases [the phrase in question was 'every effort'] have determined, like the district court here, that they impose an obligation to make all reasonable efforts to reach the identified end." Aeronautical Indus. Dist. Lodge 91 v. United Tech. Corp.., 230 F.3d 569, 578 (2d Cir. 2000) (citations omitted).

Asking for a best-efforts commitment can make business sense

Sure, there's some legal uncertainty associated with a best-efforts commitment. But from a business perspective it can make good sense to ask the other side for such a commitment anyway: a party that makes a best-efforts commitment — to the extent that it later thinks about that commitment at all — will at least be aware that it might well have to make more than just routine, day-to-day, "reasonable" efforts. That alone might be worthwhile to the party asking for the commitment.

Agreeing to a best-efforts commitment might lead to trouble

If you commit to a best-efforts obligation, and the other side later accuses you of breaching that obligation, and you can't settle the dispute, then you're likely to have to try the case instead of being able to get rid of it on summary judgment. That's because:

  • No matter what you do, if a problem arises, the other side's lawyers, with 20-20 hindsight, will argue that there were  Xnumber of things that you supposedly could have done to achieve the agreed goal.
  • You're unlikely to be able to get summary judgment that you didn't breach the best-efforts obligation. Instead, you're likely to have to go to the trouble and expense of a full trial or arbitration hearing. The judge or arbitrator may well say that the question involves disputed issues of material fact. Those issues will have to be resolved by witness testimony and cross-examination about such things as industry practices; the then-existing conditions; etc. According to the rules of procedure in many jurisdictions, that will require a trial and will not be able to be done in a summary proceeding. Your motion for summary judgment is therefore likely to be denied.
  • The tribunal, after hearing the evidence, may find that in fact you did not use your best efforts. If that happens, you're going to have a very hard time convincing an appeals court to overturn that finding.
Best-efforts takeaways

• Drafters should try very hard to be as precise as possible in specifying just what goal the best efforts are to be directed to achieving.

• Obligated parties should think long and hard before agreeing to a best-efforts obligation, because in the long run it could prove to be burdensome and expensive.

Further reading

See also:

2.10 Breach Includes Misrepresentation

For the avoidance of doubt, the term breach, in respect of the Agreement, includes a misrepresentation made in, or incorporated by reference into, the Agreement.

Comment

Technically, the term breach relates to failure to perform a covenant (including the express- or implied covenant(s) of a warranty). This clause expands that definition to encompass misrepresentations.

See also: • 8.4. Right to Terminate for Breach; as well as • 2.50. Material Breach Definition.

2.11 Business Day Definition

The term business day, whether or not capitalized, refers to a day other than a Saturday; a Sunday; or a holiday on which banks in New York City are generally closed.

Comment

For time periods greater than five- or ten business days, it might be simpler to use the term calendar day (and indeed for all time periods), so as not to have to figure out what counts as a business day, especially if different jurisdictions are involved. See a 2015 LinkedIn discussion on that subject (membership required).

See also 2.20. Day Definition.

2.12 Calendar Year Definition

(a) The term calendar year, whether or not capitalized, refers to a year according to the Gregorian calendar, beginning at the beginning of January 1 and ending at the end of the following December 31.

(b) An interval of a calendar year, specified as beginning at any time on a particular date or as following a particular date, ends at exactly 12:00:00 midnight at the beginning of the same date one year afterwards. EXAMPLE: A period of one calendar year following January 2, 20x5 ends at 12:00:00 midnight at the beginning of January 2, 20x6.

Comment

Many parties entering into contracts, even in non-Western countries, will likely operate on the West's conventional Gregorian calendar, but that might not be the case in, e.g., Muslim countries. See generally the blog post and comments at Ken Adams's post, Referring to the Gregorian calendar? (Nov. 14, 2013).

Note the use of "12:00:00 midnight at the beginning of the same date …" to remove ambiguity (is it midnight at the beginning of the day or at the end of the day)?

2.13 Claim Definition

Claim refers to any request or demand for damages or other relief by an individual or organization (including without limitation a governmental entity), where the request or demand for relief is set forth, by or on behalf of the claimant:

(1) in a written communication such as, for example, a letter or email; and/or

(2) in an original or amended complaint, petition, counterclaim, cross-claim, or other paper that is filed with (or otherwise submitted to) any court, arbitration panel, administrative agency, or other tribunal of competent jurisdiction.

Comment

This definition of claim draws on ideas set out in an article by D. Hull Youngblood, Jr. and Peter N. Flocos, Drafting And Enforcing Complex Indemnification Provisions, The Practical Lawyer, Aug. 2010, p. 21, at 27.

The writing requirement avoids putting a so-called hair trigger on provisions that depend on claims being made, e.g., claim-defense requirements.

2.14 Clear and Convincing Evidence Definition

For an assertion to be proved by clear and convincing evidence, the evidence must be sufficient to produce in the factfinder an abiding conviction that the assertion's truth is highly probable.

Comment

This definition is a rephrasing, in somewhat-plainer language, of the standard set out by the Supreme Court of the United States in Colorado v. New Mexico, 467 U.S. 310, 316 (1984) (original proceeding; holding that Colorado had not shown by clear and convincing evidence that water should be diverted from Vermejo River); see also Ninth Circuit Model Jury Instructions § 1.4.

2.15 Commercially Reasonable Definition

(a) Defining the term with an illustrative example, commercially-reasonable efforts (whether or not the term is capitalized) refers to at least those efforts that people experienced in the relevant business would generally regard as sufficient to constitute reasonable efforts in the relevant circumstances. Other uses of the term commercially-reasonable have corresponding meanings.

(b) For the avoidance of doubt, a party does not fail to act in a commercially-reasonable manner, or to take commercially-reasonable action, solely because it gives preference to its own interests over those of another party.

Comments
Overview: A "kick the can" provision

Commercially-reasonable is a kick-the-can-down-the-road term; it's often used in routine contracts, especially for matters for which the parties are confident they can amicably resolve any disputes that might arise.

Commercial reasonableness might be proved up indirectly

A party seeking to prove (or disprove) commercial reasonableness of a transaction, contract term, decision, etc., might want to focus on the process by which the transaction, etc., came into being. The U.S. Court of Appeals for the Fifth Circuit has said that "Where two sophisticated businesses reach a hard-fought agreement through lengthy negotiations, it is difficult to conclude that any negotiated term placed in their contract is commercially unreasonable." West Texas Transmission, LP v. Enron Corp., 907 F.2d 1554, 1563 (5th Cir. 1990) (affirrming district court's refusal to grant specific performance of right of first refusal) (extensive citations omitted, extra paragraphing added).

Is the term commercially reasonable too vague?

See the commentary to 2.70. Reasonable Efforts Definition for a discussion of the vagueries of that term, which of course are inherited by the term commercially reasonable.

A court might apply a "prudence" standard

In a major lawsuit between the (U.S.) state of Indiana and IBM, the contract in question took a stricter view of commercially reasonable efforts. That contract defined the term as "taking commercially reasonable steps [circularity, anyone?] and performing in such a manner as a well managed entity would undertake with respect to a matter in which it was acting in a determined, prudent, businesslike and reasonable manner to achieve a particular result." Indiana v. IBM Corp., No. 49A02-1211-PL-875, slip op. at 27 n.12 (Ind. App. Feb. 13, 2014) (emphasis added, citation to trial record omitted), affirmed, Indiana v. IBM Corp., No. 49S02-1408-PL-00513 (Ind. Mar. 22, 2016).

In that case, the contract in suit called for IBM to overhaul Indiana's computer system for managing its welfare program; the project ended up being in essence a train wreck, after which the parties sued each other. The trial court rendered judgment in favor of IBM, but a state appellate court reversed in part and remanded, holding that while IBM was entitled to be paid for its work, that payment would be subject to offset (to be determined on remand), on grounds that IBM had materially breached the contract.

Giving preference to one's own interests

The issue addressed in this clause came up in a 2014 English case arising from the financial crisis of late 2008, Barclays Bank PLC v. Unicredit Bank AG, [2014] EWCA Civ 302 (affirming trial-court ruling). There, Barclays had the right to consent to a particular type of financial transaction, but it was obligated to grant or withhold such consent in a commercially-reasonable manner. The England and Wales Court of Appeals rejected Unicredit's argument that this meant that Barclays was required to take Unicredit's interests into account, not merely Barclays's own interests. See id. at para. 16; see also this annotation.

Is "doing the needful" the standard for commercially reasonable efforts?

A holding by the Delaware chancery court suggests that the Indian-English expression do the needful might be a useful short­hand reference for commercially reasonable efforts.

  • The case involved a multi-billion-dollar oil industry merger agreement in which a buyer was to acquire the assets of a seller.
  • The agreement gave the seller an "out" from the deal: The seller would not have to close the deal if it did not get a favorable opinion from its own tax counsel (as opposed to, say, getting an opinion from an independent expert) about the deal's expected tax consequences.
  • The agreement, though, also required the seller to use commercially reasonable efforts to get a favorable opinion.

After the merger agreement was signed, the market price of crude oil collapsed. This brought with it a drastic drop in the value of the seller's assets, making the deal much less attractive to the buyer.

  • The buyer ended up backing out of the deal, citing newly-discovered concerns about the expected tax consequences. The seller tried to assuage the buyer's new concerns; when that failed, the seller sued the buyer for breach of contract. The seller alleged, among other things, that the buyer had failed to honor its commitment to use commercially reasonable efforts to obtain a favorable tax opinion.

The chancery court noted that the merger agreement did not define "commercially reasonable efforts"; it found that:

… by agreeing to make “commercially reasonable efforts” to achieve the 721 Opinion, the Partnership [i.e., the seller] necessarily submitted itself to an objective standard—that is, it bound itself to do those things objectively reasonable to produce the desired 721 Opinion, in the context of the agreement reached by the parties.

Williams Cos., slip op. at 46 (emphasis added). The court held that, in view of the facts of the case, the buyer had not breached its obligation to use commercially reasonable efforts.

2.16 Consequential Damages Definition

Consequential damages, whether or not capitalized:

(1) refers to damages for loss, where the loss in question would be, in the ordinary course of events, a natural result — but not a nec­es­sa­ry result — of a breach of the Agreement or other event or other event or situation for which the law permits damages to be awarded;

(2) includes, without limitation, lost profits from collateral business arrangements; but

(3) does not include lost profits from the transaction(s) agreed to in the Agreement itself.

Comments
What are "consequential" damages, exactly?

The difference between consequential damages and "general" damages can sometimes be unclear. The commentary to the Restatement (Second) of Contracts contrasts the two terms:

Loss that results from a breach in the ordinary course of events is foreseeable as the probable result of the breach. Such loss is sometimes said to be the "natural" result of the breach, in the sense that its occurrence accords with the common experience of ordinary persons. … The damages recoverable for such loss that results in the ordinary course of events are sometimes called "general" damages.

If loss results other than in the ordinary course of events, there can be no recovery for it unless it was foreseeable by the party in breach because of special circumstances that he had reason to know when he made the contract. … The damages recoverable for loss that results other than in the ordinary course of events are sometimes called "special" or "consequential" damages.

These terms are often misleading, however, and it is not necessary to distinguish between "general" and "special" or "consequential" damages for the purpose of the rule stated in this Section.

Restatement (Second) of Contracts § 351, "Unforeseeability And Related Limitations On Damages," comment b (citations omitted, emphasis and extra paragraphing added).

FOOTNOTE: The above-quoted Restatement excerpt exemplifies what seems to be a modern trend of collapsing the traditional two-prong formulation of Hadley v. Baxendale into a single test: Whether the claimed damages were foreseeable by the breaching party. Under that test, one way for the non-breaching party to establish that its particular damages were foreseeable is for the non-breaching party to inform the breaching party, at the time the breaching party became bound by the obligation, of the non-breaching party's particular requirements or circumstances. See generally, e.g., Thomas A. Diamond & Howard Foss, Consequential Damages for Commercial Loss: An Alternative to Hadley v. Baxendale, 63 Fordham L. Rev. 665, part I-B, esp. n.35 & accompanying text (1994) (reviewing modern approaches to Hadley).

In the Uniform Commercial Code, section 2-715(2) defines consequential damages as follows:

Consequential damages resulting from the seller's breach include[:] (a) any loss resulting from general or particular requirements and needs of which the seller at the time of contracting had reason to know and which could not reasonably be prevented by cover or otherwise …."

(Emphasis added.)

The Supreme Court of Texas has observed that:

Direct damages are the necessary and usual result of the defendant's wrongful act; they flow naturally and necessarily from the wrong…. Consequential damages, on the other hand, result naturally, but not necessarily.

El Paso Marketing, L.P. v. Wolf Hollow I, L.P., 383 S.W.3d 138, 144 (Tex. 2012) (internal quotation marks and footnote omitted, alterations by the court, emphasis added), subsequent proceeding, No. 13-0816, (Tex. Nov. 21, 2014) (reversing court of appeals order remanding for new trial on damages).

"Consequential" damages can be big

Noted practitioner-commentator Glenn D. West observes:

In 1984, an Atlantic City casino entered into a contract with a construction manager respecting the casino’s renovation. The construction manager was to be paid a $600,000 fee for its construction management services. In breach of the agreement, completion of construction was delayed by several months. As a result, the casino was unable to open on time and lost profits, ultimately determined by an arbitration panel to be in the amount of $14,500,000. There was no consequential damages waiver in the contract at issue in this case.

Glenn D. West, Consequential Damages Redux: An Updated Study of the Ubiquitous and Problematic “Excluded Losses” Provision in Private Company Acquisition Agreements, 70 BUS. L. 971, 984 (Weil.com 2015) (footnote omitted), citing Perini Corp. v. Greate Bay Hotel & Casino, Inc., 129 N.J. 479, 610 A.2d 364 (1992) (affirming judgment confirming arbitration award), abrogated on other grounds by Tretina Printing, Inc. v. Fitzpatrick & Assocs., Inc., 35 N.J. 349, 640 A.2d 788 (1994) (restricting grounds on which arbitration awards can be reviewed by courts, but stating that parties could expand those grounds by contract).

As another example, a Dr. Kitchen, an Australian opthmalmologist, wrongfully terminated his service agreement with an eye clinic. The service agreement did not include an exclusion of consequential damages. The Supreme Court of Queensland held him held liable for the clinic's lost profits and other amounts, in the total sum of AUD $10,845,476. See Vision Eye Institute Ltd v Kitchen, [2015] QSC 66, discussed in Jodie Burger and Viva Paxton, Australia: A stitch in time saves nine: How excluding consequential loss could save you millions (Mondaq.com 2015).

Consequential damages — other specific examples

Some drafters like to enumerate specific categories of risk for which damages cannot be recovered, and cross their fingers that a court will enforce the enumeration congenially to them. The following categories have been harvested from various agreement forms but should be reviewed carefully, as some could be a bad idea:

  • breach of statutory duty;
  • business interruption;
  • loss of business or of business opportunity;
  • loss of competitive advantage;
  • loss of data;
  • loss of privacy;
  • loss of confidentiality [Editorial comment: This would normally be a really bad idea, at least from the perspective of a party disclosing confidential information.]
  • loss of goodwill;
  • loss of investment;
  • loss of product;
  • loss of production;
  • loss of profits from collateral business arrangements;
  • loss of cost savings;
  • loss of use;
  • loss of revenue.

For a summary of cases in U.S., English, and Australian courts addressing such "laundry lists," see West, Consequential Damages Redux, supra, 70 BUS. L. at 987-91.

"Lost profits" will often be direct damages, not consequential damages

The laundry list of excluded damages should not be drafted, though, so as to be overly broad for the situation. That's why the lost-profits exclusion in this clause is phrased as lost profits from collateral business arrangements. See, e.g., Biotronik A.G. v. Conor Medsystems Ireland, Ltd., 2014 NY Slip Op. 02101, where New York's highest court, reviewing case law held that, on the facts of the case, "lost profits were the direct and probable result of a breach of the parties' agreement and thus constitute general damages" and thus were not barred by limitation-of-liability clause.

As the Second Circuit explained:

Lost profits are consequential damages when, as a result of the breach, the non-breaching party suffers loss of profits on collateral business arrangements.

In the typical case, the ability of the non-breaching party to operate his business, and thereby generate profits on collateral transactions, is contingent on the performance of the primary contract. When the breaching party does not perform, the non-breaching party's business is in some way hindered, and the profits from potential collateral exchanges are "lost."

Every lawyer will recall from his or her first-year contracts class the paradigmatic example of Hadley v. Baxendale, where Baxendale's failure to deliver a crank shaft on time caused Hadley to lose profits from the operation of his mill.

In New York, a party is entitled to recover this form of lost profits only if (1) it is demonstrated with certainty that the damages have been caused by the breach, (2) the extent of the loss is capable of proof with reasonable certainty, and (3) it is established that the damages were fairly within the contemplation of the parties.

By contrast, when the non-breaching party seeks only to recover money that the breaching party agreed to pay under the contract, the damages sought are general damages. The damages may still be characterized as lost profits since, had the contract been performed, the non-breaching party would have profited to the extent that his cost of performance was less than the total value of the breaching party's promised payments.

But, in this case, the lost profits are the direct and probable consequence of the breach. The profits are precisely what the non-breaching party bargained for, and only an award of damages equal to lost profits will put the non-breaching party in the same position he would have occupied had the contract been performed.

Tractebel Energy Mktg., Inc. v. AEP Power Mktg., Inc., 487 F.3d 89, 109-110 (2d Cir. 2007) (reversing judgment, after bench trial, denying plaintiff its lost profits) (citations and footnote omitted, emphasis and extra paragraphing added).

See also:

Fourth Circuit's lecture to negotiators of consequential-damages exclusions

The Fourth Circuit 'splained things to customers that negotiate services contracts containing consequential-damages exclusions:

Companies faced with consequential damages limitations in contracts have two ways to protect themselves.

First, they may purchase outside insurance to cover the consequential risks of a contractual breach, and second, they may attempt to bargain for greater protection against breach from their contractual partner.

Severn apparently did take the former precaution – it has recovered over $19 million in insurance proceeds from a company whose own business involves the contractual allocation of risk.

But it did not take the latter one, and there is no inequity in our declining to rewrite its contractual bargain now.

Severn Peanut Co. v. Industrial Fumigant Co., No. 15-1063, slip op. at 9 (4th Cir. Dec. 2, 2015) (affirming summary judgment in favor of service provider that had caused millions of dollars to its customer's facility) (extra paragraphing added).

Further reading

See:

2.17 Consumer Price Index ("CPI") Definition

Unless otherwise agreed in writing, the terms "Consumer Price Index" and "CPI" refer to the Consumer Price Index – All Urban Consumers ("CPI-U"), as published from time to time by U.S. Bureau of Labor Statistics.

Comments
Overview

CPI clauses are sometimes included in contracts for ongoing sales or goods or services. Such contracts will typically lock in the agreed pricing for a specified number of years, subject to periodic increases by X% per year (let's say) or by the corresponding increase in CPI, whichever is greater (or sometimes, whichever is less).

Depending on the industry, CPI-U might or might not be the best specific index for estimating how much a provider's costs have increased. this is explained in the FAQ page of the Bureau of Labor Statistics (accessed Aug. 16, 2012).

Caution: "The lesser of CPI or X%" could be dangerous

Prohibiting a provider from increasing its pricing by more than the increase in CPI or X percent per year, whichever is less, would force the provider to 'eat' any increases in its own costs that exceeded the increase in the particular index chosen.

Consider: What if CPI goes down?

A drafter might want to specify whether agreed pricing, rent, etc., can ever decrease as a result of changes in CPI.

Consider: Are pricing increases to be compounded?

If price increases are limited to adjusting for increases in CPI over a baseline figure, that will automatically take care of compounding.

But if the permissible price increase is "the change in CPI or X%, whichever is greater," then the X% might end up being compounded over time, so that the X% increase in Year One would itself be increased by another X% in Year Two. [NEED EXAMPLE]

See also

2.18 Customer Definition

Unless the Agreement clearly indicates otherwise, Customer has the meaning set forth in 2.68. Provider Definition.

Comment

See the commentary to 2.68. Provider Definition.

2.19 Damages Definition

Unless otherwise specified in the Agreement, the term damages (whether or not capitalized) refers broadly to any legally-cognizable harm (whether tangible or intangible) to person, property, or other legally-protected interest, where the harm is compensable by a monetary award.

Comment

This definition is synthesized from others I've seen.

2.20 Day Definition

Unless the Agreement expressly states otherwise:

(1) The term day, whether or not capitalized, refers to a calendar day; and

(2) A period of X days begins on the specified date and ends at exactly 12 midnight (UTC if not otherwise specified) at the end of the day X days later. EXAMPLE: If a five-day period begins on January 1, it ends at exactly 12 midnight at the end of January 6.

Comment

2.21 Deadline Definition

IF: The Agreement states a deadline date marking the end of a specified period, but does not clearly indicate a time at which the period ends; THEN: The period ends at exactly 12 midnight, in the time zone where the relevant actor (or action to be taken) is (or is to be) located, at the end of the indicated date.

Comment

This definition simply provides a benchmark reference point; using this definition, drafters can precisely specify deadlines as desired.

2.22 Deliverable Definition

Deliverable, whether or not capitalized, refers to an item that a party is required to cause to be delivered to another party, for example pursuant to a Statement of Work for Services, other than Toolkit Items.

Comment

See also 3.1.   Services.

2.23 Discretion Definition

Discretion, whether or not capitalized, has the same meaning as reasonable discretion.

Comments
U.S. law about discretion might vary by jurisdiction

In Illinois, a party's discretion might be constrained by an obligation of reasonableness. See Han v. United Continental Holdings, Inc., 762 F.3d 598 (7th Cir. 2014) (affirming dismissal with prejudice of purported class-action complaint). As it happens, in that case the appeals court upheld a ruling that United Airlines did not unreasonably exercise its discretion in interpreting the term "miles flown," in the rules for its frequent-flier program, as the miles between the relevant airports and not the miles actually flown by the aircraft in traveling between the two airports.

On the hand:

[U]nder Alabama law "sole discretion" means an absolute reservation of a right. It is not mitigated by an implied covenant of good faith and fair dealing in contracts because an unqualified reservation of a right in the sole discretion of one of the parties to a contract expresses the intent of the parties to be subject to terms that are inconsistent with any such implied covenant.

Shoney's LLC v. MAC East, LLC, 27 So.3d 1216, 1220-21 (Ala. 2009) (on certification by Eleventh Circuit; emphasis added, footnote and citations omitted).

See also 2.81. Sole Discretion Definition.

UK: Arbitrary, capricious, or irrational exercise of discretion might be actionable

There is case law in the UK indicating that discretion cannot be exercised arbitrarily, capriciously, or irrationally. See Barry Donnelly and Jonathan Pratt, Are you obliged to act reasonably?, in the In-House Lawyer [UK] (June 12, 2013); they summarize the case law as indicating that:

Where a contract confers on one party an absolute discretion to take a decision, choosing from a range of options which will have an impact on the interests of another contracting party, the court will, as a bare minimum, imply a term that the discretion must be exercised in good faith in a manner which is not arbitrary, capricious or irrational.

Subject to those limitations, the decision maker will be entitled to act in accordance with its own best interests.


It is very difficult, albeit not ‘utterly impossible', to exclude such an implied term.


Where, however, the only choice conferred on a contracting party is whether or not to exercise an absolute contractual right provided under the contract, no such term will be implied.


(Emphasis and extra paragraphing added.)

See also sole discretion and reasonable discretion.

2.24 Dispute Expense Definition

Dispute Expense refers to one or more of the following when incurred (for example) in a trial or arbitration hearing; an appeal at any level; or other contested proceeding in the action:

(1) reasonable fees billed by (or by one or more firms for the services of) attorneys; law clerks, paralegals, and other persons not admitted to the bar but performing services under the supervision of an attorney; and expert witnesses;

(2) reasonable expenses actually incurred by individuals and/or firms referred to in sub­div­i­sion (1) in connection with the proceeding, such as (for example) printing, photocopying, duplicating, and shipping;

(3) the costs of the litigation, arbitration, or other proceeding, such as for example costs of court; administration fees charged by an arbitration provider; and arbitrator fees and expenses; and

(4) costs, fees, and other expenses incurred in enforcing a right to recover Dispute Expenses.

Comment

The text of this provision is informed in part by the attorneys-fees clause in the contract in suit in Seaport Village Ltd. v. Seaport Village Operating Co., No. 8841-VCL (Del. Ch. Sept. 24, 2014) (letter opinion awarding attorney fees). • Note that any attorney fees, etc., incurred in enforcing the right to attorney fees are themselves recoverable.

Effective Date (cross-reference)

See the Preamble.

2.25 Ending Time Definition

(a) For the avoidance of doubt, IF: The Agreement states that a time period ends or expires on a specified day, but it does not specify the time of day that the period ends; THEN: The period ends or expires (i) at exactly 12 midnight at the end of that day, (ii) in the time zone where the party that is allowed or required to take action during the expiring time period is located. (See also 2.21. Deadline Definition clause.)

(b) For purposes of this Ending Time Definition, the term "expires on" in respect to a date has the same meaning as "ends on" in respect to that date.

Comment

Another possibility is to use Universal Time, which is basically Greenwich Mean Time, with a few technical differences; see generally the Wikipedia article Universal Time.

2.26 Ex Works and EXW Definition

Ex Works and EXW have the meanings stated in the INCOTERMS 2010 pre-defined commercial terms published by the International Chamber of Commerce (ICC).

Comment

Under the cited INCOTERMS 2010 definition, ex works means, in a nutshell, that a seller will make goods available for pickup at the seller's place of business at the buyer's risk and expense.

2.27 Example Definition

(a) Examples (and terms such as for example), whether or not capitalized, are used in the Agreement for purposes of illustration, not of limitation, unless another meaning is clear from the context.

(b) The parties do not intend for the principle of ejusdem generis to be used to limit the meaning of an exemplified term.

(c) For the avoidance of doubt, if in some places the Agreement uses longer expressions such as "by way of example and not of limitation," such usage does not mean that the parties intend for shorter expressions such as "for example" to serve as limitations unless expressly stated otherwise.

Comment

Including this definition will let drafters say, e.g., "including, for example," which is somewhat less stilted than "including, by way of example and not of limitation."

Sub­div­i­sion (b) hopes to avoid the effect of some judicial opinions that hold otherwise, as discussed here.

Expiration definition (cross-reference)

2.28 For the Avoidance of Doubt Definition

The term for the avoidance of doubt signifies agreed guidance concerning the intended meaning of a provision.

Comments

The term for the avoidance of doubt seems to be frequently used in British contracts.

In his customary collegial style (not), Ken Adams describes the term as "a turkey"; he says: "How’s this for a categorical statement: Never use for the avoidance of doubt."

(Ken's injunction illustrates something I've said from time to time: All categorical statements are bad, including this one.)

Willem Wiggers is more restrained on this subject; at his WeAgree contract-drafting site, he says that the term for the avoidance of doubt could be used, for example, when "considering the agreement as a whole, the subject matter is important enough to be addressed (i.e. not being aware of the to-be-avoided doubt may be a source of disputes or disappointment for the parties)."

My own view is that drafters should use the term for the avoidance of doubt when they want their client's litigation counsel to have a "sound bite" to use in a lawsuit or arbitration, e.g., by quoting it in a brief or showing it on a PowerPoint slide or poster board.

Force majeure (cross-reference)

2.29 GAAP Definition

GAAP refers to generally accepted accounting principles, as established and interpreted in the United States, consistently applied.

Comment

For an overview of generally accepted accounting principles, see the Wikipedia article of the same title, which also links to a discussion of the International Financial Reporting Standards (IFRS), which according to some are beginning to replace the U.S.-oriented GAAP.

2.30 Gender References

When necessary, unless the context clearly requires otherwise, any gender-specific or gender-neutral term in the Agreement (for example, he, she, it, etc.) is to be read as referring to any other gender or to no gender.

Comment

This type of provision is sometimes seen in contracts, but it's questionable whether it's a net benefit.

General-damages definition (cross-reference)

2.31 Good Faith Definition

Good faith, whether or not capitalized, refers to conduct that both (1) is honest in fact and (2) comports with reasonable commercial standards of fair dealing in the trade.

Comments
Language choices

This language is a blend of:

  • Restatement of Contracts (Second) § 205, which states: "Every contract imposes upon each party a duty of good faith and fair dealing in its performance and its enforcement"; and
  • Uniform Commercial Code § 1-304, which imposes a duty of good faith on all contracts and duties within the UCC, and § 2-103(b), which defines good faith (in the case of a merchant) as "honesty in fact and the observance of reasonable commercial standards of fair dealing in the trade."
Why bother defining good faith?

This definition follows the W.I.D.D. principle: When In Doubt, Define. Why bother? Because, as the [U.S.] Supreme Court has noted:

While most States recognize some form of the good faith and fair dealing doctrine, it does not appear that there is any uniform understanding of the doctrine's precise meaning. The concept of good faith in the performance of contracts is a phrase without general meaning (or meanings) of its own.

Of particular importance here, while some States are said to use the doctrine to effectuate the intentions of parties or to protect their reasonable expectations, other States clearly employ the doctrine to ensure that a party does not violate community standards of decency, fairness, or reasonableness.

Northwest, Inc. v. Ginsberg, 134 S. Ct. 1422, 1431, at part III (2014) (internal quotation marks, alteration marks, and extensive citations omitted).

2.32 Government Authority Definition

The terms government authority and governmental authority, whether or not capitalized:

(1) refer to any individual or group (collectively, authority), anywhere in the world, exercising de jure or de facto governmental- or regulatory power of any kind, whether administrative, executive, judicial, legislative, policy, regulatory or taxing power; and

(2) include, for example, any agency; authority; board; bureau; commission; court; department; executive; executive body; judicial body; legislative body; or quasi-governmental authority; at any level (for example, state, federal or local).

Comment

This language draws on the definition of Taxing Authority in section 3.5(f) of the Asset Purchase Agreement between Piper Jaffray Companies and UBS Financial Services, which is reproduced in David Zarfes & Michael L. Bloom, Contracts and Commercial Transactions (Wolters Kluwer Law & Business 2011).

2.33 Gross Negligence Definition

(a) Definition: The term gross negligence, whether or not capitalized, refers to conduct that evinces a reckless disregard for or indifference to the rights of others, tantamount to intentional wrongdoing; it differs in kind, not only in degree, from ordinary negligence.

(b) Proof requirement: If so specified in the Agreement, any assertion of gross negligence must be proved by clear and convincing evidence, whether the assertion is made in a claim, in a defense, or otherwise.

Comments
Language origin

With a view to usage in non-U.S. jurisdictions where the term might not be defined by law, this definition sets out a definition of gross negligence in the terms used by the Court of Appeals of New York (that state's highest court), which seems to achieve a reasonable balance of fairness and precision. See Sommer v. Federal Signal Corp., 79 N.Y.2d 540, 554 (1992).

Sub­div­i­sion (b) reminds drafters to consider requiring clear and convincing evidence of gross negligence, the same standard as is required in many jurisdictions for proof of fraud. [DCT TO DO: CITATIONS NEEDED]

Drafters can also consider including 7.3.3.  ? Serious Accusation Attorney Fees.

Business context

Contracts sometimes use the term gross negligence, as distinct from ordinary negligence. For example, a contractual limitation on a party's liability for negligence might include a carve-out saying that the limitation will not apply if the party is grossly negligent. Unfortunately, the difference between negligence and gross negligence may be hard to assess in practice.

Texas-law definition of gross negligence

A Texas statute, in the context of establishing prerequisites for awards of punitive damages, sets out a far-more restrictive definition of gross negligence, added as part of a far-reaching 2003 tort-reform package enacted by the legislature. See Tex. Civ. Prac. & Rem. Code § 41.001(11), discussed in Robert J. Witte and James G. Ruiz, House Bill 4 – Article 13 – Damages, J. Tex. Consumer L. 33 (date not available). The definition is used in § 41.003 of the Code, which conditions an award of punitive damages on a showing, by clear and convincing evidence, of fraud, malice, or gross negligence:

      (11) "Gross negligence" means an act or omission:

           (A) which when viewed objectively from the standpoint of the actor at the time of its occurrence involves an extreme degree of risk, considering the probability and magnitude of the potential harm to others; and

           (B) of which the actor has actual, subjective awareness of the risk involved, but nevertheless proceeds with conscious indifference to the rights, safety, or welfare of others.

California-law definition of gross negligence

The California supreme court, in its 2007 Janeway opinion, noted that "[g]ross negligence long has been defined in California and other jurisdictions as either a want of even scant care or an extreme departure from the ordinary standard of conduct." City of Santa Barbara v. Janeway, No. 1111681, slip op. at 6, 161 P.3d 1095 (Cal. 2007) (internal quotation marks and citations omitted, emphasis added). The supreme court held that in cases of gross negligence, advance releases of liability are unenforceable as being against public policy; the court affirmed a judgment that release language in a contract did not shield a defendant from an allegation of gross negligence in the drowning death of a disabled teen-ager at a city pool.

Federal-law definition of gross negligence

In the litigation over the notorious "BP oil spill" in the Gulf of Mexico, a federal district court wrote at length about the definition of gross negligence in the context of the (federal) Oil Pollution Act of 1990 and how BP was guilty of gross negligence; the court held that gross negligence was less than reckless conduct (much as in the California definition discussed above). See In re: Oil Spill by the Oil Rig “Deepwater Horizon” in the Gulf of Mexico, on April 20, 2010, paragraphs 481 et seq., esp. 494 & n.180, 495 (E.D. La. Sept. 4, 2014) (findings of fact and conclusions of law).

2.34 Harm Definition

Harm, whether or not capitalized, refers to any claim, demand, liability, cost, charge, suit, judgment, or expense, of any kind.

Comment

This definition comes from the insurance contract in suit in Hanover Ins. Co. v. Northern Building Co., No. 13-2675, slip op. at 8 (7th Cir. May 8, 2014) (affirming district court award of damages and attorney fees to surety bond company against its contractor-customer), affirming 891 F.Supp.2d 1019 (N.D. Ill. 2012).

2.35 Headings for Reference

Any drafting choice stated in a heading — as a hypothetical example, "Governing law: New York" — is to be given effect; otherwise, however, headings and subheadings in the Agreement are included for convenient reference only and are not to be considered in construing the corresponding text of the Agreement.

Comment

This is not an uncommon clause, but it's not an appealing one. It signals that perhaps the drafter can't be bothered to be sure the headings are consistent with the agreement — which in turn raises another question: What else is the drafter being careless about?

2.36 Hold Harmless Definition

For the avoidance of doubt, the term hold harmless (whether or not capitalized) has the same meaning as indemnify unless the Agreement clearly and expressly states otherwise.

Comment

The Common Draft definition of hold harmless reflects what seems to be a consensus by legal-writing experts as to what the term means as a matter of law. Still, it might make sense to include the definition in a contract anyway (especially with multi-national parties) to avoid the confusion that has arisen in some courts. See also 5.9.   Indemnity Procedures and its commentary.

The term "hold harmless" is very often the second part of the doublet indemnify and hold harmless. Legal lexicographer Bryan Garner marshals an impressive body of evidence that the two should be treated as synonyms, asserting that the former is Latinate in origin, while the latter is the English counterpart. See Bryan A. Garner, Garner's Dictionary of Legal Usage, at 443-45 (2011), excerpt available at http://goo.gl/LdVxN.

(This, even though courts ordinarily construe contracts so as to give effect to each provision.)

In the Majkowski case (2006), Delaware's then-vice-chancellor Leo Strine observed:

As a result of its traditional usage, the phrase "indemnify and hold harmless" just naturally rolls off the tongue (and out of the word processors) of American commercial lawyers. The two terms almost always go together.

Indeed, modern authorities confirm that "hold harmless" has little, if any, different meaning than the word "indemnify." Black's Law Dictionary in fact defines "hold harmless" by using the word "indemnify." It defines "hold harmless agreement" as a "contract in which one party agrees to indemnify the other." In defining "hold harmless clause," it simply says "[s]ee INDEMNITY CLAUSE." ) [Footnotes omitted]

Majkowski v. American Imaging Management Services, LLC, 913 A.2d 572, 588-89 (Del. Ch. 2006) (Strine, V.C.) (holding that indemnity- and hold-harmless provision did not entitle a protected person to advancement of expenses in a lawsuit against him by the indemnifying party).

Still, the conceptual distinction between hold harmless and indemnify is worth pondering.

On the one hand, the term indemnify is more-or-less universally understood as a commitment by the promisor to reimburse the protected person for stated losses or liabilities.

On the other hand, the term hold harmless has been treated by some courts as amounting to an advance waiver, release, or exculpation, of stated claims against the person held harmless. For example:

  • In its 2012 Morrison opinion, the Idaho supreme court consistently referred to an advance-release form, and to similar language in other contracts, as a "hold harmless agreement." Morrison v. Northwest Nazarene University, 273 P.3d 1253, passim (Id. 2012) (affirming summary judgment dismissing injured employee's claim against university).
  • A California court of appeals, after reviewing (and in some cases distinguishing) California case law, mused:

Are the words "indemnify'"and"'hold harmless" synonymous? No. One is offensive and the other is defensive — even though both contemplate third-party liability situations.

"Indemnify" is an offensive right — a sword allowing an indemnitee to seek indemnification.

"Hold harmless" is defensive: the right not to be bothered by the other party itself seeking indemnification.

Queen Villas Homeowners Ass'n v. TCB Prop. Mgmt., No. G037019, slip. op. at 9-10 (Cal. App. Mar. 29, 2007) (reversing summary judgment in favor of defendant; emphasis in original, extra paragraphing added).

Bryan Garner mocked the Queens Villa Homeowners reasoning as "just explicit judicial nonsense," Garner at 445, while Ken Adams, author of A Manual on Style for Contract Drafting, dismisses it as a "fabricated" distinction. See Kenneth A. Adams, Revisiting "Indemnify," July 27, 2012.

Regardless who is right, the brute fact is that opinions differ: not all lawyers and judges equate hold harmless with indemnify. Prudent contract drafters will therefore do well to follow the W.I.D.D. principle: When In Doubt, Define. If parties negotiating a contract believe that indemnify and hold harmless ought to have different meanings, then they should seriously consider drafting their contract language accordingly, so as to make their intentions clear to future readers.

With that in mind, the definition of hold harmless in the text follows what seems to be the conventional approach: It peremptorily declares hold harmless and indemnify to be synonymous. That approach also fits in with the fact that the hold-harmless language of UCC § 2-312(3), concerning infringement warranties, appears to have been treated by courts as simply an indemnification obligation. See generally the cases cited in Charlene M. Morrow, Indemnity Exclusions for Goods Made According to SpeCiFication or Industry StandArd, parts I-B and I-G (2009).

2.37 If Definition

For the avoidance of doubt, the term if, when used in granting a right or imposing an obligation that would not otherwise apply, means if and only if. EXAMPLE: Consider the sentence If Alice gives Bob $10.00 by 12 noon next Tuesday, then she may take the ballpoint pen from Bob's shirt pocket and keep it. That sentence implicitly means that Alice may not take a pen from Bob's shirt pocket unless she gives him $10.00.

Comment

The rationale for defining the word "if" is not entirely far-fetched. Consider Trovare Capital Group, LLC v. Simkins Indus., Inc., 646 F.3d 994 (7th Cir. 2011) (reversing and remanding summary judgment):

  • The principal owner of a cardboard-box manufacturer, wanting to retire, entered into a letter of intent (LOI) to sell the company.
  • The LOI stated that: "IF the Seller … provides to Buyer written notice that negotiations toward a definitive asset purchase agreement are terminated, then Seller shall pay Buyer a breakup fee of two hundred thousand dollars ($200,000)." Id. at 996 n.1 (emphasis and all-caps added).
  • The LOI also stated that after a stated termination date (which I'll call the "sunset" date), neither party would be obligated to continue pursuing the sale. See id. at 996.
  • The negotiations were contentious — so much so that, more than a month before the sunset date, the buyer began demanding that the seller pay the $200,000 breakup fee. The buyer claimed that the seller had internally decided that it no longer wished to pursue the sale, and therefore had de facto terminated negotiations, while continuing to pretend to negotiate in order to avoid having to pay the breakup fee. See id. at 997-98.
  • Communications between the parties continued until after the stated termination date. At some point, though, the seller's principal owner transferred his controlling interest in the company to his children, and his son became president of the holding company. See id. at 998.
  • The buyer sued the seller for breach of the implied covenant of good faith and fair dealing under Illinois law. See id. at 998.

By itself, this clause's definition of if probably would not have prevented the Trovare plaintiff from claiming breach of the implied covenant of good faith and fair dealing. But it might have helped establish that the seller was required to pay the breakup fee only if it sent the buyer a written notice of termination before the sunset date.

Postscript: On remand, the trial court found that the sellers had not engaged in sham negotiations and therefore did not have to pay the breakup fee; the appeals court affirmed. See Trovare Capital Group, LLC v. Simkins Indus., Inc., 794 F.3d 772 (7th Cir. 2015).

2.38 In-House Personnel Definition

The term in-house personnel, whether or not capitalized, when used in respect of a party, refers collectively to the following individuals:

(1) the employees of the party;

(2) the officers and directors of the party if the party is a corporation or comparable organization;

(3) the managers of the party if the party is a limited liability company (LLC) or comparable organization; and

(4) the general partners of the party if the party is a general- or limited partnership.

Comment

The definition in this clause can come into play in determining, for example, which personnel associated with a party can have access to another party's confidential information.

Incidental Damages (cross-reference)

2.39 Including Definition

(a) The terms including and like words (for example, include, includes, and included), whether or not capitalized:

(1) are to be deemed followed by the phrase by way of illustrative example and not of limitation if not followed literally by that phrase; and

(2) signal the parties' intent that the listed included items should not be construed, under the principle of ejusdem generis, as defining a limiting class.

(b) For the avoidance of doubt, if in some places the Agreement uses other expressions such as including but not limited to or including without limitation, such usage does not mean that the parties intend for expressions such as simply including to serve as limitations unless expressly stated otherwise.

Comment

Subdivision (a) eliminates (or at least reduces) the need to repeatedly write (and read), for example, "including without limitation." It's not uncommon in contracts, and generally uncontroversial.

Sub­div­i­sion (a)(2) hopes to avoid having a court construe a list of examples in accordance with the principle of ejusdem generis; see generally Ken Adams, An Update on "Including But Not Limited To" (AdamsDrafting.com 2015).

Subdivision (b) is a roadblock clause to try to dissuade trial counsel from making a far-fetched argument to the contrary.

2.40 Incorporation by Reference Definition

Incorporation of material by reference into the Agreement has the same force and effect as setting forth the full text of the material in the body of the Agreement.

Comments
Language origin

This clause migh be overkill, but its definition should reassure a drafter who worries that the other side might get "creative" in its contract intepretation. Its language is adapted from Clauses Incorporated by Reference in the Federal Acquisition Regulations, set forth in the Code of Federal Regulations at 48 C.F.R. § 52.252-2.

Incorporation by reference language must be clear

If an incorporation by reference of external terms is not clear and unmistakable, a court might hold that the external terms are not part of the contract. The Oklahoma supreme court ruled that a form contract for the sale of hardwood flooring, which referenced "Terms of Sale" but gave no indication where to find them, did not incorporate the external terms. The court held that:

[A] contract must make clear reference to the extrinsic document to be incorporated, describe it in such terms that its identity and location may be ascertained beyond doubt, and the parties to the agreement had knowledge of and assented to the incorporated provisions.

Walker v. BuildDirect.com Technologies, Inc., 2015 OK 30 (2015) (on certification from 10th Cir.).

In that case, a Canadian hardwood flooring company emailed a sales quotation form to an Oklahoma couple that had requested it. The problem, though, was this:

  • One of the bullet points in the sales quotation form stated, in its entirety, that “All orders are subject to BuildDirect's ‘Terms of Sale.'”
  • The sales quotation form didn't include the referenced terms of sale as an attachment, nor did it indicate where the terms of sale could be found.

The Oklahoma couple had, though, previously looked at the flooring company's Web site, where the bottom of every page included a link to the terms of sale.

The couple bought and installed $8,500 worth of hardwood flooring — and then later discovered that their house had been infested with wood-boring insects, which they believed had gotten into the house from the flooring. They sued the flooring company for damages.

The flooring company moved to compel arbitration, citing a clause in the referenced terms of sale. a federal appeals court certified the following question to the Supreme Court of Oklahoma, which ruled that the sales quotation form did not adequately incorporate the external Terms of Sale by reference. The court said:

If BuildDirect intended to make the online "Terms of Sale" part of the parties' agreement, BuildDirect could easily have accomplished that purpose by drafting the Contract employing words of express incorporation or clearly referencing, identifying and directing the Walkers to the document to be incorporated. In this Court's view, BuildDirect's reliance upon incorporation by reference must, as a matter of law, fail.

Indeed, the Contract as presented gives every appearance of being a complete agreement-capturing the price, payment method, delivery and sales terms expressly enumerated in the Contract. No reasonable prudent person, under the particular facts of this case, would have notice to think otherwise.

Therefore, BuildDirect's attempt at incorporation was nothing more than a vague allusion.

Id. at ¶ 15.

Drafting tip: At the very least, provide a Web link — preferably a short, memorable one — where the additional incorporated terms can be found.

Attachment "for general reference" might not incorporate by reference

A Nebraska case reinforces the lesson that incorporation-by-reference language must be clear:

  • A school district issued a request for proposal (RFP) for architectural services that would be rendered in connection with the construction and renovation of three schools. See Facilities Cost Mgmt. Group v. Otoe Cty. Sch. Dist., — N.W. —, 291 Neb. 642 (2015) (affirming partial summary judgment).
  • After an architecture firm submitted a response to the RFP, the school district followed up with additional written questions. One of those questions was whether the architectural firm guaranteed a maximum price — to which the architecture firm responded "yes." See id., 291 Neb. at 647.
  • The architecture firm was awarded the contract, which stated that "[t]he Architect’s Response to the District’s Request for Proposal is attached to the Agreement for general purposes including overviews of projects and services." Id. at 645-46 (emphasis added).
  • But the architect firm's response to the RFP wasn't attached to the contract; for that matter, it wasn't even titled as stated in the contract provision. See id. at 654.
  • After cost overruns, the school district stopped paying the architecture firm's invoices; the firm sued for the unpaid balance.
  • The school district defended in part on the ground that the contract incorporated the architect firm's "yes" response to the school district's question about a guaranteed maximum price.
  • The trial court granted partial summary judgment in favor of the architecture firm, holding that the firm's RFP response was not incorporated by reference into the contract.
  • Agreeing with the trial court, the state's supreme court held that "[t]he expression 'for general reference purposes,' interesting though it may be, contrasts with a provision, common in contract law, which incorporates another document by reference. … [The contract language] simply does not incorporate [the architect firm's] responses into the contract." Id. at 653-54.

Caution: It's not hard to see how another court might have held that the contract did incorporate the architecture firm's guaranteed-maximum-price response.

Still, the contract's drafters, who presumably worked for the school district, might have been more clear about their client's intent.

But a clear intent to incorporate might suffice

In a 2014 case, the Fifth Circuit held that a supplier's price quotation sufficiently incorporated by reference a standard-terms-and-conditions document published by the European Engineering Industries Association (the "ORGALIME"). The supplier's price quotation didn't expressly incorporate the ORGALIME by reference; instead it stated, "Terms and conditions are based on the general conditions stated in the enclosed ORGALIME S2000." (Emphasis added.) The Fifth Circuit reviewed Texas law on the point, summarizing that "when the reference to the other document is clear and the circumstances indicate that the intent of the parties was incorporation, courts have held that a document may be incorporated, even in the absence of specific language of incorporation." The federal court concluded that:

… The parties contemplated and contracted that absent a specific agreement regarding the details of a particular transaction, the terms of the ORGALIME were applicable.

As is common in the commercial context, the ORGALIME is designed to serve as a foundational "set of general conditions for the supply of products, which could be used worldwide." On top of this foundation, parties may add or modify terms in order to tailor the contract to their specific needs.

That is the obvious purpose of the Terms & Conditions section of the quotation. It covers issues, like training, that are not addressed in the ORGALIME, and modifies issues, like timing of payment, in order to accommodate the parties' specific needs or desires in a discrete transaction.

This interpretation is further confirmed by the other language in subsection 3.1. …

 *   *   *

Because the parties' agreement reflects the ORGALIME was part of the terms and conditions of their agreement, we conclude that the district court erred in holding there was no agreement to arbitrate.

Al Rushaid v. National Oilwell Varco, Inc., 757 F.3d 416, 420-21 (5th Cir. 2014) (reversing denial of motion to compel arbitration) (footnotes, internal quotation marks, and alteration marks omitted; extra paragraphing and bullets added).

Mentioning one provision of a document won't incorporate the whole thing

Drafters should pay attention to just what portion or portions of another document are being incorporated by reference. That issue made a difference in a Second Circuit case, where:

… Addendum 5 [to the contract in question] refers only to a single specific provision in [another agreement] – the non-compete clause. Where, as here, the parties to an agreement choose to cite in the operative contract “only a specific portion” of another agreement, we apply “the well-established rule that ‘a reference by the contracting parties to an extraneous writing for a particular purpose makes it part of their agreement only for the purpose specified.’” Lodges 743 & 1746, Int’l Ass’n of Machinists & Aerospace Workers v. United Aircraft Corp., 532 F.2d 422, 441 (2d Cir. 1975) (quoting Guerini Stone Co. v. P. J. Carlin Constr. Co., 240 U.S. 264, 277 (1916)).

VRG Linhas Aereas S/A v. MatlinPatterson Global Opportunities Partners II L.P., No. 14-3906-cv (2d. Cir. July 1, 2015) (summary order affirming denial of petition to confirm arbitration award). (Hat tip: Michael Oberman.)

Provisions following the signature blocks should be clearly incorporated by reference

Consider Dixon v. Daymar Colleges Group, LLC, No. 2012-SC-000687-DG (Ky. Apr. 2, 2015) (reversing court of appeals):

  • Students at a for-profit college sued that institution for breach of contract, fraudulent inducement, and a variety of other alleged wrongs. See id. at n.2.
  • In response, the college invoked an arbitration clause in the students' enrollment agreement.
  • Crucially, the signature blocks on the enrollment agreement were located on the front of the agreement, and the students had signed there.
  • The arbitation clause, though, was on the back of the agreement, as part of what the state supreme court described as "a sea of plain-type provisions dealing with tuition refunds, curriculum changes, Daymar's permission to contact the Students or their employer, and arbitration." Id. at part I (emphasis in original).

Consequently, said the court, the arbitration clause was not part of the agreement. The court noted that a state statute, KRS 446.060, required signatures to be at the end of the agreement. The court remarked that "[a] signature in the middle of a writing gives no assurance that the contracting parties intend to be bound by matters which [sic] do not appear above their signatures." Id. at part II-B, text accompanying n.36 (internal quotation marks and alteration marks omitted).

The college fared no better with its first fallback argument: It tried asserting that the entire-agreement clause, which did come before the signature blocks, had the effect of incorporating the arbitration clause by reference. See id. at text accompanying n.38.

The supreme court agreed that "the statute does not abolish incorporation by reference." Id. at text accompanying n.37. The court continued:

For a contract validly to incorporate other terms, it must be clear that the parties to the agreement had knowledge of and assented to the incorporated terms.

In addition, there must be clear language expressing the incorporation of other terms and conditions.

When this is the case and the signature follows afterward, it is a logical inference that the signer agrees to be bound by everything incorporated.

Id. at text accompanying nn.38-40. (footnotes, internal quotation marks, and alteration marks omitted; extra paragraphing added).

The agreement's entire-agreement clause said in part: "The Agreement and any applicable amendments, which are incorporated herein by reference, are the full and complete agreement between me and the College." Id. at n.44 (emphasis by the court). This language, said the court, wasn't sufficient to incorporate the arbitration clause by reference: "the Agreement and any applicable amendments incorporated by reference constitute the full and complete agreement; but that does not apply to the terms on the reverse side because they are not amendments." Id.

The college's last-ditch argument went down in flames as well. Just above the signature block, the agreement included the following in all-caps, preceded by a blank line for initials: "I HAVE READ BOTH PAGES OF THIS STUDENT ENROLLMENT AGREEMENT BEFORE I SIGNED IT AND I RECEIVED a COPY OF IT AFTER I SIGNED IT." The court held that this was ineffective as an incorporation by reference:

This provision is plagued by the absence of any language indicating that the Students actually assent to the terms referenced, not to mention any indication that any terms are actually being incorporated. Instead, the provision only indicates that the Students have read the terms.

Id. at text accompanying n.45. The court went on:

As we noted earlier, the provision immediately preceding the "read" provision contains clear incorporation language—obviously, if Daymar had wished plainly to incorporate the terms on the reverse side of the Agreement, it knew how to do so. But with the "read" provision, Daymar seemingly attempted to notify the Students that the Agreement continued past their signature, rather than incorporate the back-page language above the signature. KRS 446.060 does not allow this–if it did, it would be rendered null.

Incorporation by reference is consistent with an entire-agreement clause

The Seventh Circuit rejected an argument that incorporation by reference negated a contract's entire-agreement clause:

In an effort to overcome this unambiguous text, Druckzentrum argues that because the contract incorporates extrinsic materials by reference, it cannot reasonably be understood to be an exclusive statement of the parties’ agreement despite the presence of an apparently conclusive integration clause. This argument backfires. When a contract expressly incorporates specific extrinsic materials by reference, the proper inference is that other, unmentioned extrinsic agreements are not part of the contract.

Druckzentrum Harry Jung GmbH & Co. v. Motorola Mobility LLC, No 12-3057, at part II-A (7th Cir. Dec. 18, 2014) (affirming take-nothing summary judgment in favor of Motorola on Druckzentrum's claims for breach of contract and fraud).

2.41 Individual Definition

Individual refers to one human being.

Comment

This definition is adapted from Merriam-Webster's Collegiate Dictionary 635 (11th ed. 2003), quoted in Hoffman v. L&M Arts, No. 3:10-CV-0953-D, slip op. at part III‑C (N.D. Tex. Mar. 6, 2015) (holding that attorney fees could not be recovered from an LLC under Tex. Civ. Prac. & Rem. Code § 38.001).

This definition original said "a single human being," but that could be ambiguous if read out of context: Does it mean that a married person isn't an individual?

Infringement claim definition (cross-reference)

2.42 Infringe Definition

(a) Infringe, and related terms such as Infringement, refer to the infringement, misappropriation, or other violation of one or more Intellectual Property Rights specified in the Agreement.

(b) The term also encompasses inducement of, or contribution to, an activity described in subdivision (a) to the extent that applicable law provides that an inducer or contributor is liable as an infringer.

Comment

Indirect liability for the patent infringement of others is possible under U.S. law.

First is active inducement of infringement: One who "actively induces" infringement of a patent is liable as an infringer. See 35 U. S. C. § 271(b), explained in Limelight Networks, Inc. v. Akamai Technol., Inc., 134 S. Ct. 2111 (2014) (reversing Federal Circuit).

Second is contributory infringement:

Whoever offers to sell or sells within the United States or imports into the United States

a component of a patented machine, manufacture, combination or composition, or a material or apparatus for use in practicing a patented process,

constituting a material part of the invention,

knowing the same to be

especially made or especially adapted for use in an infringement of such patent,

and not a staple article or commodity of commerce suitable for substantial noninfringing use,

shall be liable as a contributory infringer.

35 U. S. C. § 271(c) (extra paragraphing added); see generally Contributory infringement (Law.Cornell.edu).

2.43 Intellectual Property Definition

The term intellectual property, whether or not capitalized, refers broadly to:

(1) approaches, concepts, developments, discoveries, formulae, ideas, improvements, inventions, know-how, methodologies, plans, procedures, processes, techniques, and technology, whether or not patentable;

(2) artwork, audio materials, graphics, icons, music, software, writings, and other works of authorship;

(3) designs, whether or not patentable or copyrightable;

(4) trademarks, service marks, logos, trade names, and the goodwill associated with each; and

(5) trade secrets and other confidential information;

(6) mask works; and

(7) all other forms of intellectual property recognized by law.

Comment

This definition is a composite of language commonly found in contracts drafted with input from IP lawyers.

2.44 Intellectual Property Right Definition

(a) The term intellectual-property right, whether or not capitalized, refers broadly to any right in intellectual property existing by law at the relevant time anywhere in the world, under intellectual-property law or industrial-property law, including without limitation the right to sue for present or past infringement of any such right.

(b) For the avoidance of doubt, the term includes, for example:

(1) all rights (whether registered or unregistered) in, or arising under laws concerning: trade secrets; confidential information; inventions; patents; trademarks, service marks, and trade names; Internet domain names; copyrights; designs; rights of publicity; and mask works;

(2) any application then pending for such a right, including for example an application for a patent or to register a copyright or trademark;

(3) any right to file such an application; and

(4) any right to claim priority for such an application.

Comment

This definition is a composite of language commonly found in contracts drafted with input from IP lawyers.

2.45 Knowledge Definition

(a) Actual knowledge required: The term knowledge, whether or not capitalized, refers to actual knowledge; words such as knows, knowingly, and like words have a corresponding meaning.

(b) Organizational knowledge: An organization is not deemed to know something unless the thing is known by an individual who has management responsibility concerning the associated subject matter.

(c) No duty of inquiry: Unless expressly agreed otherwise in writing:

(1) the parties desire that a party making a statement about its knowledge of a particular matter (a "Stating Party") should hot be deemed to have a duty of inquiry about that matter; and

(2) no party will assert, in any forum, that the Stating Party breached a duty of inquiry in making the statement.

Comment

Merger- and acquisition (M&A) agreements often contain definitions of knowledge that are much more elaborate than this one; such definitions seem to be less common in contracts for commercial transactions.

Subdivision (a) is adapted almost verbatim from sub­div­i­sion (b) of UCC § 1-202.

Other subdivisions of UCC § 1-202 are not incorporated into this definition. Some of those other subdivisions define "notice" and specify default rules for when an organization has knowledge or notice of a fact, but those default rules might conflict with the notice provisions of a contract.

Sub­div­i­sion (b) is intended to avoid imputing knowledge to an organization just because, let's say, a janitor knows it.

Sub­div­i­sion (c) unlike UCC § 1-202, does not impose a duty of inquiry. A party desiring to impose such a duty should specify it explicitly in the contract.

Sub­div­i­sion (c) is phrased very carefully, so as:

  • in sub­div­i­sion (c)(1), to recognize that courts generally do not consider themselves bound to follow orders — hence, this provision is not phrased as, for example, "this provision shall not be interpreted as giving rise to a duty of inquiry"; and
  • accordingly, in sub­div­i­sion (c)(2), to make it a separate breach of contract for a party to assert that another party had (and breached) a duty of inquiry not expressly provided for in the parties' agreement.

2.46 Law Definition

Law, whether or not capitalized, refers to any and all applicable provisions of a constitution, statute, regulation, ordinance, judgment, order, or other obligation, requirement, or prohibition having legally-binding effect at the relevant time.

Comment

It's always possible that a "creative" counsel might try to claim that some form of government requirement did not constitute "law" in connection with a contract provision. This definition is intended to forestall such an attempt. See also 9.11.  ? Governin Law clause.

2.47 Level X Support Definition

(a) Level 1 support refers to routine basic technical support for a product or service; it entails providing customers, where applicable, with compatibility information, installation assistance, general usage support, assistance with routine maintenance, and/or basic troubleshooting advice.

(b) Level 2 support refers to more in-depth attempts to confirm the existence, and identify possible known causes, of a defect in a product or an error in a service that is not resolved by Level 1 support.

(c) Level 3 support refers to advanced efforts to identify and/or correct a defect in a product or an error in a service.

Comment

2.48 Limitation Period Definition

(a) Limitation Period refers to: One year after accrual of a claim against any Signatory Party (each, a Protected Party), where the claim arises out of the Agreement.

(b) Any such claim will be permanently barred, and the Protected Party will not be liable in respect of the claim, if the claim is not asserted before a Tribunal of proper jurisdiction and venue — for example by the filing or amendment of an action — before the expiration of the Limitation Period.

(c) IF: The Agreement and/or applicable law provides that the discovery rule applies to claims of the type to which the the Limitation Period applies; THEN: For any such claim, the Limitation Period will begin on the earlier of:

(1) the date of discovery, by or attributable to the claimant, of the facts constituting or giving rise to the claim; or

(2) if earlier, the date such facts should or could have been discovered by the claimant in the exercise of reasonable diligence.

Comments
Overview

In most (but not all) U.S. states, the general rule is that, because of the public policy favoring freedom of contract, such provisions are enforceable, as long as "the contractually shortened limitations period is reasonable and not contrary to other statutory provisions or to public policy …." Creative Playthings Franchising Corp. v. Reiser, 463 Mass. 758, 760 (2012) (answering certified question from federal district court; shortened limitation was invalid for purporting to eliminate discovery rule, as discussed below).

This clause provides language for parties to agree to shorten the statutory limitation period that would otherwise apply — that is, to agree to a stated (shorter) deadline for a party to bring a claim of breach of warranty or other form of breach of contract.

Possible legal restrictions

CAUTION: The law might restrict the parties' ability to shorten a limitation period, as discussed below. (One year should be a safe minimum-limitation period in most cases, but drafters should be sure to double-check the applicable law.)

Duration of limitation period

Drafters should consider how much time might elapse before their clients were even aware of facts giving rise to a potential claim.

Applicable Disputes

Some drafters might want the shortened limitation period to apply very broadly, e.g., to all Agreement-Related Disputes.

Other parties, though, might regard that as overreaching.

Protected Parties

Some supplier contract forms say, in effect, that only the supplier is a Protected Party — i.e., that any claim against the supplier must be brought within a specified time (often one year), while imposing no such shortened time limit on any claim that the supplier might want to bring against the customer.

(A two-way limitation-period clause, in which each party is a Protected Party, will often be more palatable.)

The UCC provision for a shortened limitation period

In an agreement for the sale of goods, the [U.S.] Uniform Commercial Code allows the limitation period to be shortened to not less than one year, but the shortening must occur in the original agreement:

  1. An action for breach of any contract for sale must be commenced within four years after the cause of action has accrued.

By the original agreement the parties may reduce the period of limitation to not less than one year but may not extend it.

  1. a cause of action accrues when the breach occurs, regardless of the aggrieved party's lack of knowledge of the breach.

A breach of warranty occurs when tender of delivery is made,

except that where [i] a warranty explicitly extends to future performance of the goods and [ii] discovery of the breach must await the time of such performance[,] the cause of action accrues when the breach is or should have been discovered.

UCC § 2-725 (emphasis, extra paragraphing, and bracketed numbers added).

Other state law might restrict shortening the limitation period

A Missouri law flatly prohibits reducing the statutory limitation period: "All parts of any contract or agreement hereafter made or entered into which either directly or indirectly limit or tend to limit the time in which any suit or action may be instituted, shall be null and void." Mo. Rev. Stat. § 431.030, discussed in Brian Rogers, Contractual Limitations: Why Are You Suing Me When Our Contract Says You Can't?, TheContractsGuy.net, Nov. 30, 2012.

Missouri has enacted the Uniform Commercial Code, however, and so where the contract is for the sale of goods, the Missouri version of UCC § 2-725 presumably overrides the flat prohibition.

Other state law might impose special procedural requirements

In a 2013 case, the Nevada supreme court – after reviewing case law from other state- and federal courts – said that the state would follow the general rule that a contract can shorten the limitation period to a reasonable length, as long as doing so did not contravene a specific statute or public policy. In that case, though:

  • The contract in question was for construction of a residential condominium;
  • A Nevada statute allowed the limitation period to be shortened to no less than two years if done by a "separate instrument"; and
  • The provision shortening the limitation period was contained in an arbitration agreement, which the supreme court held did not meet the requirement for a separate instrument.

See Holcomb Condominium Homeowners' Ass'n, Inc. v. Stewart Venture, LLC, 129 Nev. Adv. Op. 18 (Nev. 2013) (reversing summary judgment dismissing homeowners' association claims as time-barred).

Use a notice deadline instead (or additionally)?

Brian Rogers, author of TheContractGuy blog, reports that many Missouri lawyers include notice-of-claim requirements in their contracts: That is, a claimant against, say, a contractor is not allowed to file suit unless it gives the contractor notice of the claim within, say, 90 days after completion of the last work by the contractor on which the claim is based.

Brian cites one 1991 Missouri appellate case in which a surety bond – in essence, an insurance policy guaranteeing payment – required that notice of the claim for payment be given within 90 days after completion of the last work. See Frank Powell Lumber Co. v. Fed. Ins. Co., 817 S.W.2d 648 (Mo. App. 1991) (affirming judgment in favor of surety company on grounds that sub-subcontractor claimant had not given notice of claim for payment within 90 days as required by bond).

Not without reason (in my view), Brian expresses concern that other courts might not go along with such a short notice period.

Discovery rule

Some U.S. jurisdictions, but not all, allow parties to a contract to agree to apply, or not apply, a discovery rule in shortening the limitation period for claims of breach of the contract.

For example:

• In 2013, a California appellate court held that a contract for construction of a hotel could cause the statutory limitation period for warranty claims to begin running upon substantial completion of construction and not when the claimed defect was (or should have been) discovered. See Brisbane Lodging, LP v. Webcor Builders, Inc., 216 Cal. App.4th 1249, 157 Cal. Rptr. 3d 467 (2013) (affirming summary judgment in favor of builder), discussed in Aaron R. Gruber, California Decision Approves Shortening Statutes of Limitation and Eliminating the Discovery Rule Via Contract, Jones Day Publications, June 2013.

• On the other hand, the Massachusetts supreme court held in 2012 that "a contractual limitations provision that did not permit operation of the discovery rule would be unreasonable and, therefore, invalid and unenforceable." The contract's language imposed an absolute 18-month deadline for bringing a claim, even if the claimant did not know and could not have known the relevant facts in time to bring the claim; the court held that this language "would appear to impose a limitation of repose, which would be per se invalid and unenforceable; limitations of repose may be imposed only by the Legislature." Creative Playthings Franchising Corp. v. Reiser, 463 Mass. 758, 764 (2012) (answering certified question from federal district court).

See also the Wikipedia entry concerning the discovery rule.

2.49 Material Definition

A thing is material (for example, material information; a material breach) if a substantial likelihood exists that a reasonable person would consider the thing important in making a relevant decision.

Comment

This definition is adapted from the opinion of the Supreme Court of the United States in Basic Inc. v. Levinson, 485 U.S. 224, 231-32 (1988), a securities-law case.

For a hair-trigger statutory definition of "material" (in the context of residential-real-estate disclosures), see Hawaii Rev. Stat. § 508D-1(3): "'Material fact' means any fact, defect, or condition, past or present, that would be expected to measurably affect the value to a reasonable person of the residential real property being offered for sale." (Emphasis added.) See generally Santiago v. Tanaka, No. SCWC-11-0000697 (Haw. Dec. 29, 2015), modified on other grounds (Haw. Jan. 15, 2016).

2.50 Material Breach Definition

(a) Except to the extent (if any) otherwise stated in the Agreement, any determination whether a breach of the Agreement was (or would be) material is to take into account the factors listed in the Restatement (Second) of Contracts § 241 (1981), considering the Agreement as a whole, with no single factor necessarily being decisive.

(b) Any breach expressly agreed in writing by the parties to be a material breach  — if any — is conclusively considered to be a material breach, in and of itself, without regard to any other consideration.

(c) A series of breaches, whether related or unrelated, whether or not cured, and none of which individually constitutes a material breach of the Agreement, may nevertheless collectively constitute a material breach of the Agreement when considering the Agreement as a whole.

Comments
The Restatement factors for determining material breach

Many U.S. courts look to the Restatement (Second) of Contracts § 241 (1981) in determining the materiality of a breach. The Restatement lists five factors that are to be taken into account, with no single factor being decisive:

(a) the extent to which the injured party will be deprived of the benefit which he reasonably expected;

(b) the extent to which the injured party can be adequately compensated for the part of that benefit of which he will be deprived;

(c) the extent to which the party failing to perform or to offer to perform will suffer forfeiture;

(d) the likelihood that the party failing to perform or to offer to perform will cure his failure, taking account of all the circumstances including any reasonable assurances;

(e) the extent to which the behavior of the party failing to perform or to offer to perform comports with standards of good faith and fair dealing.

Norfolk Southern Ry. Co. v. Basell USA Inc., 512 F.3d 86, 92 (3d Cir. 2008) (vacating and remanding summary judgment that breach of contract was not material), quoting Restatement (Second) of Contracts § 241 (1981).

Caution: "Letting it slide" could result in a waiver even of repeated material breaches

In a 2015 case, the Connecticut supreme court noted that "it is a settled principle of contract law that a party to an executory bilateral contract waives a material breach by the other party if he continues the business relationship, and accepts future performance without some warning that the contract is at an end." RBC Nice Bearings, Inc. v. SKF USA, Inc., No. SC 19253, slip op. at 8 (Ct. Sept. 22, 2015) (emphasis added, citations omitted). In that case:

  • A group of ball-bearing manufacturers (referred to here as just "the manufacturer") and a distributor entered into a long-term supply agreement.
  • Under that agreement, the distributor was required to make minimum purchases from the manufacturer each year.
  • Of historical interest: The distributor itself had formerly been a  manufacturer of ball bearings and had sold its business to the manufacturer-plaintiffs.
  • As time passed, the distributor repeatedly failed to meet the contract's minimum-purchase requirements.
  • The manufacturer, in essence, did nothing about the distributor's failures to meet the purchase requirements.
  • Eventually, the manufacturer terminated the contract and filed a breach-of-contract lawsuit against the distributor. According to the trial court, the evidence was overwhelming that the manufacturer did this in order to "cut out the middle man" and take over direct-to-market distribution on its own.

The trial court held, and the state supreme court agreed (although the intermediate appellate court didn't), that the manufacturer, by doing nothing about the distributor's repeated failures to meet the minimum-purchase requirement, had waived that requirement for the years in question in the lawsuit.

Just complaining about a material breach won't preclude a finding of waiver

In the RBC Nice Bearings case discussed above, the Connectituc supreme court also noted that, just because you complain to the other side that they're breaching the contract, that won't necessarily preclude a finding that you waived the breach:

[T]he fact that an obligee repeatedly reminds an obligor of its contractual duties, or complains of the obligor’s noncompliance, does not preclude a finding of waiver, when the obligee nevertheless continues to acquiesce in the obligor’s noncompliance and to perform under the contract.

The rule applies with particular force in the present case, where there was evidence that the plaintiffs gave the defendant intentionally mixed signals with regard to its minimum purchase requirement, and where the trial court found that the plaintiffs always had intended to terminate the contract prematurely and merely used the shortfall invoices as a pretext to do so when they decided that the time was right.

RBC Nice Bearings, Inc. v. SKF USA, Inc., No. SC 19253, slip op. at 16 (Ct. Sept. 22, 2015) (extra paragraphing added, footnotes omitted).

Getting a summary judgment about materiality can be problematic

The Norfolk Southern court noted that issues of materiality of a breach of contract might not be resolvable on summary judgment:

Whether the breach of a contract is material is generally an issue of fact. However, as is true of virtually any factual question, if the materiality question in a given case admits of only one reasonable answer (because the evidence on the point is either undisputed or sufficiently lopsided), then the court must intervene and address what is ordinarily a factual question as a question of law.

Norfolk Southern Ry. Co. v. Basell USA Inc., 512 F.3d 86, 92-93 (3d Cir. 2008) (vacating and remanding summary judgment that breach of contract was not material) (citations, alteration marks, internal quotation marks, and footnote omitted).

The court also pointed out the difficulty of rendering summary judgment on materiality when intent was at issue:

In addition, we note that, although it is not impossible, determining whether a breach is material on summary judgment is inherently problematic where, as here, the materiality analysis may well turn on subjective assessments as to the state of mind of the respective parties.

As we have emphasized in the past, a court should be reluctant to grant a motion for summary judgment when resolution of the dispositive issue requires a determination of state of mind, for in such cases much depends upon the credibility of witnesses testifying as to their own states of mind, and assessing credibility is a delicate matter best left to the fact finder.

Id. at 96 (extra paragraphing added, internal quotation marks omitted).

Indiana v. IBM (1): An appeals court substitutes its judgment about materiality

A fascinating material-breach case was (is) Indiana v. IBM Corp., No. 49A02-1211-PL-875 (Ind. App. Feb. 13, 2014) (reversing trial court in pertinent part), affirmed, Indiana v. IBM Corp., No. 49S02-1408-PL-00513 (Ind. Mar. 22, 2016). In that case:

  • The state of Indiana and IBM entered into a ten-year, $1.3 billion contract to modernize and improve the state's welfare system.
  • Things did not go as expected; three years in, the state terminated the contract, alleging material breach by IBM.
  • The state and IBM sued each other.
  • The trial court conducted a six-week bench trial, hearing 92 witnesses and admitting 7,500 exhibits. See id., slip op. at 22.
  • The trial court held that IBM had not materially breached the contract.

The appeals court reversed on the materiality question, asserting:

While IBM’s software, computers, and employee training aided in delivering welfare services, the primary focus of the contract was to provide food and medical care to our poorest citizens in a timely, efficient, and reliable manner within federal guidelines, to discourage fraud, and to increase work-participation rates.

In the most basic aspect of this contract — providing timely services to the poor — IBM failed.

We therefore reverse the trial court’s finding that there was no material breach.

Id. at 3 (emphasis added).

One judge a partial a concurrence-in-part See id. at 91 (Friedlander, J., concurring in part and dissenting in part).

Indiana v. IBM (2): The contract's statements trump the Restatement

The Indiana supreme court apparently agreed with the court of appeals's decision about material breach, but disagreed with the appellate court's reliance on the Restatement factors:

Both the trial court and the Court of Appeals majority cite to the common law Restatement (Second) of Contracts § 241 factors for analyzing the materiality of a breach. However, here, the MSA [Master Services Agreement] itself sets forth the standard for assessing the materiality of a breach. The MSA also provides performance standards and indicators to measure IBM’s performance. The policy objectives of the MSA are incorporated into those performance standards.

Consistent with Indiana’s long tradition of recognizing the freedom to contract, we hold that when a contract sets forth a standard for assessing the materiality of a breach, that standard governs. Only in the absence of such a contract provision does the common law, including the Restatement, apply.

… We hold that under the facts and circumstances of this case, looking at the performance standards and indicators provided in the MSA, IBM’s collective breaches were material in light of the MSA as a whole.

Indiana v. IBM Corp., No. 49S02-1408-PL-00513, slip op at 2 (Ind. Mar. 22, 2016) (extra paragraphing added).

Collective material breach

The Common Draft material-breach provision includes language modeled on on section 16.3.1(1)(A) of the master service agreement in Indiana v. IBM Corp., No. 49S02-1408-PL-00513, slip op. at 11 (Ind. Mar. 22, 2016). That section required the state to prove a breach by IBM that was "'material considering the Agreement as a whole.” Id., slip op. at 2 (citation and internal quotation marks omitted). Indiana's supreme court held that IBM materially breached a $1.3 billion master services agreement to modernize the state's welfare eligibility system. See the Notes for a discussion of that case.

CAUTION: The "as a whole" language probably increases the likelihood that a party's motion for summary judgment about the materiality or immateriality of a breach would be denied, as discussed here.

2.51 May Do X and May Not Do X Definitions

(a) If the Agreement states that a party may take an action, it means that the party has the right, but not the obligation, to take the action, in its sole discretion, unless the Agreement clearly states otherwise.

(b) If the Agreement states that a party may not take an action, it means that the party is prohibited from taking the action.

Comment

This clause is intended to preclude a party from arguing that another party that "may" do X must exercise good faith, or be reasonable, or anything like that. See generally Ken Adams, “May” Can Mean “Might,” But I Sleep Well at Night Anyway (AdamsDrafting.com Aug. 10, 2014).

See also 2.54. Need-Not Definition.

2.52 Misrepresentation Definition

(a) To establish a person's liability in respect of a claim for misrepresentation in connection with the Agreement, the claimant must show that all of the following are true:

(1) The person made a representation that, at that time, either: (A) was untrue as to a material fact, or (B) omitted a material fact necessary in order to make the representation, in the light of the circumstances under which it was made, not misleading.

(2) The person that made the representation either: (A) failed to use reasonable care or competence in obtaining or communicating the information comprising the representation, or (B) knew, at the time of making the representation, of the circumstances described in sub­div­i­sion (1)(A) or (1)(B), as applicable.

(3) The person knew or should have known that the party would rely on the representation—this is deemed conclusively established if the representation is expressly stated in the Agreement with language such as "Party A represents that …."

(4) The claimant's reliance on the representation was reasonable.

(5) The claimant suffered harm as a result of such reliance.

(b) If clearly so stated in the Agreement, each element of proof listed in sub­div­i­sion (a) must be shown by clear and convincing evidence.

Comment

This provision tries to synthesize various [U.S.] federal- and state-law doctrines.

A claim of misrepresentation can have massive real-world consequences. For example, HP's EDS unit ended up paying more than US$ 460 million to settle British Sky Broadcasting's successful claim for fraudulent inducement and misrepresentation in connection with a software-development contract — this, even though the contract limited EDS's liability to around 10% of that number. See BSkyB Ltd. v. HP Enterprise Services UK Ltd., [2010] EWHC 86 (TCC) and Jaikumar Vijayan, EDS settles lawsuit over botched CRM project for $460M, Computerworld, June 9, 2010.

Concerning insurance to cover misrepresentation claims, see Howard T. Spilko and Scott A. Abramowitz, Use of Representations and Warranties Insurance Grows in Middle-Market Transactions (NYLJ.com 2015).

Sub­div­i­sion (a)(1) is is adapted from the famous Rule 10b-5 promulgated by the U.S. Securities and Exchange Commission. See generally the Wikipedia article "Rule 10b-5."

Sub­div­i­sion (a)(3) takes it for granted that the claimant will rely on a (mis)representation that is stated in the agreement — otherwise, why would the parties have included the representation in the agreement in the first place? See also the notes to 9.21.  ? Reliance Disclaimer.

Concerning sub­div­i­sion (b): Many [U.S.] states, in civil cases, require proof of at least some of the elements of fraud by clear and convincing evidence, although U.S. federal statutes generally require proof of fraud only by a preponderance of the evidence. See Grogan v. Garner, 490 U.S. 279, part III, text accompanying nn.15-16 (1991) (holding that the standard of proof for the dischargeability exceptions for fraud in bankruptcy proceedings is the ordinary preponderance-of-the-evidence standard).

2.53 Month Definition

(a) Unless the Agreement expressly states otherwise:

(1) the term month, whether or not capitalized, refers to the Gregorian calendar; and

(2) a period of X months (where X is a number), beginning on a specified date, ends at exactly midnight (in the relevant time zone) at the end of the same day of the month X months later (or at the end of the last day of that later month, if earlier).

(b) Hypothetical examples: A one-month period beginning on November 15 ends at exactly midnight at the end of December 15. A two-month period beginning on December 31, 2015 ends at exactly midnight at the end of February 29, 2016.

Comment

This clause could be useful for the avoidance of doubt in contracts involving companies in Muslim countries, and possibly in Israel, where a lunar calendar might be used. See generally the blog post and comments at Ken Adams's post, Referring to the Gregorian calendar? (Nov. 14, 2013), especially the comments of Mark Anderson, Francis Davey, Richard Schafer, and Benjamin Whetsell.

2.54 Need-Not Definition

For the avoidance of doubt, a statement that a party is not required to take a particular action means that the party is under no obligation whatsoever to take the action; if for any reason or no reason the party does not take the action, then the party:

(1) is to be conclusively deemed to have complied with any applicable standard of good faith, fair dealing, or reasonableness; and

(2) will not be liable for not taking the action under any legal- or equitable theory arising from or relating to the Agreement; no party is to assert the contrary.

Comment

This is a roadblock clause to try to forestall claims that a party failed to comply with some implied obligation of good faith and fair dealing (in the same vein, see also the commentary to 2.81. Sole Discretion Definition).

Sub­div­i­sion (1) borrows from UCC § 1-302(b) (which applies only to contracts that come within the scope of the UCC), which reads as follows: "The parties, by agreement, may determine the standards by which the performance of those obligations [of good faith, etc.] is to be measured if those standards are not manifestly unreasonable."

See also 2.51. May Do X and May Not Do X Definitions.

2.55 Negligence Includes Gross Negligence

For the avoidance of doubt, the term negligence encompasses gross negligence.

Comment

I've never seen it argued that gross negligence is not a form of negligence, but who knows whether some creative litigator might be [bold] enough to try.

2.56 Negligence Or Misconduct Definition

(a) The terms Negligence Or Misconduct and Negligence and Misconduct each refers to one or more of negligence; gross negligence (including for example reckless conduct); willful misconduct; and intentional- or unintentional noncompliance with law.

(b) For the avoidance of doubt:

(1) These terms do not include noncompliance with the Agreement where the noncompliance does not include one or more of the things referred to in sub­div­i­sion (a).

(2) This definition does not alter a party's liability for breach of the Agreement that does not constitute Negligence Or Misconduct.

Comment

This definition is used in certain exceptions to indennity obligations and might also be useful in other contexts.

2.57 Net-Days Definition

For the avoidance of doubt, when used in reference to an invoice for payment, the following terms and variations on them, whether or not capitalized, have the stated meanings. The terms are defined by example; variations on the terms have corresponding meanings.

(a) Net 30 and net 30 days means that 100% of the invoiced amount is due no later than 30 days after receipt of the invoice by the paying party (or, if so agreed in writing, no later than 30 days after the date of the invoice).

(b) 2%/10 net 30 has the same meaning as net 30 except that the amount due will be reduced by 2% (that is, to 98% of the invoiced amount) if payment is received within 10 days instead of 30 days.

(c) 2% every 5 days early, net 30 means that if the invoice is paid (for example) in 10 days (that is, 20  days early, which is 4 increments of 5 days), then the amount due is equal to 92% of the invoiced amount (that is, 100% of the invoiced amount, less 4 times 2% of that amount).

Comment

Sometimes a customer will insist on payment terms beyond the normal net 30 days — say, net 45 days plus a 90-day cure period — before the vendor can terminate for nonpayment. If the vendor were to agree, the customer would get the benefit of several weeks' extra float on its money.

The vendor might be seeing the effect of tag-team negotiation from different departments within the customer's organization. For example, the customer’s finance department might have issued an edict that the accounts-payable process will only make payments on the extended terms unless an exception is approved by Finance.

If that’s the case, the actual buyers can go to the vendor and claim, possibly disingenuously, that “we’d be willing to agree to net 30 days, but we’d have to ask for approval from our finance people. That would delay closing our deal, probably into next quarter. On the other hand, if you can live with the extended payment terms, we can get it done this quarter.”

The sales person might well "need" for the sale to close this quarter, to help him make his numbers and get the commission. So he naturally will urge the vendor's contract negotiator to simply agree to the customer's proposal for extended payment terms instead of delaying the deal.

There are a couple of possible come-backs that the vendor can try with the customer:

  1. “We’d be OK with letting you have the extra float, but we’d need you to agree to pay interest at prime + X after 45 days.” The buyer's response, of course, will be that this too would have to be approved by Finance, which by hypothesis is something to be avoided if possible.
  2. It might be possible to steer the conversation into a discussion about pricing. The vendor's negotiator could responsd along the following lines: “The pricing we offered was premised on payment net 30 days. We’d be willing to let you have the additional float, but we’d need to increase the purchase pricing — we have to take into account our increased financial risk and the time value of money.” The customer’s actual buyers can then decide whether they’d rather spend the extra money or go to Finance for approval of net 30 days. (My experience is that buyers would often rather give up the extra float than pay more on the front end.)

The weakness in either of these responses, of course, is that when the shot clock is running down at the end of the quarter, some sales people can be so eager (read: desperate) to close business that they won’t hold their ground — this kind of sales person wants everyone else in the vendor’s organization to make concessions so they can get their commissions.

2.58 Non-Party Definition

Non-party, whether or not capitalized, refers to an individual or organization that is not a signatory of the Agreement unless another meaning is clear from the context.

Comment

This definition might well be overkill.

2.59 Or Definition

The term or, whether or not capitalized, refers to the inclusive or unless the context clearly and unmistakably indicates otherwise. EXAMPLE: "Provider may deliver goods on Monday or Tuesday" means that Provider may deliver goods on Monday, Tuesday, or both.

Comment

2.60   [Reserved: Order of precedence]

2.61 Organization Definition

Organization, whether or not capitalized, refers to a corporation; business trust; estate; trust; general- or limited partnership; limited liability company; association; joint venture; joint stock company; government; governmental subdivision, ‑agency, or ‑instrumentality; public corporation; or any other legal or commercial entity.

Comment

The language of this definition is adapted from UCC §§ 1-201(25) and 1-201(27).

One court noted that the term entity (the last word of this definition) refers to an "organization (such as a business or a governmental unit) that has a legal identity apart from its members or owners.” Entity, Black's Law Dictionary (10th ed. 2014), quoted in Ineos USA LLC v. Elmgren, No. 14-0507, slip op. at 9 (Tex. June 17, 2016) (emphasis by the court, internal quotation marks omitted).

2.62 Party Definition

Unless otherwise clear from the context, the term party, whether or not capitalized, refers to a party to the Agreement.

Comment

Some contracts state that the parties are (let's say) ABC Corporation and its Affiliates. This is generally a bad idea unless each Affiliate is to be a signatory party. The much-better practice is to state the specific rights and obligations that Affiliates have under the contract. See generally Mark Anderson, Don't Make Affiliates parties to the agreement (2014). See also 2.3. Affiliate Definition and the associated clauses following it.

2.63 Patent Right Definition

The term patent rights, whether or not capitalized, singular or plural, refers generally to the following (if any) that exist, in any jurisdiction unless the Agreement specifies otherwise, at a relevant time:

(1) issued patents, including but not limited to reissue patents and reexamined patents;

(2) patent applications, both pending and abandoned, including but not limited to provisional, non-provisional, divisional, continuation, continuation-in-part, and reissue applications, whether or not published;

(3) any right to claim priority under any of the foregoing; and

(4) any right to sue for infringement of any claim in, or other right arising from, an issued patent or pending patent application.

Comment

The definition can be useful in agreements relating to intellectual property, and also as a (very) brief introduction to those unfamiliar with the subject.

2.64 Person Definition

(a) The term person, whether or not capitalized, refers to an individual, corporation, business trust, estate, trust, partnership, limited liability company, association, joint venture, government, governmental subdivision, agency, or instrumentality, public corporation, or any other legal or commercial entity.

(b) Unless otherwise clear from the context, a reference to a person encompasses that person's successors and assigns. (This subdivision, however, does not in itself authorize assignment of any right or delegation of any obligation under the Agreement.)

Comment

Sub­div­i­sion (a) of this definition is adapted essentially verbatim from UCC § 1-201(27).

Note that the term entity, which is the last word of sub­div­i­sion (a), has been construed to be narrower than the term organization, as discussed in the commentary to 2.61. Organization Definition.

2.65 Prime Rate Definition

The term prime rate, whether or not capitalized, refers to the per annum rate of interest for commercial loans that, at the relevant time, was most recently announced or published by the Wall Street Journal (the Prime Rate Publisher.

Comment

Drafters should become at least somewhat familiar with how the Wall Street Journal surveys banks and periodically publishes the "prime" rate; see generally Wall Street Journal prime rate (Wikipedia).

2.66 Prompt Definition

The term prompt, along with corresponding terms such as promptly, whether or not capitalized, refer to taking specified action within a reasonable time and as a high priority, but not necessarily immediately.

Comment

This definition can be useful in requiring reasonably-fast action — but not necessarily immediate action — when the parties don't necessarily know (or perhaps can't agree on) a specific time frame for the action.

2.67 Protected Group Definition

The term Protected Group, in respect of a party that is identified by name in the Agreement as being the subject of a defense- and/or indemnity obligation (a "Protected Party"), refers to the following:

(1) the Protected Party itself;

(2) the Protected Party's Affiliates;

(3) any other individuals or organizations specified in the Agreement; and

(4) the employees, officers, directors, shareholders (in that capacity), general- and limited partners, members, managers, and other persons occupying comparable positions in respect of each individual and organization within the scope of in subdivisions (1) through (3), as applicable.

Comment

This is a "convenience" definition, used in clauses such as 5.9.   Indemnity Procedures. It specifies the scope of an indemnity obligation by defining which individuals and organizations that associated with an indemnified party are entitled to indemnity.

Some parties might want their Protected Groups also to include even their indirect customers, suppliers, etc. — but that could dramatically expand the risk for the indemnifying party.

2.68 Provider Definition

Unless clearly indicated otherwise in the Agreement, the term Provider refers to a Signatory Party that provides deliverables and/or services to, or at the instance of, another Signatory Party (Customer) as a material aspect (i) of the Agreement, and/or (ii) of a purchase order, statement of work, or other agreement entered into under the Agreement by those Signatory Parties.

Comment

The definitions of Customer and Provider refer to Signatory Parties in the interest of narrowing the universe of possible plaintiffs claiming to have been "Customers" entitled to remedies against a Provider.

2.69 Reasonable Discretion Definition

Reasonable discretion, whether or not capitalized, refers to discretion that is exercised in a manner that is not arbitrary, capricious, or irrational.

Comment

See the Annotations as well as sole discretion and discretion.

2.70 Reasonable Efforts Definition

(a) The term reasonable efforts, whether or not capitalized, refers to one or more reasonable actions reasonably calculated to achieve the stated objective.

(b) Any assessment of reasonable efforts is to give due regard to the information reasonably available, to the relevant person at the relevant time, about (for example) the likelihood of success of specific action(s); the likely cost of other actions; the parties' other interests; the safety of individuals and property; and the public interest.

(c) A requirement to make reasonable efforts:

(1) does not necessarily require taking every conceivable reasonable action; and

(2) does not require the obligated party to put itself in a position of undue hardship.

(d) A party obligated to make reasonable efforts may consider potential cost and potential return when determining what actions it must take to satisfy that obligation.

Comment

Contract negotiators often use the term reasonable efforts, despite its vagueness, in order to get to signature. That's frequently an acceptable business risk: Most contracts are never significantly disputed, and so it's unlikely that the parties will ever need to litigate the meaning of reasonable efforts.

The "undue hardship" language in subdivision (c)(2) and the "potential cost and potential return" phrase in subdivision (d) are adapted from a comment by Janet T. Erskine, Best Efforts versus Reasonable Efforts: Canada and Australia (Nov. 30, 2007).

See generally the Reading Notes on this subject.

2.71 Reckless Definition

A person (the "actor") acts recklessly when the actor consciously disregards a substantial and unjustifiable risk that harm will result from the actor's conduct. The risk of harm must be of such a nature and degree that, considering the nature and purpose of the actor's conduct and the circumstances known to the actor, the disregard of the risk involves a gross deviation from the standard of conduct that a reasonable person would observe in the actor's situation.

Comment

This definition is based on Model Penal Code § 2.02(c), as implemented in, e.g., Tex. Pen. Code § 6.03(c).

Some of the terms used here, such as substantial and unjustifiable risk and gross deviation, are of course vague and likely to be the subject of debate. Drafters could consider requiring any dispute about those terms to be decided by arbitration, possibly baseball-style arbitration.

2.72 Record Definition

Records, whether or not capitalized, refers to books, documents, and other data that are stored in any tangible- or intangible medium regardless of type, without regard to whether such items are in written, graphic, audio, video, or other form.

Comment

This definition is adapted from the (U.S.) Federal Acquisition Regulations, Contractor Records Retention, 48 C.F.R. § 4.703(a).

2.73 Regardless of Fault Definition

(a) The term REGARDLESS OF FAULT applies to any of the following provisions in the Agreement that benefit one or more persons (each such person, a Protected Person, and each such provision, an Applicable Provision):

(1) a provision exculpating the Protected Person from liability associated with an event or series of related events (collectively, the Relevant Event);

(2) a provision limiting the Protected Person's liability arising from the Relevant Event; and

(3) a provision obligating another person to indemnify the Protected Person against one or more categories of claim, loss, or expense arising from the Relevant Event.

(b) When the term Regardless of Fault is used in respect of an Applicable Provision, it means that the provision applies:

(1) even if the Relevant Event was caused — in whole or in part, proximately or otherwise — by the Protected Person's negligence (see below), willful misconduct, or other fault;

(2) even if the Protected Person's claimed negligence was ordinary or gross; sole, joint, or concurrent, comparative, or contributory; active or passive; or otherwise; and

(3) even if the Relevant Event was an occasion of strict liability under applicable law.

Comment

This definition was very significantly rewritten from one in a services agreement used by a company in the oil-and-gas industry. (Among other issues, the original definition, in all-caps boldfaced type, was difficult to read.)

2.74 Representation Definition

representation is a statement of past or present fact; the verb represent has a cor­res­pond­ing meaning.

Comments
Language notes

The phrase "statement of past- or present fact" was suggested by Professor Tina Stark, author of the well-regarded Drafting Contracts textbook. She suggests making it clear that a state­ment of future fact is not a representation; such a statement might constitute an enforceable prom­ise (possibly in the form of a warranty), or it might be an unenforceable statement of opinion.

See also:

Bryan Garner's summary

See Bryan Garner's discussion of representations and warranties quoted in this Ken Adams blog post. (As will be apparent, I disagree completely with Ken's contention that represents and warrants are supposedly synonyms, as argued in the posts linked at the beginning of his blog post.)

Bad drafting: "Representation" of future conduct

A curious set of facts is seen in Lyon Fin. Serv., Inc. v. Illinois Paper & Copier Co., 848 N.W.2d 539 (Minn. 2014) (on cert­if­ic­a­tion from 7th Circuit). In that case, a company that sold photo­copy­ing machines entered into a contract with a financing company. (This is not an un­com­mon way for a seller to do business: the seller makes a deal with a customer, but then sells the equipment to the financing company, which pays the seller and then leases the equipment to the customer.)

The contract between the photocopier seller and the financing company included a rep­re­sent­a­tion and warranty (!) by the seller that it would submit, to the financing company, only agreements with end-customers that complied with applicable law. That turned out not to be the case for one of the photocopier seller's customers, a municipality, which stopped payment two years into its six-year lease because a state statute limited municipal equipment leases to no more than five years. See id., slip op. at 3.

The financing company sued the photocopier seller for breach of the representation that it would submit only valid customer lease paper. In response, the seller asserted (among other things) that the financing company could not recover damages because it had not shown that it had relied on the representation.

The Minnesota supreme court noted (rightly) that "[b]ecause [the seller] manifested an intention to act in a specified way … a breach of contract action may be the more appropriate action." Id. at 543 n.4 (emphasis added). The court then treated the so-called representation, in effect, as a promise (or covenant) by another name; it held that proof of reliance on the representation was not needed:

[T]he representation of future legal compliance in this case was much more than a mere expression of opinion. Illinois Paper specifically agreed to indemnify and hold Lyon harmless from any loss resulting from Illinois Paper's breach of the representation that all lease transactions presented to Lyon would be valid and enforceable.

Id. at 540 (emphasis added). The court continued:

… In this case, the parties agreed to allocate the risk of legal noncompliance to Illinois Paper. Holding parties to their promises, without requiring separate reliance on those promises, furthers freedom of contract principles, and there is no reason to refuse to enforce the terms of the parties' bargain here.

Id. at 545 (emphasis added).

Rep-and-warranty insurance

See Howard T. Spilko and Scott A. Abramowitz, Use of Representations and Warranties Insurance Grows in Middle-Market Transactions (NYLJ.com 2015).

2.75 Responsible Definition

The term responsible, whether or not capitalized, refers to action that is both reasonable and conscientious. As an illustrative example, to make responsible efforts to achieve an objective (whether or not the term is capitalized) means to make at least such efforts as a reasonable person would make in a conscientious attempt to achieve that objective.

Comment

The term responsible is perhaps vague, but it's not unknown in the law. For example, the Delaware chancery court, in describing the duration of a preliminary injunction, referred to it as a "responsible period," albeit shorter than the period to which the claimant arguably would have been entitled. See Martin Marietta Materials, Inc v. Vulcan Materials Co., 56 A.3d 1072, 1147 (Del. Ch. 2012), aff'd, 45 A. 3d 148 (Del. 2012) (en banc).

2.76 Seasonable Definition

An action is taken seasonably (whether or not the word is capitalized) if the action is taken at or within the time agreed or, if no time is agreed, at or within a reasonable time.

Comment

The language of this definition is adapted essentially verbatim from UCC § 1-205.

Section Definition (cross-reference)

2.77 Serious Dispute Definition

The term Serious Dispute refers to any Agreement-Related Dispute that becomes, or appears reasonably likely to become, the subject of litigation or arbitration.

Comment

This definition can provide a useful shorthand for various dispute-management and -resolution clauses.

2.78 "Shall" Definition

Unless the context clearly and unmistakably requires otherwise:

(a) Terms such as "Party A shall take Action X" mean that Party A is required to take Action X.

(b) Likewise, terms such as "Party B shall not take Action Z" means that Party B is prohibited from taking Action Z.

Comment

This definition is provided because not all English speakers understand the term "shall" to mean "must."

A plain-language drafting guide published by a coalition of (U.S.) federal employees says:

The word “must” is the clearest way to convey to your audience that they have to do something. “Shall” is one of those officious and obsolete words that has encumbered legal style writing for many years. The message that “shall” sends to the audience is, “this is deadly material.” “Shall” is also obsolete. When was the last time you heard it used in everyday speech?

Besides being outdated, “shall” is imprecise. It can indicate either an obligation or a prediction. Dropping “shall” is a major step in making your document more userfriendly. Don’t be intimidated by the argument that using “must” will lead to a lawsuit. Many agencies already use the word “must” to convey obligations. The US Courts are eliminating “shall” in favor of “must” in their Rules of Procedure. One example of these rules is cited below.

Instead of using “shall”, use:

  • “must” for an obligation,
  • “must not” for a prohibition,
  • “may” for a discretionary action, and
  • “should” for a recommendation.

Federal Plain Language Guidelines at 25 (PlainLanguage.gov 2011).

Likewise, in some English-speaking countries, the term shall might be construed as tentative or optional, not as mandatory. See, e.g., a New Zealand legislative drafting guide:

A3.33 Although “shall” is used to impose a duty or a prohibition, it is also used to indicate the future tense. This can lead to confusion. “Shall” is less and less in common usage, partly because it is difficult to use correctly. “Shall” is now rarely used in New Zealand legislation (for a rare example, see the Royal Warrant of the New Zealand Service Medal 1946–1949 2002, SR 2002/225). “Must” should be used in preference to “shall” because it is clear and definite, and commonly understood.

And this Australian legislative-drafting guide, at page 20:

83. The traditional style uses “shall” for the imperative. However, the word is ambiguous, as it can also be used to make a statement about the future. Moreover, in common usage it’s not understood as imposing an obligation.

Say “must” or “must not” when imposing an obligation, not “shall” or “shall not”. [sic; note that the the period is outside the closing quotation mark]

If you feel the need to use a gentler form, say “is to” or “is not to”, but these are less direct and use more words.

(Thanks to English solicitor Paul de Cordova for the links to the above Australian- and New Zealand drafting guides.)

For a Supreme Court dispute about whether the word shall was mandatory in the context of a particular federal statute, see Gutierrez de Martinez v. Lamagno 515 U.S. 417, 433 n.9 & accompanying text (1995); id. at 439 & n.1 (Souter, J., dissenting). (From a strictly-lexical perspective, it seems to me that Justice Souter had the better of the argument.)

See also the commentary to 2.93. "Will" Means "Must" Definition.

2.79 Signatory Party Definition

(a) Signatory Party refers to an individual or organization that enters into the Agreement as a named party to it.

(b) For the avoidance of doubt, no third-party beneficiary of the Agreement (if any) is a Signatory Party.

Comment

Sometimes it's useful to be very explicit that certain rights (usually) or obligations are reserved for the specific parties that are entering into the agreement.

2.80 Signed Definition

Signed and like terms such as sign, signing, and signature, whether or not capitalized, with respect to a writing or other record (collectively, "record"), refer to executing or adopting a symbol, or carrying out a process, attached to or logically associated with the record, with the intent to adopt, accept, or authenticate the record.

Comment

This definition of signed, etc., is a combination of: • the definitions of signed and writing in UCC §§ 1-201(37) and 1-201(43); and • the definitions of electronic signature and electronic record in the [U.S.] Electronic Signatures in Global and National Commerce Act ("E-SIGN"), 15 U.S.C. § 7006.

The definition also draws on the definition of writing in Rule 1.00(v) of the 2010 proposed amendments to the Texas Disciplinary Rules of Professional Conduct [for lawyers]. (Those proposed amendments were rejected, for unrelated reasons, in a referendum of the State Bar of Texas.)

See generally the Reading Notes on this subject.

2.81 Sole Discretion Definition

(a) IF: The Agreement states that a party (the "electing party") may take (or not take) an action in its sole discretion (whether or not the term is capitalized); THEN: Unless the Agreement expressly states otherwise:

(1) The electing party is free to take or not take the action, with a view solely toward its own interests and desires as it perceives them.

(2) The electing party's action or inaction per se is to be conclusively deemed (i) to have complied with any applicable standard of reasonableness, good faith, or fair dealing, and (ii) not to be arbitrary, capricious, or irrational.

(b) No other party is to make any claim against an electing party that is inconsistent with sub­div­i­sion (a); this sub­div­i­sion (b), however, does not in itself preclude a claim by another party that an electing party took action in a particular manner that breached the Agreement or applicable law.

2.82 Specify Definition

Defining by example: Suppose that the Agreement states that a party P must take an action, but only if (elsewhere) the Agreement so "specifies" (whether or not the word specified is capitalized). In that situation, P must take the action if the Agreement clearly so indicates; the Agreement need not say so explicitly using those exact words.

Comment

This (experimental) definition is used in various places; the intent is to be a bit more accommodating (and forgiving) to drafters who might not use The Exact Magic Words.

2.83 Substantial Evidence Definition

Substantial evidence is more than a mere scintilla. It means such relevant evidence as a reasonable mind might accept as adequate to support a conclusion.

Comment

This commonly-used formulation is quoted verbatim from an opinion of the (U.S.) Supreme Court, Consolidated Edison Co. v. NLRB, 305 U.S. 197, 229 (1938).

2.84 Tax Definition

(a) The term tax, whether or not capitalized, refers to any tax, assessment, charge, duty, levy, or other similar governmental charge of any nature, imposed by any government authority.

(b) For the avoidance of doubt, the term tax does not encompass a price charged by a government authority for (i) services rendered, or (ii) goods or other assets sold or leased.

(c) Illustrative examples of taxes include the following, whether or not an obligation to pay the same is undisputed and whether or not a return or report must be filed:

(1) all taxes on income, gross receipts, employment, franchise, profits, capital gains, capital stock, transfer, sales, use, occupation, property, excise, severance, windfall profits, sick pay, and disability pay;

(2) all ad valorem, alternative minimum, environmental, license, payroll, registration, social security (or similar), stamp, stamp duty reserve, unemployment, value added, and withholding taxes; and

(3) all other taxes, assessments, charges, customs and other duties, fees, levies or other similar governmental charges of any kind whatsoever, together with

(4) all estimated taxes, deficiency assessments, additions to tax, fines, penalties, and interest.

Comment

This definition draws on:

  • the contract language quoted by the Court of Appeals of New York in Innophos, Inc. v. Rhodia, S.A., 10 N.Y.3d 25, 27-28 (2008). In that case, the state of New York's highest court upheld a summary judgment that a $20 million-plus water usage charge, levied by a Mexican government entity, was a "tax" within the meaning of the contract's laundry-list definition; and
  • section 3.5(e) of the Asset Purchase Agreement between Piper Jaffray Companies and UBS Financial Services, available at the SEC's EDGAR Web site and reproduced in David Zarfes & Michael L. Bloom, Contracts and Commercial Transactions (Wolters Kluwer Law & Business 2011).

See also 4.4.   Sales Taxes.

2.85 Taxing Authority Definition

The term Taxing authority, whether or not capitalized, refers to any government authority exercising de jure or de facto power to impose, regulate, or administer or enforce the imposition of taxes.

Comment

See also the commentary to 2.84. Tax Definition, as well as 2.32. Government Authority Definition.

2.86 Term of Agreement Definition

(a) The term of the Agreement begins on the Effective Date of the Agreement and continues until the end of the day on the end date (if any) specified in the Agreement.

(b) If no end date is specified, then the term continues indefinitely, subject to any provision for termination stated in the Agreement or by law.

(c) If an end date is specified, then the term will not be extended except:

(1) by written agreement of the parties; or

(2) if the Agreement clearly provides for its term to be extended, either (i) unilaterally or (ii) on an automatic, "evergreen" basis.

2.87 Time (of day) Definition

Unless clearly stated otherwise:

(1) Any reference to the time of day indicates the exact time. Hypothetical example: The term "5 p.m." refers to exactly 5:00:00.00 p.m.

(2) References to midnight on a stated day are to 12:00:00.00 midnight at the end of that day.

Comment

For a really in-depth discussion about the significant of the time of day, see generally two Ken Adams blog postings and their comments:

  • March 20, 2015;
  • March 9, 2009, where Ken discusses two Canadian cases where this issue arose in the context of disputes whether contract bids had been timely submitted; the two courts reached opposite results:
    • First was Smith Bros. & Wilson (B.C.) Ltd. v. B.C. Hydro, 30 BCLR (3d) 334, 33 CLR (2d) 64 (1997): A company's bid for a construction contract was time-stamped as having been submitted at 11:01 a.m.; the deadline was 11:00 a.m. Technical analysis indicated that the time clock was fast, and that the actual time of the bid submission was sometime between 11:00 a.m. and 11:01 a.m.. The British Colombia supreme court held that the bid was untimely.
    • In contrast was Bradscot (MCL) Ltd. v. Hamilton-Wentworth Catholic District School Board, 42 O.R. (3d) 723, [1999] O.J. No. 69. In that case, the contract bids were due no later than 1 p.m. The winning bid was submitted at 1 p.m. and 30 seconds. The Ontario court of appeals held that the bid was timely submitted because the clock had not yet reached 1:01 p.m.

2.88 Timely Definition

An action is timely (whether or not the word is capitalized) if the action is taken at or within the time agreed or, if no time is agreed, at or within a reasonable time.

Comment

This definition is the same as that of seasonably in 2.76. Seasonable Definition. It allows drafters to use timely as a synonym for seasonably. (Many modern readers seem not to be familiar with the latter term.)

2.89 Toolkit Item Definition

(a) The term Toolkit Item refers to any concept, idea, invention, strategy, procedure, architecture, or other work, that:

(1) is, in whole or in part, created by a service provider in the course of providing services to a customer; but

(2) is not specific, and/or is not unique, to the customer and its business.

(b) For the avoidance of doubt, the term Toolkit Item does not encompass Confidential Information of the customer.

Comment

Sub­div­i­sion (a) relates to the ownership of intellectual-property rights in services deliverables.

2.90 Trademark Definition

(a) Unless otherwise clear from the context, for purposes of this Article, the term Trademark, whether or not capitalized, refers to trademarks, service marks, and trade names.

(b) As non-limiting illustrations: Things that can function as trademarks, alone or in combinations, include, for example:

brand names;

two- and three-dimensional designs;

domain names;

sounds;

colors;

color combinations;

aromas;

tastes;

logos.

Comment

See generally, e.g.:

2.91 Tribunal Definition

(a) Tribunal, whether or not capitalized, refers a panel of one or more neutral officials, where:

(1) one or more parties prsents evidence or legal argument or both to the panel; and

(2) thereafter, the panel renders a binding legal judgment that directly affects the interests of one or more parties in the matter in question.

(b) Examples of tribunals include a court, an arbitral tribunal, or an administrative agency or legislative body acting in accordance with sub­div­i­sion (a).

Comment

This definition is adapted from proposed amendments to Rule 1.00(u) of the 2010 proposed amendments to the Texas Disciplinary Rules of Professional Conduct [for lawyers]. (The proposed amendments were rejected in a referendum for unrelated reasons.)

2.92 USD Defintion

The term USD refers to U.S. dollars.

Comment

"USD" is the ISO 4217 standard abbreviation for U.S. dollars; it is used to distinguish U.S. money from other currencies called dollars.

2.93 "Will" Means "Must" Definition

Unless the context clearly and unmistakably requires otherwise, terms such as "Party A will take Action X" mean that Party A is required to take Action X"; likewise, "Party B will not take Action Z" means that Party B is prohibited from taking Action Z.

Comments
A court might interpret will as meaning optional

The Common Draft definition of /will/ can be useful because "Party A will take Action X" can mean at least two different things:

  • Party A anticipates taking Action X in the future; or
  • Party A contractually commits to taking Action X in the future.

Bad things could happen if a court were to read the term will in the "wrong" way.

For example: In a 2014 opinion, the Supreme Court of Texas ruled that the term will, in context, did not establish a contractual obligation, but merely stated the intent of one of the parties. As a result, a tenant was blocked from suing its government landlord for breach of contract. The court said: "The dissent acknowledges that the word 'will' has many possible meanings depending on the context, but determines that the context here indicates a promise to provide a 'ticketing service.' … Within this context, we read the provision as expressing the parties’ acknowledgment of Church & Akin’s intent to issue tickets, not as a contractual promise to do so." See Lubbock County Water Control & Improvement Dist. v. Church & Akin, L.L.C., 442 S.W.3d 297, 306 n.10 (Tex. 2014) (reversing court of appeals and dismissing claim for want of jurisdiction) (emphasis added, internal quotation marks modified).

A dissenting justice disagreed, arguing that "[The majority's] reading of the contract flouts the wording of the contract, which states the marina will provide the ticketing service. In this context, 'will,' although it has many possible meanings depending on context, here indicates a mandatory requirement." Id. at 310-11 (Willett, J, dissenting) (emphasis in original, footnote omitted). In a footnote, the dissent quoted Webster's Third New International Dictionary 2617 (3rd ed. 1961) for the proposition that "will" may be "used to express a command, exhortation, or injunction." Id. at 311 n.8.

Similar disputes might be avoided if the term will is defined as meaning must. In many cases that might well be overkill, but it also might be one of those situations where a few extra words can be cheap insurance against a creative trial counsel.

Use shall instead of will?

Conceivably, the result in Lubbock County might have been avoided by using shall instead of will in the contract language. My friend Professor Tina Stark thinks that contract obligations should always be signaled by shall, not by will. See generally Tina L. Stark, Drafting Contracts: How and Why Lawyers Do What They Do ch. 13 & § 10.2.1 (2d ed. 2014). So too does Ken Adams; see generally his A Manual of Style for Contract Drafting (3d ed. 2013); a Google search will help the reader to find Ken's various on-line postings about shall versus will.

Even so, I still prefer using the term will, not shall, for contract obligations, because:

• Contracts should be in plain, contemporary English wherever possible; the term shall, though, carries with it the faint whiff of musty, archaic legalese. (When I read sentences such as Party a shall take Action X, it makes me think of my late grandmother; when I was a child, she'd say things such as, "I shall have a cup of tea.")

• The term will has a more-collaborative feel to it, and less of a master-servanty tone, than shall. That, I think, can provide just a smidgen of help in establishing a cooperative attitude among the parties, which can be important to a successful long-term relationship or even to just a one-shot transaction.

• From a sales-psychology perspective, will is softer and more deferential; it pays the customer the respect of (implicitly) acknowledging that the customer can walk away at any time before signature.

See also the commentary to 2.78. "Shall" Definition.

2.94 Willful Definition

(a) Basic definition: The term willful (and its variant spelling wilful), in the context of action or conduct — for example, willful act or willful action or willful conduct or willful misconduct or willful neglect) — refers to action or conduct as to which it is shown, by clear and convincing evidence, that:

(1) the party that engaged in the action or conduct (the "actor") specifically intended to cause a particular consequence;

(2) the consequence was unlawful;

(3) the actor knew or should have known that the consequence was unlawful; and

(4) the action or conduct was not privileged.

(b) Failure to act is included: For the avoidance of doubt, for purposes of determining willfulness, the terms act, action, and conduct include one or more failures to act.

(c) Exclusions: For the avoidance of doubt, the term willful, in the context of action or conduct, does not encompass:

(1) efficient breach of contract; nor

(2) otherwise-lawful action or conduct where the actor intended at least in part to advance its own lawful interests.

Comments
Language origins

This definition is based on that of New York law. If the definition ever becomes relevant, it might well be in connection with a carve-out to a limitation of liability.

Even without this definition, if New York law applied, a court might hold that the the term willful in such a carve-out had approximately the meaning stated in this clause — but it doubtless would cost the parties a lot of money in legal fees to get to that result.

U.S. Supreme Court precedent

In a federal bankruptcy case, a physician had been held liable for malpractice after his patient had to have her leg amputated because of infection caused by the physician's discontinuance of antibiotics. The physician filed for bankruptcy protection. The question before the court was whether the malpractice judgment was ineligible for discharge under the statutory exceptions for "willful and malicious injury by the debtor …." the U.S. Supreme Court noted that:

The word "willful" in [§ 523](a)(6) [of the Bankruptcy Code] modifies the word "injury," indicating that nondischargeability takes a deliberate or intentional injury, not merely a deliberate or intentional act that leads to injury. Had Congress meant to exempt debts resulting from unintentionally inflicted injuries, it might have described instead "willful acts that cause injury. … [The] more encompassing interpretation could place within the excepted category a wide range of situations in which an act is intentional, but injury is unintended, i.e., neither desired nor in fact anticipated by the debtor."

The Court held that, because the malpractice judgment was based on negligence or recklessness, and not on intentional misconduct, the judgment was dischargeable in bankruptcy. See Kawaauhau v. Geiger, 523 U.S. 57, 61-62 (1998) (affirming court of appeals).

Exclusions from "willful"

Consider the situation in Metropolitan Life Ins. Co. v. Noble Lowndes Int'l, Inc., 84 N.Y.2d 430, 643 N.E.2d 504, 618 N.Y.S.2d 882 (1994) (affirming Appellate Division's reversal of trial court's judgment). This was a case in which:

• A customer, in this case an insurance company, bought a license to use a software package and engaged the software supplier to make custom modifications.

• As sometimes happens in such cases, the customer ended up wanting more modifications than the software supplier thought were called for by the contract.

• The customer refused to agree to a price increase.

• The supplier walked away from the contract.

• The customer sued the software supplier.

• The supplier responded to the lawsuit, in part, by asserting that it was protected by two limitation of liability provisions in the contract. One provision precluded the customer from recovering, among other things, "lost savings." the other provision was a damages cap that limited the customer's total monetary recovery to the amount it had paid the supplier.

• The contract, however, also included a carve-out from those limitation provisions, for cases of "intentional misrepresentations, or damages arising out of [defendant's] willful acts or gross negligence" (emphasis and alteration marks by the court).

• The customer claimed that the supplier's abandonment of the contract constituted a "willful act," and therefore the supplier should be fully liable for breach.

• The jury agreed with the customer, and found the software supplier liable for $3.9 million — nearly ten times the contract price — with $2.8 million of that being "lost savings."

• The intermediate appellate court reduced the award to the amount of the damages cap (plus interests, costs, and disbursements). The court's rationale was that in context, the term willful act referred to acts constituting the commission of a tort, and not to intentionally refusing to perform its contractual obligations.

The Court of Appeals of New York (that state's highest court) affirmed the appellate court, albeit on slightly different grounds:

… The issue is what the parties intended by "willful acts" as an exception to their contractual provision limiting defendant's liability for consequential damages arising from its "non-performance under this agreement". * * *

Repeatedly throughout their Agreement here, the parties agreed to shift to plaintiff the risk of a substantial portion of any economic loss caused by defendant's nonperformance by excluding plaintiff's right of recovery of consequential damages such as those it now claims. * * *

In excepting willful acts from defendant's general immunity from liability for consequential damages …, we think the parties intended to narrowly exclude from protection truly culpable, harmful conduct, not merely intentional nonperformance of the Agreement motivated by financial self-interest. Under the interpretation tool of ejusdem generis applicable to contracts as well as statutes, the phrase "willful acts" should be interpreted here as referring to conduct similar in nature to the "intentional misrepresentation" and "gross negligence" with which it was joined as ex­cep­tions to defendant's general immunity from liability for consequential damages.

We, therefore, conclude that the term willful acts as used in this contract was intended by the parties to subsume conduct which is tortious in nature, i.e., wrongful conduct in which defendant willfully intends to inflict harm on plaintiff at least in part through the means of breaching the contract between the parties.

As thus defined, limiting defendant's liability for consequential damages to injuries to plaintiff caused by intentional misrepresentations, willful acts and gross negligence does not offend public policy.

Metropolitan Life, 84 N.Y.2d at 435, 438 (emphasis and extra paragraphing added, citations omitted).

Workmanlike definition (cross-reference)

2.95 Writing & Written Definition

Writing and written, whether or not capitalized, refer to any tangible or electronic record of a communication or representation. The terms encompass, for example, handwriting, typewriting, printing, photocopying, photography, audio or video recording, and e-mail.

Comment

Portions of this definition are adapted from proposed amendments to Rule 1.00(v) of the 2010 proposed amendments to the Texas Disciplinary Rules of Professional Conduct [for lawyers]. (The proposed amendments were rejected in a referendum for unrelated reasons.)

3   Major Business Provisions

3.1   Services

3.1.1 Definitions: Provider, Customer

(a) Provider refers to: Any party that provides services, where the services are governed by the Agreement.

(b) Customer refers to a party or parties to which the services referred to in sub­div­i­sion (a) are provided.

Comment

The definitions of both Provider and Customer are set up to allow a drafter to simply incorporate this by reference ("grab and go").

CAUTION: Drafters should consider whether there might be a dispute about whether particular services performed by a provider are "governed by the Agreement" — conceivably there might be circumstances in which one party or another claims that particular services were, or were not, so governed.

3.1.2 Statements of Work Ground Rules

3.1.2.1 Exclusive Services Obligations in Statements of Work

(a) The only obligations of Provider to perform services under the Agreement (Services), and the only obligations of Customer to pay for Services, will be as set forth in one or more written statements of work, each signed by Provider and Customer (each, a Statement of Work or SOW).

(b) The Agreement itself may contain a Statement of Work in its provisions, in an exhibit, in an appendix, etc.

Comment

It's extremely common for services agreements to separate the "technical" details of a services contract in a statement of work.

Caution: Some contract reviewers make the mistake of ignoring statements of work, on the sometimes-mistaken assumption that only "technical" information is to be found there. It's a worthwhile exercise for a contract drafter or reviewer (here, "reviewer") at least to glance through any statement of work, because:

  • the reviewer will be better able to negotiate the terms and conditions if she has some idea of the technical details; and
  • perhaps unconsciously — or perhaps not unconsciously — the other side's drafter might have included important "legal"-type terms and conditions in the statement of work, in the hope that the contract reviewer might overlook them.
3.1.2.2 No Obligation to Agree to Statement of Work

For the avoidance of doubt, no party is obligated to enter into or agree to any particular Statement of Work under the Agreement except to the extent (if any) that the Agreement expressly states otherwise.

Comment

This section is intended to rule out claims by a contractor that a customer implicitly guaranteed that the contractor would get X amount of work. This was litigated in a case by a small contractor against, I believe, IBM; if memory serves, IBM won the case on summary judgment, but it still had to defend against the claim. (Unfortunately I can't find a citation.)

3.1.2.3 Requirement for Written Changes to Statements of Work

No change to a Statement of Work — including, for example, to its specification of the scope, cost, or schedule of Services or Deliverables — will be binding unless set forth in a writing signed by the party sought to be bound; each party specifically agrees not to assert the contrary.

Comment

Both parties often want to require that changes to statements of work must be in writing, but it's not clear that a court would enforce it – see the discussion in the commentary to 9.1. Amendments in Writing.

3.1.2.4 Terms re Statements of Work as Separate Agreements

Each Statement of Work is to be treated as a separate agreement that incorporates the Agreement by reference, whether or not the incorporation is expressly stated.

Comments

This provision states that each statement of work is a separate agreement. In contrast, some services contracts purport to incorporate each statement of work into the "main" agreement, so that each statement of work becomes part of the main agreement. This is unwise, in my view, because:

  • a default in one statement of work could affect other statements of work (this is sometimes referred to as "cross-default"); and
  • if the vendor's liability for damages were to be capped at "the amounts paid under the Agreement," then that amount would grow over time as more statements of work were completed; the customer might like that just fine, but the vendor likely wouldn't be wild about the idea.
3.1.2.5 Precedence of Statements of Work

In the event of a conflict or other inconsistency between a Statement of Work and the Agreement, the Statement of Work will take precedence, but only if it says so explicitly and conspicuously in the top half of its first page.

Comments

Not without reason, some corporate legal departments want to maintain tight control over contract-related documentation; they don't want statements of work — which might not be reviewed by "Legal" and could raise all kinds of legal issues — to supersede the contract provisions. (To paraphrase a private remark by a lawyer who shall remain nameless, I keep trying to make my master services agreements idiot-proof, but they keep making better idiots.)

That approach, though, can conflict with the way parties actually do business and could delay getting things done.

This provision attempts a compromise, namely to allow a statement of work to override the terms of a master agreement — but the parties must be explicit about it.

3.1.2.6 Electronic Signatures for Statements of Work

Statements of Work may be signed electronically.

Comment

Some companies are reluctant to allow electronic signatures for statements of work — because of the wide variety of communications that might qualify as "signatures," for example, emails — and instead prefer to require "wet ink" signatures on paper.

3.1.3 Permits and Licenses Responsibilities

3.1.3.1 Provider Responsibilities

Provider, at its own expense, will cause to be timely obtained:

(1) any professional- or occupational licenses required by law for the performance of services generally (e.g., contractor licenses) by Provider and/or its subcontractors (if any) to the extent necessary for performance of the Services;

(2) any government permits (for example, building permits and the like) that are required by law for performance of the Services; and

(3) any third-party intellectual-property licenses required for Provider to take the specific actions involved in performing the Services, including, for example, any such licenses required for Provider's use of software, data compilations, and similar tools.

Comments
Caution: Starting licensed work without a license may cost big bucks

In California, a contractor that undertakes work required to be done by a licensed contractor (e.g., certain construction- or remodeling work), but that does not itself have the proper license(s) at all times while performing the work, may forfeit its right to be paid for any of the work. See, e.g., Great West Contractors, Inc., v. WSS Industrial Construction, Inc., 162 Cal. App. 4th 581, 76 Cal. Rptr. 3d 8 (2d Dist. 2008) (reversing $220,000-plus judgment in favor of subcontractor, on grounds that subcontractor had not obtained the required license when it prepared initial shop drawings and did other preliminary work).

Moreover, under a 2002 'disgorgement' amendment to the California statute, such a contractor might have to repay any payments it did receive for the work. Cf. The Fifth Day, LLC v. Bolotin, 72 Cal. App. 4th 939 (2d Dist. 2009) (reversing summary judgment that party was barred from recovering compensation for services; party was not a "contractor" within the meaaning of the statute).

Caution: Using an unlicensed subcontractor can lead to liability for wages, etc.

California courts have looked to Cal. Lab. Code § 2750.5 to hold that a contractor that uses an unlicensed subcontractor is responsible for unpaid wages, withholding, and worker’s compensation premiums of the subcontractor’s employees; see generally this Pillsbury Winthrop memo.

Other notes

Sub­div­i­sion (2): In some circumstances — building a natural-gas pipeline comes to mind — the government-permitting process could be a decidedly non-trivial matter.

Sub­div­i­sion (3): Note that this is a different subject than IP licenses needed for Customer's use of deliverables, discussed below.

3.1.3.2 IP Licenses for Customer's Use of Deliverables

(a) Except as stated in sub­div­i­sion (b), as between Provider and its subcontractors (if any) on the one hand, and Customer on the other hand, it is Customer's exclusive responsibility to obtain any licenses or other authorizations required for Customer's use of the Deliverables.

(b) Sub­div­i­sion (a) does not apply to the extent that Provider expressly warrants that Customer's use of Deliverables will not infringe any third-party intellectual-property rights.

Comment

Even if the Agreement includes a warranty that Deliverables per se do not infringe third-party IP rights, that might not provide Customer with much comfort about third-party infringement claims arising from Customer's use of the Deliverables. In the U.S., cf. UCC § 2-312, which provides in part that:

(3) Unless otherwise agreed a seller who is a merchant regularly dealing in goods of the kind warrants that the goods shall be delivered free of the rightful claim of any third person by way of infringement or the like but a buyerwho furnishes specifications to the seller must hold the seller harmless against any such claim which arises out of compliance with the specifications.

3.1.3.3 Procedure for Disagreements About Permit- and License Requirements

IF: Provider advises Customer in writing that a particular third-party approval, of any kind, may be necessary for Provider to perform some or all of the Services;

AND: Customer responds in writing that, in Customer's view, the approval in question is not required to proceed with the portion of the Services in question;

THEN: Provider will not be in breach of the Agreement or the relevant Statement of Work if, by written notice to Customer, Provider suspends work, temporarily or indefinitely, on the relevant portion of the Services.

Comment

Suppose that Provider believes that (let's say) performance of the Services would infringe a third party's patent rights, but Customer disagrees. Provider might want to:

See also the indemnity option for permits.

3.1.3.4  ? Indemnity Obligation for Permits and Licenses 

Any party obligated to obtain permits and licenses under the Agreement will defend and indemnify each other party against any third-party claim arising from the party's failure timely to carry out that obligation.

Comment

See:

Keep in mind that damages for breach of a contractual obligation would normally be limited to foreseeable damages, whereas an indemnity obligation might encompass even unforeseeable damages (unless otherwise specified in the indemnity language); see this note for additional details.

3.1.4 Services Performance Obligation

3.1.4.1 Workmanlike Performance

Provider will cause all Services to be performed:

(1) in a workmanlike manner — this refers to a manner that generally would be considered proficient by those who successfully engage in the relevant trade or profession, without necessarily rising to the level of being exceptional, outstanding, or original; and

(2) in accordance with any additional requirements of performance, timeliness, or both, stated in the Statement of Work.

Comment
Business context

The performance-related provisions of services contracts are sometimes intensely negotiated. Customers can sometimes want very-demanding performance requirements (often because they've been "burned" before by poor performance). This provision requires the performance of services not only to meet the Performance Standard, but also to meet any timeliness requirements of the Statement of Work.

Language notes

This performance-requirement language sets forth a covenant, that is, a promise, and not a representation or warranty – although a warranty is a type of covenant (specifically, a conditional covenant); see Black's Law Dictionary at 1725 (9th ed.2009), quoted in Fed. Ins. Co. v. Winter, 354 S.W.3d 287, 293 (Tenn. 2011).

The "considered proficient" language comes from a decision by the Supreme Court of Texas, discussing the implied warranty of good and workmanlike quality of services in connection with the repair of tangible goods. See Melody Home Mfg. Co. v. Barnes, 741 S.W.2d 349, 354 (Tex. 1987), quoted in Ewing Constr. Co. v. Amerisure Ins. Co., 420 S.W.3d 30, 37 (Tex. 2014) (responding to certified question from Fifth Circuit).

The "without necessarily rising to the level of being exceptional, outstanding, or original" language is adapted from an alternate definition in the Merriam-Webster dictionary, namely "competent and skillful but not outstanding or original."

What does "workmanlike" mean?

The term workmanlike, defined in a Common Draft provision, seems to be widely used in court decisions, sometimes as "skillful and workmanlike" (which would be redundant). See generally Fed. Ins. Co. v. Winter, 354 S.W.3d 287, 292-93 (Tenn. 2011) (extensively reviewing case law and treatises).

Implied warranties of workmanlike performance

Drafters should be aware that in some states the law might automatically impose a warranty of workmanlike performance, or something close to it. See, e.g., Fed. Ins. Co. v. Winter, 354 S.W.3d 287, 291-94 (Tenn. 2011) (citing numerous authorities but not defining workmanlike).

Implied warranties of workmanlike performance come into play especially in connection with the sale of a new residence. The imposed warranty might even be non-waivable and/or non-disclaimable. For example:

  • Home construction: Forty-three states provide an implied warranty of habitability for new residences, according to the Utah supreme court, while three others provide a warranty of workmanlike manner. See generally Davencourt at Pilgrims Landing Homeowners Association v. Davencourt at Pilgrims Landing LC 30, 2009 Utah 65, 221 P.3d 234, 250 (reversing dismissal of implied-warranty claim; "in every contract for the sale of a new residence, a vendor in the business of building or selling such residences makes an implied warranty to the vendee that the residence is constructed in a workmanlike manner and fit for habitation").
  • Repairs of tangible goods or property: In its Melody Homes decision, cited above, the Texas supreme court held that an implied warranty of good and workmanlike performance extends to repairs of tangible goods or property. Two sharp dissents (in the form of concurrences in the judgment) noted that the court had defined that implied warranty in a manner that might well require expert testimony in many cases (but that would seem to be true of almost any standard of performance of services).

See also 3.19.3.  ? Implied Warranty Disclaimer and its associated commentary.

Alternative performance standards

Some service providers might balk at using the term "workmanlike" performance because they fear the term could be ambiguous. They might prefer in accordance with the specifications, or perhaps competent and diligent.

Of course, any of those terms is likely to involve factual determinations in litigation or arbitration, so it's hard to see how one is more- or less favorable than the other.

On the other hand, some customers prefer stricter standards of performance such as, for example:

  • In a professional manner: This is found in many customer-oriented forms, but providers don't like it because of a concern that, in the minds of judges and juries, the term professional might subtly raise the bar of expected performance.
  • In accordance with industry standards: This phrase and workmanlike seem synonymous, in which case the latter term is more conventional and more likely to find acceptance among contract reviewers and the courts.
  • In accordance with the highest professional industry standards: For a provider, this is the worst of all worlds: Not only is the phrase vague, but a provider that agrees to this might as well hang a "Kick Me" sign on its own back, because anything less than perfection would be open to cricitism in court. (On a related note, see also the discussion of best efforts.)
Performance standards: Further reading

See generally, e.g.:

3.1.4.2 All Necessary Tasks and Materials

Without limiting section 3.1.4.1: Except to the extent (if any) provided otherwise in the Agreement and/or in the Statement of Work, Provider will cause the following to be done at no additional expense to Customer:

(1) the performance of all individual tasks necessary for the proper rendering of the Services set forth in the Statement of Work, even if one or more such individual tasks is not expressly set forth there; and

(2) the provision of all materials, equipment, supplies, computer hardware and -software, work locations, electrical power, Internet- and other communications capability, and other items needed for Provider's performance of the Services — this obligation includes any necessary acquisition, installation, and maintenance of all such items.

Comment

For some services projects, it might make sense for Customer to provide some of the listed items. If so, that should be documented in the Statement of Work.

Sub­div­i­sion (2): Some customers are likely to want this language for comfort purposes. A provider might be concerned that such language could lead to disputes about expensive (and delay-causing) "scope creep"; my own guess, though, is that this language wouldn't do any significant harm. Here's why: Suppose the parties were to end up fighting about the scope of what the provider is supposed to do. In that case, the presence or absence of this language seems unlikely to make a difference one way or the other. So, if this language gives a customer some comfort, why not include it; doing so can help to remove a potential delay on the path to signature.

3.1.4.3 Provider Control of Means and Manner

As between Provider and Customer, Provider will at all times have the exclusive right and the exclusive obligation to control:

(1) the means and manner, and

(2) except as specified otherwise in the Statement of Work, the time and place,

of the performance of the Services.

Comment

See the commentary to the independent-contractor provision(s).

3.1.4.4 Defects

Provider will address any defects in Services, or in Deliverables as delivered by or on behalf of Provider, in accordance with section 3.4.

Comment

The "as delivered" phrase takes into account the possibility that the customer might modify a Deliverable after delivery, in which case the provider likely won't want to have to fix defects for free if the defect was not the provider's doing.

3.1.4.5 Limitation on Provider Use of Customer Confidential Information

Under the Agreement, Provider:

(1) will not obtain any ownership of Customer's confidential information or other intellectual property as a result of performing the Services; and

(2) may not utilize Customer's confidential information or intellectual property, EXCEPT that Provider may do so solely to the extent necessary for performance of the Services.

Comment

This is a "comfort" clause intended to reassure the customer.

3.1.4.6 Notification of Bodily Harm or Significant Property Damage

IF: Any injury to person or significant property damage occurs in connection with the Services; THEN: Provider will promptly:

(1) notify Customer;

(2) respond orally to any reasonable inquiry by Customer and/or Customer's agents concerning the event(s) in question; and

(3) if so requested by Customer, provide Customer or its designee with a non-privileged report of the event(s).

Comment

The idea for this provision came from negotiation of a services agreement used by a company in the oil-and-gas industry.

3.1.4.7 Provider Cooperation With Other Customer Contractors

(a) If so requested by Customer, Provider will provide reasonable cooperation with other contractors of Customer in their provision of goods or services for Customer.

(b) The obligation of sub­div­i­sion (a) is not to be interpreted as, in itself, requiring Provider to do any of the following:

(1) share its confidential information with other contractors;

(2) license its proprietary technology (if any) to other contractors;

(3) perform services not within the scope of the Statement of Work;

(4) take or omit any action where (i) doing so is not required by the Statement of Work, and (ii) a non-trivial risk exists that doing so would increase Provider's cost of complying with the Statement of Work.

Comment

Providers should keep an eye out for areas in which this obligation could (i) cause disputes about the scope of Provider's obligations under the statement of work, or (ii) lead to finger-pointing if things were to get messed up.

3.1.4.8  ? Customer Option to Perform Services Itself

(a) Customer may elect to perform itself some or all Services (the Elected Services).

(b) Provider will provide reasonable cooperation with Customer in Customer's performance of the Elected Services if Customer so requests.

(c) As between Provider and Customer, Customer will be solely responsible for the performance of all Elected Services.

(d) Any failure of timely performance of the Elected Services is to be taken into account in determining whether Provider is liable for failure to timely perform other Services that are dependent on the Elected Services.

(e) For the avoidance of doubt, this section does not in itself require Provider to share its confidential information with, nor to license its proprietary technology (if any) to, Customer.

Comment

This language could lead to finger-pointing if — as not-infrequently happens — things start to go wrong, work gets delayed, costs increase, etc.

3.1.4.9   Limitation of Customer Liability for Hindering Performance

(a) This section applies if Customer, directly or indirectly, delays, obstructs, disrupts, or hinders the performance of the Services (collectively, Customer Hindrance).

(b) Except to the extent (if any) that the Agreement expressly provides otherwise, in sub­div­i­sion (c) or elsewhere:

(1) Provider will not be entitled to damages for any Customer Hindrance, of reasonable duration, that was within the reasonable contemplation of the parties;

(2) Provider will not make any claim for monetary relief in respect of any such Customer Hindrance; and

(3) Provider's EXCLUSIVE REMEDY for any such events will be an extension of time to complete Provider's performance, of a duration sufficient to compensate for the Customer Hindrance.

(c) For purposes of sub­div­i­sion (b)(1), denial of job-site access by Customer is not within the reasonable contemplation of the parties unless the denial of access is:

(1) expressly contemplated by the Agreement or otherwise agreed in writing by the parties;

(2) required in case of genuine emergency; or

(3) in accordance with clearly-established and clearly-applicable standard practice.

(d) For purposes of sub­div­i­sion (b)(1), willful misconduct and reckless- or grossly-negligent conduct by Customer or its agents are not within the reasonable contemplation of the parties.

Comment

This optional provision immunizes Customer if it gets in Provider's way; the provision adapts ideas from:

  • C and E Elec., Inc. v. Town of Bethel, No. SC 19162 (Conn. Aug. 5, 2014), in which the state supreme court affirmed rejection of an electrical contractor's claim for additional costs incurred during its work at a school due to interference from ongoing asbestos abatement at the school;
  • Jeff Yick, No Damage for Delay (MDCSystems.com, undated), which contains numerous case citations and discussions; and
  • Daniel J. Kraftson, No-Damage-for-Delay Contract Clauses (KraftsonCaudle.com, undated), which discusses numerous specific examples of Customer-caused delays.

Drafters should consider including "active interference" by Customer as among the carve-outs to the no-damages-for-delay clause; see generally the discussions in the Yick and Kraftson articles cited above.

In some jurisdictions, though, such a carve-out might be unnecessary, because the majority rule in the U.S. appears to be that, for public-policy reasons, no-damages-for-delay clauses are unenforceable with respect to delays resulting from deliberate and wrongful interference. See Zachry Constr. Co. v. Port of Houston Auth., 449 S.W.3d 98 (Tex. 2014) (reversing court of appeals, with extensive case citations). In that case, the Texas supreme court joined the majority view, although four of its nine justices dissented on other grounds, namely that governmental immunity barred recovery of such damages in that particular case.

3.1.4.10   Restrictions on Suspension of Work 

In no event may Provider suspend or terminate performance of the Services except as expressly provided in the Agreement or in the relevant Statement of Work.

Comment

This language ties up a potential loose end in an American Institute of Architects contract form, the relevant clause of which was litigated in U.W. Marx, Inc. v. Koko Contracting, Inc., 124 AD 3d 1121 (N.Y. App. 2015).

3.1.4.11   Presumption of Proper Performance

A performance of Services that conforms to the express requirements of the Agreement (including for example those set forth in the relevant Statement of Work, if applicable) is presumed to have met the Performance Standard; overcoming that presumption as to particular Services requires a showing that those Services were negligently performed.

Comment

The presumption of satisfactory performance comes from Coulson v. Lake LBJ Mun. Utility Dist., 734 S.W.2d 649, 651 (Tex. 1987) (reversing and remanding court of appeals's setting aside of judgment on jury verdict in favor of defendant service provider).

3.1.5 Services Billing Ground Rules

3.1.5.1 Billing Requirements

Billing for Services is to be:

(1) as specified in the Statement of Work (if applicable);

(2) accompanied by supporting detail sufficient to document the invoiced charges; and

(3) in accordance with 4.1.1. Payment Terms.

3.1.5.2  ? Option to Suspend Work for Nonpayment

IF: Customer does not pay Provider an amount due under the Agreement within seven days following the original payment due date (the Nonpayment Grace Period; AND: The nonpayment is not due to fault attributable to Provider; THEN:

(1) Provider may suspend its performance of the relevant Services at any time beginning at the end of seven days following notice of suspension (the Required Suspension Notice Period), without prejudice to Provider's other remedies for the nonpayment; and

(2) The price of the relevant Services is to be appropriately adjusted for account for Provider's reasonable costs, including for example those (if any) associated with:

(A) any resulting delay; and

(B) redeployment of personnel- and material resources in connection with (i) the suspension of work and (ii) any resumption of work.

Comment

This language is modeled on an American Institute of Architects contract form, which was litigated in U.W. Marx, Inc. v. Koko Contracting, Inc., 124 AD 3d 1121 (N.Y. App. 2015).

Drafters should consider providing for an independent expert to oversee and, if necessary, to decide the pricing adjustment in sub­div­i­sion (2).

See also 3.1.4.10.   Restrictions on Suspension of Work .

3.1.5.3  ? Requirement of Timely Payment as Condition of Customer's Rights

Customer's timely payment of any amounts required by the applicable Statement(s) of Work in respect of a particular Deliverable is a prerequisite to Customer's continued exercise of its rights in that Deliverable.

Comment

A customer likely will object to a clause like this; the customer will assert that a minor payment dispute should not call into question the customer's right to use the deliverable(s), possibly even disrupting an M&A transaction.

A provider, on the other hand, will legitimately be concerned that the customer might file for bankruptcy protection, meaning that the customer would continue to enjoy its rights in the deliverable(s) while paying the provider pennies on the dollar if anything.

In the U.S., as a compromise the provider might want: •

  • to take a security interest in the customer's right to use the deliverable(s), using a clause provision such as [TO BE DRAFTED]; and
  • to "perfect" the security interest by filing a UCC-1 financing statement.
3.1.5.4   Prohibition of Work Suspension for Payment Disputes

In no event may Provider suspend or terminate performance of the Services because of a payment dispute.

Comment

This language is modeled on § 2.5 of a 2008 outsourcing agreement between Boise Cascade, L.L.C., and Boise Paper Holdings, L.L.C.

3.1.6   [Reserved: Services indemnities]

3.1.7 Customer's Rights in Deliverable

3.1.7.1 Customer's Right to Use Deliverables

(a) Customer has the right to utilize any and all Deliverables in Customer's business as Customer sees fit, EXCEPT to the extent (if any) that the Agreement, or the relevant Statement of Work, expressly states otherwise.

(b) Customer's right under sub­div­i­sion (a) applies to any and all intellectual-property rights owned or otherwise assertable by Provider.

(c) Customer acknowledges that its right under sub­div­i­sion (a) might be subject to any applicable rights of third parties, for example intellectual-property rights, UNLESS Provider warrants otherwise in writing.

3.1.7.2 Option for Provider to Decline Support for Others' Modifications

(a) Provider may, in its sole discretion, decline to provide support for a Deliverable if Provider reasonably determines that the request for support arises from or relates to modification of the Deliverable by any individual or organization other than (i) Provider, or (ii) an individual or organization expressly authorized or directed in writing by Provider to make that modification of the Deliverable.

(b) This section neither authorizes nor prohibits Customer from modifying any Deliverable.

Comment

Providers will often be reluctant to take on any responsibility for deliverables that anyone else has "messed with."

3.1.7.3 Customer's Right to Further Develop Deliverables

(a) Customer may modify any Deliverable or have it modified by one or more third parties. For this purpose, "modify" includes, for example, development of improved or otherwise-revised or -altered versions of the Deliverable, including for example derivative works in the case of copyrightable works.

(b) Customer may not modify any Deliverable, nor cause or induce the same, in violation of:

(1) any restrictions imposed by law, for example export-controls laws that might preclude sending Deliverables (or technical information about them) to contractors in other countries; and

(2) Provider's intellectual-property rights not relating to the Deliverable(s) as delivered (if any) to the extent (if any) that such modification or further development is not authorized in writing by Provider. (This subdivision does not limit Customer's right to utilize the Deliverable as delivered by or on behalf of Provider pursuant to section 3.1.7.1)

Comment

Customers sometimes want the unfettered right to modify or further develop the deliverables furnished by the provider. Their general attitude can be summed up as: We paid for you to build this, so we should be able to do whatever we want with it.

A customer's right to modify Deliverables is not always a given, though. under standard intellectual-property law, just because a customer paid for a deliverable does not mean it necessarily gets to do whatever it wants with the deliverable. In particular, if the deliverable is a copyrighted work of authorship such as computer software, the provider might have the right to prevent the customer from modifying or inproving the deliverable without the provider's permission.

(In litigation the customer might be able to argue successfully that the provider implicitly granted the customer a license to do whatever it wanted with the deliverable; see, e.g., TO DO: CITATION TO SOFTWARE DEV. CASES NEEDED.)

If a provider will be creating something that the customer will be using in its business, the customer might well want to nail down its right to modify or further develop the deliverable.

Some software-related deliverables, though, might include trade secrets of the provider. In that type of situation, the provider likely won't want any of its competitors to have access to the deliverables.

CAUTION: Subdivisions (a) and (b)(2) have been drafted to tr to avoid having them be inconsistent, but drafters should pay attention to that possibility.

3.1.7.4   Prohibition of Customer Service-Bureau Use of Deliverables

Customer may not use any Deliverable, nor knowingly assist or permit the use of any Deliverable, for service-bureau use, which refers to the providing of services to or for third parties where such services are comprised substantially of functions performed by one or more Deliverables.

Comment

A provider might want to prevent the customer from using the provider's own software, equipment, etc. to go into competition with the provider. (The provider should ask, though, how likely this is to happen, and whether the associated business risk is worth arguing about it with the customer.)

3.1.8 Ownership of Services-Produced IP

(a) As between Provider and Customer, unless the Agreement expressly provides otherwise, Provider (the IP Owner) will own the intellectual-property rights in and to:

(1) any Deliverables, and/or

(2) any Toolkit Items,

that may be created, in the performance of Provider's obligations under the Agreement, by one or more employees of Provider (and/or of Provider's subcontractors, if any).

(b) The provisions of 5.10.   Intellectual Property Ownership apply to all such intellectual-property rights; upon request by the IP Owner, the other party or parties will take the steps called for by that section.

(c) IF: Customer is the IP Owner under sub­div­i­sion (a); THEN: Provider will seasonably disclose to Customer, in writing and in detail, all intellectual property to be owned by Customer under sub­div­i­sion (a).

(d) IF: Provider is the IP Owner under sub­div­i­sion (a); THEN: Provider's ownership rights are subject to Customer's rights in the Deliverables under the Agreement.

Comment

Subdivision (a): Note the separation of ownership of the intellectual property contained in Deliverables versus IP in Toolkit Items.

It's not unusual for a big customer with barganing power to insist on owning the IP rights in any intellectual property that a smaller provider might create in the course of a services project. Such a customer's attitude is usually along the lines of, "if I pay for it, I own it."

Such a customer might want the right to sue third parties for infringing the IP rights in the Deliverables. If that were ever to be the case, it might be necessary for the customer to own the IP rights in order to establish the customer's standing to bring an infringement action. [CITATION NEEDED] In many cases, though, the customer really won't be especially concerned about third-party infringement, which would tend to negate that purported justification for demanding ownership of the IP rights.

Often a customer's insistence on IP ownership simply won't make business sense, because:

  • The provider's ability to do projects at a reasonable price will often depend on its ability to re-use its work product from its prior projects.
  • The customer's ownership could choke the provider's ability to compete in its market;
  • The customer might have no particular reason to own the IP, other than "I wanna."
  • The provider might not have standing to sue for infringement of the IP rights.

FALLBACK: If the customer persists in demanding outright ownership, the provider could propose that:

  • The customer's ownership of intellectual-property rights extends only to the specific Deliverables identified in the statement of work.
  • The provider has a permanent, irrevocable, worldwide, royalty-free license to use the IP for any and all purposes.

These would not be ideal for the provider, but could be an acceptable business risk.

3.1.9 Ground Rules for Termination of Statement of Work

3.1.9.1 Delivery of Work-in-Progress

Unless the Statement of Work provides otherwise, upon any termination of a Statement of Work, Provider is to promptly deliver to Customer all completed- and partially-completed Deliverables for that Statement of Work.

Comment

It's not unusual for a customer to "pull the plug" on a statement of work if the provider isn't getting the job done. In that situation, the customer likely will want to get as much finished- and partially-completed work product as it can, so that the customer will have the option of getting someone else to finish the job.

3.1.9.2 Payment for Completed Work

(a) Upon Customer's compliance with its obligations under section 3.1.9.1 after any termination of a Statement of Work, Customer is pay Provider as provided in the Statement of Work for all materials delivered under that section.

(b) IF: The Statement of Work specifies that payments are to be made based on meeting particular performance criteria, for example, milestone achievement; THEN: Provider will be entitled to payment only in accordance with the criteria actually and completely met as of the effective date of termination.

(c) IF: The Statement of Work is terminated for material breach by Provider; THEN: Customer's payment obligation under this section is to be adjusted (i) as agreed by the parties, or (ii) as determined by a tribunal of competent jurisdiction.

Comment

Subdivision (c) is likely to be important to a customer that "pulls the plug" because of (alleged) poor performance by the provider.

Drafters should consider requiring that disputes about amounts due must be resolved using 7.2.11. Baseball Arbitration Procedure.

{{{ADDLNOTES(Termination of statements of work)

DCT notes from an article in a State Bar of California publication:

Upon termination of a technology-related services agreement, the customer will generally want:

  • the right to obtain all its data in a usable form
  • transfers of equipment, software licenses, third-party contracts
  • the right to continue using Provider's proprietary technology
  • access to Provider personnel

See Blaine Green and Michael Murphy, Lessons from Litigating Technology Services Agreements (PillsburyLaw.com 2014).

Additional notes: Services

In services contracts, customers typically want:

  • for the obligations of service providers to be clearly specified;
  • to get what they're paying for; and
  • to shift as much responsibility and risk as possible onto the shoulders of the provider (and/or the provider's insurance carrier).

On the other hand, service providers typically want:

  • to prevent "scope creep" (sometimes known as "requirements creep" or "mission creep") from causing cost increases or delays;
  • to be free to re-use as much of their work product as they can for other work and other clients;
  • to limit their liability for errors; and
  • (of course) to get paid — on time, without having to bug the customer about it or fight out a dispute in court or arbitration.

3.2   [Reserved: Sales of goods]

3.3   [Reserved: Acceptance]

3.4   Defect Correction Procedure

3.4.1 Definitions: Provider; Customer; Defect

(a) Provider refers to a Signatory Party that, under the Agreement, is to provide goods or services to another party.

(b) Customer refers to a party to which Provider provides goods or services under the Agreement.

(c) Defect refers to any failure, by one or more deliverables or one or more services provided under the Agreement, to comply with agreed written specifications (for example, in the Agreement or in a purchase order or statement of work).

Comments

This language is set up in generic terms with a view to having this provision be serviceable even if a drafter doesn't fill in deal-specific details..

The definition of Defect is fairly standard. Notably, it does not include a materiality qualifier; the materiality of Defects can be addressed in other provisions.

3.4.2 Timely Defect Reporting

Provider's obligations in this section 3.4 apply to Defects that Customer reports in writing wtihin 60 days after delivery of the relevant deliverable or completion of the relevant service, as applicable (the Defect-Reporting Deadline).

Comments

Providers will want to establish a cutoff date for their defect-correction obligations.

Customers, of course, will want to make sure that the cutoff date is far enough ahead that defects are reasonably certain to become apparent.

3.4.3 Correction or Workaround

For any Defect reported in accordance with section 3.4.2, Provider — at its own expense — will do one or both of the following before 30 days after Customer's report of the Defect to Provider under sub­div­i­sion (a) (the Defect-Correction Deadline):

(1) correct the Defect, which may include repairing or replacing a defective deliverable and/or re-performing defective services; and/or

(2) deliver a commercially-reasonable workaround for the Defect if Provider reasonably determines the actions in sub­div­i­sion (1) to be impractical.

Comments

The concept of a workaround comes from the software world; it might or might not be relevant in other fields.

3.4.4 Backup Remedy: Refund of Defect-Related Payments

IF: Provider does not timely take the action or actions required by this section 3.4 in respect of any Defect; THEN: Unless the Agreement expressly states otherwise, at Customer's written request, Provider will promptly:

(1) cause a refund to be made of all amounts paid, by or on behalf of Customer, for the relevant deliverable(s) or service(s); and

(2) cancel any unpaid invoice calling for payment, by or on behalf of Customer, for those deliverable(s) and service(s).

Comments

This section states that Provider will "cause" a refund to be made; this language anticipates that Customer might have purchased the relevant goods or services via a reseller or other third party.

Providing the right to a refund as a "backup" remedy might be crucial in case other remedies fail.

  • Consider: UCC § 2-719(2) provides: "Where circumstances cause an exclusive or limited remedy to fail of its essential purpose, remedy may be had as provided in this Act."
  • UCC article 2 applies only to the sale of goods, of course, but courts have sometimes looked to article 2 for guidance in non-goods cases.)
  • In other words, if providing a correction or workaround for a defect is the customer's exclusive remedy, but the provider is unable to make good on doing so, then in some jurisdictions all limitations of liability might be out the window, including for example an exclusion of consequential damages or a cap on damages.

See, e.g., John F. Zabriskie, Martin J. Bishop, and Bryan M. Westhoff, Protecting Consequential Damages Waivers In Software License Agreements (2008).

For a now-dated student note reviewing case law in this area, see Daniel C. Hagen, Sections 2-719(2) & 2-719(3) of the Uniform Commercial Code: the Limited Warranty Package & Consequential Damages, 31 Val. U. L. Rev. 111, 116-18 (1996).

3.4.5 Policy re EXCLUSIVE REMEDIES for Defects

Provider's defect-correction obligations stated in section 3.4 are Provider's only obligations, and the EXCLUSIVE REMEDIES available to Customer (or any individual or organization claiming through Customer), for any defect in goods or other deliverables or in services.

Comments

Suppliers are very prone to include exclusive-remedy provisions like this in their terms of sale.

Under section 2-719 of the [U.S.] Uniform Commercial Code, a contract for the sale of goods can specify that a remedy is exclusive (but there are restrictions and exceptions to that general rule).

A real-world eample is BAE Sys. Information & Electr. Sys. Integration, Inc. v. SpaceKey Components, Inc., 752 F.3d 72 (1st Cir. 2014):

  • A vendor delivered lower-quality integrated circuits ("ICs") to a customer than had been called for by their contract.
  • The vendor had previously alerted the customer in advance that the ICs in question would not conform to the agreed specifications.
  • The customer accepted the ICs anyway. (The customer later asserted that it assumed the vendor would reduce the price.)
  • The customer refused to pay for the nonconforming ICs.
  • The vendor terminated the contract and sued for the money due to it.
  • The customer counterclaimed — but it did not first invoke any of the contract's specified remedies, namely repair, replace, or credit (as opposed to refund).

For that reason, the trial court granted, and the appellate court affirmed, summary judgment in favor of the vendor.

Additional notes: Defect correction

The provisions below represent a fairly-standard protocol for correction of software defects; it should also be useful in other contexts.

Some drafters might want to provide a schedule of different reporting deadlines for different categories of Defect, based on (for example) how long it might take for a particular category of Defect to become apparent.

CAUTION: To provide some protection for limitations of liability, providers should seriously consider including section 3.4.4 (refunds) in the Agreement, especially if they include section 3.4.5 (exclusive remedies).

3.5   Letter of Intent

Comment

Letters of intent can be quite dangerous, as discussed at length in the additional notes.

3.5.1 Final, Formal Agreement Prerequisite

(a) The parties are entering into a letter of intent, which is referred to here as "the LOI" (and which might be captioned as a memorandum of understanding or some similar title), for the following purposes:

(1) to set out the parties' agreed "ground rules" for their anticipated discussion concerning the potential transaction or relationship that is the subject matter of the LOI, referred to here as the Proposed Arrangement; and

(2) to provide the parties with a tentative, written summary of at least some aspects of their current thinking about the Proposed Arrangement, for use as a convenient reference.

(b) The parties currently intend, but are not making a binding commitment, to negotiate, sign, and deliver a final, integrated, definitive agreement that sets forth all material terms of the Proposed Arrangement (referred to here as an Arrangement Agreement).

(c) Each party acknowledges — with the intent that the other party rely on that acknowledgement in entering into the LOI — and expressly agrees not to assert otherwise:

(1) that the parties have not yet reached agreement on all material terms for the Proposed Arrangement;

(2) that in respect of the Proposed Arrangement, neither party will have any enforceable right against the other nor be bound by any obligation — whether the purported right or obligation allegedly arises in contract, tort, strict liability, quantum meruit, quasi-contract, or otherwise — other than those rights and obligations identified in the LOI as binding, if any — unless and until:

(i) all parties have signed and delivered an Arrangement Agreement, assuming one is agreed to; and

(ii) any other prerequisites stated in the LOI have been met; and

(3) that the other party would not go forward with discussions about the Proposed Arrangement but for the parties' acknowledgement above and the parties' agreement to these "ground rules."

Comment

Sub­div­i­sion (a) explains to a future reader — mainly, judges — why the parties are bothering to enter into a letter of intent instead of simply proceeding straight to drafting and negotiating an Arrangement Agreement.

Sub­div­i­sion (a)(1): The term "Proposed Arrangement" is borrowed from generally accepted accounting principles, which require "[p]ersuasive evidence of an arrangement" before revenue can be recognized.

Sub­div­i­sion (b): Concerning the "intent that the other party rely" language, see the discussion of reliance disclaimers.

Sub­div­i­sion (c)(2): For annotated examples of short- and long-form provisions that the parties might wish to indeed be binding, see American Bar Association Section of Business Law, Letters of Intent (Ancillary Document B to Model Stock Purchase Agreement, Second Edition), Part Two, at 10.

3.5.2 Preservation of Any Separate Confidentiality Agreement

For the avoidance of doubt, the LOI neither limits nor expands any separate confidentiality agreement that may exist between the parties.

Comment

Letters of intent often contain their own extensive confidentiality provisions, but sometimes parties enter into separate confidentiality agreements. See also the Common Draft confidentiality provisions.

3.5.3 Exclusivity (if Any) to Be Expressly Stated

Unless the LOI expressly states otherwise, the LOI is non-exclusive; each party is free to seek, discuss, negotiate, and/or enter into arrangements that are similar (or even identical) to the Proposed Arrangement, with other parties, even if as a result the party in question would no longer be willing or able to enter into the Proposed Arrangement.

Comment

In some LOIs, one or both parties might insist on an exclusivity provision; this should be negotiated carefully.

3.5.4 Option to Terminate Negotiations

Unless the LOI expressly states otherwise:

(a) No party is obligated to continue in negotiations for the Proposed Arrangement; any party may terminate or withdraw from such negotiations at any time unless, and until, an Arrangement Agreement is signed and delivered by all parties.

(b) For the avoidance of doubt, unless the LOI expressly states otherwise, a party that wishes to terminate or withdraw from negotiations may do so:

(1) in its sole discretion;

(2) with a view toward none but its own interests and desires; and

(3) without obligation or liability of any kind, under any legal- or equitable theory, to any other party.

Comment

Note the "optics" approach taken by sub­div­i­sion (b)(2), which specifically does not state that any obligation of good faith and fair dealing implied by law will not apply. Leaving aside whether such a statement would be enforceable, imagine how a judge or juror might react to the statement — or how it might look if reported in the newspaper.

Analogously, consider UCC § 1-302(b) (which applies only to contracts that come within the scope of the UCC): "The parties, by agreement, may determine the standards by which the performance of those obligations [of good faith, etc.] is to be measured if those standards are not manifestly unreasonable."

3.5.5 Good-Faith Obligations Deemed Satisfied

Each party is to be considered to have satisfied any applicable standard of good faith, fair dealing, or similar duty, in the negotiation of an Arrangement Agreement.

Comment

This provision tries to forestall a claim that a party failed to comply with a putatively-applicable duty of good faith or fair dealing.

This provision isn't phrased as "the duty of good faith doesn't apply." Leaving aside whether such a statement would be enforceable, imagine how a judge or juror might react to the statement — or how it might look if reported in the newspaper.

Analogously, consider UCC § 1-302(b) (which applies only to contracts that come within the scope of the UCC): "The parties, by agreement, may determine the standards by which the performance of those obligations [of good faith, etc.] is to be measured if those standards are not manifestly unreasonable."

3.5.6 Performance Before Signature Not Binding

(a) The parties anticipate that one or both parties might begin performance of some or all of its obligations, [[#AndOrDefn][and/or] the exercise of some or more of its rights, contemplated for the Proposed Arrangement, before all parties have signed and delivered the Arrangement Agreement.

(b) Each party agrees:

(1) not to assert that neither such performance nor such exercise by a party, nor the acceptance of such performance by another party, in itself, constitutes the agreement, by that party or any other, to be bound in respect of the Proposed Arrangement until the prerequisites of this section 3.5 have been satisfied; and

(2) that any such performance or exercise is at the acting party's own risk and expense except to the extent (if any) that the parties have expressly agreed otherwise in writing.

Comment

Every first-year law student (at least in the U.S.) learns that an offer for a contract can be accepted by performance. See, e.g., UCC § 2-206. Moreover, under state law a partnership can arise even without a contract.

According to a Texas jury, a partnership arose in that way in the Energy Transfer Partners, L.P. v. Enterprise Products Partners case, where:

  • The parties got well underway in building an oil pipeline, even though they'd only signed a supposedly-non-binding (but quite-detailed) "non-binding" letter agreement (which I'll call a letter of intent or "LOI").
  • The jury found that:
    • the parties, by their post-LOI actions, had in fact formed a partnership, and
    • the defendant had breached its fiduciary duties as a partner, notwithstanding all the disclaimers in their LOI.
  • The jury awarded the plaintiff $319 million in damages; the judge later added $150 million in disgorged profits and $66.4 million in pre-judgement interest

The case is discussed in ETP v. Enterprise Products: a Cautionary Tale for Prospective Joint Venturers (Sidley.com 2014); see also, e.g., Olivia Pulsinelli, Judge orders Enterprise Products Partners to pay $535.8M in pipeline dispute, Houston Business Journal, July 30, 2014. At this writing, so far as I know, an appeal is pending.

In that case, the LOI included the following language:

Neither this letter nor the JV [Joint Venture] Term Sheet create any binding or enforceable obligations between the Parties

and, except for the Confidentiality Agreement dated March 16, 2011 between the Parties (the "Confidentiality Agreement"),

no binding or enforceable obligations shall exist between the Parties with respect to the Transaction

unless and until the Parties have received their respective board approvals

and definitive agreements memorializing the terms and conditions of the Transaction

have been negotiated, executed and delivered by both of the Parties.

Unless and until such definitive agreements are executed and delivered by both of the Parties, either EPD or ETP, for any reason, may depart from or terminate the negotiations with respect to the Transaction at any time

without any liability or obligation to the other, whether arising in contract, tort, strict liability or otherwise.

Defendants' Exhibit 1 (provided to the author by ETP's trial counsel; extra paragraphing added).

An earlier letter agreement stated that Enterprise and ETP intended to get started on preparations for the pipeline project while they continued to negotiate a definitive agreement — and it spelled out how the parties would unwind the deal if they did not sign and deliver a definitive agreement by a stated date.

Enterprise later walked away from the project and built another pipeline in collaboration with a  different company.

The jury accepted that, despite what the LOI said, Enterprise had acted like a partner — a key ETP demonstrative exhibit (provided to the author by ETP's trial counsel) argued that Enterprise had:

  • issued press releases;
  • made representations to third parties; and
  • exercised joint control.

A commentator noted another example:

If the draft agreement contains terms that are unfavorable to a party and that party performs, but the agreement is never executed, that party may have to live with those unfavorable terms.

In DC Media Capital, LLC v. Imagine Fulfillment Services, LLC, 2013 WL 46652 (Cal. App. Aug. 30, 2013) (unpublished), a California appellate court held that a contract electronically sent by a customer to a vendor and not signed by either party was nevertheless enforceable where there was performance by the offeree.

The court held that the defendant’s performance was acceptance of the contract, particularly because the agreement did not specifically preclude acceptance by performance and expressly require a signature to be effective.

Jeffrey Neuburger, Meeting of the Minds at the Inbox: Some Pitfalls of Contracting via Email (Proskauer.com June 2015) (extra paragraphing added). (Hat tip: Brian Rogers a.k.a. @theContractsGuy.)

3.5.7   Good-Faith Negotiation Obligation

Each party will negotiate in good faith in attempting to reach agreement to the Arrangement Agreement.

Comment

CAUTION: Business people sometimes like to include provisions like this to signal (or protest) their own bona fides. But business people also sometimes think such provisions are mere throwaways. That's far from the case: in many jurisdictions, an agreement to negotiate in good faith will be legally binding — and is likely to be a serious mess to litigate.

[DCT TO DO: Links to further reading?]

Additional notes: Letters of intent

Business reasons for a letter of intent

Business people often like to sign a letter of intent ("LOI") when negotiating a transaction. Many lawyers prefer to go straight to contract drafting, but the business people's perspective is understandable, because:

  • A letter of intent gives the business people something they can take to their bosses to demonstrate that they are making "progress" in getting the deal done.
  • A letter of intent can also be useful for publicity purposes — although a public disclosure of a letter of intent might be taken for an indicator that the parties really intended for the LOI to be a binding agreement.
Letters of intent are like teen-aged sex (SFW)

Letters of intent and business people can be like sex and teenagers: You can tell the business people that they're likely to be better off not doing it, but sometimes they really, REALLY want to. You won't always be there to chaperone them, and let's face it, in the throes of desire they're likely to forget — or ignore — your advice.

The “consequences” of entering into a letter of intent can be significant if a court finds that the parties intended to enter into a binding contract. The canonical example of this danger, of course, is that of Texaco, Inc. v. Pennzoil Co., discussed below. In that case, Texaco was hit with a damage award of some $10.5 billion, or more than $22 billion in 2014 dollars, for interfering with Pennzoil's agreement with Getty Oil — in the form of a memorandum of understanding — under which Pennzoil would buy Getty.

Unless you want to be stuck dealing with such consequences, it might be a good idea to try to make sure that your "teenagers" use protection if they ignore your advice and start messing around with LOIs. The usual form of protection takes the form of various disclaimers of any intent to be bound.

All the disclaimer language in the world might not be enough

A supposedly-nonbinding letter of intent is one of the scarier types of contract out there. The same is true of its sibling, the memorandum of understanding (MOU). Despite all the disclaimers in the world, a court might hold that the parties' subsequent actions resulted in a binding commitment. For an example of strong LOI language that was nevertheless trumped by the parties' actually getting underway with performance of their putative contract (and a resulting $500-plus-million jury verdict and profits award), see the discussion of the Energy Transfer Partners v. Enterprise Products Partners lawsuit.

As an American Bar Association task force report noted:

There are many things that can overcome the carefully crafted words in a letter of intent purporting to make a document or certain provisions in a document nonbinding.

Loosely worded e-mails, oral communications, and other actions are often given great weight by courts in interpreting the intent of the parties.

Oral statements such as "Looks like we have a deal!" or handshakes can indicate an intent to be bound.

American Bar Association Section of Business Law, Letters of Intent (Ancillary Document B to Model Stock Purchase Agreement, Second Edition), at 4-5 (extra paragraphing added).

Pennzoil v. Texaco: The granddaddy of all LOI lawsuits

Any drafter preparing a letter of intent is well-advised to become familiar with the opinion of the Texas court of appeals in the famous case of Pennzoil v. Texaco, where a jury held Texaco liable for over $10 billion for tortiously interfering with Pennzoil's agreement to buy shares of stock in Getty Oil. See Texaco, Inc. v. Pennzoil Co., 729 S.W.2d 768 (Tex. App. – Houston [1st Dist.] 1987, writ ref'd n.r.e.) (affirming judgment against defendant Texaco as to liability and actual damages, but ordering a remittitur as to punitive damages); see also, e.g., Tamar Lewin, Pennzoil-Texaco Fight Raised Key Questions, N.Y. Times, Dec. 19, 1987.

The facts in Texaco are somewhat complicated; the key facts are basically this: Pennzoil and the owners of some 51% of Getty Oil signed a "Memorandum of Agreement" that by its terms was subject to approval by the board of Getty Oil. The board initially rejected the deal, but then approved it after a modification (to which Pennzoil agreed). Shortly afterwards, Texaco swooped in with a better offer; the Getty Oil board repudiated the Pennzoil deal and accepted Texaco's offer. Pennzoil's lawsuit against Texaco then followed.

(Author's note: the case was tried in Houston, where it and the subsequent appeals were front-page news for weeks on end.)

On appeal, the parties agreed that New York substantive law applied; the opinion of the Texas court of appeals summarized the relevant points of that law:

Under New York law[:]

  • [I]f parties do not intend to be bound to an agreement until it is reduced to writing and signed by both parties, then there is no contract until that event occurs.
  • If there is no understanding that a signed writing is necessary before the parties will be bound, and the parties have agreed upon all substantial terms, then an informal agreement can be binding, even though the parties contemplate evidencing their agreement in a formal document later.
  • If the parties do intend to contract orally, the mere intention to commit the agreement to writing does not prevent contract formation before execution of that writing, and even a failure to reduce their promises to writing is immaterial to whether they are bound.
  • However, if either party communicates the intent not to be bound before a final formal document is executed, then no oral expression of agreement to specific terms will constitute a binding contract.

Thus, under New York law, the parties are given the power to obligate themselves informally or only by a formal signed writing, as they wish.

The emphasis in deciding when a binding contract exists is on intent rather than on form. … Several factors have been articulated to help determine whether the parties intended to be bound only by a formal, signed writing:

  1. whether a party expressly reserved the right to be bound only when a written agreement is signed;
  2. whether there was any partial performance by one party that the party disclaiming the contract accepted;
  3. whether all essential terms of the alleged contract had been agreed upon; and
  4. whether the complexity or magnitude of the transaction was such that a formal, executed writing would normally be expected.

Id. at 788-89 (extra paragraphing and bullets added, citations omitted).

Saying "subject to contract" likely won't be enough

Just saying that the LOI is "subject to contract" might not be enough to avoid a binding effect. In Pennzoil v. Texaco, the press releases issued by the Getty entities and Pennzoil, announcing their deal, said that "the transaction is subject to execution of a definitive merger agreement." That wasn't enough to save Texaco from liability of over $10 billion; the court said that "[r]egardless of what interpretation we give to the conditional language in the press release, we conclude that it did not so clearly express the intent of the parties not to be bound to conclusively resolve that issue, as Texaco asserts." Texaco, Inc. v. Pennzoil Co., 729 S.W.2d 768, 789-90 (Tex. App. – Houston [1st Dist.] 1987, writ ref'd n.r.e.) (affirming judgment against defendant Texaco as to liability and actual damages, but ordering a remittitur as to punitive damages) (quoting press release).

Drafting tip: "Would do X" is better than "will do X"

Another lesson from the Texaco v. Pennzoil case is that an LOI's description of the proposed deal should say that the parties would do X, Y, and Z if the deal goes through, as opposed to that they will do X, Y, and Z — the latter could well be viewed as evidence that the parties had indeed reached a final and binding agreement:

Any intent of the parties not to be bound before signing a formal document is not so clearly expressed in the press release to establish, as a matter of law, that there was no contract at that time.

The press release does refer to an agreement "in principle" and states that the "transaction" is subject to execution of a definitive merger agreement.

But the release as a whole is worded in indicative terms, not in subjunctive or hypothetical ones. The press release describes what shareholders will receive, what Pennzoil will contribute, that Pennzoil will be granted an option, etc.

729 S.W.2d at 790 (emphasis in original, extra paragraphing added).

An ABA committee recommends going even further:

In Paragraph 1 and throughout Part One [setting out a non-binding outline of the proposed deal], the word "would" is used this word is intended to convey the conditional nature of the proposed acquisition and to contrast with the more definite words used in the binding provisions of Part Two, such as "will."

Other conditional terms may also be used, such as "prospective buyer," "prospective seller," and "proposed transaction." While the conditional language of Part One may appear awkward and stilted at times, it provides another indication of the parties’intent that the provisions of Part One are not be [sic] binding.

American Bar Association Section of Business Law, Letters of Intent (Ancillary Document B to Model Stock Purchase Agreement, Second Edition), at 7 (extra paragraphing added).

Further reading

See also, for example: 8 Steps to Keep Your Letter of Intent Non-Binding (angellawoffices.com; undated).

3.6   [Reserved: Asset transfers]

3.7   [Reserved: Due diligence]

3.8   [Reserved: Software- and technology licensing]

3.9   [Reserved: Resale & distribution]

3.10   [Reserved: Referrals]

3.11   [Reserved: Trademark licensing]

3.12   Confidential Information

3.12.1 Definitions: Disclosing Party; Receiving Party

(a) Disclosing Party refers to each Signatory Party when providing its Confidential Information to another party; only the Confidential Information of a Disclosing Party is protected by this.

(b) Receiving Party refers to a party, bound by the Agreement, to which Confidential Information is disclosed.

Comments
Overview

The term Disclosing Party implicitly defines whose Confidential Information will be protected. One of the first issues the parties likely will confront is whether the agreement should protect just one party's Confidential Information, or that of each party.

In many cases, a two-way confidentiality agreement that protects each party's Confidential Information will:

  • get to signature more quickly;
  • be safer for both sides; and
  • reduce the chance of future embarrassment for the drafter(s).
A two-way confidentiality agreement will usually be signed sooner

A confidentiality agreement protecting just one party's information will usually take longer to negotiate. That's because a confidentiality agreement will (usually) be more balanced — and therefore quicker to negotiate and easier to work with — if its provisions will apply equally to the confidential information of each party, not just one party.

  • If only one party will be disclosing confidential information, and that disclosing party is doing the drafting, then the confidentiality provision might contain burdensome requirements that the receiving party would have to review carefully.
  • Conversely, if the receiving party is doing the drafting, then the disclosing party would have to review the confidentiality provisions carefully to make sure it contained sufficient protection for Confidential Information

In contrast, a two-way provision is likely to be more balanced — it's a variation of the "I cut, you choose" principle — because each negotiator keeps in mind that today's disclosing party might be tomorrow's receiving party or vice versa.

(Beware, though: even if an agreement is nominally a two-way agreement, it still can be drafted so as subtly to favor the drafter's client.)

A two-way confidentiality agreement will usually be safer

A two-way agreement can avoid the danger of future, "afterthought" confidential disclosures by the receiving party. With a one-way agreement, only the (original) disclosing party's information is protected, and so any disclosures by the receiving party might be completely unprotected, resulting in the receiving party's losing its trade-secret rights in its information.

That's just what happened to the plaintiff in Fail-Safe, LLC v. A.O. Smith Corp. 674 F.3d 889, 893-94 (7th Cir. 2012) (affirming summary judgment for defendant). There, the plaintiff's confidentiality agreement with the defendant protected only the defendant's information. Consequently, said the court, the plaintiff's afterthought disclosures of its own confidential information were unprotected.

A two-way agreement might help avoid future embarrassment

Suppose that Alice and Bob enter into a confidentiality agreement that protects only Alice's information.

Also suppose that the agreement's terms were strongly biased in favor of Alice.

Now suppose that, at a later date, the parties decide that they also needed to protect Bob's confidential information as well, so that Bob can disclose it to Alice.

In that case, with the shoe on the other foot, Alice might not want to live with the obligations that she previously made Bob accept.

As a result, whoever negotiated the (one-way) confidentiality agreement for Alice might find himself in a doubly-embarrassing position:

  • First, Alice's negotiator would be asking Bob to review and sign a new confidentiality agreement, and having to explain why Alice isn't willing to live with the same terms she pressed upon Bob.
  • Second, Alice might ask pointedly of her negotiator, Why didn't you do this the right way in the first place, instead of wasting everybody's time?

So it's often a good idea to insist that any confidentiality provisions be two-way in their effect from the start, protecting the confidential information of both parties.

3.12.2 Definition of Confidential Information

3.12.2.1 Basic Definition of Confidential Information

Confidential Information refers to information — including, for example, information in the categories listed in section 3.12.2.2 — where all of the following are true:

(1) the information is the subject of efforts that are reasonable under the circumstances to maintain its secrecy, by and/or on behalf of a Disclosing Party; and

(2) the information is initially disclosed, by or with the authorization of the Disclosing Party, to a Receiving Party during the term of the Agreement (the Protected-Disclosure Period);

(3) the initial disclosure referred to in sub­div­i­sion (2) is in connection with the Agreement or a transaction or relationship resulting from the Agreement; and

(4) the information is not excluded from Confidential-Information status under the Agreement by, for example, the enumerated exclusions below or failure to comply with a marking requirement (if applicable).

Comments
Language origins

Sub­div­i­sion (1): The language, "the subject of efforts reasonable under the circumstances," is adapted from the Uniform Trade Secrets Act; see, e.g., Cal. Civ. Code § 3426.1(d)(2); Tex. Civ. Practice & Rem. Code § 134A.002(6)(B); see also these notes. (See also the discussion in the Annotations concerning the secrecy requirement for information to be treated as confidential.)

Sub­div­i­sion (2): Protected Disclosure Period: A receiving party wouldn't want to be ambushed by claims that disclosed information was supposedly secret when the information was first provided to the receiving party long after the agreement was signed — by which time the parties' business people might well have forgotten that their companies still technically had a confidentiality agreement in place.

A receiving party might want to request an even shorter disclosure period such as (for example) the expected duration of a negotiation, plus perhaps a safety margin.

CAUTION: Even disclosures made outside the Protected-Disclosure Period might still be subject to obligations of confidence under applicable law, for example, the laws governing protected health information or nonpublic personal financial information.

Sub­div­i­sion (3): In connection with the Agreement: This language helps put fences around the parties' confidentiality obligations. That can be useful for large companies that might have multiple dealings with each other, including other dealings outside the scope of the Agreement, and that don't necessarily want confidentiality obligations spilling over from one transaction to the parties' other dealings.

Sub­div­i­sion (4): A transaction or relationship: See the arbitration-clause commentary.

Public policy

One [U.S.] state supreme court summarized the public-policy basis for enforcing confidentiality agreements:

The basic logic of the common law of trade secrets recognizes that private parties invest extensive sums of money in certain information that loses its value when published to the world at large.

Based on this logic, trade secret law creates a property right defined by the extent to which the owner of the secret protects his interest from disclosure to others.

In doing so, [trade secret law] allows the trade secret owner to reap the fruits of its labor ….

Trade secret law promotes the sharing of knowledge, and the efficient operation of industry; it permits the individual inventor to reap the rewards of his labor by contracting with a company large enough to develop and exploit it. [Quoting Kewanee Oil Co. v. Bicron Corp., 416 U.S. 470, 493 (1974).]

DVD Copy Control Assn., Inc. v. Bunner, 31 Cal.4th 864, 880, 75 P.3d 1 (2003) (reversing court of appeal, and holding that preliminary injunction against Web site operator, prohibiting disclosure of trade secrets, did not violate the First Amendment) (citations omitted, extra paragraphing added), as excerpted by Altavion, Inc. v. Konica Minolta Sys. Lab. Inc., 226 Cal. App. 4th 26, 34 (2014) (affirming judgment of trade-secret misappropriation) (alteration marks edited, emphasis added).

The law protects just about any information that is kept confidential and provides a competitive advantage. This prerequisite generally comes from the definition of "trade secret," as found either in the relevant statute — which typically will be a variation of the Uniform Trade Secrets Act — or section 757 of the Restatement of Torts. As summarized by the Seventh Circuit court of appeals:

Illinois courts frequently refer to six common law factors (which are derived from § 757 of the Restatement (First) of Torts) in determining whether a trade secret exists:

(1) the extent to which the information is known outside of the plaintiff's business;

(2) the extent to which the information is known by employees and others involved in the plaintiff's business;

(3) the extent of measures taken by the plaintiff to guard the secrecy of the information;

(4) the value of the information to the plaintiff's business and to its competitors;

(5) the amount of time, effort and money expended by the plaintiff in developing the information; and

(6) the ease or difficulty with which the information could be properly acquired or duplicated by others.

Learning Curve Toys, Inc. v. PlayWood Toys, Inc., 342 F.3d 714, 722 (7th Cir. 2003).

Fort-Knox security measures aren't necessary (usually)

Some people mistakenly think that legal protection won't be available for confidential information unless every possible security measure is taken. That's not how the law works. It's not mandatory to keep confidential information locked up in Fort Knox-like secrecy; in many circumstances, less-strict security measures may well suffice. See, e.g., Learning Curve Toys, Inc. v. PlayWood Toys, Inc., supra (reversing judgment as a matter of law and remanding with instructions to reinstate jury verdict of misappropriation; applying Illinois law).

As one court remarked:

… there always are more security precautions that can be taken. Just because there is something else that Luzenac could have done does not mean that their efforts were unreasonable under the circumstances. In light of undisputed precautions that Luzenac took, we do not think that the record demonstrates beyond dispute that Luzenac's measures to protect the secrecy of 604AV were merely "superficial." … Whether these precautions were, in fact, reasonable, will have to be decided by a jury.

Hertz v. Luzenac Group, 576 F.3d 1103, 1113 (10th Cir. 2009) (emphasis added, citations omitted); in that case, the appeals court vacated a summary judgment that legal protection was not available for a company's talc-production process, and remanded the case back to the lower court for a trial.

But some secrecy efforts are virtually mandatory

Still, the disclosing party will have to show that it made at least some efforts to keep the information confidential — obviously "more is better," but more is also more costly.

Failure on this point can be fatal to a trade-secret claim: In one case, the Seventh Circuit noted pointedly that the party asserting misappropriation had made no effort to preserve the so-called trade secrets in confidence. See Fail-Safe, LLC v. A.O. Smith Corp. 674 F.3d 889, 893-94 (7th Cir. 2012) (affirming summary judgment for defendant; applying Illinois law).

3.12.2.2 Examples of Confidential Information

Except to the extent (if any) that the Agreement specifically provides otherwise, the term Confidential Information encompasses, by way of example and not of limitation, the following types of information when the information is otherwise eligible under the Agreement:

Algorithms. Audit reports.

Biological materials. Business plans. Business records.

Circuit records. Commercial information. Compounds. Computer programs. Contracts. Construction records.

Data-center designs. Designs. Diagrams. Documents. Draft publications. Drawings.

Engineering records.

Financial information. Financial projections. Financial statements. Forecasts. Formulas.

Hardware items.

Ideas. Interpretations. Invention disclosures.

Leases.

Machine-readable data. Maps. Market projections. Marketing information. Methods.

Offers. Operational data. Opinions.

Patent applications (when unpublished). Plans. Pricing information. Procedures. Processes. Product development plans. Product information programs. Projections. Proposals.

Research data. Research plans.

Samples. Server-configuration designs. Source code for computer programs. Specifications. Strategies.

Tax bills. Technical information. Technical reports. Technological developments. Test data. Title reports.

Comments

This laundry list is a "roadblock" clause; disclosing-party counsel sometimes want to include such examples to serve as explicit reminders to the receiving party (and also as ammunition in litigation).

3.12.2.3 Receiving Party Notes

The term Confidential Information likewise encompasses the following, prepared by (or for, or on behalf of) the Receiving Party, when they contain Confidential Information: Analyses; compilations; forecasts; interpretations; notes; reports; studies; summaries; and similar materials.

Comments

This is another roadblock clause, and also a reminder to the receiving party.

3.12.2.4 Third-Party Information

Information owned or maintained by a third party, when otherwise eligible, is considered Confidential Information to the same extent as if the information were that of the Disclosing Party, if the third-party information is disclosed or made accessible to the Receiving Party, by or on behalf of the Disclosing Party, pursuant to the Agreement.

Comments

A receiving party might want to include 3.12.2.10.  ? Warranty of Disclosure Authority provision.

3.12.2.5 Specific Selections and Combinations

A specific selection or combination of items of information can be eligible for Confidential Information status even if some or all of the items are not themselves confidential.

Comment

This language reflects established law (at least in the U.S.). See, e.g.:

  • Tewari De-Ox Systems, Inc., v. Mountain States/Rosen, L.L.C., 637 F.3d 604, 613-14 (5th Cir. 2010), where the appeals court held that a genuine dispute existed as to whether the plaintiff's specific combination of published- or otherwise commonly-known information about meat packing was itself confidential, and thus vacated a summary judgment in favor of the defendant (citing cases);
  • Hertz v. Luzenac Group, 576 F.3d 1103, 1110 (10th Cir. 2009), where the appeals court likewise vacated a summary judgment that a company had no trade-secret rights in its process for producing vinyl silane-coated talc;
  • Integrated Cash Mgmt. Servs., Inc. v. Digital Transactions, Inc., 920 F.2d 171, 174 (2d Cir. 1990), in which the appeals court affirmed an injunction against the defendant's use of the plaintiff's "winning combination" of generic software programs. (It probably did not help the defendant's case that a defecting employee had brought copies of the plaintiff's computer code with him to his new job with the defendant.)
3.12.2.6 Exclusions from Confidential Information

At any particular time, the term Confidential Information does not include information that is shown — with reasonable corroboration — to be or to have been, at that time, within one or more of the following categories:

(1) The Receiving Party knew the information before obtaining access to it under the Agreement; or

(2) Both of the following are true:

(A) A third party provided the information to the Receiving Party, and

(B) at the time that happened, the third party was not under a legally-enforceable confidentiality obligation that (i) contained specific obligations equivalent to those of section 3.12.4 that are contained in the Agreement; and (ii) benefited the Disclosing Party (a Comparable Confidentiality Obligation);

(3) The Receiving Party independently developed the information without using Confidential Information; or

(4) The information was published, or otherwise made generally available to one or more others not under a legally-enforceable obligation of confidence benefiting the Disclosing Party, without breach of the Agreement by the Receiving Party; or

(5) Both of the following are true:

(A) The Disclosing Party (or someone authorized by the Disclosing Party) disclosed the information to one or more third parties, and

(B) at that time (or at any time afterwards), at least one of the third parties was not under a Comparable Confidentiality Obligation.

NOTE: The fact that information comes within the scope of a subpoena or other Compulsory Legal Demand does not in itself mean that the information becomes categorically excluded from Confidential Information status.

Comments
Language choices

Most confidentiality agreements contain express exclusions from confidentiality such as these. This numbered list of exclusions is fairly typical.

Sub­div­i­sion (1): The prior-knowledge exception is one of those where the corroboration requirement can come into play. Without corroborating evidence, a judge or jury might well be skeptical of an accused misappropriator's too-convenient claim, after the fact, that: We can't be liable for misappropriating your confidential information because knew the information before you gave it to us.

Sub­div­i­sion (2): If a third party has the information in question, and isn't obligated to keep the information secret, then it's tough for the Disclosing Party to argue that the information really is the confidential information of the Disclosing Party.

Sub­div­i­sion (3) (independent development): As a practical matter, an accused misappropriator of confidential information might have a hard time convincing a judge or jury that it independently developed the allegedly-misasppropriated information on its own. For an example, see Celeritas Technologies Ltd. v. Rockwell Int'l, Inc., 150 F.3d 1354 (1998), where a federal-court jury in Los Angeles awarded a startup company more than $57 million because the jury found that Rockwell had breached a confidentiality agreement; the jury rejected Rockwell's assertion that its engineers had independently developed the technology in question after having been exposed to the startup company's information. (Disclosure: I was part of Rockwell's trial team in that case.)

Sub­div­i­sion (5): A disclosing party might try to omit this exclusion, but in that case:

  • The receiving party would probably push back, on the theory that if you [the disclosing party] allow others to use its information without legal restriction, then I get to do the same thing.
  • Moreover, it's unclear what the legal effect of omitting exclusion #5 would be, because by law (at least in the U.S.), such a disclosure of information to a third party without confidentiality restrictions would have the effect of killing any trade-secret rights the discloser might have had in the information, as discussed here.

NOTE: Some badly-drafted confidentiality exclusions state that subpoenaed information is excluded from confidentiality. This could be a big mistake for a disclosing party — a receiving party could later argue that the mere issuance of a third-party subpoena automatically resulted in the subpoenaed information being excluded from confidentiality status, even if a court were to issue a protective order restricting what the third party could do with the information. The better approach is the one taken by this provision.

Corroboration of exclusion claims: Analogies from patent law

This list of exclusions requires only reasonable corroboration of a claim of exclusion from confidentiality, as opposed to some provisions of this kind that require documentary proof of the claim. This balances:

  • the interest of the disclosing party in avoiding self-interested (or even fraudulent) claims of, say, independent development by the receiving party, against
  • the interest of the receiving party in not having to meet an impossible burden of proof.

The U.S. Court of Appeals for the Federal Circuit explained this balancing concept in an analogous context, namely the patent-law requirement that claims of prior invention must be corroborated. According to the court, that requirement helps to guard against the possibility that someone might "describe [their] actions in an unjustifiably self-serving manner …. the purpose of corroboration [is] to prevent fraud, by providing independent confirmation of the [witness's] testimony." See Sandt Technology, Ltd. v. Resco Metal & Plastics Corp., 264 F.3d 1344, 1350 (Fed. Cir. 2001) (affirming relevant part of summary judgment; internal quotation marks and citation omitted).

Another useful patent-law analogy might the requirement of corroboration to support an assertion that an issued patent is invalid due to prior public use. "This corroboration requirement for testimony by an interested party is based on the sometimes unreliable nature of oral testimony, due to the forgetfulness of witnesses, their liability to mistakes, their proneness to recollect things as the party calling them would have them recollect them, aside from the temptation to actual perjury." TransWeb LLC v. 3M Innovative Properties Co., No. 2014-1646, slip op. at 6 (Fed. Cir. Feb. 10, 2016) (affirming award of treble damages and trebled attorney fees; internal quotation marks omitted), quoting Washburn & Moen Mfg. Co. v. Beat ‘Em All Barbed-Wire Co., 143 U.S. 275, 284 (1892).

Such cases are governed by a rule of reason; not every detail need be "independently and conclusively supported by corroborating evidence," id. at 7 (internal quotation marks and citation omitted); "there are no hard and fast rules as to what constitutes sufficient corroboration, and each case must be decided on its own facts." Id.

3.12.2.7 Disclaimer of Unstated Warranties and Licenses

For the avoidance of doubt, EXCEPT to the extent (if any) that the Agreement or another written agreement between the parties expressly states otherwise:

(1) The Agreement does not grant to the Receiving Party, nor to any other individual or organization, any license right or ownership right of any kind, in Confidential Information, nor in other any intellectual property of the Disclosing Party; and

(2) The Disclosing Party DISCLAIMS all warranties, representations, conditions, and terms of quality, express or implied, about Confidential Information, including for example all warranties of completeness or accuracy; all Confidential Information is provided or otherwise made available AS IS, WITH ALL FAULTS.

(c) THE DISCLOSING PARTY WILL NOT BE LIABLE for any use of Confidential Information made by the Receiving Party EXCEPT to the extent (if any) expressly stated otherwise in the Agreement, for example:

(1) in a warranty clause concerning the Confidential Information, if applicable; and/or

(2) in a relevant indemnity obligation concerning the Confidential Information, if applicable.

Comment

Some drafters make a practice of including disclaimer language like this for use as litigation sound bites.

Some language in this disclaimer is in all-caps bold-faced type so that the language will be conspicuous.

3.12.2.8  ? Protected Information Categories

For particular information to be considered Confidential Information, it must fall into a Protected Information Category specified in the Agreement (all categories if not otherwise specified).

Comment

A receiving party might want to limit its confidentiality obligations to specific categories of information, such as (for example) financial data, design data, etc. That way, if the disclosing party (or its personnel) provide other types of information to the receiving party, the provided information will be free for use by the receiving party without restriction.

3.12.2.9  ? Confidentiality of Affiliate' Information

(1) The information of one or more affiliates of a Disclosing Party is to be considered Confidential Information to the same extent as if it were owned or maintained by the Disclosing Party itself, BUT ONLY IF the information is clearly marked as being subject to the Agreement.

(2) For the avoidance of doubt, the marking requirement of sub­div­i­sion (a) applies regardless whether the Agreement requires Confidential Information of the Disclosing Party itself to be marked as such.

Comment

This affiliate-information language reflects a compromise between the following party positions: • A disclosing party will often want its affiliates' confidential information to be protected without the affiliates' having to negotiate and sign separate confidentiality agreements. • On the other hand, a receiving party might insist on knowing exactly which companies conceivably might sue the receiving party someday for breach of contract. • This language allows affiliate information to be protected, while reducing the chances that the receiving party might someday be ambushed by claims of mis­ap­pro­pri­a­tion of information that its people had no real reason to know was confidential.

3.12.2.10  ? Warranty of Disclosure Authority

The Disclosing Party will not disclose to the Receiving Party, any information that, at the time of disclosure, is subject to a legally-enforceable right of a third party to prohibit the disclosure, unless the Disclosing Party possesses either:

(1) the third party's consent to make the disclosure; or

(2) a legally-enforceable right to make the disclosure without the third party's consent.

Comment

Clauses like this are occasionally requested by a receiving party, to try to innoculate itself against claims by a third party that the disclosing party violated the third party's rights by providing information to the receiving party.

3.12.2.11   Presumption of Confidentiality

All information of, or maintained by, the Disclosing Party is to be presumed to be Confidential Information unless and until shown otherwise.

Comment

A disclosing party might well want this presumption of confidentiality, but a receiving party might not be enthusiastic about reversing the law's usual burden of proof in this way.

3.12.2.12   Consent Requirement for Specific Disclosures

The Receiving Party will be under no obligation of confidence under the Agreement with respect to any Confidential Information disclosed to it unless the Receiving Party first consents in writing to the specific disclosure.

Comment

A receiving party might want to maintain tight control over the specific information (or categories of information) for which the receiving party commits to observing confidentiality obligations.

3.12.2.13   Disclosing Party's Indemnity Obligation

The Disclosing Party will defend and indemnify the Receiving Party and its Protected Group from any claim, by any third party, that the Disclosing Party's disclosure to the Receiving Party was in violation of the third party's rights in the information in question.

Comment

Some drafters like to say that a breaching party must indemnify the other party (usually the drafter's client) against any damages resulting from the breach. Such an indemnity obligation, though, might expose the breaching party to greater liability than it would otherwise have; see Indemnity liability might be much more than plain breach-of-contract damages for a more extensive discussion.

3.12.3 Confidential Information Marking

3.12.3.1 Marking Requirement

(a) Information that is made available to the Receiving Party in connection with the Agreement, by or on behalf of the Disclosing Party, will not be considered Confidential Information unless the information is marked as provided in the Agreement.

(b) Except as otherwise stated below, for information to be considered Confidential Information, the information must:

(1) be set forth (or summarized) in tangible form (including for example an electronic storage device); and

(2) be marked with a reasonably-prominent, visually-readable notice such as (for example) "Confidential information of [name]" or "Subject to NDA."

Comments
Purpose of marking requirement

The basic objectives of the marking requirement are usually:

  • to alert the receiving party's personnel that particular information is subject to confidentiality obligations;
  • conversely, to let the receiving party's personnel know what particular information is not subject to confidentiality obligations and therefore may be used freely; and
  • perhaps most importantly (at least from a litigation perspective), to help courts and arbitrators sift through claims that particular information was or was not subject to confidentiality obligations.
Courts pay attention to the absence of marking

In assessing whether a disclosing party in fact maintained particular information in confidence, a court very likely will give significant weight to whether the disclosing party caused the information to be marked as confidential.

In the Seventh Circuit's Fail-Safe case, the court pointedly noted that the plaintiff had not marked its information as confidential; the court affirmed the district court's summary judgment dismissing the plaintiff's claim of misappropriation. See Fail-Safe, LLC v. A.O. Smith Corp. 674 F.3d 889, 893-94 (7th Cir. 2012) (affirming summary judgment for defendant; applying Illinois law).

To like effect was a Seventh Circuit case, nClosures, Inc. v. Block & Co., 770 F.3d 598, 600 (7th Cir. 2014), where the court affirmed a summary judgment that "no reasonable jury could find that nClosures took reasonable steps to keep its proprietary information confidential," and therefore the confidentiality agreement between the parties was unenforceable.

A disclosing party's failure to mark its confidential information as such when required by a confidentiality agreement or nondisclosure agreement ("NDA") can be fatal to a claim of misappropriation of trade secrets or misappropriation of confidential information. For example, in Convolve v. Compaq, the computer manufacturer Compaq (now part of Hewlett-Packard) defeated a claim of misappropriation of trade secrets concerning hard-disk technology because the owner of the putative trade-secret information did not follow up its oral disclosures with written summaries as required by the parties' non-disclosure agreement. See Convolve, Inc. v. Compaq Computer Corp., No. 2012-1074, slip op. at 14, 21.

Caution: Some information might be confidential by law even without marking

Applicable law might independently impose a confidentiality obligation benefiting third parties, regardless of marking. For example, the U.S. Health Insurance Portability and Accountability Act (HIPAA) imposes such obligations in respect of patients' protected health information.

Should marking be required even for in-place access?

A slightly-tricky situation is when a receiving party's people are allowed to look at a disclosing party's internal files but not to make notes, take away copies, etc. In such a situation, it might well be burdensome for the disclosing party to have to go each of the files to ensure that all confidential information is marked, on pain of losing confidentiality protection. There might also later be a he-said, she-said proof problem if a dispute were to arise about whether particular information had in fact been marked.

3.12.3.2 Catch-Up Marking Option

(a) The Catch-Up Marking Period for Confidential Information is ten business days after the initial unmarked disclosure of the specific information in question.

(b) IF: A Disclosing Party discloses putatively-Confidential Information that is not marked as such (for example, disclosure in an unmarked writing or by a demonstration or oral disclosure); THEN: The Disclosing Party may retroactively mark the information as confidential, with the same effect as if the information had been timely marked, as stated in subdivisions (c) and (d).

(c) At the time of the initial unmarked disclosure of the information in question, the Disclosing Party must advise the Receiving Party, orally or otherwise, that the Disclosing Party considers the information to be Confidential Information.

(d) In addition, no later than the end of the Catch-Up Marking Period, the Disclosing Party must:

(1) furnish the Receiving Party with a copy or written summary of the Confidential Information that is marked as Confidential Information; and

(2) give the Receiving Party notice that it has done so.

Comments
Business context

In business, confidential information is sometimes disclosed in unmarked form, e.g., orally or in a demonstration, facilities tour, etc. With that possibility in mind:

  • The disclosing party likely would prefer not to have a marking requirement at all — but that would mean that all disclosed information would be considered Confidential Information;
  • The receiving party likely would prefer having any unmarked information be immediately and permanently deemed non-confidential and thus free for the receiving party to use and/or disclose as it saw fit;
  • Allowing for catch-up marking is a frequently-adopted compromise between those two preferences.
Notice of catch-up marking

If a disclosing party were to make an initial unmarked disclosure but then later do catch-up marking:

  • The receiving party likely would want a formal written reminder that the information is confidential.
  • Sending the notice would help document the fact that the disclosing party did in fact do catch-up marking; the disclosing party might later be grateful that it had created such documentation.
Forgetting catch-up marking can destroy trade-secret rights

A company's failure to do catch-up marking of confidential information after an oral disclosure to another party can kill the company's claim to trade-secret rights in the information. In Convolve v. Compaq, the computer manufacturer Compaq (then part of Hewlett-Packard) defeated Convolve's claim that Compaq had misappropriated Convolve's trade secrets concerning hard-disk technology. Compaq won because Convolve, which claimed trade-secret rights in certain information, had disclosed some of that information orally to Compaq, but didn't follow up those oral disclosures with written summaries, which was required by the parties' non-disclosure agreement. See Convolve, Inc. v. Compaq Computer Corp., No. 2012-1074, slip op. at 14, 21 (Fed. Cir. July 1, 2013) (affirming summary judgment; non-precedential).

3.12.3.3   Marking Exception for Clearly-Confidential Information

The marking requirement of section 3.12.3 does not apply to information that would be recognized, by a reasonable person familiar with the type of information in question, as clearly being Confidential Information.

Comment

Some disclosing parties might not want to be bothered with having to mark their confidential information as such. Such a preference can be accommodated at least somewhat by using this provision.

A receiving party, though, might well object to this provision because it's necessarily vague, which could later lead to disputres about whether particular information qualified as "clearly" confidential.

3.12.4 Confidentiality Obligations

Comment

A disclosing party should always insist on imposing confidentiality obligations on a receiving party; otherwise, a court is likely to hold hold that the disclosing party had failed to make reasonable efforts to protect its confidential information. See, e.g.:

  • Gal-Or v. United States, No. 09-869C (Ct. Fed. Cl. Nov. 21, 2013) (dismissing plaintiff's trade-secret claims): "[I]nstances in which Mr. Gal-Or took proactive steps to protect the confidentiality of his trade secrets are simply overwhelmed [emphasis in original] by the number of times he did not. … In sum, because Mr. Gal-Or disclosed trade secrets to others, who were under no obligation to protect the confidentiality of the information, Mr. Gal-Or lost any property interest he may have held." [Emphasis added.]
  • Southwest Stainless, LP v. Sappington, 582 F.3d 1176, 1189-90 (10th Cir. 2009) (reversing judgment of misappropriation of trade secrets): A supplier gave specific price-quote information to a customer without any sort of confidentiality obligation; that defeated the supplier's claim of trade-secret misappropriation against a former employee.
  • Lockheed Martin Corp. v. L-3 Comm. Integrated Sys. L.P., No. 1:05-CV-902-CAP (N.D. Ga. March 31, 2010) (granting L-3's motion for new trial): The court set aside a $37 million damages verdict for trade-secret misappropriation in favor of Lockheed after it came to light that Lockheed had disclosed the trade secrets in question to a competitor without restrictions. The case later settled; see, e.g., R. Robin McDonald, Discovery Failure Sinks Lockheed's $37 Million Win, Apr. 6, 2010; see also R. Robin McDonald, Lockheed and L-3 settle five-year battle, Nov. 29, 2010. For a more-detailed discussion of the specifics of the lawsuit, see this blog entry of Apr. 6, 2010 by "Todd" (Todd Harris?) at the Womble Carlyle trade secrets blog.
  • E.I. DuPont De Nemours & Co. v. Kolon Industries, Inc. 748 F.3d 16 (4th Cir. 2014): A jury found South Korea-based Kolon Industries liable for misappropriating DuPont's trade-secret information in DuPont's Kevlar® production process. The jury awarded DuPont nearly $1 billion in damages, and the trial judge enjoined Kolon from producing Kevlar-type fiber for 20 years.During the trial, Kolon had argued that DuPont, in earlier litigation with its then-primary competitor, had supposedly failed to keep the information confidential. The trial judge, though, did not allow Kolon to put on evidence of this. Kolon had better luck with this argument on appeal: The appellate court reluctantly vacated the jury verdict and ordered a new trial. (The appellate court also ordered that a different district judge be assigned to hear the case.) The civil case later settled on undisclosed terms; this was in conjunction with Kolon's guilty plea in a related criminal case, where Kolon agreed to pay a $360 million penalty. See Andrew Zajac, Kolon Guilty in Kevlar Secrets Case, Settles with DuPont (Bloomberg.com Apr. 30, 2015).
  • Events Media Network, Inc. v. The Weather Channel Interactive, Inc., No. 13-03 (D.N.J. Feb. 3, 2015): Events Media Network ("EMNI") was in the business of collecting, reviewing, and compiling detailed information about various local and national events and attractions. EMNI licensed the information to other companies, including The Weather Channel ("TWC"). EMNI made its information available on its Web site; it claimed that technical restrictions precluded anyone from accessing all of the information. TWC's license agreement with EMNI allowed TWC to use the EMNI information in TWC's own Web properties. The parties allowed the license agreement to expire. EMNI claimed that TWC continued using the EMNI information after expiration, and that this allegedly constituted misappropriation of EMNI's trade secrets and breach of contract. TWC moved for summary judgment dismissing EMNI's trade-secret claim, on grounds that the information in question wasn't preserved in confidence and therefore could not be the subject of a trade-secret misappropriation claim. The district court granted that part of TWC's summary-judgment motion — the court said that under the license agreement, "EMNI was not attempting to protect the Information from public disclosure, but increase its dissemination, giving TWC broad discretion over how and where it would use the Information publicly to achieve this end." Id., slip op. at 16 (emphasis added).
3.12.4.1 Secrecy Precautions Obligation

At all times during the Confidentiality-Obligation Period, the Receiving Party must cause the following precautions to be taken to safeguard Confidential Information in its possession, custody, or control:

(1) at least the same precautions as the Receiving Party takes for its own information of comparable significance;

(2) in no case less than those precautions that a prudent person would take in the same circumstances; and

(3) any other particular secrecy precautions stated in the Agreement.

Comment

In many situations, these "standard" precautions are likely to satisfy the disclosing party's desires, but for some types of Confidential Information, a disclosing party might want to insist on special precautions — especially in the era of criminal hackers, and even state actors, breaking into insufficiently-secure computer systems and stealing valuable information, such as happened to Sony Pictures Entertainment, allegedly at the hands of North Korea, and to Home Depot, which booked a charge of $161 million after a 2014 theft of customers' credit-card data.

3.12.4.2 Limitation on Receiving Party Use, Etc.

At all times during the Confidentiality-Obligation Period, the Receiving Party must not disclose, use, or copy Confidential Information, in whole or in part, except as expressly provided in the Agreement.

Comment

This is an "umbrella" limitation on what the Receiving Party is allowed to do with Confidential Information; it is subject to the express rights of use, disclosure, and copying stated below.

3.12.4.3 Obligation to Comply with Law

The Receiving Party is to take prudent measures to ensure that any use, disclosure, or copying of Confidential Information, by or on behalf of the Receiving Party or any party receiving Confidential Information from the Receiving Party complies with applicable law, including for example any applicable law concerning (i) privacy or (ii) export controls.

Comment

A requirement like this can be handy if the Receiving Party will be dealing with information whose distribution is restricted by law, for example personal health information or export-controlled information.

This provision uses a prudent-measures standard instead of an absolute obligation.

See also 3.12.4.18.   Receiving Party Obligation re Indemnity.

3.12.4.4 Duration of Confidentiality Obligation

(a) Confidentiality-Obligation Period refers to the period beginning on the ef­fect­ive date of the Agreement, and continuing until such time — if any — as the information in question becomes subject to an exclusion from confidentiality status under section 3.12.2.6.

(b) The obligations of section 3.12.4 apply only during the Confidentiality-Obligation Period; during that time, though, those obligations will continue to apply to all Specimens of Confidential Information, even after any termination or expiration of the Agreement.

Comments
Introduction

Disclosing parties will normally be reluctant to agree to a fixed confidentiality period. That's because doing so can result in destruction of the disclosing party's trade-secret rights in its confidential information after the end of the confidentiality period.

Receiving parties, of course, generally prefer to have fixed expiration dates for confidentiality obligations.

Negotiation arguments for letting confidentiality obligations expire

Whether confidentiality obligations should ever expire might depend on the circumstances:

  • Some types of confidential information will have a limited useful life, e.g., future plans. Such information might reasonably have its protection limited to X months or years.
  • Other types of confidential information might have essentially-unlimited useful life — for example (putatively), the recipe for making Coca-Cola® syrup.

A receiving party might want an expiration date for confidentiality obligations as a safe harbor. After X years have gone by, it might well take time and energy for the receiving party to figure out (1) which information of the disclosing party is still confidential, and (2) whether the receiving party might be using or disclosing confidential information in violation of the NDA. The receiving party likely would prefer instead to have a bright-line "sunset," after which the receiving party can do whatever it wants without having to incur the burden of analyzing the facts and circumstances.

A disclosing party might regard an expiration date for confidentiality obligations as acceptable, depending largely on:

  1. how sensitive the information is, in the disclosing party's eyes, and
  2. how long it will be until the confidentiality obligations expire.

For example: Suppose that:

  • the confidential information relates to the design of a product manufactured and sold by the disclosing party, and
  • the disclosing party knows that, in two years, it will be discontinuing the product and will no longer care about the product-design information.

In that situation, the disclosing party might be willing to have the receiving party's confidentiality obligations expire in three or four years. That would provide the receiving party with a bright-line sunset date as well as providing the disclosing party with a year or two of safety margin.

Danger of letting confidentiality obligations expire

If the receiving party's confidentiality obligations are allowed to expire, the disclosing party might thereafter find it difficult — or, more likely, impossible — to convince a court to enforce any trade-secret rights in the relevant information. [CITATION NEEDED]

Possible expiration dates for confidentiality obligations

The parties could specify that the Receiving Party's confidentiality obligations will expire  Xmonths or years after:

  • the date that all copies of the information are returned or destroyed;
  • the effective date of the Agreement;
  • the effective date of termination or expiration of the Agreement.
Expiration of other obligations doesn't affect confidentiality obligations

The language, any other right or obligation under the Agreement, addresses the situation in which an agreement includes noncompetition or non-solicitation provisions in addition to confidentiality provisions — the language attempts to make it clear that the confidentiality obligations continue even if (for example) the non-competition covenant expires.

Expiration of confidentiality doesn't affect other IP rights

Hat tip: Erik Verbraeken in a LinkedIn discussion comment (LinkedIn group membershp required).

Rule against perpetuities?

Conceivably, a receiving party might try to argue that post-termination confidentiality obligations violated the Rule against Perpetual Contracts and therefore were terminable at will. See generally Brett A. August and Andrew N. Downer, Equitable Exceptions to the Rule Against Perpetual Contracts, Intellectual Property Litigation, Volume 21, No. 4 (ABA Section of Litigation, summer 2010).

Such an argument, though, would have to overcome the long-established rule that "[t]rade secret licenses may endure even where the trade secret itself is destroyed by general disclosure." Nova Chemicals, Inc. v. Sekisui Plastics Co., 579 F.3d 319, 328 (3d Cir. 2009), discussing Aronson v. Quick Point Pencil Co., 440 U.S. 257, 266 (1979) and Warner-Lambert Pharm. Co. v. John J. Reynolds, Inc., 178 F.Supp. 655, 665-66 (S.D.N.Y. 1959), aff'd, 280 F.2d 197 (2d Cir. 1960) (per curiam, adopting district court opinion).

3.12.4.5 Survival of Other Rights and Obligations

For the avoidance of doubt, any termination or expiration of the Confidentiality-Obligation Period:

(1) will not waive or otherwise affect the Disclosing Party's ability to enforce its other intellectual-property rights (for example, copyrights and patents) against the Receiving Party except to the extent, if any, that the parties expressly agree otherwise in writing; and

(2) will not affect any obligation of confidentiality imposed by law.

Comment

This is another "roadblock" clause sometimes requested by disclosing parties.

3.12.4.6 Disclaimer of Implied Fiduciary Obligations

For the avoidance of doubt, the Receiving Party's undertaking of the obligations of the Agreement concerning Confidential Information is not intended and should not be interpreted as in itself establishing a confidential‑ or fiduciary relationship between the parties.

Comment

A receiving party likely would not want to take on the higher burden of entering into a fiduciary relationship with the disclosing party. (Opinions seem to vary as to whether the term fiduciary relationship and confidential relationship are synonyms; the answer might depend on the jurisdiction. See generally John A. Day, Difference Between Fiduciary Relationships and Confidential Relationships (JohnDayLegal.com) (citing Tennessee cases).

3.12.4.7  ? Obligation to Segregate Confidential Information

The Receiving Party will keep all Confidential Information segregated from other information, so as to facilitate any necessary return or destruction of the Confidential Information under section 3.12.4.9.

Comment

Drafters should consider whether the receiving party's notes can realistically be segregated.

A segregation requirement might have been useful in S.W. Energy Prod. Co. v. Berry-Helfand, No. 13-0896 (Tex. June 10, 2016). In that case, an independent oil-and-gas reservoir engineer disclosed trade-secret information to a production company under a nondisclosure agreement; when the relationship waned, the engineer asked for the information to be returned, but that proved problematic, as one individual ended up retaining some of the information in his files. See id., slip op. at 7.

3.12.4.8  ? Obligation to Instruct Individual Recipients

Before Confidential Information may be provided to an individual recipient under section 3.12.5.1, the Receiving Party must first take reasonable steps to cause the individual to be specifically instructed that he or she has a duty to abide by the confidentiality obligations of the Agreement.

Comment

This is an extra precaution that some disclosing parties like to require of receiving parties.

3.12.4.9  ? Return or Destruction Obligation

(a) Specimen of Confidential Information is any copy of, and any physical object embodying, Confidential Information — for example, any paper- or electronic copy and any specimen of hardware — where the copy or physical object is in the possession, custody, or control of: (i) the Receiving Party, and/or (ii) any individual or organization to which the Receiving Party made Confidential Information accessible.

(b) IF: The Disclosing Party makes a seasonable written request following any termination or expiration of the Agreement; THEN: except as provided in sections 3.12.4.10 and (if applicable) 3.12.4.22, the Receiving Party will promptly:

(1) return Specimens of Confidential Information to (i) the Disclosing Party, or (ii) another individual or organization designated in writing by the Disclosing Party; and

(2) subject to section 3.12.4.11 (if applicable), destroy any Specimens not returned.

Comment

An obligation to return or destroy Confidential Information might not be practical if (for example) Confidential Information is embodied in a deliverable (for example, custom-developed computer software, or a physical object) that the receiving party will have the right to keep on using; this might be the case in a services agreement.

PRO TIP: Unfortunately, sometimes parties forget about return-or-destruction obligations. A disclosing party will want to follow up to be sure that the return-or-destruction requirement is actually complied with; if it were to fail to do so, a receiving party (or a third party) could try to use that as evidence that the disclosing party did not take reasonable precautions to preserve the secrecy of its confidential information; see generally the Annotations.

Likewise, if the receiving party were to forget to comply with its return-or-destruction obligations, then the disclosing party might use that fact to bash the receiving party in front of a judge or jury.

SUGGESTION: Consider requiring segregation of Confidential Information for easier compliance with this section.

3.12.4.10  ? Exception to Return-or-Destruction Obligation

(a) Specimens of Confidential Information need not be returned or destroyed to the extent that they are not reasonably capable of being readily located and segregated without undue burden or expense — for example, Confidential Information contained in email correspondence or electronic back-up systems.

(b) For the avoidance of doubt, any Specimen of Confidential Information not returned or destroyed remains subject to the Confidentiality Obligations.

Comment

A receiving party might find it to be tremendously burdensome and expensive to try to return or destroy all copies of a disclosing party's confidential information, even those in emails, backup systems, etc.

3.12.4.11  ? Requirement to Obtain Advance Consent to Destruction

When returning or destroying The Receiving Party may not destroy any Specimen of Confidential Information without the prior written consent of the Disclosing Party.

Comment

The requirement of disclosing-party consent to destruction has in mind the situation in which the disclosing party doesn't itself have a copy of Confidential Information to be destroyed. That might occur if, say, (i) a contractor had developed particular information that, under the parties' agreement, was the property of the customer, but (ii) the contractor hadn't yet provided any copies of the information to the customer.

3.12.4.12  ? Obligation to Provide Certificate of Return or Destruction

IF: The Disclosing Party so requests in writing within a reasonable time after the return-or-destruction provisions of the Agreement become applicable; THEN: The Receiving Party will promptly provide the Disclosing Party with a certificate of its compliance with those provisions. The certificate must:

(1) be signed by an officer of the party or other individual authorized to bind the party;

(2) note any known compliance exceptions; and

(3) for each exception, note whether and how the exception is authorized by the Agreement.

Comment

Requiring the Receiving Party to certify its compliance with the return-or-destruction requirements would:

  • provide the Disclosing Party with "they lied!" ammunition in case it turned out that some Specimens of Confidential Information were not returned or destroyed; BUT …
  • thereby give the Receiving Party an incentive to do a good job in complying with the return-or-destruction requirement; and
  • thus help the parties identify specific areas that might need attention before a dispute arose, and thus possibly help to avoid the dispute in the first place.
3.12.4.13  ? Agreement Not to Rely on Confidential Information

The Receiving Party is not entitled to rely, and agrees not to rely, on Confidential Information for any purpose, except to the extent (if any) expressly stated otherwise in the Agreement.

Comment

Some language in this provision is in bold-faced type to make it conspicuous.

See also 9.21.  ? Reliance Disclaimer.

3.12.4.14  ? Disclaimer of Obligation to Provide Confidential Information

For the avoidance of doubt, the Disclosing Party is not required to provide any particular Confidential Information to the Receiving Party except to the extent, if any, that the Agreement expressly indicates otherwise.

Comment

Some disclosing parties might want this kind of clause; I've not seen it used much if at all.

3.12.4.15  ? Option to Retain Archive Copies

(a) Unless otherwise agreed, the Receiving Party may maintain archive copies of Confidential Information for an indefinite period.

(b) The archive copies of Confidential Information may include reasonable backup copies.

(c) No archive copy of Confidential Information is to be used except for the following:

(1) helping the Receiving Party to ascertain and confirm its compliance with its continuing confidentiality obligations;

(2) documenting the parties' interactions in connection with the Agreement; and

(3) reasonable testing of the accuracy the archive copies

(d) Archive copies must be maintained in accordance with commercially-reasonable security standards, for example in the custody of a reputable commercial records-storage organization that is contractually obligated to maintain the archive copies in confidence.

(e) Archive copies and the Confidential Information contained in the copies are not to be made accessible to Receiving-Party personnel — other than Archive Custodians, if the Agreement permits Receiving-Party personnel to serve in that role — except (1) with the Disclosing Party's prior written consent, or (2) as directed or permitted by a tribunal of competent jurisdiction.

Comment

A receiving party might want to be able to retain copies of Confidential Information — even after termination of the agreement — in case, for example: • the parties later got into a dispute about what the disclosing party did or did not actually disclose; or • a third party sued the receiving party (e.g., a customer of the disclosing party that claimed to have been injured as a result of the receiving party's work) and the receiving party wanted to use Confidential Information in its defense.

3.12.4.16  ? Requirement for Archive-Custodian Independence

The Receiving Party may engage one or more independent Archive Custodians, each of which must be reasonably acceptable to the Disclosing Party, to maintain, in strict confidence, on behalf of the Receiving Party, a set of archive copies of Confidential Information.

Comments

If the Archive Custodian(s) does not need to be "independent" (a term well-understood by corporate lawyers), then the Custodian(s) might be, for example, the receiving party's IT staff. Alternatively, a disclosing party might want the Archive Custodian(s) to be limited to the receiving party's outside counsel. (The phrase outside counsel only is well understood by lawyers who work in litigation. See, for example, paragraph 11(c) of the protective order entered in an antitrust case brought by the [U.S.] Department of Justice.)

3.12.4.17   Right to Inspect Confidentiality Compliance

(a) At any time that the Receiving Party has Confidential Information in its possession, the Disclosing Party, upon reasonable advance written notice to the Receiving Party, may cause reasonable inspections of the Receiving Party's relevant properties and premises to be conducted to confirm compliance with the Receiving Party's confidentiality obligations under the Agreement.

(b) For the avoidance of doubt, the right of inspection of this provision extends, by way of illustrative example and not of limitation, to any or all hard-copy and electronic records of any kind in the possession, custody, or control of the Receiving Party.

Comment

Receiving parties are highly likely to balk at this provision. In some cases, though, a disclosing party might feel it was necessary.

3.12.4.18   Receiving Party Obligation re Indemnity

(a) The Receiving Party will defend and indemnify the Disclosing Party, its Affiliates, and the Associated Individuals of each of them, against:

(1) any claim by a third party arising out of the use or disclosure of Confidential Information by, on behalf of, or with the permission of, the Receiving Party;

(2) all harm resulting from any violation of law in the use or disclosure of Confidential Information by, on behalf of, or with the permission of, the Receiving Party.

(b) For the avoidance of doubt, the obligations of this provision will survive any termination or expiration of the Agreement.

Comment

Some disclosing parties will want this kind of clause.

Some receiving parties might balk at this indemnity requirement, especially if the indemnity obligation might encompass unforeseeable harm; see this note for additional details.

3.12.4.19   Obligation to Cooperate Against Misappropriators

During the Authorized-Use Period, in response to any reasonable request by (and at the expense of) the Disclosing Party, the Receiving Party will provide reasonable cooperation with the Disclosing Party and/or its designees in investigating and/or taking action against a third party in connection with possible misappropriation of Confidential Information provided to the Receiving Party.

Comment

See also section 3.12.4.21 (cooperation against misappropriators).

3.12.4.20   Obligation to Provide Recipient Confidentiality Agreements

(a) Upon request by the Disclosing Party, the Receiving Party will provide the Disclosing Party with a copy of the written confidentiality agreement between the Receiving Party and each individual or organization to which the Receiving Party provides Confidential Information.

(b) Such copies may be redacted, if so desired by the Receiving Party, to prevent disclosure to the Disclosing Party of confidential information of the Receiving Party.

Comment

This requirement might be burdensome for the receiving party, but in some situations the disclosing party might have a legitimate need for it.

3.12.4.21   Statement re Liability for Recipient Misappropriation

IF: A third party, referred to as the Recipient – for this purpose including, for example, any employee of the Receiving Party – obtains or otherwise accesses Confidential Information in question as a result of the Recipient's relationship with the Receiving Party;

AND: The Recipient uses, discloses, and/or copies that Confidential Information in a manner not permitted by the Agreement;

THEN: The Receiving Party will be liable to the Disclosing Party for any resulting harm to the Disclosing Party or its interests, to the same extent as if the damage had been caused by use, disclosure, or copying of the Confidential Information by the Receiving Party.

Comment

A disclosing party will sometimes ask a receiving party to be liable (or, "be responsible") for any misappropriation of Confidential Information by the receiving party's employees, contractors, etc. This is an example of the "one throat to choke" principle. (OK, OK, that's an outdated expression; it's still useful.)

If a receiving party objects to this provision, the objection might trigger questions from the disclosing party about the receiving party's intentions (or competence).

See also 3.12.4.19.   Obligation to Cooperate Against Misappropriators.

3.12.4.22   Reasonable-Efforts Option re Return or Destruction

The Receiving Party need only make commercially-reasonable efforts to carry out its obligations of the return-or-destruction provisions of this section.

Comment

The reasonable-efforts option reflects the fact that, by the time a return-or-destruction obligation kicks in, the value of the Confidential Information might be low enough that it's simply not worth spending a lot of time or money on finding extant specimens.

3.12.5 Authorization for Certain Uses

3.12.5.1 Pre-Authorized Uses

(a) Authorized Use Period refers to the term of the Agreement.

(b) Solely during the Authorized Use Period, the Receiving Party may use Confidential Information to the extent reasonably necessary for one or more of the following:

(1) performing the Receiving Party's obligations under the Agreement;

(2) exercising the Receiving Party's rights under the Agreement;

(3) assessing whether to enter into another agreement with the Disclosing Party; and

(4) any other particular authorized uses expressly agreed to in writing by the parties — it is immaterial if one or more of such other authorized uses, if any, falls within any of subdivisions (1) through (3) above.

Comment

Many confidential-information clause templates don't specify any pre-authorized uses of Confidential Information; typically, the parties end up negotiating some fairly-standard categories of authorized use. To save negotiation time, this provision simply goes ahead and pre-authorizes some of those particular categories of use.

A receiving party might want to state explicitly that that certain specified uses are authorized.

3.12.5.2  ? Receiving Party Representation of Intentions

(a) The Receiving Party makes a representation to the Disclosing Party (the Receiving Party's Representation), concerning the Receiving Party's status and its intentions for the use of Confidential Information, as follows: FILL IN.

(b) The Receiving Party makes the Receiving Party's Representation:

(1) to induce the Disclosing Party to provide the Receiving Party with access to Confidential Information, and

(2) with the intent that the Disclosing Party rely on that representation.

Comment

Having the Receiving Party certify its status and its intentions for the Confidential Information would "tee up" a fraud claim against the Receiving Party if it turned out that the Receiving Party in fact intended to make an unauthorized use of Confidential Information.

A clause of this kind can be seen in [TO DO: CITE TO AT&T AGREEMENT NEEDED].

3.12.5.3  ? Receiving Party Freedom of Action

(a) This provision applies in respect of any information that the Disclosing Party causes to be disclosed or made available to the Receiving Party pursuant to the Agreement ("Disclosed Information").

(b) The Receiving Party is bound solely by:

(1) the confidentiality obligations of the Agreement;

(2) any confidentiality obligations that may exist in any other extant and applicable written agreement between the parties; and

(3) any confidentiality obligations imposed by applicable law (for example, privacy law).

(c) Consequently, as between the parties, so long as the Receiving Party abides by the confidentiality obligations of the Agreement, the Receiving Party is free to use and/or disclose any or all such Disclosed Information:

(1) as the Receiving Party sees fit in its sole and unfettered discretion;

(2) without any obligation of compensation to the Disclosing Party or any other party claiming through the Disclosing Party;

(3) but only if such use or disclosure does not violate another intellectual-property right of the Disclosing Party (if any), such as, for example, patent rights, trademark rights, or copyrights.

Comment

Some receiving parties might want this "roadblock" clause to use as ammunition in litigation.

3.12.5.4   Residuals Rights

(a) Residuals refers to ideas, concepts, know-how, techniques, and similar information that may be retained in the unaided memory of the Receiving Party's personnel who did not intentionally memorize the information for that purpose.

(b) The Receiving Party may use Residuals as it sees fit without obligation to the Disclosing Party — this subdivision, however, does not negate any restriction of the Agreement on the Receiving Party's disclosure of Confidential Information to third parties.

(c) For the avoidance of doubt, any use of Residuals by the Receiving Party will be subject to any applicable patent rights, copyrights, trademark rights, or other intellectual-property rights owned or assertable by the Disclosing Party.

Comment

A disclosing party likely will push back strongly against any request for this provision. In practice, the provision can amount to a blank check for the receiving party and its people to do whatever they want with the disclosing party's confidential information.

See also: • Michael D. Scott, Scott on Information Technology Law § 6.25[D] (accessed Nov. 26, 2010) • Brian R. Suffredini, Negotiating Residual Information Provisions in IT and Business Process Outsourcing Transactions (2004) • Tom Reaume, This Residuals Clause Left a Bad Residue (2011).

3.12.6 Authorization for Certain Disclosures

3.12.6.1 Preauthorized Disclosures

(a) Solely during the Authorized-Use Period, the Receiving Party may disclose Confidential Information — on a strict need-to-know basis in connection with the Receiving Party's use of Confidential Information permitted by the Agreement — to one or more of the following, if any:

(1) the Receiving Party's officers, directors, and employees, and individuals having comparable status if the Receiving Party is a non-corporate type of organization (for example, managers of a limited liability company and general partners of a general- or limited partnership); and

(2) any other authorized recipients expressly agreed to in writing by the parties, if any. (It is immaterial if one or more such other authorized recipients comes within the scope of sub­div­i­sion (1) above.)

(b) Each individual to whom Confidential Information is disclosed by, or with the authorization of, the Receiving Party must be legally bound to comply with the provisions of the Agreement protecting Confidential Information, either:

(1) by a written agreement containing confidentiality obligations, comparable to those of the Agreement, that apply to Confidential Information; or

(2) as a matter of law, for example where (A) the recipient is an employee of the the Receiving Party and (B) under applicable law an employee is bound to preserve in confidence the confidential information of the employer.

Comment

Drafters should consider the extent — if any — to which the Receiving Party's contractors, affiliates, etc., should be permitted to receive Confidential Information. This will be especially true if the Receiving Party's workforce includes so-called leased employees or other individuals working long-term in independent-contractor status.

Limiting disclosures by the Receiving Party to a need-to-know basis is pretty standard in confidentiality provisions.

Subdivision (b) ia a corollary to the confidentiality obligations; see generally its commentary.


3.12.6.2 Disclosure Under Subpoena, Etc.

(a) Compulsory Legal Demand refers to a demand for information such as (for example) a subpoena; a search warrant; a civil investigative demand; or a discovery request in a lawsuit; if in each such case, both of the following are true:

(1) the demand for information is initiated or propounded by a third party such as (for example) a litigant or a governmental entity; and

(2) the Receiving Party's compliance with the demand for information may be compelled under penalty of law.

(b) The Receiving Party may disclose Confidential Information in response to a Compulsory Legal Demand, as follows:

(1) The Receiving Party must seasonably advise the Disclosing Party of the Compulsory Legal Demand (to the extent that doing so is not prohibited by law).

(2) The Receiving Party must disclose only so much Confidential Information as is required to comply with the Compulsory Legal Demand.

(3) If so requested by the Disclosing Party, the Receiving Party must provide reasonable cooperation with any efforts by the Disclosing Party to limit the disclosure, and/or to obtain legal protection for the information to be disclosed, in response to the Compulsory Legal Demand.

(4) Upon request by the Receiving Party, accompanied by (and/or supplemented with) reasonable supporting documentation, the Disclosing Party will reimburse the Receiving Party for all reasonable expenses incurred in providing the cooperation referred to in sub­div­i­sion (1), including for example reasonable attorney fees.

(c) For the avoidance of doubt, this section 3.12.6.2 does not authorize any disclosure Confidential Information that does not qualify as a Compulsory Legal Demand (for example, a discretionary filing under the securities laws).

Comment

This provision makes it clear that voluntary or discretionary disclosures of Confidential Information are not allowed, for example in public filings with the Securities and Exchange Commission (SEC). For a case in which the voluntary-filing issue was litigated, see Martin Marietta Materials, Inc v. Vulcan Materials Co., 56 A.3d 1072 (Del. Ch. 2012), aff'd, 45 A. 3d 148 (Del. 2012) (en banc). There, the court held that Martin Marietta had breached a non-disclosure agreement by including Vulcan's confidential information in an SEC filing about Martin Marietta's proposed takeover of Vulcan.

See also 3.12.6.5.   Disclosure in Public Filings.

3.12.6.3 Other Legally-Authorized Disclosures

(a) The confidentiality provisions of the Agreement are not to be interpreted:

(1) as precluding the Receiving Party from disclosing Confidential Information — in confidence and to the minimum extent required by law — as part of any of the following:

(A) reporting possible violations of law or regulation to any governmental agency or entity having jurisdiction, including but not limited to the United States Department of Justice, Securities and Exchange Commission, Congress, and any agency inspector general, as well as any other federal, state or local government official; nor

(B) disclosure to an attorney solely for the purpose of reporting or investigating a suspected violation of law;

(C) disclosure in a complaint or other document filed in a lawsuit or other proceeding, if the filing is made under seal;

(D) disclosure to an attorney representing the Receiving Party for use in the court proceedings of a lawsuit alleging that the Disclosing Party retaliated against the Receiving Party for reporting a suspected violation of law, as long as any document containing the Confidential Information is filed in court only under seal and the Receiving Party does not otherwise disclose the Confidential Information except under a court order;

(E) making other disclosures by the Receiving Party that are positively authorized by law or regulation, for example the [U.S.] National Labor Relations Act or other labor- or employment law; nor

(2) as requiring the Receiving Party to obtain the prior consent of the Disclosing Party to make such reports or disclosures; nor

(3) as requiring the Receiving Party to notify the Disclosing Party that it has made such reports or disclosures.

(b) In the interest of promoting the prompt identification and correction of possible violations of law or regulation, the Receiving Party is strongly urged to promptly advise the Disclosing Party of any facts, material to the Disclosing Party or to the relationship between the Disclosing Party and the Receiving Party, that would be contained in any report or disclosure referred to in sub­div­i­sion (a)(1).

Comment

Subdivisions (a)(1)(A) through (a)(1)(D) have in mind the (U.S.) Defend Trade Secrets Act, enacted in 2016. [CITE NEEDED]. This legislation followed fierce assertions by several U.S. Government agencies that a company may not even arguably discourage, let alone prohibit, the company's employees from disclosing whistleblower information to the agencies. For example, in 2015 the Securities and Exchange Commission went after well-known government contractor KBR for this; the contractor agreed to the entry of a cease-and-desist order and to pay $130,000 settlement. [SEC press release] [SEC order] [Houston Chronicle article] See also the discussion of how the [U.S.] National Labor Relations Board has taken a similar view about employees' discussing salary- and working-conditions with each other.

3.12.6.4   Disclosure in Secure Data Room

(a) The Receiving Party may, without the Disclosing Party's consent, disclose Confidential Information to a prospective acquirer of:

(1) substantially all shares (or equivalent ownership interest under applicable law) of the Receiving Party itself; or

(2) substantially all of the assets of the Receiving Party's business specifically associated with the Agreement.

(b) Any such prospective recipient of Confidential Information must agree in writing to abide by the Receiving Party's obligations in the Agreement relating to Confidential Information.

(c) Any such disclosure must be done in one or more secure physical data rooms or via a secure online data room.

(d) The Receiving Party must not allow the recipient to keep copies of Confidential Information without the Disclosing Party's prior written consent.

Comment

This provision was inspired by a blog posting by English lawyer Mark Anderson.

See generally the Wikipedia article Data room.

3.12.6.5   Disclosure in Public Filings

The Receiving Party may include Confidential Information in a submission to a regulatory agency or other governmental body, if all of the following conditions are met:

(1) the inclusion is compelled by law, to the same extent as if the inclusion were compelled by law in response to a Compulsory Legal Demand;

(2) the Receiving Party first consults with the Disclosing Party a sufficient time in advance to give the Disclosing Party a reasonable opportunity to seek a protective order or other relief;

(3) the Receiving Party discloses only so much Confidential Information as is required to comply with the law; and

(4) the Receiving Party provides reasonable cooperation with any efforts by the Disclosing Party to limit the disclosure, and/or to obtain legal protection for the information to be disclosed, in the same manner as if the proposed disclosure were in response to a Compulsory Legal Demand.

Comment

A Receiving Party that is publicly traded (or wants to be) might feel it must disclose Confidential Information in its public filings. Such disclosure, though, can destroy the confidentiality status of the information. See generally, e.g., Ruckelshaus v. Monsanto Co., 467 U.S. 986, 1011-12, esp. text accompanying n.15 (1984) (noting that Environmental Protection Agency's disclosure of Monsanto's pesticide test data would destroy Monsanto's trade-secret rights in the data).

This basic issue arose in Martin Marietta Materials, Inc v. Vulcan Materials Co., 56 A.3d 1072, 1147 (Del. Ch. 2012), aff'd, 45 A. 3d 148 (Del. 2012) (en banc): In that case, Martin Marietta was held to have breached a confidentiality agreement by including confidential information of Vulcan Materials in a public filing with the Securities and Exchange Commission.

3.12.7 Authorization for Certain Copying

(a) During the Authorized-Use Period, but not afterwards, the Receiving Party may make copies and excerpts of Confidential Information, solely to the extent reasonably necessary for use or disclosure permitted by the Agreement.

(b) The Receiving Party must ensure that any such copy or excerpt is marked, with reasonable prominence, as the Confidential Information of the Disclosing Party.

(c) For the avoidance of doubt, the confidentiality obligations of the Agreement apply to all such copies or excerpts.

Comment

In some situations, a disclosing party might want to tighten up on the receiving party's ability to make copies and excerpts.

Additional notes: Confidential Information

Gouge (that is, important points to know)

FOR PARTIES THAT MIGHT BE DISCLOSING THEIR CONFIDENTIAL INFORMATION:

  • Whose information should be protected? If the other party is also a Disclosing Party, then the first Disclosing Party would have confidentiality obligations concerning the other party's Confidential Information.
  • Too-short a Protected-Disclosure Period could result in the Disclosing Party's inadvertently blowing its legal rights in later-disclosed Confidential Information.
  • Too-short a Confidentiality-Obligation Period: Ditto.
  • If the agreement includes a marking requirement for Confidential Information, the Disclosing Party might inadvertently neglect to comply with the marking requirement as to particular information — which might destroy the Disclosing Party's legal rights in that information.
  • Some of the receiving-party playbook options could be troublesome.

FOR PARTIES THAT MIGHT BE RECEIVING ANOTHER PARTY'S CONFIDENTIAL INFORMATION:

Business context

It's quite common for parties to enter into a confidentiality agreement as a prelude to negotiation of another agreement such as a sale- or license agreement or a merger- or acquisition agreement.

It's also quite common for other types of agreement to include confidentiality provisions, for example services agreements; license agreements; and employment agreements.

Confidentiality agreements ("NDAs") and potential investors

Potential investors in a company might be reluctant to sign a nondisclosure agreement ("NDA"). Venture capitalists in particular often flatly refuse to do so. With folks like that, you basically have to take your chances that they won't "steal" your idea.

As a practical matter, going without an NDA with venture capitalists might not be a bad bet, because:

  • You can try to be very, very selective about what you disclose without an NDA, so that you're not giving away the "secret sauce" of your idea.
  • Investors and others generally do have one or two other things on their minds. They generally see lots of entrepreneurs who are convinced they've got a world-beating idea. You'll probably be lucky to get these investors to pay attention for two minutes. Ask yourself how likely it is that they'll want to take your idea and spend time and money building a business around it without you.
  • Contracts aren't the only thing that discourage bad behavior. If an investor stole someone's idea, and if word got around, then that investor might later find it hard to get other people to talk to him.
  • You have to decide what risks you want to take. Your business might fail because an investor steals your idea and beats you to market. Or it might fail because you can't raise the money you need to get started.

    It's sort of like having to take a trip across the country. You have to decide whether to fly or drive. Sure, there's a risk you could die in a plane crash flying from one side of the country to the other. But if you were to drive the same route, your risk of dying in a car crash has been estimated as being something like 65 times greater than flying.

As the old saying goes, you pays your money and you takes your choice.

Caution: NDAs and prospective BigCo partners / acquirers

It's not unheard of for a big company to approach a small company about being "partners," perhaps hinting that the big company might want to acquire the small company. In that situation, the small company should be alert to the possibility that the big company might be trying to get a free look at the small company's confidential information. See, e.g., this story told by an anonymous commenter on Hacker News.

An NDA can come in very handy in such situations. Enforcing an NDA can take a lot of time and money, especially if the big company is convinced (or convinces itself) that it hasn't done anything wrong. But a jury might well punish a company that it found breached the contract. See, e.g., Celeritas Technologies Ltd. v. Rockwell Int'l, Inc., 150 F.3d 1354 (1998), where a federal-court jury in Los Angeles awarded a startup company more than $57 million because the jury found that Rockwell had breached an NDA. (Disclosure: I was part of Rockwell's trial team in that case.)

3.13   [Reserved: Escrow]

Cal. S. Ct.'s explanation of escrow agent's duties: https://scholar.google.com/scholar_case?case=11301981884307642549

3.14   [Reserved: Insurance]

See Insurance for notes on this subject.

3.15   International contracts (rough notes only)

:PROPERTIES :CUSTOMID: IntlContracts

See generally Ken Adams and René Mario Scherr, Top Ten Tips in Drafting and Negotiating International Contracts (acc.com April 2015) (see also the PDF file)

3.16   Recordkeeping

3.16.1 Definition of Required Records

(a) The term Required Records refers to the records specified in sub­div­i­sions (b) and (c) below.

(b) During the term of the Agreement (the Recordkeping Period), any party engaged in activities described in subdivisions (1) through (4) below (each, a Recordkeeping Party) is to create and maintain records sufficient to document the following, as applicable:

(1) all deliveries of goods and services, by the Recordkeeping Party to another Signatory Party, under the Agreement;

(2) billing of charges or other amounts, by the Recordkeeping Party to another Signatory Party, under the Agreement;

(3) all payments, by the Recordkeeping Party to another Signatory Party, under the Agreement, of amounts not verifiable by the payee, such as, for example, royalties or rents to be paid to the other party as a percentage of the Recordkeeping Party's sales; and

(4) all other information (if any) that the Agreement requires the Recordkeeping Party to report to another Signatory Party.

(c) The Required Records are to include, for example, where applicable, the following: Sales journals; purchase-order journals; cash-receipts journals; general ledgers; and inventory records; as well as any other records expressly required by the Agreement.

Comments

According to a study of U.S. construction companies, interviewees reported that unless the contract spells out in detail just what records are to be kept, "it is incredibly difficult to obtain the proper records from the Contractor in order to conduct a proper audit." Albert Bates, Jr. and Amy Joseph Coles, Audit Provisions in Private Construction Contracts: Which Costs Are Subject to Audit, Who Bears the Expense of the Audit, and Who Has the Burden of Proof on Audit Claims?, 6 J. Am. Coll. Constr. Lawyers 111, 114 (2012) (footnote omitted).

sample clause published by the Association of Certified Fraud Examiners contains a laundry list of specific types of documents that a vendor might want to require a contractor to maintain.

The list in subdivision (c) is is adapted from the contract in suit in Zaki Kulaibee Establishment v. McFliker, No. 11-15207, slip op. at 14 n.13 (11th Cir. Nov. 18, 2014) (reversing, as abuse of discretion, and remanding district court's denial of plaintiff's request for an accounting).

In some situations, parties might want to negotiate specific records to be kept.

3.16.2 Standards for Recordkeeping

All Required Records are:

(1) to be accurate;

(2) to be materially-complete; and

(3) to comply with:

(A) at least commercially-reasonable standards of recordkeeping; and

(B) if stricter, any other recordkeeping standards specified in the Agreement.

Comments

The term used to describe the Required Records is materially-complete and accurate. Some drafters use the term true and correct, but that seems both redundant and incomplete. Perhaps in an archaic sense the term true might be interpreted broadly to mean materially complete and accurate, but there seems to be little reason to take a chance that a judge would see it that way.

In some situations, parties might want to negotiate specific recordkeeping standards.

3.16.3 Record Retention Obligation

The Recordkeeping Party will keep each of the Required Records for at least the longest of the following (the Record-Retention Period):

(1) any retention period required by applicable law;

(2) the duration of any timely-commenced audit of the Required Records permitted by the Agreement; and

(3) any other period specified in the Agreement, if any.

Comment

When services are involved, retaining records for two- to four years after final payment seems to be a not-uncommon requirement. See, for example, the [U.S.] Federal Acquisition Regulations, e.g., Contractor Records Retention, 48 C.F.R. §§ 4.703(a)(1), 4.705.

Some industries or professions might require specific record-retention periods.

NOTE: The Record-Retention Period is not the same as the Recordkeeping Period.

3.16.4 Right to Audit Records

Any other Signatory Party described in section 3.16.1(b) may audit the Required Records in accordance with the procedures set forth in section 3.17.

Comment

See generally the Reading Notes on this subject..

3.16.5   Record Retention Per FAR Standards

(a) If expressly so stated in the Agreement, the Recordkeeping Party will maintain each of the Required Records for at least the period that the record would be required to be maintained under the (U.S.) Federal Acquisition Regulations ("FARs"), Contractor Records Retention, 48 C.F.R. Subpart 4.7.

(b) For the avoidance of doubt, this section is included for the convenient reference of the parties, who do not intend to imply or concede that the Agreement and/or their relationship are in any way subject to the FARs.

Comment

The FARs' record-retention requirements go into some detail; drafters might want to take advantage of that specificity.

Additional notes: Recordkeeping

Any contract drafter who will be negotiating recordkeeping- and audit clauses would do well to study carefully the primer found in Ryan C. Hubbs, The Importance of Auditing In An Anti-Fraud World — Designing, Interpreting, And Executing Right to Audit Clauses For Fraud Examiners (Assoc. of Certified Fraud Examiners 2012).

See also 3.17.   Audits.

3.17   Audits

3.17.1 Audit Definitions

Auditable Records refers to records sufficient to document each of the following, as applicable,

(1) labor performed and billed under the Agreement;

(2) materials billed under the Agreement;

(3) other items billed under the Agreement;

(4) compliance with specific requirements of the Agreement; and

(5) any other matters as to which, under the Agreement, the Auditing Party has the right to audit records.

Auditing Party refers to a specified party that has the right to cause Auditable Records to be audited under the Agreement.

Permissible Auditors refers to:

(1) any Big Four accounting firm; and

(2) any other auditor proposed by the Auditing Party by written notice and reasonably acceptable to the Recordkeeping Party.

Recordkeeping Party refers to any party that, under the Agreement, is required to keep records that come within the definition of Auditable Records.

Comment

This language is set up in generic terms with a view to having this provision be serviceable even if a drafter doesn't fill in deal-specific details..

3.17.2 Right to Conduct Audits

The Auditing Party may cause one or more audits of Auditable Records to be conducted, in accordance with the audit provisions of the Agreement, by one or more Permissible Auditors.

Comment

In some cases involving multiple parties to a contract, a recordkeeping party might want to defined Auditing Party to include only selected other parties.

The "cause" language has in mind that:

  • An auditing party might not want to bear the expense of having an outside auditor do the job, and instead might prefer to send in one of its own employees to "look at the books";
  • On the other hand, a recordkeeping party might not want the auditing party's own personnel crawling around in the recordkeeping party's records, but might be OK with having an outside accountant (or other independent professional) do so.

A recordkeeping party might want the absolute right to veto the auditing party's choice of auditors, instead of having the right to give reasonable consent. On the other hand, the auditing party might not trust the recordkeeping party to be reasonable in exercising that veto, and could be concerned that a dispute over that issue would be time-consuming and expensive. This provision represents a compromise.

An auditing party might want to add that consent is deemed given if the recordkeeping party doesn't object in writing within X days after receiving or refusing the auditing party's written proposal of an auditor.

3.17.3 Audit Access

(a) The Recordkeeping Party will provide the auditor(s) with access to the Auditable Records to the extent reasonably necessary for the audit, in the form, electronic or otherwise, in which the Recordkeeping Party keeps those records in the ordinary course of the Recordkeeping Party's business.

(b) The Recordkeeping Party will make its relevant personnel reasonably available to the auditor(s), and direct them to answer reasonable questions from the auditor(s), except as otherwise provided in the Agreement.

Comment

Sub­div­i­sion (a): An auditing party probably would not want a recordkeeping party to just print out its electronic records on paper and deliver them to the auditors; in all likelihood, that would significantly increase the cost of the audit. See Ryan C. Hubbs, The Importance of Auditing In An Anti-Fraud World — Designing, Interpreting, And Executing Right to Audit Clauses For Fraud Examiners, at 4 (Assoc. of Certified Fraud Examiners 2012).

A party agreeing to an audit clause might want to restrict the auditor's access to the facilities, computers, etc., of the party being audited. For example, software vendors often include audit provisions in their license agreements, to allow a vendor to audit a customer's use of the software to confirm that all such use is appropriately licensed (and paid for). A software vendor's audit clause might allow the vendor to access the customer's computer systems, but the customer might not want this, especially if the customer is in a sensitive industry such as finance or health care. A possible compromise might be to allow a third-party auditor to have limited access to computer systems, etc., under a strict confidentiality agreement. (Hat tip: Christopher Barnett, Top Three Revisions To Request In Software License Audit Clauses (ScottAndScottLLP.com 2015).)

Sub­div­i­sion (b): Audits sometimes happen after business relationships start to turn sour. In situations like that, it's not unheard of for recordkeeping parties' personnel to be uncooperative. So, it can help to lay out ground rules for what might otherwise be an unfriendly episode.

3.17.4 Post-Audit Adjustments

(a) IF: An audit reveals the apparent existence of a billing- or payment discrepancy such as (for example) over- or underbilling or over- or underpayment; THEN: The party benefiting from that discrepancy is to promptly take such action as may be necessary to remedy ("true-up") the discrepancy, including, for example, refunding an overpayment or paying a shortfall, as the case may be.

(b) IF: A party — due to an error that it made or for which it is otherwise responsible — must pay a shortfall or refund an overpayment under section 3.17.4; THEN: That party must also pay interest on the shortfall or refund at 1.5% simple interest per month or the maximum rate permitted by law, whichever is less.

Comment

Subdivision (b) (interest charges): Drafters should be very careful about usury laws, which can have real teeth.

CAUTION: If an agreement is going to provide for charging interest on past-due amounts apart from an audit provision, then that interest provision probably should be separate from the audit provision. In the 2014 Cellport case, a contract drafter's failure to keep the two provisions separate resulted in a contract plaintiff's winning the case, but receiving a much-lower interest rate than was called for by its contract. See Cellport Sys., Inc. v. Peiker Acustic GmbH & Co., KG, 762 F.3d 1016, 1028-29 (10th Cir. 2014).

3.17.5 Reimbursement of Audit Expenses

The Recordkeeping Party is to reimburse the Auditing Party for reasonable expenses actually incurred — for example, reasonable auditors' fees and expenses — if an audit reveals the existence of any of the following, if the Recordkeeping Party is responsible for it under the Agreement:

(1) a discrepancy in billing or payment, for the period being audited, that:

(A) is equal to or greater than 5%; and

(B) was caused by an error made by, or imputable to, the Recordkeeping Party; and

(C) favors the Recordkeeping Party; and/or

(2) an uncured material breach of the Agreement, and/or

(3) fraud.

Comment

Sub­div­i­sion (1): The discrepancy revealed by the audit must exceed the stated threshold percentage for the period being audited. That will help to avoid unfair expense shifting if, say, a discrepancy for a single month was discovered in an audit for five years' worth of records. In that kind of situation, the Recordkeeping Party argably shouldn't have to foot the bill for the entire five-year audit; on the other hand, neither should the Recordkeeping Party necessarily escape the consequences of the ten-percent discrepancy in that one month. The language of this provision represents a compromise position.

Subdivision (1)(A): The threshold for shifting audit expenses might well be negotiable, often falling in the range between 3% and 7% for royalty-payment discrepancies and perhaps in the range of 0.5% for billing discrepancies in services.

Sub­div­i­sion (2): Consider also 3.17.21.   Recordkeeping Party Expenses.

3.17.6 Audit Time and Place

Unless otherwise agreed, each audit is to be conducted:

(1) at the location or locations where the Auditable Records are kept in the ordinary course of business, during the regular working hours, at that location, of the party having custody of the records; or

(2) at the Recordkeeping Party's option, at one or more other reasonable times and places designated in advance by the Recordkeeping Party in consultation with the Auditing Party.

Comment

This provision reminds drafters that in an unfriendly audit, the recordkeeping party might try to demand that auditable records be produced for audit at a location not desired by the auditing party, or vice versa.

In some contracts it might be desirable for the audit provision to specify either (1) an agreed location for audits, or (2) if a specific location can't be satisfactorily determined in advance, an agreed procedure for determining the location if the parties are unable to agree on one. (This is an example of the truth that if parties can't agree in advance on an outcome – possibly because one or more of them simply doesn't know what outcome they want – then perhaps they can agree on a process for determining the outcome when the circumstances arise.)

3.17.7 Exclusion of Certain Information

Unless the Agreement expressly states otherwise, the Auditing Party's right to audit Auditable Records does not extend to any of the following:

(1) information that, under applicable law, would be immune from discovery in litigation, for example on grounds of attorney-client privilege, work-product immunity, or any other privilege;

(2) trade secrets and other confidential information relating to formulae and/or processes; and

(3) clearly-unrelated or -irrelevant information.

Comment

This clause excludes from auditing any information that is subject to the attorney-client privilege and any other applicable privilege. That's because in the case of the attorney-client privilege, disclosure of privileged information to outsiders likely would waive the privilege in many jurisdictions and thus make the privileged information available for discovery by others, including third parties. (A recordkeeping party might also want to specify other particular audit exclusions.)

Sub­div­i­sion (2) might be open to dispute, but at least it gives the Recordkeeping Party ammunition with which to oppose an unreasonable "fishing expedition" by the Auditing Party.

3.17.8 Audit Notice

The Auditing Party must give the Recordkeeping Party at least ten business days' advance written notice of any proposed audit except for good reason.

Comment

Normally, both parties will benefit if the recordkeeping party has a reasonable time to collect its records, remedy any deficiencies, etc., before the auditor(s) get there. On the other hand, if the auditing party suspects cheating or other malfeasance, a surprise audit might be in order.

3.17.9 Audit Frequency

The Auditing Party may conduct audits no more than once per 12-month period and once per period audited except for good reason.

Comment

An audit might end up being at least somewhat burdensome and disruptive to the recordkeeping party; most recordkeeping parties will want to limit the auditing party's ability to initiate audits. See also • the definition of good reason; and • the option requiring the Auditing Party to reimburse the Recordkeeping Party's expenses.

3.17.10 Deadlines for Audit Requests

(a) Except for good reason, the deadline for the Auditing Party to request an audit for any given Auditable Record is the later of:

(1) the end of any legally-enforceable record retention period for that Auditable Record, if any; and

(2) three years after the end of the calendar quarter in which the substantive content of that Auditable Record was most-recently revised.

(b) For the avoidance of doubt, this subdivision does not in itself require the Recordkeeping Party to maintain that Auditable Record for that period of time, but only states a deadline for the audit request.

Comment

An audit request should be timely; otherwise, a creative counsel might try to argue that the party had the right to conduct an audit even when, for example, the underlying agreement had expired or been terminated. A would-be auditing party's counsel tried unsuccessfully to make such an argument in New England Carpenters Central Collection Agency v. Labonte Drywall Co., No. 14-1739 (1st Cir. July 31, 2015) (affirming district court's judgment after bench trial).

At some point, the recordkeeping party might want to be able to get rid of its records; also, it won't want to have to support an audit of (say) 20 years of past records.

3.17.11 Audit Confidentiality Obligation

(a) Absent consent of the Recordkeeping Party, the Auditing Party:

(1) may not use any nonpublic information that is learned or derived in the course of any such audit, except to the extent necessary to protect the Auditing Party's rights and/or for the Auditing Party's performance of its obligations under the Agreement;

(2) may not disclose any such information to third parties except in response to compulsory legal process, after first:

(A) advising the Recordkeeping Party of such process (where not prohibited by law); and

(B) providing reasonable cooperation in any efforts by the Recordkeeping Party to preserve the confidentiality of such information.

(b) The Auditing Party must enter into binding written agreements with its auditors requiring them to comply with the audit-confidentiality requirements of the Agreement.

Comment

This provision includes what amounts to a nondisclosure agreement ("NDA") in miniature. For especially-sensitive matters, the parties might wish to negotiate a separate NDA for the auditor(s) to sign.

3.17.12 Auditor Work Space

IF: An audit is to be conducted at one or more sites controlled by the Recordkeeping Party; THEN: The Recordkeeping Party is to cause the audit site(s) to be furnished with with appropriate facilities of the type customarily used by knowledge-based professionals, including, for example, furniture, lighting, air conditioning, electrical outlets, and Internet access.

Comment

In an unfriendly audit, an uncooperative recordkeeping party might try to make the auditors work in a closet, a warehouse, or worse.

3.17.13 Audit "Good Reason" Definition

For purposes of the audit provisions of the Agreement, good reason, whether or not capitalized, includes, for example, any one or more of the following:

(1) significant lack of cooperation, by the Recordkeeping Party, in an audit under the Agreement; and

(2) the discovery of substantial evidence of fraud, or of material breach of the Agreement, on the part of the Recordkeeping Party.

Comment

Either of the two listed items might well warrant setting aside the usual agreed limitations on advance notice, deadlines, etc.

3.17.14 Survival of Audit Provisions

The audit provisions of the Agreement will survive any termination or expiration of the Agreement (but will also remain subject to all deadlines and other limitations stated in the Agreement).

Comment

Not specifying that audit rights survive termination of the Agreement might result in the audit right ending when the Agreement does. That happened in New England Carpenters Central Collection Agency v. Labonte Drywall Co., No. 14-1739 (1st Cir. July 31, 2015) (affirming district court's judgment after bench trial).

3.17.15  ? Right to Receive Copy of Audit Report

The Recordkeeping Party is entitled to receive, from the auditor(s), upon request, at the Auditing Party's expense, a copy of any audit report produced.

Comment

The Recordkeeping Party might not care about getting a copy of an audit report if the report says, basically, everything's cool here. But if the Recordkeeping Party will have to come up with extra money, or is accused of a material breach, it likely will indeed want to get a copy of the audit report.

The Auditing Party might object to providing the Recordkeeping Party with a copy of the audit report. But face it: If the dispute goes to litigation or even arbitration, the odds are high that the Auditing Party's lawyers will be able to get a copy of the audit report as part of the discovery process (for example, by issuing a subpoena to the auditors)

Note for contract-drafting students: This provision is intentionally phrased in a form of passive voice in an effort to make it not only clear but also "palatable."

3.17.16  ? Flowdown of Audit Provisions

(a) The Recordkeeping Party is to include, in each subcontract under the Agreement, if any, provisions for the benefit of the Auditing Party as a third-party beneficiary, as follows:

(1) a requirement that the subcontractor permit audits by the Auditing Party in accordance with the audit provisions of the Agreement; and

(2) an authorization for the subcontractor to deal directly with the Auditing Party and its auditor(s) in connection with any such audit.

(b) For the avoidance of doubt, sub­div­i­sion (a) neither authorizes nor prohibits the Recordkeeping Party's use of subcontractors under the Agreement.

Comment

Flowdown requirements are often found in U.S. Government contracts, among others.

3.17.17  ? Deadline for Audit Completion

Except for good reason, the deadline for the auditor(s) to complete a given audit is three months after the effective date of the Auditing Party's advance written notice of the audit.

Comment

Three months should normally be more than enough time for an auditor to complete a reasonable audit unless one or another party is unreasonable about scheduling, access, etc.

3.17.18   Restriction on Audit-Report Content

The auditor(s) must agree in writing (and provide a copy of the agreement to the Recordkeeping Party):

(1) to disclose to the Auditing Party only whether a reportable discrepancy was revealed by the audit, and if so, the size and general nature of the discrepancy; and

(2) that the Recordkeeping Party is a third-party beneficiary of that written agreement.

Comment

A Recordkeeping Party might want this if it is concerned that the auditor(s) might need to delve into confidential information that the Recordkeeping Party doesn't want to be provided to the Auditing Party.

3.17.19   Limitation of Remedies for Audit Discrepancies

IF: In respect of any invoicing- or payment discrepancy revealed by an audit, the Recordkeeping Party complies with the obligations of section 3.17.4 and section 3.17.5 within 30 days after receiving notice of the discrepancy and a copy of the audit report; THEN: The Recordkeeping Party will have no further obligation or liability for that discrepancy or the actions or omissions that caused it.

Comment

An auditing party might object to this provision if it wanted to be free also (i) to terminate the Agreement if the discrepancy were material, and/or (ii) to demand a greater measure of damages for the discrepancy if that were available by law (such as indirect damages resulting from copyright infringement).

As a contrary example, though: A software customer might want this provision as a shield against an aggressive software licensor in case an audit by the licensor revealed that the customer was making more use of the software than it had paid for. See, e.g., Christopher Barnett, Top Three Revisions To Request In Software License Audit Clauses (ScottAndScottLLP.com 2015). (Software licensors might well be willing to go along with such a limitation of liability — but possibly with the proviso that any catch-up license purchases would be at full retail price, regardless of any negotiated discount; otherwise the customer would have an incentive to roll the dice and cheat on obtaining licenses.)

3.17.20   Auditor Retention of Record Copies

The auditor(s) may make and keep copies of the records that it audits, so long as the auditor(s):

(1) comply with the audit-confidentiality requirements of the Agreement; and

(2) return or destroy the copies, in accordance with the auditor's regular, commercially-reasonable policies and processes, within a reasonable time after the end of the last period for which Auditable Records are required to be maintained under the Agreement or by law.

Comment

An auditing party's auditors might well find it burdensome (and therefore more expensive for the auditing party) to be precluded from making copies of the recordkeeping party's records.

Outside auditors might insist on being able to take copies with them to file as part of their work papers.

In some circumstances, the recordkeeping party might want to negotiate for limits on the types of records that the auditor(s) are allowed to copy and take away.

3.17.21   Recordkeeping Party Expenses

IF: For a particular audit, the Recordkeeping Party is not required to reimburse the Auditing Party's expenses of the audit; THEN: The Auditing Party is to reimburse the Recordkeeping Party (and the Recordkeeping Party's subcontractors, if applicable) for reasonable expenses actually incurred in connection with the audit, such as (for example) reasonable fees and expenses for an auditor engaged by the Recordkeeping Party to monitor the audit.

Comment

An article by two construction lawyers points out that "audit provisions rarely address the apportionment of the costs incurred by the Contractor or its subcontractors in facilitating the audit, managing the audit, reviewing and responding to the audit results, and other related activities if the audit fails to demonstrate signicant overbilling by the Contractor." Albert Bates, Jr. and Amy Joseph Coles, Audit Provisions in Private Construction Contracts …, 6 J. Am. Coll. Constr. Lawyers 111, 132 (2012) (emphasis added).

Additional notes: Audits

A real-world example

The nuclear Navy, in which I served, has a saying: You get what you inspect, not what you expect. This saying can be equally true in the world of contract relationships: Mistakes can happen — and sometimes, so can creative accounting, stonewalling, and even outright fraud. Here's a real-world situation in which an audit provision in a contract came in handy for the would-be auditing party:

  • A Saudi company signed a consignment agreement with a Florida company. Under that agreement, the Florida company would sell what was expected to be around $500 million worth of aircraft parts.
  • The parties apparently didn't have any procedure in place for confirming just what parts the Saudi company had shipped to the Florida company to be sold off. (The court's opinion suggests that the Florida company might have used "creative" accounting techniques in that regard.)
  • The Saudi company tried to get discovery to find out just how much the Florida company had really sold.
  • The Florida company evidently stonewalled on producing its records.
  • The district court refused to order an accounting — this, even though the parties' contract included an audit provision.
  • The appellate court reversed and remanded, stating that the district court abused its discretion by refusing to order an accounting.

See Zaki Kulaibee Establishment v. McFliker, 771 F.3d 1301 (11th Cir. 2014).

Some things an audit might uncover

One fraud examiner asserts that "entities often implicitly trust vendors. but just as good fences make good neighbors, vendor audits produce good relationships." Craig L. Greene, Audit Those Vendors (2003). Greene lists a number of things that fraud examiners watch for, including, for example:

  • fictitious "shell entities" that submit faked invoices for payment;
  • cheating on:
    • shipments of goods (e.g., by short-shipping goods or sending the wrong ones) or
    • performance of services (e.g., by performing unnecessary services or by invoicing for services not performed);
  • billing at higher-than-agreed prices;
  • kickbacks and other forms of corruption;

and others. See id.

3.18   Safety

3.18.1 Safety-Measures Definitions

This section 3.18 applies if the Agreement specifies that one or more parties (each, an Obligated Party) is to take safety measures.

Comment

The need for this clause will obviously depend on what kind of activities are to be engaged in under the parties' agreement.

In some contracts it might make more sense to have only one party be designated as an Obligated Party.

3.18.2 Reasonable Safety Measures Requirement

In connection with its activities under the Agreement, each Obligated Party will cause at least the following Minimum Safety Measures to be taken:

(1) commercially-reasonable safety measures; and

(2) any other safety measures specified in the Agreement.

Comment

Some parties might want to specify particular safety measures, e.g., those conforming to particular industry requirements or published specifications.

3.18.3   Safety Measures Indemnity Clause

Each Obligated Party will defend and indemnify each other Signatory Party and that Signatory Party's Protected Group against any claim, by any third party in any forum or before any tribunal, arising out of the Obligated Party's noncompliance with the safety obligations of this Agreement.

Comment

The indemnity-obligation option is a canary in the coal mine clause: If a prospective Obligated Party were to balk at it, that might raise questions about that party's long-term intentions or capabilities.

Insurance: As with any indemnity obligation, a would-be protected party should check whether the indemnifying party has the financial assets with which to meet the obligation; if not, the protected party should consider including a requirement that the indemnifying party carry suitable insurance coverage.

For a contract with more than two Signatory Parties, it might make sense to limit the number of protected parties.

3.19   Warranty Ground Rules

3.19.1 Warranty Definition

(a) The noun warranty (whether or not the term is capitalized) refers to a statement by a party warranting that a specified state of affairs exists (or existed or will exist at or during a specified time). The verb warrant has the corresponding meaning. HYPOTHETICAL EXAMPLE: Alice warrants that the widgets, as delivered to Bob, will be substantially free of defects in materials or workmanship.

(b) A warranty benefits all individuals and organizations expressly specified in the warranty or otherwise in the Agreement (each, a Warranty Beneficiary), for example by language such as "Alice warrants to Bob and Bob's Affiliates."

(c) If not otherwise specified, the only Warranty Beneficiary is the other Signatory Party (if more than one, all other Signatory Parties) (each, a Signing Beneficiary).

(d) Unless the Agreement expressly states otherwise: IF: A Warranty Beneficiary shows that the warranted state of affairs did not exist at the relevant time; THEN: As the Warranty Beneficiary's EXCLUSIVE REMEDY, the warranting party will pay the Warranty Beneficiary for any foreseeable damage shown to have thereby resulted to the Warranty Beneficiary. (This payment obligation is subject to any limitations of liability that are stated in the Agreement or that apply by law.)

(e) For the avoidance of doubt, each Signing Beneficary of a warranty is deemed to have relied on that warranty as part of the basis of the bargain of the Agreement.

Comments
What is a warranty?

The concept of "warranty" is not necessarily an easy one to grasp. One widely-held view was expressed by the legendary judge Learned Hand:

[A warranty is] an assurance by one party to a contract of the existence of a fact upon which the other party may rely.

It is intended precisely to relieve the promisee of any duty to ascertain the fact for himself[.]

[I]t amounts to a promise to indemnify the promisee for any loss if the fact warranted proves untrue ….

CBS, Inc. v. Ziff-Davis Publishing Co., 75 N.Y.2d 496, 503, 553 N.E.2d 997, 1001 (1990), quoting Metropolitan Coal Co. v Howard, 155 F.2d 780, 784 (2d Cir 1946) (emphasis by the Ziff-Davis court edited, extra paragraphing added).

Bryan Garner's summary

See Bryan Garner's discussion of representations and warranties quoted in this Ken Adams blog post. (As will be apparent, I disagree completely with Ken's contention that represents and warrants are supposedly synonyms, as argued in the posts linked at the beginning of his blog post.)

No need to prove negligence or intent

Under this clause, a beneficiary doesn't need to prove that the warranting party acted negligently or intentionally in misstating the warranted state of affairs. This is in contrast to tort-based theories of misrepresentation, where a party claiming misrepresentation must provide such proof; see the commentary to 2.74. Representation Definition.

No need to prove justified reliance

The phrase "basis of the bargain" is adapted from UCC § 2-313.

In the so-called modern [U.S.] view, a beneficiary is not required to prove that it justifiably relied on a warranty; a leading case on point is from the Court of Appeals of New York (that state's highest court); see CBS, Inc. v. Ziff-Davis Publishing Co., 75 N.Y.2d 496, 503, 553 N.E.2d 997, 1001 (1990). Cf. Lyon Fin. Serv., Inc. v. Illinois Paper & Copier Co., No. A13-1944, slip op. at 9 n.6 (Minn. July 2, 2014) (declining to decide whether requirement of reliance in 1944 opinion of supreme court is still good law); see generally Matthew J. Duchemin, Whether Reliance on the Warranty is Required in a Common Law Action for Breach of an Express Warranty, 82 Marq. L. Rev. 689 (1999).

A different situation might be presented, however, if, before the contract was signed, a warranting party disclosed that a warranty was not accurate. While the law seems still to be evolving in this area, the influential U.S. Court of Appeals for the Second Circuit summarized New York law thusly:

… a court must evaluate both the extent and the source of the buyer's knowledge about the truth of what the seller is warranting.

Where a buyer closes on a contract in the full knowledge and acceptance of facts disclosed by the seller which would constitute a breach of warranty under the terms of the contract, the buyer should be foreclosed from later asserting the breach.

In that situation, unless the buyer expressly preserves his rights under the warranties … The buyer has waived the breach.

The buyer may preserve his rights by expressly stating that disputes regarding the accuracy of the seller's warranties are unresolved, and that by signing the agreement the buyer does not waive any rights to enforce the terms of the agreement.

On the other hand, if the seller is not the source of the buyer's knowledge, e.g., if it is merely "common knowledge" that the facts warranted are false, or the buyer has been informed of the falsity of the facts by some third party, the buyer may prevail in his claim for breach of warranty.

In these cases, it is not unrealistic to assume that the buyer purchased the seller's warranty as insurance against any future claims, and that is why he insisted on the inclusion of the warranties ….

In short, where the seller discloses up front the inaccuracy of certain of his warranties, it cannot be said that the buyer — absent the express preservation of his rights — believed he was purchasing the seller's promise as to the truth of the warranties.

Accordingly, what the buyer knew and, most importantly, whether he got that knowledge from the seller are the critical questions.

Rogath v. Siebenmann, 129 F. 3d 261, 264-65 (2d Cir. 1997) (vacating and remanding partial summary judgment that seller had breached contract warranty; emphasis added).

Special case: Sales of goods under the Uniform Commercial Code

In a contract for the sale of goods, if Vendor were only to represent that X were true, that representation might well constitute a warranty anyway under the Uniform Commercial Code. UCC § 2-313 provides that, if the representation is related to the goods and forms part of the basis of the bargain, it's deemed a warranty, no matter what it's called.

Is a warranty a guarantee?

Colloquially the terms "warranty" and "guarantee" are alike, but technically there are some differences; see the commentary to 4.10.   Guaranty.

Is "represents and warrants" necessary?

It's tempting to write the well-known couplet represents and warrants as if by reflex. The two, though, are distinct legal concepts, with different proof requirements and different legal effects. See generally the commentary to 2.74. Representation Definition and 9.21.  ? Reliance Disclaimer.

This provision tries to make it clear that a warranty is akin to an insurance policy, a contractual commitment to assume certain risks. As the Restatement (Second) of Contracts puts it:

d. Promise of event beyond human control; warranty. Words which in terms promise that an event not within human control will occur may be interpreted to include a promise to answer for harm caused by the failure of the event to occur. An example is a warranty of an existing or past fact, such as a warranty that a horse is sound, or that a ship arrived in a foreign port some days previously. Such promises are often made when the parties are ignorant of the actual facts regarding which they bargain, and may be dealt with as if the warrantor could cause the fact to be as he asserted. …

Restatement (Second) of Contracts § 2 cmt. d.

For extensive additional citations in this area, see, e.g., Tina Stark's scholarly pummeling of the misguided notion that represent and warrant are supposedly interchangeable, in two comments on Ken Adams's blog. (Disclosure: Tina is a friend and mentor and the author of Drafting Contracts, a well-regarded law school course book.)

For an earlier piece on the same subject by Stark, see her Nonbinding Opinion: Another view on reps and warranties, Business Law Today, January/February 2006.

Some of Ken Adams's earlier essays espousing the purported synonymity of the two terms can be found at:

See also Robert J. Johannes & Thomas A. Simonis, Buyer's Pre-Closing Knowledge of Seller's Breach of Warranty, Wis. Law. (July 2002) (surveying case law).

An English court decision highlighted the difference between representations and warranties: See Sycamore Bidco Ltd v Breslin & Anor [2012] EWHC 3443 (Ch) (2012), discussed in, e.g.:

Be careful what you warrant

In a British Columbia case:

  • A supplier sold water pipes to a customer for use in a construction project designed by the customer.
  • The pipes conformed to the customer's specifications — in other words, the supplier delivered what the customer ordered.
  • Flaws in the customer's design led to problems.
  • The contract's warranty language stated that the supplier warranted that the pipes were "free from all defects arising at any time from faulty design" (emphasis added).
  • As a result, the supplier was held liable because of its warranty, even though the problem was the customer's fault.

See Greater Vancouver Water Dist. v. North American Pipe & Steel Ltd., 2012 BCCA 337 (CanLII) (reversing trial court's judgment in favor of supplier). The appeals court said:

[24] North American was obliged to deliver pipe in accordance with the appellant’s specifications. North American agreed to do so.

Quite separately, it warranted and guaranteed that if it so supplied the pipe, it would be free of defects arising from faulty design. These are separate contractual obligations. The fact that a conflict may arise in practice does not render them any the less so.

The warranty and guarantee provisions reflect a distribution of risk.

* * * 

[34] Clauses such as 4.4.4 distribute risk. Sometime they appear to do so unfairly, but that is a matter for the marketplace, not for the courts.

There is a danger attached to such clauses. Contractors may refuse to bid or, if they do so, may build in costly contingencies. Those who do not protect themselves from unknown potential risk may pay dearly. … Parties to construction or supply contracts may find it in their best interests to address more practically the assumption of design risk. To fail do to so merely creates the potential for protracted and costly litigation.

Id. at ¶¶ 24, 32 (extra paragraphing added).

3.19.2 Materiality of Warranties

For the avoidance of doubt, each warranty stated in the Agreement is a material provision of the Agreement.

Comment

CAUTION: Warranting parties should be careful about agreeing to a provision such as this, because it might mean that even an inconsequential breach of warranty might be a material breach that could entitle the other party to terminate or even rescind the Agreement.

3.19.3  ? Implied Warranty Disclaimer

(a) For the avoidance of doubt, any express warranties stated in the Agreement (if any) are unaffected by subdivisions (b) through (d) below.

(b) Each party (each, a Disclaiming Party KNOW­ING­LY, VOL­UN­TAR­I­LY, IN­TEN­TION­AL­LY, PERM­A­NENT­LY, AND IR­REV­O­CAB­LY DISCLAIMS all Implied Warranties, namely all warranties, representations, conditions, and terms of quality EXCEPT those that are expressly stated in (or incorporated by reference into) the Agreement.

(c) Without limiting the disclaimer of sub­div­i­sion (b), the parties intend for that subdivision to encompass, for example, any and all Implied Warranties concerning any of the following:

(1) Merchantability.

(2) Fitness for a particular purpose (whether or not the Disclaiming Party or any of its suppliers or affiliates know, have reason to know, have been advised, or are otherwise in fact aware of any such purpose).

(3) Quiet enjoyment.

(4) Title.

(5) Noninfringement.

(6) Absence of viruses.

(7) Results.

(8) Workmanlike performance or effort.

(9) Implied term of quality.

(10) Non-interference.

(11) Accuracy of informational content.

(12) Correspondence to description.

(d) Without limiting subdivisions (b) and (c), those subdivisions apply regardless whether any allegedly-implied warranty is claimed to arise by law; by reason of custom or usage in the trade; by course of dealing or performance; or by trade practice.

(e) No party will assert that a Disclaiming Party has breached any Implied Warranty.

Comments
Language notes

Sub­div­i­sion (b): The terms conditions and terms of quality are included to address the requirements of disclaimers under UK law, as discussed below. (The bold-faced, all-caps type is for conspicuousness.)

Sub­div­i­sion (c): The "without limiting the disclaimer" preamble phrase is intended to avoid a very-strange holding by the Georgia supreme court, discussed below.

Sub­div­i­sion (c)(2): Concerning the special requirements for disclaimers of the implied warranty of merchantability of goods sold (which arises automatically under the (U.S.) Uniform Commercial Code), including a conspicuousness requirement, see UCC § 2-316(2) and (3).

Sub­div­i­sion (c)(3): In some jurisdictions an implied warranty of quiet enjoyment might arise in a lease of real property.

Sub­div­i­sion (c)(4): The (U.S.) Uniform Commercial Code imposes special requirements for a disclaimer of the implied warranty of title in a sale of goods. See UCC S 2-312.

Sub­div­i­sion (c)(5): Under the (U.S.) Uniform Commercial Code, a "merchant" that sells goods is deemed to give an implied warranty that the goods are free from third-party claims of infringement. See UCC S 2-312.

Sub­div­i­sion (c)(8): See the definition of workmanlike.

Sub­div­i­sion (c)(9): "Implied term of quality" is a British-ism.

Sub­div­i­sion (d): See generally UCC §§ 1-303 and 2-314(3).

Sub­div­i­sion (e): The intent here is to make such an assertion a separate breach of contract, so that a party making such an assertion would be liable for damages in the form of attorney fees even without an attorney-fee provision.

Consumer-protection statutes vs. warranty disclaimers

Any company offering consumer-product warranties (in the U.S.) should carefully study the requirements of various federal- and state consumer protection laws, such as:

  • the Magnuson-Moss Warranty Act, which is the federal law that governs consumer product warranties; it requires manufacturers and sellers of consumer products to provide consumers with detailed information about warranty coverage, and also affects both the rights of consumers and the obligations of warrantors under written warranties (this paragraph is adapted from the FTC guide linked above); and
  • state statutes such as California's Song-Beverly Act, which requires manufacturers of consumer goods sold in California to jump through various hoops (and imposes stringent requirements if the manufacturer wants to disclaim the implied warranties of merchatability and fitness).

The E-Warranty Act of 2015 requires any written warranty for consumer products costing more than $15 to be made available before the sale, as discussed here.

A bizarre Georgia supreme court holding

In the Common Draft warranty-disclaimer language, the phrase "[w]ithout limiting the dis­claim­er of sub­div­i­sion (a)" shouldn't be necessary, but Georgia's supreme court seemed to think that the words in a contract's warranty disclaimers mean whatever the court wants them to mean. In that court's opinion in Raysoni v. Payless Auto Deals, the main facts (in my view) were the following:

  • The plaintiff, Raysoni, had bought a used minivan. Before the sale, he allegedly asked the sales representative whether the vehicle had ever been in an accident; the sales rep allegedly said no, and gave Raysoni a clean CarFax report.
  • The sales contract included numerous disclaimers — and also disclosed that at the auction (where presumably the dealership acquired the vehicle), the vehicle had been an­nounced as having had unibody damage; moreover, the con­tract said, the buyer was urged to have the vehicle checked out before buying it.
  • Two months after the sale, Raysoni allegedly learned that the vehicle had in fact been in an accident and suffered frame damage. The dealership rejected Raysoni's request to undo the deal and get his money back. Raysoni sued for fraud.
  • The trial court granted judgment on the pleadings in favor of the dealership, saying that in view of the disclaimers in the sales contract, it would have been unreasonable for Raysoni to rely on the alleged written- and oral statements by the sales representative, and therefore Raysoni's fraud claims couldn't succeed. The court of appeals affirmed.

But then the state's supreme court took — how shall I put this — an intriguing view of the meaning of the disclaimer language, holding that:

The more prominent and general disclaimer of warranties—a provision that the minivan was sold "AS IS NO WARRANTY"—is followed immediately by an explanation that arg­u­a­bly qualifies and limits [sic] that disclaimer: "The dealership assumes no responsibility for any repairs regardless of any oral statements about the vehicle."

Raysoni v. Payless Auto Deals, LLC, 296 Ga. 156, 766 S.E.2d 24, 26 (2014) (emphasis added).

Seriously? The court's interpretation seems utterly contrary to the plain, unambiguous language of the contract. The agreement's no-responsibility-for-repairs sentence doesn't qualify or limit the as-is-no-warranty disclaimer, it emphasizes one of its implications.

And that's not all—the supreme court continued:

Likewise, the additional disclaimers of specific warranties that appear in the fine print of the contract are followed by the provision that "NO SALESMAN VERBAL REP­RE­SENT­A­TION IS BINDING ON THE COMPANY," and to the extent that the latter provision can be understood as an explanation of the foregoing disclaimers, it limits [sic] those disclaimers.

Id. (emphasis added). As young people might say: WTF?

Look, I get it; the Georgia supreme court didn't like it that the dealership allegedly gave the buyer a clean CarFax report but then tried to rely on a warranty disclaimer and a written warning that the car had been reported to have been damaged.

But despite the supreme court's unanimous opinion, I still don't see how anyone could reasonably conclude that the dealership's warranty disclaimer was "qualifie[d] and limit[ed]" by the additional contract language.

Moreover, on the facts as stated by the supreme court, I'm not sure what else the dealership could reasonably have done.

The danger now is that every contract drafter whose work might end up in a Georgia court must wonder whether even the most explicit of warranty disclaimers will be enough to avoid a jury trial on fraud charges.

Warranty disclaimers for UK transactions should also disclaim “conditions”

If you're a vendor doing a sales transaction under UK law (England, Wales, Northern Ireland), be sure that your warranty disclaimer addresses not just implied warranties but also implied “conditions.”  An oil seller failed to do so and learned that its disclaimer didn't preclude liability.  See [KG Bominflot Bunkergesellschaft Für Mineralöle mbh & Co KG v. Petroplus Marketing AG, [2009] EWHC 1088 (Comm). In that case:

  • The parties entered into a contract for the sale of gasoil, a type of heating oil.  The contract was governed by English law. 
  • The contract provided that delivery was complete, and title and risk passed to the buyer, when the gasoil was loaded onto a certain ship.
  • The gasoil met the contractual specifications when it was loaded. By the time the ship arrived at its destination, however, the gasoil no longer met the agreed specifications.  The claimed damages were in excess of US$3 million. Id. para. 8.

The seller took the position that all title and risk had passed, therefore the damages were the buyer's problem. The buyer, though, argued that under the Sale of Goods Act 1979, “it was an implied condition of the sale contract that the goods would be reasonably fit for the purpose of remaining, during their time on the vessel and for a reasonable time thereafter, within the specifications set out in the sale contract." Id. para. 7 (quoting buyer's argument).

The judge agreed with the buyer, holding that by failing to disclaim implied conditions as well as implied warranties, the seller had left itself open to the buyer's claim:

49. If the failure to use the word “condition” renders clause 18 [the warranty dis­claim­er] of little or no effect, so be it. The sellers agreed to the wording of clause 18 in the face of Wallis v Pratt and must live with the consequences.

(Hat tip: Ken Adams.)

Further reading

See generally, e.g.:

3.19.4  ? Warranty Survival

(a) This section applies in any case in which any warranty stated in the Agreement (each, a Surviving Warranty) is alleged to have been breached.

(b) Subject to the limitations stated in sub­div­i­sion (c), all Surviving Warranties will survive the closing or other consummation of the transaction or transactions contemplated by the Agreement (the Closing) for the period stated in sub­div­i­sion (c).

(c) To be entitled to any remedy for breach of a Surviving Warranty, the party alleging the breach must:

(1) give the breaching party notice of the breach before one year after the date of the Closing; and

(2) bring any judicial- or other action for the breach before the expiration of one year and three months after the date of the Closing.

Comment

This provision tries to make it very clear just how, and for how long, specified warranties survive the closing of a contract for the sale of assets. It is intended to address the so-called merger doctrine that, in some circumstances, can extinguish warranties set forth in the contract.

In a contract for sale of real property, the seller will generally make certain stated war­rant­ies (which are often extensively negotiatied).

  • In some jurisdictions, at the closing of the sale, all such warranties are deemed to "merge" into — and thus be extinguished by — the seller's delivery of the deed conveying the property, that is unless the contract provides otherwise.
  • That way, "the deed is deemed to express the final and entire contract between the parties." Ram's Gate Winery, LLC v. Roche, 235 Cal. App. 4th 1071, 1079, 185 Cal. Rptr. 3d 935 (2015) (reversing and remanding summary adjudication and holding that fact issue remained as to whether parties intended warranties to survive closing) (citations and internal quotation marks omitted).

A similar but not-identical issue can arise in corporate merger & acquisition (M&A) transactions: Careless use of the phrase "warranties will survive the closing" can create confusion: If a warranty breach allegedly occurs, it might be unclear whether the non-breaching party must merely notify the breaching party witnin a stated period of time after closing, or whether the non-breaching party must file a lawsuit or demand for arbitration within that time. See, e.g., Jeffrey H. LaBarge, They don't call it a survival clause for nothing … (NixonPeabody.com 2011).

3.19.5  ? Warranty Claims Deadline

(a) For Provider to be liable for breach of any warranty stated in or otherwise relating to the Agreement, the matters stated in subdivisions (b) through (d) must all be true.

(b) Customer must give Provider written notice that states, in reasonable detail, the facts constituting the alleged breach. The notice must be effective no later than 90 days (the Warranty Notice-Period Duration) after the date that Customer (i) knows, or (ii) in the exercise of reasonable diligence, should know, of the existence of the alleged breach (the Warranty Limitation-Period Start Date).

(c) At Provider's request from time to time, Customer must furnish Provider with reasonable information about the facts constituting the alleged breach.

(d) Customer must duly file and duly serve a claim for the alleged breach no later one year after the Warranty Limitation-Period Start Date.

Comment

An action normally “accrues” at the time of the injury. In some jurisdictions, the discovery rule applies; that rule holds that, in certain circumstances, a claim accrues — and the limitation period starts to run — when the plaintiff first had, or reasonably should have had, a suspicion of wrongdoing. See, e.g., Miller v. Bechtel Corp., 33 Cal. 3d 868, 663 P.2d 177 (1983) (affirming summary judgment on limitation grounds), discussed in Jolly v. Eli Lilly & Co., 44 Cal. 3d 1103, 1111, 751 P.2d 923 (1998) (same).

4   Payments & Related Provisions

4.1   Payments

4.1.1 Payment Terms

Unless otherwise agreed in writing, all payments required by the Agreement:

(1) are to be made by any method to which the payee does not timely and reasonably object in writing (each, an Acceptable Payment Method); and

(2) are due and payable on or before net 30 days from receipt of a correctly-stated invoice (the Payment Due Date).

Comment

In the alternative, drafters might wish to consider one or more of the following: • Change receipt of a correctly-stated invoice to the date of a correctly-stated invoice (which would give the payer less time to make a timely payment). • Specify a discount for early payment, e.g., 2/10 net 30. • Require payment by check; certified check; cashier's check; wire transfer or ACH to a bank account specified in writing by the payee; or, immediately-available funds. • specify that any check must be drawn on a U.S. bank, or a bank reasonably acceptable to the payee.

For an example of very customer-biased payment terms, see section 13 of a Honeywell purchase order form, which provides not only for net-120-day terms, but for payment not even to be scheduled until then.

4.1.2 Payment Disputes

(a) Any party disputing an amount that it putatively owes under the Agreement (for example, any party disputing an invoice) must:

(1) bring the dispute to the attention of the putative payee no later than the putative due date of the payment;

(2) furnish the putative payee with a written explanation of the paying party's basis for disputing the amount owed, together with (where applicable) reasonable supporting documentation; and

(3) timely pay any undisputed amount.

(b) IF: Other than for good reason clearly shown, the paying party does not comply with sub­div­i­sion (a); THEN: The invoice in question invoice will be rebuttably presumed to be correct.

Comment

Occasionally, a customer's accounts-payable people will wait until the last minute to raise a payment dispute, which could restart the clock and delay the payment obligation still more.

4.1.3  ? Separate Invoicing of Disputed Amounts

IF: A paying party disputes part but not all of an amount invoiced; THEN: To facilitate timely payment:

(1) Upon written request by the payee, the paying party will issue a separate invoice for the undisputed portion.

(2) Payment for the undisputed portion will be due on the date that payment would have been due for the original invoice if none of it had been disputed.

Comment

The idea for this provision came from a services contract form used by a large company in the oil-and-gas industry.

4.2   Expense Reimbursement

4.2.1 Reimbursement Requirement

(a) Reimbursing Party refers to a party required by the Agreement to reimburse another party, referred to as the Incurring Party, for expenses.

(b) When invoiced by the Incurring Party, the Reimbursing Party is to reimburse the Incurring Party for reasonable expenses actually incurred by the Incurring Party in the performance of the Incurring Party's obligations under the Agreement.

Comment

Expense-reimbursement provisions are typically seen in, for example, services agreements, in which the Incurring Party might be a services provider or a subcontractor; the Reimbursing Party might be the customer of a services agreement, or possibly a prime contractor that must reimburse a subcontractor for the latter's expenses.

In sub­div­i­sion (b), note the "reasonable" and "actually incurred" qualifiers.

4.2.2 Expense Mark-Up Limitation

(a) In invoicing reimbursable expenses, the Incurring Party may mark up the expenses by up to the Maximum Permissible Expense Markup specified in the Agreement, if any.

(b) IF: the Agreement does not specify a Maximum Permissible Expense Markup; THEN: Expenses to be reimbursed under the Agreement are to be invoiced on a straight pass-through basis, with no markup.

Comment

See also:

Many contracts prohibit marking up of expenses, but some contracts are "cost-plus."

4.2.3  ? Written Expense-Reimbursement Policies

(a) From time to time the Reimbursing Party may provide the Incurring Party with a copy of the Reimbursing Party's then-current standard written reimbursement policy.

(b) IF: The Reimbursing Party provides the Incurring Party with such a written policy so at least a reasonable time before the Incurring Party incurs the relevant expense(s) or otherwise becomes obligated to pay them; THEN: The Incurring Party will not invoice the Reimbursing Party for expenses, and the Reimbursing Party is not required to reimburse expenses, except in conformance with that policy.

(c) IF: The Agreement specifies that the Reimbursing Party's current written reimbursement policy is attached or has been otherwise provided to the Incurring Party (e.g., by email); THEN: That policy will apply until such time, if any, as the Reimbursing Party provides the Incurring Party with a different written policy.

Comment

Customers' various expense-reimbursement policies are sometimes an administrative pain for providers, but they're often a practical necessity, especially for large corporate customers that by law must comply with internal-controls requirements. • A customer might or might not want to impose a specific written-reimbursement policy at the time of contracting, while leaving that option open for the future.

4.2.4  ? Expense Pre-Approval

The Reimbursing Party is not required to reimburse any expenses that it did not expressly approve in writing in advance.

Comment

This will be overkill for many relationships, but some reimbursing parties might want this language so as to keep very-tight control over reimbursable expenditures.

4.2.5  ? Direct Billing of Expenses

(a) The Incurring Party may arrange for individual expenses of at least USD $1,000 (the Direct Billing Threshold Amount) to be billed directly to the Reimbursing Party; the Reimbursing Party is to timely pay any such direct-billed expense.

(b) If so requested by the Reimbursing Party for a particular expense, the Incurring Party will consult with the Reimbursing Party before arranging for direct billing of that expense to the Reimbursing Party.

Comment

Sub­div­i­sion (a): The Direct Billing Threshold Amount has in mind that, as a matter of prudent cash-flow management, a service provider or other contract party might want its customer to "front" significant reimbursable expenses.

4.3   Invoice Requirements

A party desiring payment from another party of an amount due under the Agreement must send the other party an invoice that meets the following requirements:

(a) The invoice must be in the language in which the Agreement is written or, if required by law, the destination country’s official language.

(b) The invoice must be sent to the invoicing address specified in the Agreement, if any, or if different, the invoicing address specified in the relevant ordering document, or failing both, at any reasonable address.

(c) The invoice must state at least the amount due and, in reasonable detail, what the amount is due for.

(d) If the Agreement expressly sets forth an invoice-submission schedule and/or an invoice-submission deadline: the invoice must be submitted in accordance with that schedule and no later than that deadline, as applicable, failing which the Invoicing Party may in its sole discretion deem payment to have been WAIVED and decline to pay the invoice.

Comment

Companies almost invariably want to receive invoices before paying amounts due, not least because they might be required to do so as part of their internal financial controls to help detect and prevent fraud. Yet many contracts don't even address the subject of invoices (although many do so).

Sub­div­i­sion (b): A savvy party submitting an invoice will confirm the current address to which the invoice should be sent, lest the invoice be lost in the other party's internal correspondence routing system. (With the rise of electronic invoicing- and payment systems, this provision might become less relevant.)

Sub­div­i­sion (c): Some companies want their suppliers' invoices to include (in addition to the details specified in this provision) information such as, for example:

  • a purchase-order number;
  • a supplier identification code;
  • a contract identifier;
  • part numbers;
  • quantities;
  • units of measure;
  • hours billed;
  • unit- and total prices;
  • export- and safety-related information.

Sub­div­i­sion (d): Invoicing schedules are often a subject covered in construction- and other services agreements, where the service provider wants to be paid as work is done, as opposed to waiting to be paid until the work is 100% complete.

Under (U.S.) generally-accepted accounting principles, publicly-traded companies likely will be required to account for expenses in a particular fiscal quarter, and might make it a policy not to pay invoices where that's not possible due to delay in submission. That's because if a supplier were to submit an invoice very late, conceivably the customer could have to restate its earnings for the relevant period. As the Hertz rent-a-car company's 2014 restatement reminded us, for a company to restate its earnings is generally considered a Very Bad Thing, not least because it can almost immediately lead to shareholder lawsuits claiming securities fraud.

HORROR STORY: This got my attention back when I was general counsel of a public company: I read about the general counsel of another public company. That company was incurring big legal bills (for a lawsuit, I think). From what I recall:

  • The general counsel didn't submit the law firm's invoices to the company's finance department for payment; instead, he just put them in a drawer.
  • When the general counsel did finally submit the invoices for payment, the newly-recorded legal expense had an unwanted effect: it materially affected his company's bottom line for the relevant time period.
  • That meant that the company had to restate its earnings.
  • The general counsel was fired.

I've tried to find the story online, including just now (August 2014), but have been unable to do so.)

4.4   Sales Taxes

4.4.1 Definitions: Collecting Party; Sales Tax

(a) The term Collecting Party refers to any party that, under the Agreement, invoices another party for goods, services, or other things potentially subject to sales taxes (as defined below).

(b) The term sales tax (whether or not capitalized) includes all sales taxes; use taxes; value-added taxes; excise taxes; other forms of ad valorem tax and consumption tax; and equivalent taxes.

Comment

Sales-tax provisions are common in supply agreements and services agreements.

See generally:

4.4.2 Collecting Party Obligations

Unless the parties agree otherwise in writing in connection with a particular transaction, the Collecting Party will do the following, at its own expense:

(1) determine what if any sales taxes must be paid to an applicable jurisdiction in connection with the transaction;

(2) separately list all sales taxes in the relevant invoice; and

(3) timely report and remit all sales taxes to all relevant taxing authorities anywhere in the world (the Sales-Tax Authorities).

Comment

Determining just where sales taxes must be paid can be a non-trivial task. The issue has drawn major attention from taxing authorities in the age of Amazon.com and other Internet sellers. In supply- and services agreements, customers often want suppliers to take on this responsibility.

See also:

4.4.3 Income-Tax Exclusion

For the avoidance of doubt, each party is solely responsible for payment of taxes based on its income, franchise, or capital, and such taxes are not to be billed to any other party under the Agreement, unless expressly stated otherwise in the Agreement.

Comment

Provisions like this are not uncommon in supply- and services agreements. On the other hand, though, in some transactions the price might be "grossed up" so that the amount received by the payee, net of all taxes, is a stated amount.

4.4.4  ? Sales-Tax Indemnity Obligation

The Collecting Party is to defend and indemnify (i) each invoiced party, and (ii) each member of the invoiced party's Protected Group, against any claim by a taxing authority for unpaid Sales Taxes.

Comment

Customers sometimes ask for sales-tax indemnity provisions in supply- and services agreements.

As with any indemnity obligation, a would-be protected party should check whether the indemnifying party has the financial assets with which to meet the obligation; if not, the protected party should consider including a requirement that the indemnifying party carry suitable insurance coverage.

4.5   Deposits

Deposits and other advance payments, if any, are to be applied as stated in the Agreement or as otherwise agreed in writing; any remaining balance of a deposit paid under the Agreement is to be promptly refunded, without interest.

Comment

Drafters can consider stating instead that deposit balances will be refunded with interest at a specified rate. CAUTION: Be very careful about usury laws.

4.6   Pay If Paid

(a) This section applies if the Agreement clearly states that an obligation on the part of a Paying Party to make a particular payment (the Contingent Payment) is "pay if paid" or comparable wording, regardless of capitalization, in respect of the Paying Party's receipt of one or more Third-Party Payments.

(b) The Paying Party is not required to make the Contingent Payment until all specified Third-Party Payments have been unconditionally made to and accepted by the Paying Party — once that occurs, however, the Paying Party must promptly make the Contingent Payment.

(c) The Paying Party is not required to make any particular efforts to collect any Third-Party Payment; if the Paying Party elects to make such efforts, it does so in its sole discretion and solely for its own benefit.

(d) The party to which the Contingent Payment is owed (the "Payee") represents and warrants that in entering into the Agreement, the Payee:

(1) has considered each third party's solvency and willingness and ability to perform the terms of its contract with the Paying Party;

(2) is relying on the credit and willingness and ability to pay of the third party or third parties, not that of the Paying Party, for the Contingent Payment; and

(3) KNOW­ING­LY, VOL­UN­TAR­I­LY, IN­TEN­TION­AL­LY, PERM­A­NENT­LY, AND IR­REV­O­CAB­LY ASSUMES AND ACCEPTS THE RISK that one or more third parties might be unable or unwilling to perform the terms of its contract with the Paying Party, in which case the Contingent Payment will not be paid (or will not be paid in full).

Comments
Introduction and example

Suppose that:

  • A contractor enters into a contract with a homeowner, under which the contractor will remodel the homeowner's kitchen.
  • The contractor enters into a subcontract with a painter, under which the painter will do the necessary painting in the kitchen.

In this example, pay if paid means that the contractor is not required to pay the painter unless the homeowner pays the contractor.

A pay-if-paid clause might preclude collecting on a surety bond

See BMD Contractors, Inc. v. Fid. & Dep. Co., 679 F.3d 643 (7th Cir. 2012) (applying Indiana law; affirming summary judgment in favor of surety). (The Common Draft pay-if-paid language is modeled in part on the pay-if-paid provision in that case; see id. at 647.) Hat tip: Steven L. Jones, “Paid If Paid” Clauses – Who Is Left Holding the Bag When a Project Owner Fails to Pay? (IceMiller.com 2015).

Pay-if-paid might be void as against public policy

In some jurisdictions, a pay-when-paid clause implicitly means within a reasonable time; for example, if an end-customer does not pay a prime contractor within a reasonable time, then the prime contractor — or more likely, the insurance carrier that wrote the prime contractor's payment bond — must pay the subcontractor anyway.

On the other hand, in a situation like this, a pay-if-paid clause makes the end-customer's payment a condition precedent to the subcontractor's right to payment; in other words, if the end-customer doesn't pay the prime contractor, then the subcontractor isn't entitled to payment even from the prime contractor's performance bond. This essentially puts the risk of non-payment on the subcontractor — and as a result, in in some jurisdictions the clause might be void as against public policy.

• For example, in New York, pay-if-paid clauses are void, but pay-when-paid are enforceable, according to that state's highest court:

We hold that a pay-when-paid provision which forces the subcontractor to assume the risk that the owner will fail to pay the general contractor is void and unenforceable as contrary to public policy set forth in the Lien Law.

By contrast, a pay-when-paid provision which merely fixes a time for payment does not indefinitely suspend a subcontractor's right to payment upon the failure of an owner to pay the general contractor, and does not violate public policy as stated in the Lien Law.

West-Fair Elect. Contractors v. Aetna Cas. & Surety Co., 87 N.Y.2d 148, 158, 661 N.E.2d 967 638 N.Y.S.2d 394 (1995) (on certification from Second Circuit) (extra paragraphing added). The contract clause in question was this:

"IT IS SPECIFICALLY UNDERSTOOD AND AGREED THAT THE PAYMENT TO THE TRADE CONTRACTOR [plaintiff] IS DEPENDENT, AS A CONDITION PRECEDENT, UPON THE CONSTRUCTION MANAGER [the general contractor] RECEIVING CONTRACT PAYMENTS, INCLUDING RETAINER FROM THE OWNER".

Id. at 154 (alterations by the court, capitalization in original).

• In contrast, the Ohio supreme court upheld a pay-if-paid clause in Transtar Electric, Inc. v. A.E.M. Electric Serv. Corp., 2014 Ohio 3095; the court affirmed a summary judgment that the contract's "condition precedent" payment language was sufficient to transfer the risk of nonpayment by a customer from the prime contractor to its subcontractor. That language was as follows:

{¶ 4} … (c) the Contractor shall pay to the Subcontractor the amount due under subparagraph (a) above only upon the satisfaction of all four of the following conditions: * * * (iv) the Contractor has received payment from the Owner for the Work performed by the Subcontractor. RECEIPT OF PAYMENT BY CONTRACTOR FROM THE OWNER FOR WORK PERFORMED BY SUBCONTRACTOR IS A CONDITION PRECEDENT TO PAYMENT BY CONTRACTOR TO SUBCONTRACTOR FOR THAT WORK.

Id. (capitalization in original, bolding omitted). The decision was subject to some criticism for not addressing public-policy considerations; see Scott Wolfe, Jr., Ohio Supreme Court Gets Pay If Paid Decision Wrong, Hurts Subcontractors (ZLien.com 2014).

• In New Jersey, the courts are split about pay-if-paid clauses, according to Michelle Fiorito, The Consequences of "Pay-If-Paid" and "Pay-When-Paid" Construction Contracts Clauses (ZDLaw.com 2012).

• Still another court — in passing, and arguably in a dictum — seems to have implicitly treated a pay-if-paid clause as a pay-when-paid provision. The case was Allstate Interiors & Exteriors, Inc., v. Stonestreet Constr., LLC, 730 F.3d 67 (1st Cir. 2013) (affirming judgment below; rejecting end-customer's challenge to district court's exercise of supplemental jurisdiction). In that case, the relevant contract clause was as follows: "It is agreed that the Contractor [Stonestreet], as a condition precedent to payment of any monies which become due to the Subcontractor, must first receive payment from the Owner." Id. at 70 (emphasis added). The court described the clause as a pay-when-paid clause. See id.

4.7   Pay When Paid

(a) This section applies if the Agreement clearly states that an obligation on the part of a Paying Party to make a particular payment (the Contingent Payment) is "pay when paid" or comparable wording, regardless of capitalization, in respect of the Paying Party's receipt of one or more Third-Party Payments.

(b) The Paying Party is not required to make the Contingent Payment until it has received the Third-Party Payment, but the Paying Party must:

(1) make reasonable efforts to collect the Third-Party Payment; and

(2) make the payment promptly upon receiving the Third-Party Payment.

Comment

See the commentary to 4.6.   Pay If Paid.

4.8   Interest

(a) A party to which payment is owed under the Agreement may charge interest on past-due unpaid amounts at no more than 5% per annum simple interest or the maximum rate permitted by law under the circumstances, whichever is less (the Maximum Interest Rate), beginning no earlier than 30 days after the payment due date (the Earliest Interest Start Date).

(b) All payments are to be applied first to accrued interest (if any), then to unpaid principal, in each case in the order in which the obligations were incurred (that is, oldest-first).

Comments
Sequence of payments application

Sub­div­i­sion (b): Provisions of this kind are often seen in promissory notes. This clause is adapted from a suggestion in David Cook, The Interest Tail Wags the Profit Dog, in Business Law News Issue No. 3, 2014 (State Bar of California Business Law Section; available on-line to Section members).

Will a payee really try to collect interest?

Whether a payee will actually charge and try to collect interest is a real question. For example, suppliers sometimes hesitate to charge interest to their customers, even if their contracts permit them to do.

Some large customers have been known to announce, imperiously: We don't pay interest, period. (On the other hand, some customers can be notoriously slow payers, insisting on as high as net-120-day terms from their suppliers.)

Putting an “interest on past due amounts” clause in an “audit rights” provision might backfire

It's probably a good idea to separate an interest clause from an audit-rights clause. Cellport Systems, Inc. won a lawsuit against Peiker, a German company, for unpaid patent royalties under a license agreement. The agreement included an audit provision that required Peiker to pay interest on past-due royalties at 1.5% per month. The trial court, however, awarded Cellport interest at the (lower) statutory rate, on grounds that, in context, the contractual interest rates was intended to apply only to underpayments revealed in an audit. The Tenth Circuit agreed that the lower rate was proper:

According to Cellport, the License Agreement's reference to the rate contains no limitations on its application.

As the district court explained, however, the sentence is in the middle of a paragraph devoted to Cellport's right to verify the royalty payments it is owed through audits. And we must interpret this provision in its context.

We agree with the district court that the interest rate was contractually intended to apply only to accounting disputes. The application of the statutory rate was appropriate.

Cellport Sys., Inc. v. Peiker Acustic GmbH & Co., KG, No. 13-1029, slip op. at 21-22 (10th Cir. Aug. 5, 2014) (affirming trial-court judgment in part; emphasis and extra paragraphing added).

4.9   Usury Savings

The parties intend for any interest charged or paid in connection with the Agreement, in any contingency, to comply with law. Accordingly, IF: A charge or payment in connection with the Agreement is properly characterized as interest; AND: The charge or payment is determined to have exceeded the maximum interest permitted by law (after taking all permitted steps to spread such payments over time); THEN:

(1) The excess interest is to be deemed the result of an inadvertent error, even if the party charging or paid the excess intended to take the action(s) resulting in the excess;

(2) If the excess interest has not yet been paid, then the charge for the excess interest will be canceled; and

(3) If the excess interest has been paid, then the party that was paid the excess interest will refund it, or credit it to any balance still owed by the payer, along with interest on the excess at the maximum rate permitted by law.

Comments
Even an invoice for interest charges can be usurious without an agreement

Vendors sometimes add interest charges to invoices; doing so without the customer's prior agreement can result in the charge being usurious. See Ross Spence, Usury and How to Avoid It: Impact of New Legislation on Collection Practices at part VI-B at 24-25, (SnowSpenceLaw.com; undated), which includes extensive citations to Texas case law.

Usury laws about maximum interest rates can have real teeth

If a party will be charging "interest," then before specifying an interest rate (or an interest start date), the party should be sure to check applicable usury laws, which can have real teeth, including forfeiture of principal and perhaps even criminal penalties. For example, in a case under Rhode Island's usury statute, a court found that "a $4 filing fee — which accounted for the only interest in excess of the maximum interest rate — rendered the entire loan usurious." NV One, LLC v. Potomac Realty Capital, LLC, 84 A.3d 800 (R.I. 2014), citing In re Swartz, 37 B.R. 776, 779 (Bankr. D.R.I. 1984).

Usury-savings provisions might not be given effect

Provisions such as this one, stating that excess interest will be promptly refunded, might or might not be effective in a given jurisdiction. Consider two contrasting examples:

  • Texas law permits usury-savings clauses. See Ross Spence, Usury and How to Avoid It: Impact of New Legislation on Collection Practices at 34 (SnowSpenceLaw.com; undated).
  • On the other hand, Rhode Island's state supreme court acknowledged that Rhode Island's usury statute was "draconian" and "strong medicine." American Steel Coatings, LLC v. New England Development R.I., LLC, No. 2012-238-Appeal, slip op. at 11 (R.I. June 20, 2014). The court said that the legislature had put the risk of charging too-high an interest rate onto the lender in "an inflexible, hardline approach to usury that is tantamount to strict liability," id. at 13. The supreme court affirmed a trial-court ruling that a commercial loan agreement for more than $400,000 was void as usurious.
Interest start dates can also implicate usury laws

The usury statutes in some states (e.g., Texas) might prohibit charging interest before the end of a specified grace period.

Is a given late charge really "interest"?

Not all so-called "interest" charges will be subject to usury laws. For example, in Texas, interest is defined by statute as "compensation for the use, forbearance, or detention of money. The term does not include time price differential, regardless of how it is denominated. …" Tex. Fin. Code § 301.002(4); See Ross Spence, Usury and How to Avoid It: Impact of New Legislation on Collection Practices at 9 (SnowSpenceLaw.com; undated).

What is this "time price differential" of which the statute speaks? One article explains the quoted term in relation to Texas law:

If certain requirements are met and a transaction is not designed to circumvent the usury laws, a merchant may sell merchandise at a higher price for credit than for cash and the price difference is not usurious. The new statute codifies the common law time-price doctrine.

In order to apply the time-price doctrine, it must be shown that the seller clearly offered to sell goods for both a cash price and a credit or time price, that the purchaser was aware of the two offers, and that the purchaser knowingly chose the higher time or credit price.

If an agreement fails to qualify as a time-price differential contract, then the finance charges may be found to constitute usurious interest.

Spence, supra, part VI-F at 27 (citations omitted, extra paragraphing added).

4.10   Guaranty

4.10.1 Guaranty Definitions

Guarantor refers to each individual or organization that states, in a  writing signed by the individual or organization, that the individual or organization guarantees a Guaranteed Payment Obligation.

Creditor refers to any individual or organization to which a Guaranteed Payment Obligation is owed.

Payer refers to any person that owes a Guaranteed Payment Obligation.

Guaranteed Payment Obligation refers to any payment, under any Guaranteed Agreement, that is guaranteed in writing.

Guaranteed Agreement refers to the Agreement.

Guaranty Enforcement Forum refers to any court having jurisdiction.

Comment

The default definitions of Guarantor, Creditor, etc., are designed to give contract drafters additional flexibility: they allow a drafter to incorporate this provision by reference without having to worry about using the exact defined terms verbatim. For example, a contract drafter representing "Alice" in a negotiation with "Bob" could say, in the draft contract, "Buford guarantees Bob's payment obligation to Alice in accordance with the Common Draft   Guaranty."

Only payment obligations are guaranteed here; that's because guaranties of performance of other types of obligation (for example, an obligation to perform consulting services, repair work, building construction, etc.) might well require considerably-more negotiation and customized language.

Drafters representing guarantors will want to be careful to define just which payment obligations are being guaranteed. A bit of an oddball case on this point was McLane Foodservice, Inc. v. Table Rock Restaurants, LLC, 736 F.3d 375 (5th Cir. 2013) (affirming district-court judgment in favor of alleged guarantor):

  • A restaurant company, Table Rock, went out of business owing a food-service company, McLane Foodservice, some $447,000.
  • McLane Foodservice apparently noticed that nearly 14 years earlier, the treasurer and 40%-owner of the Table Rock restaurant company had signed a personal guaranty of the debts of another restaurant company, Border Patrol, to a division of PepsiCo.
  • In the interim, the PepsiCo division had sold its assets to another company, Ameriserve, which later filed for bankruptcy protection and sold its assets to McLean Foodservice, which presumably had the treasurer's signed guaranty in the files it inherited.
  • Importantly (at least to the courts), the PepsiCo division never extended credit to the Table Rock restaurant company; it was McLane Foodservice, PepsiCo's successor-twice-removed, that did so.

Both the trial court and the appellate court held that the treasurer's guaranty, by its terms, covered only debts to the PepsiCo division — and because Table Rock had never incurred any such debts, its treasurer wasn't liable to McLane Foodservices under the guaranty.

The appellate court's opinion didn't even mention that, judging by the facts recited in the opinion, Table Rock's treasurer apparently had not guaranteed Table Rock's debts — his guaranty, from nearly 14 years before, was for the debts of the Border Patrol restaurant company, which had no evident connection to Table Rock. (If those were indeed the facts, then I'm surprised that McLane Foodservices' counsel wasn't sanctioned by the court for bringing a frivolous lawsuit against the treasurer.)

LESSON: Leaving aside the problem mentioned in the previous paragraph, the guaranty in McLane Foodservices could have recited that the guaranty covered all credit extended to the by the PepsiCo division and by PepsiCo's successors and assigns.

4.10.2 Guaranty Obligation

(a) Each Guarantor guarantees — to each Creditor and also to that Creditor's successors and assigns — the full and prompt payment, by each Payer, when due, of each Guaranteed Payment Obligation.

(b) The guaranty of sub­div­i­sion (a) applies without regard to:

(1) how or when the Guaranteed Payment Obligation in question previously came to exist, is coming to exist now, or comes to exist in the future (including, for example, by acceleration or otherwise); or

(2) whether the Guaranteed Payment Obligation is direct or indirect, absolute or contingent.

(c) Each Guarantor undertakes its obligations under this in consideration of, and to induce, the entry, by each Creditor, into the Guaranteed Agreement.

(d) Any action to enforce that guaranty against a Guarantor may be brought in any Guaranty Enforcement Forum.

Comment

Some of the language of this provision is informed by the language of the guaranty in suit in Knauf Insulation, Inc. v. Southern Brands, Inc., No. 15-3157, slip op. at 2 (7th Cir. May 3, 2016) (affirming judgment that guarantors were liable for guaranteed payment obligations) (Posner, J).

Sub­div­i­sion (c): The "in consideration of" language is included because otherwise a court might hold a guaranty to be unenforceable. The required consideration might well be the guarantor's desire to support the creditor — but not always. EXAMPLE: In Yellow Book, Inc. v. Tocci, 2014 Mass. App. Div. 20 (2014), a company's bookkeeper signed an order for ad space in a Yellow Pages phone book; unhappiily for her, she didn't read the fine print, which contained a statement that she personally guaranteed payment. A court held that she was not liable on the guaranty, because she had received no consideration for it. See id. at 22-23. The case is discussed in Robert W. Stetson, Four Tips for Drafting Enforceable Personal Guarantees, in (BNA) Corporate Counsel Weekly Newsletter, Apr. 9, 2014, which includes numerous case citations.

Sub­div­i­sion (d): A forum-selection provision much like this one was readily enforced by the Seventh Circuit in the Knauf Insulation case, even though the guarantors purportedly did not have "minimum contacts" with the selected forum; the court remarked that the guarantors "didn't have to have any contacts" with that forum. See slip op. at 3 (citing cases; emphasis in original).

4.10.3 Guarantor Acceptance Waiver

Each Guarantor KNOW­ING­LY, VOL­UN­TAR­I­LY, IN­TEN­TION­AL­LY, PERM­A­NENT­LY, AND IR­REV­O­CAB­LY WAIVES (i) acceptance of the Guaranty by the Creditors, (ii) notice of such acceptance, and (iii) signature of the Guaranty by the Creditors.

Comment

Many guaranty clauses include waiver-of-acceptance and waiver-of-signature language, even though such language might very well merely duplicate applicable law. See, e.g., US Bank Nat'l Ass'n v. Polyphase Elec. Co., No. 10-4881 (D. Minn. Apr. 23, 2012): In that case, the court granted granted summary judgment that a bank was entitled to enforce guaranties of loans made by the bank, even though the bank had not signed the guaranty documents.

4.10.4 Guaranty Collection Expenses

The Guarantor must pay or reimburse all court costs and all reasonable expenses — including for example reasonable attorney fees and expenses — that any Creditor incurs in attempting to enforce one or more of: (1) that Creditor's rights against that Guarantor under the Guaranty; and (2) the Guaranteed Payment Obligation in question.

Comment

Language similar to that of this clause was used in clause 4 of the guaranty in Eagerton v. Vision Bank, 99 So. 3d 299, 305 (Ala. 2012). See also 7.3.1. Attorney Fees Award.

4.10.5 Bankruptcy Refunds

(a) This provision applies if a Creditor:

(1) refunds (as defined below) a payment made by a Payer on a Guaranteed Payment Obligation because of a requirement of bankruptcy law; fraudulent-transfer law; or comparable law; or

(2) makes a partial refund of such a payment in settlement of a claim for a larger refund.

(b) In any such case, each Guarantor, jointly and severally, must reimburse the Creditor for the amount of the refund or partial refund and as well as reasonable attorney fees and expenses and costs of court, if any.

(c) For purposes of this provision, the term refund includes payments made by the Creditor to third parties, for example to a trustee in bankruptcy, a debtor-in-possession, or a receiver.

Comment

If a principal of a guaranteed payment obligation were to file for bankruptcy protection (under U.S. law), then the obligation's creditor might be forced to return any payments that were made by the principal within the 90 days preceding the bankruptcy filing date. Such payments are known as "avoidable preferences." See generally, e.g., Patricia Dzikowski, The Bankruptcy Trustee and Preference Claims (Nolo.com; undated); see also the guaranty language in Cooperatieve Centrale Raiffeisen-Boerenleenbank, B.A. v. Navarro, 2015 NY Slip Op 4753, at part I.

A creditor in bankruptcy has the right to contest its obligation to refund an avoidable preference. That can be difficult, though; the creditor must successfully jump through some hoops to prove that it was entitled to the payment. See generally, e.g., Kathleen Michon, Pre-Bankruptcy Payments to Creditors: Can the Trustee Get the Money Back? (Nolo.com; undated).

As a practical matter, many avoidable-preference cases are settled, with the creditor making a partial refund in lieu of incurring the expense of jumping through those proof hoops. In such a situation, if the original obligation had been guaranteed, then the creditor likely would want to try to recoup the partial refund from the guarantor.

4.10.6  ? Guarantor Deficiency Liability

Each Guarantor will be (and remain) liable, to the fullest extent permitted by applicable law, for any deficiency remaining after foreclosure of any lien or other security interest in collateral or other rights or property securing a Guaranteed Payment Obligation, even if the Payer's liability for such a deficiency is discharged pursuant to statute or judicial decision.

Comment

This language is based on that of the guaranty in Eagerton v. Vision Bank, 99 So. 3d 299, 309 (Ala. 2012); see also the similar language of the guaranty in Cooperatieve Centrale Raiffeisen-Boerenleenbank, B.A. v. Navarro, 2015 NY Slip Op 4753, at part I.

4.10.7   Guaranty Defenses WAIVER

Except to the extent that the Agreement expressly states otherwise, each Guarantor KNOW­ING­LY, VOL­UN­TAR­I­LY, IN­TEN­TION­AL­LY, PERM­A­NENT­LY, AND IR­REV­O­CAB­LY WAIVES — and expressly agrees that it will not assert (and it will cause its affiliates not to assert):

(1) any claim or defense that the Guarantor's obligations under this Guaranty are allegedly illegal, invalid, void, or otherwise unenforceable;

(2) any claim or defense pertaining to any Guaranteed Payment Obligation, other than the defense of discharge by full performance, including without limitation any defense of waiver, release, statute of limitations, res judicata, statute of frauds, fraud, incapacity, minority, usury, illegality, invalidity, voidness, or other unenforceability that may be available to the Payer or any other person liable in respect of any Guaranteed Payment Obligation;

(3) any setoff available to the Payer or any other such person liable, whether or not on account of a related transaction;

(4) all rights and defenses arising out of an election of remedies by a Creditor, even if that election of remedies, such as a nonjudicial foreclosure with respect to security for a Guaranteed Payment Obligation, resulted in impairment or destruction of the Guarantor's rights of subrogation and reimbursement against the Payer; and

(5) any other circumstance which might otherwise constitute a defense available to, or a discharge of, the Payer or any Guarantor; and

(b) Each Guarantor KNOW­ING­LY, VOL­UN­TAR­I­LY, IN­TEN­TION­AL­LY, PERM­A­NENT­LY, AND IR­REV­O­CAB­LY WAIVES

Comment

This waiver language is adapted from California Civil Code § 2856(c) and (d).

The use of bold-faced type is for conspicuousness.

The phrase "will not assert" is designed to make it a breach of contract — for which attorney fees might be recoverable as damages — for a guarantor to make any of the listed assertions.

Sub­div­i­sion (2): Some of the listed items are based on those of the respective guaranties in:

Sub­div­i­sion (3): The "setoff" language is not uncommon; see, e.g., the guaranty in suit in Moayedi v. Interstate 35/Chisam Road, LP, 438 S.W.3d 1, 3 (Tex. 2014) (affirming that guarantor's waiver of defenses negated statutory right of offset).

After sub­div­i­sion (5), some drafters might wish to consider adding: Each Guarantor also waives any defense to liability that could be asserted by any Payer in respect of the Guaranteed Payment Obligation.

4.10.8   Joint and Several Guarantor Liability

Except to the extent (if any) that the Agreement expressly states otherwise, each Guarantor is jointly and severally liable to each Creditor for each Guaranteed Payment Obligation.

Comment

It's a really good idea for drafters (and reviewers) to be clear about the extent to which multiple guarantors are to be jointly and severally liable for the guaranteed payment obligation(s). In a given transaction, for example, Alice might guarantee the obligations of Alan, and Bob might guarantee the obligations of Betty, but not vice versa — that is, Alice does not guarantee Betty's obligations nor does Bob guarantee Alan's obligations.

4.10.9   Unconditional Guarantor Liability

Except to the extent (if any) that the Agreement expressly states otherwise:

(a) Each Guarantor's obligations under the Guaranty: (1) are unconditional, direct and primary; and (2) will accrue immediately, upon written demand by the Creditor to the Guarantor, after any default by the Payer in the relevant Guaranteed Payment Obligation.

(b) IF: The Guaranteed Agreement provides the Payer with the right to notice and a cure period in which to cure an alleged breach of a Guaranteed Payment Obligation; THEN: The Guarantor's obligations under the Guaranty will not accrue before the end of that cure period.

(c) The Creditor is not required to attempt to enforce the Guaranteed Payment Obligation against the Payer; for example, the Guarantor is not required to attempt: (1) to collect a judgment against the Payer, nor (2) to foreclose on any lien, security interest, or other collateral securing the Guaranteed Payment Obligation.

Comment

Sub­div­i­sion (a): See the notes accompanying 4.10.11.   Reasonable Collection Efforts.

An "absolute and unconditional" guaranty is likely to be enforced even in what might seem like unfair circumstances such as collusion between the lender and the principal. For an example of this, see the decision by the Court of Appeals of New York (which is that state's highest court) in Cooperatieve Centrale Raiffeisen-Boerenleenbank, B.A. v. Navarro, 2015 NY Slip Op 4753. In that case, a guarantor sought to avoid liability as provided under an "unconditional and absolute" guaranty in favor of plaintiff, on grounds that the default judgment against the guarantor was obtained by the plaintiff's collusion. The court of appeals concluded that the plaintiff's collusion claim constituted a defense, and therefore was barred by the express language of the guaranty. (The court of appeals also concluded that the guarantor's claim of collusion was contradicted by the record.) See id., slip op. at 1-2.

4.10.10   Alteration of Guaranteed Obligation

For the avoidance of doubt, an amendment to or modification of a Guaranteed Payment Obligation does not discharge or otherwise affect the guaranty obligation of any Guarantor in respect of that Guaranteed Payment Obligation.

Comment

The intent of this provision is to override the general rule — which is strictly applied by courts — that "a guarantor is discharged if, without his or her consent, the contract of guaranty is materially altered." Eagerton v. Vision Bank, 99 So. 3d 299, 305-06 (Ala. 2012) (holding that modification of loan discharged guarantors from further obligations) (citations, quotation marks, and alterations omitted); accord, Sterling Development Group Three, LLC, v. Carlson, 2015 N.D. 39 (affirming holding that guaranty was discharged by alteration of guaranteed obligations without guarantor's knowledge or consent) (citing state statute). For an example of clause language like this, see the guaranty in Cooperatieve Centrale Raiffeisen-Boerenleenbank, B.A. v. Navarro, 2015 NY Slip Op 4753, at part I.

4.10.11   Reasonable Collection Efforts

This Guaranty may not be enforced as to any Guaranteed Payment Obligation until the Creditor:

(1) has obtained a final judgment against the Payer, from which no further appeal is taken or possible, enforcing, in whole or in part, the Guaranteed Payment Obligation in question; and

(2) has been unable to collect the judgment after diligently making reasonable efforts to do so.

Comment

Creditors will typically object to this language; they normally want to be able to go after guarantors immediately to get their money, as opposed to incurring the delay, burden, expense, and uncertainty of first having to file suit against their debtors.

4.10.12   Guarantor Liability Cap

In no event will the Guarantors, in the aggregate, be liable under the Guaranty for more than FILL IN (the Maximum Guarantor Liability).

Comment

In some transactions a cap on Guarantor liability might be a possible negotiation point.

Negotiators can consider attaching other conditions and limitations to guaranty obligations. For example, a guaranty for a lease agreement might state that the landlord cannot proceed against the guarantor before the landlord has exhausted all possible avenues of collection against the tenant, including obtaining a judgment against the tenant (this is known as a guaranty of collection).

Additional notes: Guaranties

Spelling: Guaranty, or gurantee?

In U.S. law, the terms "guaranty" and "guarantee" are usually associated with a third party's commitment to make good on a principal party's failure to comply with an obligation. Traditionally, "guaranty" is the noun, while "guarantee" is the verb; see, e.g., Uhlmann v. Richardson, 287 P.3d 287 (Kan. App. 2012), citing Bryan Garner, Garner's Dictionary of Legal Usage 399 (3d ed. 2011).

For example, when my daughter was in college, I signed a guaranty (noun) in which I guaranteed (verb) her payment of her apartment rent.

A related point: People sometimes use the terms guarantee (or guaranty) and warranty interchangeably, but but technically there are some differences in conventional usage that drafters should keep in mind; see the commentary to 3.19.1. Warranty Definition for additional discussion.

Both guarantors and creditors should be cautious

Drafters of guaranties will want to be careful, because in the U.S., guaranties are typically construed strictly in favor of the guarantor, with ambiguities resolved against the creditor. See, e.g., Haggard v. Bank of Ozarks Inc., 668 F.3d 196, 201-02 (5th Cir. 2012) (vacating and remanding summary judgment in favor of bank).

Signers of guaranties, though, should be equally cautious if not more so, because an "absolute and unconditional" guaranty is likely to be enforced even in what might seem like unfair circumstances such as collusion between the lender and the principal. See this discussion.

Consider other ways of "guaranteeing" payment, too

Drafters representing a guaranty creditor should consider other possible ways of securing the guaranteed payment obligation, such as (for example):

  • standby letter of credit from a bank or other financial institution;
  • payment bond, which is a type of surety bond, which is in essence an insurance policy (and is often issued by an insurance carrier);
  • taking — and perfecting — a security interest in an asset that could be seized and sold, with the sale proceeds being used to satisfy the payment obligation in whole or in part and any remaining proceeds being delivered to the (previous) owner(s) of the asset.

An interesting form of payment security can be seen in Falco v. Farmers Ins. Gp., No. 14-2733 (8th Cir. Aug. 3, 2015) (affirming summary judgment in favor of defendants). In that case:

  • An independent insurance agent's contract with an insurance carrier entitled the agent to a certain termination payment if he ever ceased representing the carrier.
  • Some 16 years after signing on with the insurance carrier, the agent took out a line-of-credit loan from the carrier's employee credit union.
  • As part of the loan documentation, the agent signed a power of attorney giving the credit union the power to submit the agent's resignation from representing the carrier, in which case the carrier would pay the agent's termination payment to the credit union.
  • Five years later, the agent didn't make his payments on his line-of-credit loan, so the credit union did just as described above: It tendered the agent's resignation from representing the insurance carrier; collected the termination payment and applied it to the agent's outstanding loan balance; and remitted the balance to the agent.

The agent filed suit against pretty much everyone in sight. The district court granted summary judgment in favor of all defendants; the appeals court affirmed.

Additional reading about guaranties

See, e.g.:

[DCT to-do items]

Add language for:

  • Guarantor must provide audited financials periodically
  • Guarantor consents to jurisdiction somewhere convenient to the creditor (e.g., where leased property is located if guarantor is guaranteeing tenant's payment of lease)
  • Guarantor appoints an agent for service of process
  • Representation by signer of corporate guaranty that the signer is duly authorized to do so.

These are inspired by Pamela Westhoff, Charles Donovan and Lydia Lake, Commercial Lease Guaranties From Foreign Entities: What You Need to Know to Safeguard Your Security (Shepard Mullin 2015).

4.11   Standby Letter of Credit (notes only)

A standby letter of credit (known as a "SLOC" or "L/C") can be thought of as a special type of guaranty. An L/C is issued by a bank to a third party when requested by one of the bank's customers. The L/C is, in essence, a promise, by the bank to the third party, that the bank will pay the third party if the bank's customer fails to meet its own payment obligation to the third party. The bank charges the customer a fee for issuing the letter of credit; the bank also requires the customer to sign an agreement to indemnify the bank (that is, reimburse the bank) if the bank is ever required to pay the third party under the L/C.

A useful teaching example can be found in Mago Int'l v. LHB AG, No. 15-2776 (2d Cir. Aug. 15, 2016) (affirming summary judgment in favor of defendant bank). In that case:

  • A New York-based supplier entered into an agreement to sell meats to a customer in Kosovo. As part of the agreement, the customer's bank and a confirming bank issued a standby letter of credit to the supplier, guaranteeing payment by the customer.
  • The supplier shipped twelve containers of meats to the customer. The customer, though, "stiffed" the supplier.

See id., slip op at 3-4.

In its opinion, the Second Circuit explained the basic operation of standby letters of credit:

An SLOC is an agreement by a bank to pay a beneficiary on behalf of a customer who obtains the letter, if the customer defaults on an obligation to the beneficiary.

Originally devised to function in international trade, a letter of credit reduced the risk of nonpayment in cases where credit was extended to strangers in distant places.

  • The issuing bank, or a bank that acts as confirming bank for the issuer, takes on an absolute duty to pay the amount of the credit to the beneficiary, so long as the beneficiary complies with the terms of the letter.
  • However, in order to protect the issuing or confirming bank, this absolute duty does not arise unless the terms of the letter have been complied with strictly. Adherence to this rule ensures that banks, dealing only in documents, will be able to act quickly, enhancing the letter of credit’s fluidity.
  • Literal compliance with the credit therefore is also essential so as not to impose an obligation upon the bank that it did not undertake and so as not to jeopardize the bank’s right to indemnity from its customer.
  • Therefore, in determining whether to pay, the bank looks solely at the letter and the documentation the beneficiary presents to determine whether the documentation meets the requirements in the letter.
  • The corollary to the rule of strict compliance is that the requirements in letters of credit must be explicit and that all ambiguities are construed against the bank. Since the beneficiary must comply strictly with the requirements of the letter, it must know precisely and unequivocally what those requirements are.

Id., slip op. at 4-5 (emphasis, extra paragraphing, and bullets added, alteration marks by the court omitted). Unhappily for the meat supplier, the first time it sought payment from the bank under the L/C, it did not provide the required documentation showing that it had in fact shipped the meat to the Kosovo customer; by the time the supplier did furnish the necessary documentation, it was too late. The district court accordingly granted summary judgment in favor of the bank, and the Second Circuit affirmed. See id. at 5-7.

4.12   Payment Offsets Authorization

Unless otherwise agreed in writing, a paying party may, in its sole discretion, offset against amounts it allegedly owes to another party, any amount that the other party owes to it; otherwise, the paying party may not offset any such amount.

Comment

Apparently in some jurisdictions (e.g. France), an automatic right of offset might not be enforceable, according to a LinkedIn commenter (see http://goo.gl/aWpjDv; membership required).

See also 4.13.   Payment Offsets Prohibition.

4.13   Payment Offsets Prohibition

A paying party may not offset against amounts it allegedly owes to another party, any amount that the other party owes to it.

4.14   COD Terms After Nonpayment

For the avoidance of doubt, in case of (i) multiple late payments, or (ii) one or more significant late payments, by a party, the other party may require cash-on-delivery (COD) terms for any subsequent transactions.

Comment

Applicable law might well implicitly permit a payee to demand COD terms after late payment if the late payment constituted a material breach of the Agreement.

4.15   Non-Payment Not Infringement

For the avoidance of doubt, IF: A party (Customer does not timely pay another party (Provider amounts required by the Agreement for goods or services furnished by Provider; THEN: Provider's remedies (if any) will be for breach of contract and not for infringement of Provider's intellectual property rights.

Comment

A customer purchasing and using (or reselling) goods, or acquiring a license to use software, might be interested in this clause. Without such a clause, non-payment of the required fee might conceivably result in the customer's infringement of the provider's intellectual property rights, which in some circumstances could result in a significantly-higher damage award than simply having to pay the required fee.

Consider the case of Frank Music Corp. v. Metro-Goldwyn-Mayer, Inc., 886 F.2d 1545 (9th Cir. 1989) (Frank Music II):

  • The MGM Grand Hotel had a floor show called Hallelujah Hollywood!, which included ‘tributes' to various MGM movies.
  • The floor show incorporated significant portions of the musical Kismet, which had been made into an MGM movie.
  • The court found that this went beyond MGM's ‘movie rights' and therefore infringed the copyright in the musical.
  • The resulting damage award included not just a portion of profits from the floor show itself, but 2% of the overall profits from the MGM Grand's hotel operations — including 2% of the casino profits — which, the court found, were indirectly attributable to the promotional value of the infringing floor show.

This clause would avert such a result if a customer were to fail to pay a provider.

Cf. also the Cincom case, in which a software customer found itself having to pay copyright-infringement damages to the software vendor, in an amount equal to the licensee fee that the customer had already paid, because the customer switched the use of the software to an unauthorized affiliate.

5   Supporting Provisions

5.1   Automatic Approval of Requests

(a) This section applies whenever the Agreement specifies that a party (the Reviewing Party) has a stated period of time (the Request Review Period) in which to approve a particular request for approval (the Approval Request).

(b) The Request Review Period begins on the date that the Approval Request is received by the Reviewing Party.

(c) The Reviewing Party is to be deemed to have approved the Approval Request if the Receiving Party has not delivered, to the Requesting Party, a written objection to the Approval Request by the end of the Request Review Period.

Comment

Some contracts include automatic-approval language, but many parties are uncomfortable with the concept.

5.2   Background Checks

5.2.1 Background-Check Definitions

Applicable Background Checks refers to the specific background check(s) are to be performed under the Agreement, namely Criminal-History Checks if not otherwise specified.

Checked Individuals refers to the individual or individuals whose backgrounds are to be checked under the Agreement, namely any individual whom a Checking Party, directly or indirectly, causes or permits to engage in one or more Restricted Activities if not otherwise specified.

Checking Party refers to a party that is required to perform background checks under the Agreement.

Credit Check refers to standard credit reporting from all major credit bureaus serving the jurisdiction in question.

Criminal History, as to a Checked Individual, refers to the Checked Individual's having been convicted of, or having pled guilty or no contest to, one or more of (A) a felony; and/or (B) a misdemeanor involving fraud or moral turpitude.

Criminal-History Check refers to a nationwide check of records of arrests, convictions, incarcerations, and sex-offender status. A Criminal-History Check is not required to include fingerprint submission to confirm identity.

Critical Activity refers to any activity involving a substantial possibility of (i) bodily injury to or death of one or more individuals, including but not limited to a Checked Individual; and/or (ii) loss of, or damage to, tangible or intangible property of any kind; such loss or damage might be physical and/or economic.

Driving-Record Check refers to a check of records of accidents; driver's-license status; driver's-license suspensions or revocations; traffic violations; criminal charges (e.g., DUI).

Drug Misuse, as to a Checked Individual, refers to evidence of use, by the Checked Individual, of one or more of: (1) illegal drugs; and/or (2) prescription drugs other than in accordance with a lawfully-issued prescription.

Drug Testing refers to testing for illegal drugs and controlled pharmaceuticals.

Education Verification refers to confirmation of dates of attendance, fields of study, and degrees earned.

Employment Verification refers to confirmation of start- and stop dates and titles of employment for the past seven years.

Lien, Civil-Judgment, and Bankruptcy Check refers to a check of records of tax- and other liens; civil judgments; and bankruptcy filings.

Personal Reference Check refers to telephone- or in-person interviews with at least three personal references, seeking information about the individual's ethics; work ethic; reliability; ability to work with others (including, for example and where relevant, peers, subordinates, superiors, customers, and suppliers); strengths; areas with room for improvement; personality.

Requesting Party refers to the Signatory Party other than the Checking Party.

Residence Address Verification refers to confirmation of dates of residence addresses for the past seven years.

Restricted Activity refers to any one or more of the following, when engaged in, in connection with the Agreement, by an employee of, or other individual under the control of, a Checking Party:

(1) working on-site at any premises of a Requesting Party;

(2) having access (including for example remote access) to the Requesting Party's equipment or computer network;

(3) having access to the Requesting Party's confidential information;

(4) interacting with the Requesting Party's employees, suppliers, or customers; and

(5) any Critical Activity.

Comment

Some drafters will want to specify additional background checks.

The defined term used here is Applicable Background Checks, as opposed to Required Background Checks, for two reasons:

  1. To avoid creating the implication that the Applicable Background Checks are always an absolute, mandatory requirement, because that could create future difficulties if a background check were skipped and then the checked individual did something bad; and
  2. less importantly, to have the term be alphabetized with the other definitions just above.

Credit checks, if not done correctly, can get a checking party in trouble under the [U.S.] Fair Credit Reporting Act, as discussed in the Annotations.

Criminal records checks in basic form seem to be available from any number of Web sites at low cost. (I've never personally used any such site and can't recommend any particular one; your company's or client's HR people might be able to recommend one.)

CAUTION: Using criminal-records checks to deny employment might lead to trouble with government agencies or with the persons checked if the denials have the effect of unlawful discrimination against minorities or other protected classes.

Critical Activities: This definition is used in the restrictions on assigning personnel to engage in such activities if their background checks indicate Drug Misuse.

Drug testing: Customers with safety concerns might want its contractors' employees to be drug-tested. Depending on the position, even legal drugs might disqualify an individual. For example, an individual taking certain prescription medications might be disqualified from (say) driving a bus or other commercial vehicle.

Companies, though, should be cognizant of disability laws such as the Americans with Disabilities Act, which might affect a company's ability to deny employment because of prescribed drug use.

Companies might also consider the possible effect on employee morale of asking them to take a drug test – and about what they might have to do if a valued employee were to bust the test. As the saying goes, be careful about asking a question if you're not prepared to deal with the answer.

Educational references: This check is sometimes used as a way of detecting people who falsify their résumés about their education. Sadly, résumé padding is not an uncommon occurrence. For example, in 2014 the chief spokesman of Walmart resigned after the retail giant learned that he had falsely claimed to have graduated from college, when in fact he had not finished his course work (DailyMail.com 2014). Ditto the former dean of admissions at MIT (NPR.org 2015).

Employment verification: Verification of employment dates, in particular, can help expose undisclosed résumé gaps — or "fudging" of employment dates as listed on the résumé to shorten or eliminate gaps.

It's thought by some that a good practice is not to rely on employer contact information provided by the (former) employee, but instead to find the contact information independently. Otherwise, it's possible that the "employer" is actually someone colluding with the former employee to provide false information.

Some parties might want to obtain more than just the listed information, adding (for example) job duties, salary history, reason for leaving, and/or eligibility for rehire.

Some parties want employment history for the past five to ten years, or for the past two to five employers.

Residence addresses: This check has in mind that an individual might omit one or more previous residence addresses in the hope of evading a criminal-records check.

5.2.2 Background Check Requirement

The Checking Party is to cause all Applicable Background Checks to be conducted on all Checked Individuals, as follows:

(a) Any Applicable Background Check by the Checking Party itself is to be performed in a commercially-reasonble manner.

(b) Each other Applicable Background Check is to be performed by a reputable service provider.

Comment

The Checking Party's obligation is to cause background checks to be conducted. Very few parties will actually conduct their own background checks. Even those (few) parties that might be able to conduct their own checks are likely to want to "outsource" that responsibility to an outside party that can do such things more cost-effectively (and at which the finger can be pointed if something goes wrong).

This language gives the Checking Party a safe harbor: If it hires a reputable service provider, then it will have complied with its obligation under this provision. This obligation can be beefed up by using 5.2.6.  ? Checking Party Indemnity Obligation.

5.2.3 Compliance with Law Requirement

The Checking Party is to take prudent measures to cause each background check to be conducted in accordance with law, including, for example:

(1) any applicable privacy laws, including for example any requirement to obtain the consent of the relevant Checked Individual; and

(2) any applicable requirement (for example, in credit-reporting laws) that the relevant Checked Individual must be notified before or after a decision is made using information learned in the background check.

Comment

This obligation is phrased in terms of "prudent measures," as opposed to an absolute obligation; it can be beefed up by using 5.2.6.  ? Checking Party Indemnity Obligation drop-in clause.

Expressly requiring the Checking Party to comply with law is arguably superfluous. Still, doing so can be useful —

  • to remind drafters and parties of privacy laws protecting employees and consumers, including for example:
  • to give the other party a contractual remedy — not to mention a certain amount of political cover — in case the party required to conduct background checks violates the law in doing so.

See generally, e.g.:

5.2.4 Criminal-History Consequences

(a) IF: A Checked Individual's background check reveals any Criminal History; THEN: The Checking Party is not to assign, nor permit, that individual to engage in any Restricted Activity without first consulting with the Requesting Party.

(b) IF: A Checked Individual's background check indicates any Drug Misuse; THEN: The Checking Party must not assign nor permit that individual:

(1) to engage in any any Critical Activity without the express prior written consent of the Requesting Party; nor

(2) to engage in any other Restricted Activity without first consulting with the Requesting Party.

Comment

This provision requires the Checking Party only to consult with the Requesting Party, as opposed to obtaining the Requesting Party's consent. (The latter seems to be traditional in provisions of this type.) This is because in recent years the practice of automatically disqualifying people with criminal convictions has come under fire from government regulators and the plaintiff's bar as being potentially discriminatory (the so-called "ban the box" movement), as discussed in the Notes.

For obvious reasons, sub­div­i­sion (b) imposes tighter restrictions on Critical Activities than on other Restricted Activities.

5.2.5  ? Independent Reference Contacts

As a safeguard against falsified references, all reference checks (if any) other than personal character references are to be completed using contact information obtained other than from the Checked Individual.

Comment

This provision helps to guard against the possibility that an applicant might provide a Checking Party with fake contact information when listing former employers, etc., as references. Then when the Checking Party contacts the "references," it ends up talking to one of the applicant's friends who is in on the scam.

5.2.6  ? Checking Party Indemnity Obligation

The Checking Party must defend and indemnify the Requesting Party and its Protected Group against any and all third-party claims — including but not limited to any claim by a Checked Individual and any claim by a government authority — arising from any allegation of breach of governing law in the performance of background checks under the Agreement by or at the direction of the Checking Party.

Comment

This indemnity obligation is worded carefully to focus on just what breaches are subject to that obligation.

As with any indemnity obligation, drafters should consider pairing this indemnity obligation with an insurance requirement.

5.2.7  ? Requesting Party Background Checks

The Requesting Party may cause its own background checks to be conducted on any or all Checked Individuals, in which case:

(1) in conducting any such background checks, the Requesting Party will comply with the background-check provisions of the Agreement, and defend and indemnify the Requesting Party for any noncompliance, as though the Requesting Party were the Checking Party and vice versa;

(2) the Requesting Party will bear its own expenses associated with any background checks that it conducts;

(3) The Checking Party will provide reasonable cooperation with the Requesting Party in attempting to obtain any necessary consent for checks from each Checked Individual; and

(4) The Requesting Party will provide the same defense and indemnity to the Checking Party and its Protected Group (if any) as the Checking Party must provide under section 5.2.6 (that is, the parties' roles under that section will be reversed).

Comment

This provision allows (for example) a service provider's customer to initiate its own background checks on service-provider personnel.

5.2.8   Checking Party Expenses

The Requesting Party is to reimburse the Checking Party for all reasonable out-of-pocket expenses incurred by or on behalf of the Checking Party in connection with performing background checks required by the Agreement.

Comment

Service providers often take the view that any customer that wants background checks to be conducted on the provider's personnel should pony up for that cost.

On the other hand, a customer might take the position that background checks should be an overhead expense that the provider must bear.

Additional notes: Background checks

Background-check overview
Business purpose

It's not uncommon for customers to want service providers to do background checks on the providers' key personnel. The goal is normally to identify people with criminal records or other indicia of potential trouble. As discussed below, this can be a sensitive topic, possibly with legal complications.

A customer might especially want (or need) for a supplier to have background checks run on the supplier's personnel, for example:

  • if the customer is a government contractor;
  • if the supplier will have access to the customer's confidential- or sensitive information;
  • if the supplier's personnel will "face" the customer's own customers or clients, that is, be seen or heard by them.
Caution: Obtaining consent of Checked Individuals might be advisable even if not legally mandatory

Parties conducting or commissioning background checks should be sure to check applicable law to see if any particular form of consent is required. See also 5.2.3. Compliance with Law Requirement.

It might well be prudent to obtain consent to a background check even if the law doesn't require it. If the individual were to learn of an unconsented background check, his displeasure might go viral on social media, especially given today's heightened sensitivity to privacy concerns.

Have background checks already been done?

It's entirely possible that, due to the nature of the industry (e.g., technology consulting services), the contractor might have already had background checks performed on its relevant people.

Further reading

Consider checking the Wikipedia entry on background checks to get ideas for further research on this subject.

Credit-check issues under the Fair Credit Reporting Act

Credit checks can get a checking party in trouble under the [U.S.] Fair Credit Reporting Act. One particular procedural requirement seems to come up in class-action lawsuits: Section 1681b(b)(2)(A) of the Act, which states that, with certain very-limited exceptions:

… a person may not procure a consumer report, or cause a consumer report to be procured, for employment purposes with respect to any consumer, unless–

  1. a clear and conspicuous disclosure has been made in writing to the consumer at any time before the report is procured or caused to be procured, in a document that consists solely of the disclosure, that a consumer report may be obtained for employment purposes; and

ii) the consumer has authorized in writing … the procurement of the report by that person.

(Emphasis and paragraphing added.) Hat tip: Ken Remson, Employers Hit With Background Check Lawsuits, May 20, 2014; see also Todd Lebowitz, Publix to Pay $6.8 Million Settlement over Noncompliant Background Check Forms (EmploymentClassActionReport.com Nov. 3, 2014).

In July 2015, the Chuck E. Cheese restaurant company settled a class-action lawsuit by employees who asserted that the company's background-check consent form did not comply with the FCRA's strict requirements. See, e.g., David M. Gettings, Timothy St. George and David N. Anthony, Chuck E. Cheese Settles Background Check Lawsuit For $1.75 Million (Mondaq.com).

Legal risks of disqualifying personnel who "fail" a background check
Caution: Restricting personnel assignments might be attacked as discriminatory

A blanket prohibition against using personnel with criminal records could be problematic: It might be alleged to have a disproportionate impact on racial- or ethnic minorities and thus to be illegal in the U.S. See generally the EEOC general counsel's enforcement guidance published in April 2012.

The EEOC has filed lawsuits against employers who allegedly "violated Title VII of the Civil Rights Act by implementing and utilizing a criminal background policy that resulted in employees being fired and others being screened out for employment …." EEOC press release, June 11, 2013.

Companies should also be cognizant of disability laws such as the Americans with Disabilities Act, which might affect a company's ability to deny employment because of prescribed drug use, as opposed to making accommodations of some sort.

Caution: State- or federal law might restrict employers' personnel decisions

In addition, some states might likewise restrict an employer's ability to rely on criminal background information in making employment-related decisions. Drafters should pay particular attention to the law in New York, Massachusetts, Illinois, and Pennsylvania (not necessarily an exhaustive list).

On a related note: "Bills pending in both houses of Congress would make it unlawful for most federal contractors to request a job applicant, whether orally or in writing, to disclose criminal history record information before the applicant has received a conditional offer of employment." Garen E. Dodge, Richard I. Greenberg, and Susan M. Corcoran, Proposed ‘Ban the Box’ Legislation Would Limit Criminal History Inquiries by Federal Contractors (JacksonLewis.com 2015).

For a list of states and cities with ban-the-box laws, see Michelle Natividad Rodriguez and Nayantara Mehta, Ban the Box: U.S. Cities, Counties, and States Adopt Fair Hiring Policies (NELP.com 2015).

Legal-compliance indemnity option
Motivation

Suppose that Customer requires Provider to have background checks done on all Provider personnel who will be accessing Customer's premises. Then suppose that a Provider employee complains that the background check violated his rights under applicable law. The Provider employee might be tempted to sue Customer, not just Provider. In that situation, this provision would require Provider to protect Customer from the cost of defending and/or paying damages for such claims.

"Cause to be …"

The "cause … to be defended and indemnified" language has in mind that Provider likely would hire a presumably-reputable professional firm to do background checks. In that situation, Provider party likely wouldn't want to be obligated to indemnify Customer itself, but instead would want the professional firm to be responsible for any third-party claims arising from the firm's work.

Indemnity liability – greater than ordinary contract damages?

As with any indemnity obligation, drafters should consider whether the indemnifying party might be liable for unforeseeable damages as well as foreseeable damages; see this note for additional details.

5.3   Consultation

5.3.1 Notice and Opportunity to Be Heard

(a) This section 5.3 applies whenever the Agreement provides that a specified party (the "acting party"):

(1) must consult with another party before taking or omitting a specified action, or

(2) must take or omit the action "in consultation with" another party or words to that effect.

(b) Before taking or omitting the action in question, the acting party must:

(1) seasonably advise the other party, preferably but not necessarily in writing, that it intends to take or omit the action; and

(2) if so requested by the other party, provide the other party with:

(A) such relevant information about the acting party's intentions as the acting party deems appropriate in its reasonable discretion; and

(B) a reasonable opportunity to be heard by the acting party concerning the action to be taken or omitted.

Comment

Suppose that Alice and Bob are negotiating a contract under which Alice demands that Bob obtain Alice's consent before proceeding with a specified action (e.g., raising prices). Bob, not wanting to limit his flexibility, pushes back in response; he wants to be able to raise prices in his sole discretion. A possible compromise would be for the parties to agree that Bob will not raise prices without first consulting with Alice.

The term consult is vague, though; that vagueness could later lead to disputes about whether Bob had complied with the consultation obligation. With that in mind, this definition sets out a specific procedure for consultation, while leaving the ultimate decision authority alone.

This provision is drafted in contemplation that it might be part of a package of clauses that as a group, but not individually, are incorporated by reference into an agreement.

This provision does not specifically require the acting party to advise the other party in writing. The acting party, though, will of course want to consider doing so in order to avoid later "he said, she said" disputes about whether the acting party complied with this requirement.

See also 2.76. Seasonable Definition.

5.3.2 Freedom of Action Not Limited

For the avoidance of doubt, a consultation requirement in itself does not limit the freedom of the acting party to take or omit the specified action unless the Agreement expressly states otherwise.

Comment

This subdivision is a "roadblock" provision, intended to reassure an acting party that might be nervous about about how a court might interpret this.

5.4   Cooperation (rough draft only)

(a) Applicability: This Annex applies in any case as to which the Agreement provides, in this clause or elsewhere, that a party must cooperate with another party in connection with the other party's performance of obligations or exercise of rights under the Agreement. This includes, for example, situations in which the other party is:

(1) attempting to diagnose and/or repair a defect or malfunction of the cooperating party's equipment, software, configuration, or the like;

(2) rendering other services to or for the benefit of the cooperating party;

(3) inspecting or auditing the cooperating party or its records.

(b) Reasonable information to be provided: The cooperating party will timely provide relevant information to the other party or its agents when reasonably requested by one or more of them. (See also the confidentiality provisions of the Agreement, if any, to the extent applicable.)

(c) Option: Suitable working space: IF: The Agreement states that the cooperating party must provide suitable working space; THEN: The cooperating party will timely make the following available to the other party or its agents to the extent reasonably requested by the other party:

(1) working space, appropriately located and ‑furnished;

(2) any necessary utilities, such as (for example) electrical power, heating and air conditioning, and water;

(3) Internet connectivity; and

(4) any necessary parking space.

Comment

These materials need further thought; I'm posting them for use as a reference. The idea for this definition came from, among other places, an Oracle license-agreement document.

Sub­div­i­sion (c) was inspired by tales of parties intentionally making it difficult and uncomfortable for other parties to take actions.

5.5   Extension (Evergreen)

5.5.1 Evergreen-Extension Definitions

Evergreen Period refers to: Any otherwise-expiring period that the Agreement states is subject to evergreen- or automatic extension.

Extension Duration refers to: One year.

Maximum Number of Extensions refers to: An unlimited number.

Party Eligible to Opt Out refers to: Each party.

Opt-Out Deadline refers to: 12 midnight at the end of the last business day before the then-current expiration date of the Extendable Period.

Comments
Business purpose

Evergreen clauses are typically used by parties who expect to be in a long-term contractual relationship but want the ability to opt out every now and then in case things aren't going well.

Checklist question: Which party has the right to opt out?

This provision allows either party to opt out, but in some contractual relationships (e.g., a customer-supplier relationship), one party might might feel that it should have more flexibility than the other party to opt out of an evergreen extension.

Choosing the deadline for non-extension notice

The deadline for giving notice of non-extension should be considered carefully for its possible business implications.

In some supplier-customer relationships, a customer might want the ability to opt out right up to the then-current expiration date, or even for a limited period of time after the automatic extension.

On the other hand, a supplier might want several months' advance warning that its customer was opting out of the relationship, or vice versa, to allow time for planning to wind down the relationship, find replacement business, etc.

Pro tip: Be sure to calendar the Opt-Out Deadline — a client of mine once missed an important opt-out date, as discussed below.

Evergreen extension periods could be of different lengths

It's not carved in stone that all automatic-extension periods should be of the same duration. For example, in some contractual relationships, a first extension period might be relatively short, to give the parties a chance to find out what it's like working together. Then, if neither party opts out, subsequent extension periods could be of longer duration.

Long extension periods can be problematic

Here's a real-world example of an evergreen automatic-extension provision gone awry:

  • A client of mine once agreed to give a steep pricing discount to a particular customer for five years, if memory serves. (I hadn't been involved in that deal.)
  • The agreement provided that the the discount would be automatically extended for another five years if my client didn't opt out when the first five-year period was expiring.
  • Sure enough, no one in the client's organization noticed that the five-year discount period was ending.
  • As a result, the client didn't send the customer a notice that the client was opting out of the pricing commitment.
  • The client had to honor the steeply-discounted pricing for that customer for another five years. This, even though the client had raised its prices significantly for the rest of its customer base.
Maximum number of extensions

If the parties' relationship is working well and either party can opt out, then there might be no reason to have it come to an end unless one party wants it to end.

On the other hand, it might be that only one party has the right to opt out. This might be the case in a supply agreement, in which the customer may opt out but the supplier may not. In that situation, the supplier might want to limit the number of automatic extension periods.

Caution: Statutory restrictions on evergreen extensions

Some states restrict automatic extension or renewal of certain contracts unless specific notice requirements are met. Examples of such states include California, Illinois, New York, North Carolina, and Wisconsin. See Cal. Bus. & Prof. Code § 17600-17606 (consumer contracts); 815 ILCS § 601 (consumer contracts); N.Y. Gen. Oblig. L. § 5-903, contracts for services, maintenance or repair N.C. Gen. Stat. § 75-41 (consumer contracts); Wis. Stat. § 134.49 (business equipment leases and business services).

Further reading

See the discussion of the distinction between extend and renew.

5.5.2 Automatic Extension Subject to Opt-Out

Each Evergreen Period will be automatically extended for the Extension Duration, with no other extension action required by either party, for up to the Maximum Number of Extensions, with such extensions (if any) running successively and continuously, UNLESS a Party Eligible To Opt Out, in its sole discretion, gives notice of non-extension to each other party; any such notice of non-extension must be effective no later than the then-current Opt-Out Deadline.

Comment

The "sole discretion to opt out" language is intended to forestall any claim that non-extension is subject to some sort of duty of good faith and/or fair dealing. See the cases (including U.S. cases) cited by by the Supreme Court of Canada in Bhasin v. Hrynew, 2014 SCC 71 [2014] 3 S.C.R. 495, ¶ 91.

CAUTION: In a Canadian case decided after Bhasin, the agreement in suit involved the software giant Oracle Corporation and a member of Oracle's partner network. The agreement gave Oracle the sole discretion to accept the partner's application to renew the agreement. For 20 years the agreement was renewed each year. In 2014, though, Oracle invited the partner to renew the agreement, but then rejected the partner's renewal application. The partner filed suit; the trial court denied Oracle's motion to dismiss, holding that a dictum in Bhasin "does not stand for the (extreme) proposition that under no circumstances does a 'sole discretion' contract renewal power have to be exercised reasonably." Data & Scientific Inc. v. Oracle Corp., 2015 ONSC 4178 (CanLII).

5.5.3   Extension Opt-Out Fee

(a) Any party opting out of an extension under section 5.5.2 before [specify date] must pay the other party an Early Opt-Out Fee, in an amount specified in the Agreement, no later than 12 midnight UTC at the end of the day on the then-current expiration date of the Extendable Period; otherwise, the extension will go into effect, and the right to opt out of the extention will expire, automatically with no further action by any party.

(b) For the avoidance of doubt, the Early Opt-Out Fee is intended as a form of alternative performance and not as liquidated damages.

Comment

This provision was inspired by an analogous provision in Foodmark, Inc. v. Alasko Foods, Inc., 768 F.3d 42 (1st Cir. 2014). In that case, the court of appeals affirmed a summary judgment that Alasko, a Canadian food distributor, owed Foodmark, a U.S. marketing firm, a fee for electing not to renew the parties' "evergreen" agreement.

The intent of the Early Opt-Out Fee is to give the other party a specified minimum time in which, say, to recoup the investments it makes in supporting the parties' contractual relationship.

5.6   Extension (Unilateral)

5.6.0.1 Comment

Customers often want the right to extend the duration of supply agreements; resellers sometimes want the right to extend the duration of their territory rights.

The unilateral-extension concept could be applied not only to the term of the Agreement, but to just about any right or obligation that has an expiration date.

5.6.1 Right to Extend Unilaterally

Except to the extent (if any) that the Agreement provides otherwise, any party specified in the Agreement (each, an Extending Party) may extend the term specified in the Agreement (each such term, an Extendable Period) for up to an unlimited number of successive periods of one year each.

Comment

One year seems to be fairly typical as the duration of an Extension Period. CAUTION: Too-long an Extension Period could lock in terms and conditions (e.g., pricing) that the other party might regard as unfavorable, as discussed in this note.

Concerning the maximum number of permitted extensions, see the Notes.

5.6.2 Advance Notice Requirement

To extend an Extendable Period, the Extending Party must give notice of extension to each other party; each notice of extension must be effective no later than 90 days before the then-current expiration date of the Extendable Period in question.

Comment

The required extension notice might be appropriate for negotiation, for example if another party will need time to prepare if a party having the right to extend elects to let the notice deadline go by without extending.

5.6.3 Same Terms and Conditions

Unless the parties agree otherwise in writing, any unilateral extension of an Extendable Period will be on the same terms and conditions as were in effect immediately before (what would have been) the expiration of that Extendable Period.

Comment

This language is intended to forestall the result in an Eighth Circuit case, where the appellate court affirmed a declaratory judgment that a lease agreement had given the tenant an option to renew rather than an option to extend; consequently, under a state law, the landlord was free to demand that the terms be renegotiated — this, even though the lease agreement expressly termed the option as a right to extend. See Camelot LLC v. AMC ShowPlace Theatres, Inc., 665 F.3d 1008 (2012) (8th Cir. 2012).

In contrast, the Third Circuit held that a contractual right to renew an insurance policy meant renewal on the same or nearly the same terms and conditions. See Indian Harbor Ins. Co. v. F&M Equip., Ltd., No. 14-1897 (3d Cir. Oct. 15, 2015). The appellate court vacated the trial court's denial of the insured's motion for summary judgment and remanded with instructions to enter summary judgment.

5.6.4 Right to Terminate Not Affected

The fact that an Extendable Period is unilaterally extended will not affect any right that any party might have, under one or more provisions of the Agreement or of applicable law, (i) to terminate that Extendable Period, and/or (ii) to terminate the Agreement.

Comment

Conceivably there might be negotiated agreements in which this provision wouldn't be appropriate.

5.6.5 Extension Opt-Out Right

A unilateral extension will not go into effect if the other party gives notice of non-extension to the Extending Party; that notice must be effective no later than ten business days before expiration of the Extendable Period.

Comment

The concept underlying the opt-out right is extremely common in unilateral-extension provisions, because the non-extending party will usually want the right to "bail" at the end of the relevant term (possibly to use as bargaining leverage to renegotiate the deal).

5.6.6  ? Permanent Lapse of Extension Right

IF: For any reason an an Extending Party does not duly extend an Extendable Period before that period expires; THEN: The Extending Party's right to unilaterally extend that Extendable Period will permanently and irrevocably lapse.

Comment

This is a "fish or cut bait" provision.

5.6.7   Extension Opt-Out Fee

IF: A party wishes to opt out of an extension of an Extendable Period; THEN: In addition to giving timely notice under section 5.6.2, that party must pay the Extending Party an Opt-Out Fee in an amount specified in the Agreement. The payment is due no later than the then-current expiration date of the Extendable Period. If the payment is not timely made, then the extension will go into effect and the right to opt out will expire automatically. For the avoidance of doubt, the Opt-Out Fee is intended to provide an alternative form of performance and not as liquidated damages.

Comment

See the note to the evergreen opt-out fee provision.

5.7   [Reserved: Right-of-first-refusal procedure]

5.8   Force Majeure

5.8.1 Force Majeure Definition

Force-Majeure Event refers generally to any event or series of events (other than one or more Excluded Events (if any; none unless expressly agreed otherwise)) as to which both of the following are true:

(1) the event or series of events causes a failure of timely performance under the Agreement; and

(2) a prudent person, in the position of the party invoking force majeure, would not reasonably have been able to anticipate and avoid the failure of timely performance.

Comment

The "actual or imminent occurrence" language in sub­div­i­sion 2 contemplates that a party might invoke force majeure before the fact — for example, if a hurricane were approaching — as well as after the fact.

5.8.2 Force Majeure Excused Performance

(a) In response to actual or imminent occurrence of one or more Force-Majeure Events, either party (an Invoking Party may invoke force majeure by advising another affected party by notice or other reasonable means.

(b) An Invoking Party that seasonably invokes force majeure will not be liable under the Agreement for any loss, injury, delay, damages, or other harm suffered or incurred by another affected party due to failure of timely performance, by the Invoking Party, resulting from the force majeure.

(c) Each party is to make any efforts expressly specified for that party in the Agreement — if any — with respect to mitigating (the Required Mitigation Efforts) and remediating (the Required Remediation Efforts) the effects of the force majeure. (This subdivision is not to be interpreted as implicitly requiring any party to make any such efforts.)

Comments
Force-majeure provisions codify common-law concepts

Force majeure clauses are not uncommon in commercial contracts. To one degree or another, they mirror the way that the law generally works anyway in many jurisdictions. The Supreme Court of North Dakota provided a useful recap of the (U.S.) law concerning force majeure:

… Black's Law Dictionary defines a force majeure clause as "[a] contractual provision allocating the risk of loss if performance becomes impossible or impracticable, esp[ecially] as a result of an event or effect that the parties could not have anticipated or controlled." Black's Law Dictionary 718 (9th ed. 2009).

According to 30 Williston on Contracts § 77.31, at 364 (4th ed. 2004), a force majeure clause is equivalent to an affirmative defense. "What types of events constitute force majeure depend on the specific language included in the clause itself." Id.

"[N]ot every force majeure event need be beyond the parties' reasonable control to still qualify as an excuse." Id. at 367.

"A party relying on a force majeure clause to excuse performance bears the burden of proving that the event was beyond its control and without its fault or negligence." Id. at 365.

[A] force majeure clause relieves one of liability only where nonperformance is due to causes beyond the control of a person who is performing under a contract. An express force majeure clause in a contract must be accompanied by proof that the failure to perform was proximately caused by a contingency and that, in spite of skill, diligence, and good faith on the promisor's part, performance remains impossible or unreasonably expensive. Id. at 366.

Entzel v. Moritz Sport & Marine 2014 N.D. 12 (extra paragraphing added, alteration marks by the court).

Mitigation- and remediation efforts

Mitigation, remediation, or both? Note that there are two distinct options presented here: One for mitigation, one for remediation, which are two different things.

CAUTION: Some customers might insist that the other party use its "best efforts" to mitigate or remediate the effects of of force majeure; see, e.g., section 4 of a set of Honeywell purchase-order terms and conditions, apparently from February 2014. A supplier might be reluctant to agree to a best-efforts commitment for the reasons discussed in the commentary to 2.9. Best Efforts Definition; such a supplier might prefer a commercially-reasonable efforts commitment instead.

Of course, a drafter should be careful not to commit a client to either mitigation or remediation efforts if such efforts are not part of the client's business model.

In a supply- or services agreement, the customer might not want to be bound by any mitigation obligation.

If Required Mitigation or -Remediation Efforts are going to be defined, it might make sense to refer to an exhibit or appendix where the term can be spelled out in appropriate detail.

But are force-majeure clauses even appropriate anymore?

Lawyer Jeff Gordon makes the thought-provoking argument that "most [force-majeure events] can be planned for … even something like terrorism and war (especially when they're happening right now), should be planned for," and that contracting parties should have a backup plan for such events. See Jeff Gordon, Things that shouldn't count as force majeure (Jan. 5, 2010).

Of course, as a matter of business-risk allocation, parties negotiating a contract might not want to take the time for detailed planning, especially if they don't really know what such detailed plans should be. In that situation, it might well be a defensible business decision to use a force-majeure clause instead.

Further reading about force majeure

See, e.g.:

5.8.3 Force Majeure Examples

For the avoidance of doubt, the term Force-Majeure Event includes the following, when otherwise eligible under the Agreement:

(1) any event that (i) is not an Excluded Event and (ii) falls within one or more of the following categories (some are in bold-faced type to call drafters' attention to them):

Act of a public enemy;;

Act of any government or regulatory body, whether civil or military, domestic or foreign, not resulting from violation of law by the Invoking Party;

Act of war, whether declared or undeclared, including for example civil war;

Act or omission of the other party, other than a material breach of the Agreement;

Act or threat of terrorism;

Blockade;

Boycott;

Civil disturbance;

Court order;

Drought;

Earthquake;

Economic-condition changes generally;

Electrical-power outage;

Embargo imposed by a governmental authority;

Epidemic;

Explosion;

Fire;

Flood;

Hurricane;

Insurrection;

Internet outage;

Invasion;

Labor dispute, including for example strikes, lockouts, work slowdowns, and similar labor unrest or strife;

Law change, including any change in constitution, statute, regulation, or binding interpretation;

Legal impediment such as an inability to obtain or retain a necessary authorization, license, or permit from a governmental authority;

Nationalization;

Payment failure resulting from failure of or interruption in one or more third-party payment systems;

Riot;

Sabotage;

Storm;

Supplier default;

Telecommunications service failure;

Transportation service unavailability;

Tornado;

Weather in general; and

(2) all other particular examples of Force Majeure (if any) identified in the Agreement — it is immaterial if one or more of them also comes within the scope of sub­div­i­sion (1) above.

Comment

The "laundry list" of force-majeure examples in sub­div­i­sion (1) was drawn from various agreement specimens.

Concerning economic changes generally, see Kevin Jacobs and Benjamin Sweet, 'Force Majeure' In the Wake of the Financial Crisis, Corp. Coupsel, Jan. 16, 2014.

In some customer-oriented supply- and service contract forms, labor difficulties are excluded from the definition of force-majeure event.

This list of examples does not include so-called acts of God because of the vagueness of that term.

Some drafters might want to use the "other particular examples …" option in sub­div­i­sion (b) to specify particular force-majeure risks of concern.

5.8.4  ? Force Majeure Rights Extension

IF: One or more properly-invoked Force-Majeure Events make it impracticable or impossible for an Invoking Party to timely exercise a right, under the Agreement; THEN: The time for exercising that right will be deemed extended for the duration of the delay resulting from the Force-Majeure Event or Events.

Comment

This clause addresses a potential gap (depending on one's perspective) in many force-majeure clauses. This gap caused fracking companies to lose a case in New York's highest court. See Beardslee v. Inflection Energy, LLC, 25 N.Y.3d 150, 31 N.E.3d 80, 8 N.Y.S.3d 618 (on certification from Second Circuit), subsequent proceeding, 798 F.3d 90 (2d Cir. 2015) (affirming judgment of district court). In that case, the New York court of appeals aligned itself with courts in several other "oil" jurisdictions. See id., 25 N.Y.3d at 159.

5.8.5  ? Force Majeure Termination

Effective upon written notice to all other Signatory Parties (or at such later time as may be stated in the notice), any Party Entitled To Terminate (namely, each party) may terminate its obligations under the Agreement if the aggregate effect of the relevant Force-Majeure Event(s): (1) is material to the Agreement as a whole; and (2) lasts past the Earliest Termination Date (namely, 30 days after invocation of force majeure by any party entitled to do so under the Agreement).

Comment

The "material to the Agreement as a whole" language is is adapted from the "outsourcing" master services agreement in Indiana v. IBM Corp., No. 49Dl0-1005-PL-021451, slip op. at 1, 47 (Marion Cty In. Sup. Ct. July 18, 2012) (granting judgment for IBM), reversed, 4 N.E.3d 696 No. 49A02-1211-PL-875, (Ind. App. Feb. 13, 2014), affirmed, Indiana v. IBM Corp., No. 49S02-1408-PL-00513 (Ind. Mar. 22, 2016).

The parties might negotiate different Earliest Termination Dates for different parties or different situations. For example, in a supply- or services agreement, the customer might want to be able to "pull the plug" after a relatively-short period, while keeping the supplier "on the hook" for a longer period.

5.8.6  ? Force Majeure Efforts-Only Option

An Invoking Party is considered not to be reasonably able (or not to have been reasonably able, as applicable) to avoid a failure of timely performance resulting from one or more Force-Majeure Events if avoidance is (or was) not possible at a commercially-reasonable cost.

Comment

This language gives an invoking party an "economic out" from having to deal with a Force-Majeure Event.

5.8.7   Force Majeure Subcontractor Requirements

A failure of timely performance by an Invoking Party that is caused by a failure of performance of a subcontractor or supplier to the Invoking Party will be excused under this clause only if:

(1) the failure by the subcontractor or supplier otherwise qualifies as one or more Force-Majeure Events; and

(2) it was not reasonably possible for the Invoking Party to timely obtain, from one or more other sources, the relevant goods or services that were to have been provided by the subcontractor or supplier.

Comment

Some customers might want to include this clause in their contracts with their suppliers.

5.8.8  ? Force Majeure Status Reports

(a) If so requested by another affected party, the Invoking Party will provide reasonable information, from time to time, about its efforts, if any, to remedy or mitigate the effect of the force majeure.

(b) Any party receiving any force-majeure status information from an Invoking Party must maintain that information in confidence unless and until the information becomes available to the general public.

Comment

Depending on the nature of the contract, a party might not want to commit to providing force-majeure status reports. For example, suppose that the force-majeure clause were part of a consumer-services contract. In that situation, the service provider might well be willing to update its customers about the status of a force-majeure service outage — especially in this era of near-instantaneous public criticism on social media. On the other hand, the provider might equally well not want to be contractually obligated to provide such status reports.

Subdivision (b): A party invoking force majeure might not want its business made public.

5.9   Indemnity Procedures

Comment

Some of the provisions below are based on ideas stated in a 2011 presentation by Ira Schreger, who was then with Vinson & Elkins LLP in New York.

5.9.1 Applicability

This section 5.9 applies any time that that an Indemnifying Party must defend and/or indemnify a Protected Person against a Covered Claim.

Comment

These ground rules are set up so that incorporating them by reference in an agreement should automatically make them applicable to any defense‑ and/or indemnity obligations.

5.9.2 Indemnity Definitions

5.9.2.1 Agreement Activities Definition

Agreement Activities, whether or not capitalized, refers to a party's action and inaction in one or more of (i) the performance of its obligations, and (ii) the exercise of its rights, under the Agreement.

Comment

An indemnity concerning Agreement Activities would be narrower than one concerning Business Activities.

5.9.2.2 Basket Definition

Basket: See the definitions for Deductible Basket and First-Dollar Basket, below. For the avoidance of doubt, the existence of a basket does not in itself negate, decrease, or increase an agreed limitation of an Indemnifying Party's liability for defense and indemnity, if any.

Comment

A basket amount could:

  • apply to all protected parties collectively instead of to each protected party;
  • apply to all claims collectively instead of to each claim.

See also:

5.9.2.3 Business Activities Definition

Business Activities, whether or not capitalized, in respect of an Indemnifying Party, refers to the Indemnifying Party's activities in any aspect of its business.

Comment

Suppose that a contract required Alice to indemnify Bob in respect of Alice's business activities. Without more, Bob likely wouldn't have to prove that Alice was negligent to be entitled to indemnity. For citations of cases to that effect from various jurisdictions, see the Montana supreme court's opinion in A.M. Welles, Inc. v. Montana Materials, Inc., 2015 MT 38, slip op. at 5-7 (reversing denial of summary judgment in favor of indemnified party).

5.9.2.4 Consequential-Damages Indemnity Exclusion Definition

IF: The Agreement provides that consequential damages are excluded from a particular indemnity obligation; THEN: In respect of that indemnity obligation, the Indemnifying Party in question:

(1) is not required to indemnify any Protected Person for consequential, indirect, special, punitive, exemplary, or similar damages suffered by the Protected Person, including (for example) loss of profits from collateral business arrangements or damages from business interruption, other than to the extent any such damages are required to be paid to a third party — other than an affiliate of the Protected Person — pursuant to a claim against the Protected Person by the third party; and

(2) is not required to defend any Protected Person against a claim that seeks no relief other than damages described in sub­div­i­sion (1).

Comment

The list of excluded damages is adapted from 7.13.11.  ? Exclusion of Consequential Damages, Etc.; portions are adapted from the definition of "Excluded Damages" offered by Glenn West as "a po­ten­tial starting point" for drafting. See West, Consequential Damages Redux, supra, 70 BUS. L. at 1001. In some situations, drafters might prefer simply to cap the Indemnifying Party's financial exposure to indemnity- and defense obligations for particular indemnity obligations, instead of potentially getting into disputes about what kinds of damages were or were not excluded under this language.

5.9.2.5 Covered Claim Definition

Covered Claim, whether or not capitalized, refers to any claim that is subject to an obligation of defense and/or indemnity under the Agreement, EXCEPT THAT unless expressly agreed otherwise in writing, the term does not include any claim by one Protected Person against another Protected Person.

Comment

This provision excludes claims by one Protected Person against another. This is akin to the exclusion found in many insurance policies, excluding coverage of claims by one insured against another insured. These exclusions stem from two possible concerns of the indemnifying party:

  • Moral hazard: Suppose that Alice and Bob were both protected persons under an agreement that obligated third-party Isabel to indemnify each of them. In that situation, Alice would have an economic incentive to be careless, or worse, in her dealings with Bob. That's because Alice would know that, whatever harm she (Alice) might cause to Bob, it would be Isabel, not Alice or Bob, who would be obligated to pay for the harm.
  • Another possible concern might arise if Alice and Bob were affiliates: In such a situation, Alice and Bob might collude to have Alice file (say) a lawsuit for patent infringement against Bob, knowing that indemnifying-party Isabel would be obligated to pay any resulting damage award. That would result in the Alice-Bob corporate family's being able to fatten its combined corporate coffers at Isabel's expense.
5.9.2.6 Covered Infringement Claim Definition

Covered Infringement Claim (whether or not the term is capitalized), refers to a Covered Claim that a Protected Person has Infringed, or is or will be Infringing, one or more of the following:

(1) any copyright or trade-secret right of the third party;

(2) if so stated in the Agreement, any U.S. patent or design patent; and

(3) if so stated in the Agreement, any non-U.S. patent or design patent.

Comment

This provision automatically covers only claims of copyright infringement and trade-secret misappropriation; it covers claims of patent infringement only if the Agreement so states. That's because:

  • As a general rule, for copyrights and trade secrets, it should be comparatively easy for an indemnifying party to gain reasonable confidence that a product or service was independently created. This is relevant because proof of independent creation would normally provide an absolute defense against copyright- and trade-secret claims, which in turn would limit the indemnifying party's risk of liability from such claims.
  • In contrast, for utility patents (which is what people usually mean when they say "patent") and design patents:
    • Independent creation is not a defense; that means that a product or service could infringe a patent or design patent that no one had ever heard of (cf. the phenomenon of patent trolls).
    • This means in turn that it is a non-trivial undertaking for an indemnifying party to gain reasonable confidence that a product or service does not infringe any patent or design patent; doing so is often burdensome, expensive, and subject to uncertainty.
    • As a result, indemnifying parties are often reluctant to take on sweeping indemnity obligations concerning the possibility of patent infringement without specifically negotiating such obligations.
5.9.2.7 Covered Monetary Award Definition

Covered Monetary Award, whether or not capitalized, refers to any award of money (no matter how computed or styled) to the asserter of a Covered Claim upon the successful assertion of the claim, as part of a final judgment or arbitration award from which no further appeal or other challenge is taken or possible. A Covered Monetary Award could include, for example, one or more of the following as awarded to the asserter of the Covered Claim:

(1) monetary damages, including for example the Protected Party's profits and/or the asserter's lost profits;

(2) reasonable attorney fees and other reasonable expenses incurred by the asserter of the Covered Claim; and/or

(3) costs of court or of arbitration in respect of the Covered Claim.

Comment

This definition should reduce the need to enumerate the listed monetary amounts.

5.9.2.8 Deductible Basket Definition

Deductible Basket: IF: The Agreement provides that a particular indemnity obligation is subject to a Deductible Basket (whether or not the term capitalized) of a stated amount; THEN: The Indemnifying Party is not required to indemnify any Protected Person until, and then only to the extent, that the aggregate amount that the Indemnifying Party would be required to pay or reimburse exceeds the stated amount.

Comment

Another term for this concept is "true deductible." See generally Danielle Rosato and Tracy A. Belton, Basics In M&A: Indemnification Provisions (Mondaq 2016).

5.9.2.9 Defend & Defense Obligation Definition

Defend and Defense Obligation: Each of these terms, whether or not capitalized, in respect of an indemnity obligation under the Agreement, means that the Indemnifying Party, at its own expense, will provide each Protected Person with a defense against each Covered Claim in accordance with section 5.9.4.

Comment

Note that this is only a definition; it does not in itself impose any defense obligation. See also 5.9.4. Defense Obligation and its commentary.

5.9.2.10 First-Dollar Basket Definition

First-Dollar Basket: IF: The Agreement provides that a particular indemnity obligation is subject to a First-Dollar Basket (whether or not the term capitalized) of a stated amount; THEN:

(1) The Indemnifying Party is not required to indemnify any Protected Person until the aggregate amount that the Indemnifying Party would be required to pay or reimburse equals at least the stated amount; but

(2) once that stated amount is reached or exceeded, the Indemnifying Party must pay or reimburse up the entire aggregate amount in question.

Comment

Another term for this concept is "tipping" basket: once the deductible is reached, the indemnifying party is responsible for all losses in the basket, not just the "overflow" losses as with a deductible- or "true" basket. See generally Danielle Rosato and Tracy A. Belton, Basics In M&A: Indemnification Provisions (Mondaq 2016).

5.9.2.11 Indemnified Financial Obligation Definition

Indemnified Financial Obligation, whether or not the term is capitalized, refers to any of the following:

(1) any Covered Monetary Award;

(2) any settlement of a Covered Claim that, under the Agreement, must be paid or otherwise funded by the Indemnifying Party; and

(3) any Loss Or Expense that has been suffered or incurred (or will imminently be suffered or incurred) by a Protected Person, as to which the Agreement requires the Indemnifying Party to indemnify the Protected Person.

Comment

This is another verbiage-reduction definition.

5.9.2.12 Indemnifying Party Definition

Indemnifying Party, whether or not the term is capitalized, refers to a party obligated by the Agreement to indemnify another party.

Comment

In some contracts, the drafters might be more comfortable specifically identifying the Indemnifying Party or ‑Parties.

5.9.2.13 Indemnity Definition

Indemnity, whether or not the term is capitalized, as well as corresponding terms such as indemnify and indemnity obligation, all refer to reimbursing a person for one or more Indemnified Financial Obligations.

Comment

This definition is adapted from the Maryland supreme court deision in Bd. of Trustees v. Patient First Corp., No. 89, slip op. at 1 (Md. Aug. 18, 2015), (footnote omitted), citing BLACK'S LAW DICTIONARY (9th. ed. 2009) at 837-38; see also the explanation of the concept of indemnity by a California court, quoted at length in the research notes. The definition falls in the category of "stating the obvious," but one never knows whether a party's trial counsel might try to argue that capitalization was significant, as discussed in this commentary.

5.9.2.14 Liability Cap Definition

Liability Cap IF: The Agreement provides that a particular indemnity obligation is subject to a Liability Cap (whether or not the term is capitalized) of a stated amount; THEN: In relation to that indemnity obligation, that Indemnifying Party is not obligated to pay or reimburse more for indemnity and/or defense under the Agreement — in the aggregate, to all parties in respect of all Indemnified Financial Obligations and all Protected Parties combined, unless the Agreement expressly states otherwise — than the stated Liability Cap amount.

Comment

Drafters might want to negotiate a special cap on indemnity liability, separate from any general cap. Unless applicable law has something weird in it, there shouldn't be any reason that contracting parties couldn't agree to limitations of liability for an indemnification obligation. Indemnities are essentially insurance policies, and insurance companies routinely impose policy limits and policy exclusions.

A party being asked to commit to an indemnity obligation might be more willing to agree to the obligation if:

  • its liability were capped at, say:
    • a stated dollar amount, or
    • a stated multiple of the sums paid to it, or
    • the limits of its insurance coverage (if insurance were available); or
  • the indemnity did not kick in until the aggregate of all indemnifiable claims exceeded a stated amount, as in the "first-dollar basket" definition.
5.9.2.15 Loss and Expense Definition

Loss And Expense and Loss Or Expense, whether or not capitalized, each refers to any and all foreseeable losses, costs, expenses, and damages of any kind (but not including liabilities resulting from third-party claims, which are addressed separately).

Comment

This definition was harvested from a variety of contracts.

Note the exclusion of third-party claims: Absent such an express exclusion, an indemnity obligation might be interpreted as encompassing more losses or expenses incurred by the protected party than just those arising from third-party claims.

That result occurred, for example, in Hot Rods, LLC, v. Northrop Grumman Sys. Corp., No. G049953 (Cal. App. 4th Dist. Dec. 7, 2015) (reversing and remanding damages award). "Indemnity provisions typically refer to third party claims, but if the parties so intend, such provisions may also encompass direct claims." Id., citing Zalkind v. Ceradyne, Inc., 194 Cal. App. 4th 1010, 1023 (2011). "The question whether an indemnity agreement covers a  case turns primarily on contractual interpretation, and it is the intent of the parties as expressed in the agreement that should control. When the parties knowingly bargain for the protection at issue, the protection should be afforded." Id. (citation, internal quotation marks, and alteration marks omitted).

In contrast, then-Vice Chancellor Strine noted that the indemnification provisions of an an asset-sale agreement specifically distinguished third-party claims from claims covered generally under the agreement's indemnification remedy. See Certainteed Corp. v. Celotex Corp., No. 471, slip op. at 6-7 & n.7 (Jan. 24, 2005) (denying defendant's motion to dismiss certain claims as time-barred).

See also Nevadacare, Inc. v. Dept. of Human Services, 783 N.W.2d 459, 470 (Ia. 2010): The contract between the parties included an indemnity provision. The defendant, after prevailing at trial, sought an award of attorney fees under the indemnity provision. The supreme court noted that "there is a split of authority as to whether an indemnification provision applies to claims between the parties to the agreement or only to third-party claims." (The court held that under the state's law, an indemnity provision could not be used to recover attorney fees in a dispute between the parties.)

Noted practioner-commentator Glenn West asserts that, in the context of merger-and-acquisition agreements, the term indemnity is understood to have a less-expansive meaning than under common law:

This author believes that much of this confusion is caused by the use of the term “indemnification” itself. In the specific context of a U.S.-style private company acquisition agreement, the term indemnification is used as a contractual term of art to describe a contractual remedy for breaches of representations and warranties. It is not the same as the common law right known as indemnity, which requires the existence of a third-party claim.

Glenn D. West, Consequential Damages Redux: An Updated Study of the Ubiquitous and Problematic “Excluded Losses” Provision in Private Company Acquisition Agreements, 70 BUS. L. 971, 999-1000 (Weil.com 2015) (footnotes, alteration marks, and internal quotation marks omitted, emphasis added).

See also Ken Adams's blog post, Indemnification: Glenn West Wades In! (2011), especially the dialogue between Adams and West in the comments to the post.

5.9.2.16 Negligence or Misconduct Exception Definition

Neglience or Misconduct Exception and Negligence and Misconduct Exception (regardless of capitalization), in respect of an indemnity obligation, each means that the Indemnifying Party is not required to indemnify any Protected Person against any Covered Claim that is attributable solely to Negligence Or Misconduct by that Protected Person.

Comment

In many jurisdictions, an indemnity obligation is unenforceable to the extent it purports to indemnify a party against the consequences of its own negligence. (Insurance policies are usually exceptions to this rule.) For more details, see the discussion in the research notes.

In some states, e.g., Texas, this rule is tempered by the express-negligence doctrine, which holds that a party can be indemnified from the consequences of its own negligence if the contract provision to that effect is expressed in specific and conspicuous terms, also as discussed in the research notes.

5.9.2.17 Not Assignable Without Consent Definition

Not Assignable Without Consent: IF: The Agreement specifies that a right to indemnity and/or defense is Not Assignable Without Consent, whether or not the term is capitalized; THEN: An assignee (direct or indirect) of a Protected Person (direct or indirect) is entitled to indemnity and defense under that obligation only if the Indemnifying Party specifically and expressly consented in writing to assignment of the right to indemnity and/or defense.

Comment

See generally 9.3.   Assignment of Agreement and its commentary.

5.9.2.18 Protected Party Definition

Protected Party, whether or not capitalized, refers to a party entitled to indemnity under the Agreement.

Comment

Note the distinction between a Protected Party and a Protected Person, defined just below.

5.9.2.19 Protected Person Definition

Protected Person, whether or not capitalized, refers to:

(1) each Protected Party;

(2) each Affiliate of each Protected Party;

(3) any Other Protected Group Members expressly identified in the Agreement, if any; and

(4) the employees, officers, directors, shareholders (in that capacity), general- and limited partners, members, managers, and other persons occupying comparable positions in respect of each organization within the scope of in subdivisions (1) through (3), as applicable.

Comment

This is a convenience definition.

Protected Group definition (cross-reference)
Additional notes: Using indemnity definitions

Drafters can use these indemnity definitions to quickly specify detailed indemnity obligations. Here are a few examples:

5.9.3 Claim Notification

IF: A Protected Person does not advise the Indemnifying Party of the claim in writing on or before the Claim-Notification Deadline (namely, ten business days after first learning of the claim by any means); THEN:

(1) The Indemnifying Party will have no obligation to indemnify the Protected Person against any harm resulting from the delay in notification.

(2) For the avoidance of doubt, the delay in notification will not otherwise affect the indemnity obligation.

Comment

A drafter representing an indemnifying party might prefer to say instead that the indemnifying party will be completely absolved from any duty to defend or indemnify the protected person against the claim. That, of course, would be a much stronger statement. On the other hand, the prospective protected person would likely push back against such a variation.

5.9.4 Defense Obligation

Unless the Agreement expressly states otherwise, the Indemnifying Party, at its own expense, will provide each menber ot the Protected Group with a competent, diligent defense against the claim in accordance with (and subject to the prerequisites of) the Agreement.

Comments

The law might impose a duty to defend a Protected Person even if the parties' agreement didn't expressly do so. For example:

  • The California Supreme Court has held that, by statute — specifically, Cal. Civ. Code § 2778(3) — unless the parties to a contract agree otherwise, a party having an indemnity obligation under the contract is also obligated, upon request, to provide a defense for the protected person. See Crawford v. Weather Shield Mfg. Inc., 44 Cal.4th 541, 553 (2008) (affirming court of appeal’s affirmance of trial-court judgment).
  • A California appeals court held in 2010 that the duty to defend applies even without an allegation that the indemnifying party was negligent. See UDC-Universal Development v. CH2M Hill, No. H033610, 181 Cal. App. 4th 10 (6th Dist. 2010) (affirming judgment that engineering firm was liable to real-estate developer for cost of defending against negligence suit by homeowner association).

On the other hand, as Dentons partner Stafford Matthews pointed out in a 2014 LinkedIn discussion thread (membership required): "Under the common law of most states, including New York and Illinois for example, an indemnitor generally has no duty to defend unless the contract specifically requires such defense. See, e.g., Bellefleur v. Newark Beth Israel Med. Ctr., 66 A.D.3d 807, 809 (N.Y. App. Div. 2d Dep't 2009); CSX Transp. v. Chicago & N. W. Transp. Co., 62 F.3d 185, 191-192 (7th Cir. 1995)." (Emphasis added; Mr. Matthews was responding to one of my comments there about Califorina law.)

5.9.5 Defense Without Request

(a) IF: A Protected Person does not request defense against a Covered Claim; THEN: The Indemnifying Party may (in its sole and unfettered discretion) nevertheless defend the Protected Person against the claim.

(b) IF: An Indemnifying Party exercises its right under sub­div­i­sion (a) to defend a Covered Claim; THEN: The Indemnifying Party must comply with the provisions of the Agreement that apply to the defense of Covered Claims as if the elected defense were mandatory.

Comment

An indemnifying party might want to defend against a third-party claim even if the protected person has no interest in doing so. EXAMPLE: Suppose that:

  • A customer is sued by a third party, claiming that the customer's past use of a particular product infringed the third party's patent rights.
  • The manufacturer, a large and well-funded company, is obligated to defend and indemnify the customer against such claims.
  • The customer has discontinued its use of the manufacturer's product; it therefore doesn't care whether or not the third-party infringement claim succeeds, because the manufacturer, not the customer, will have to pay any resulting damage award.

In that situation, the customer will have little or no "skin in the game" and might not even request a defense against the infringement claim. The manufacturer, though, might be keenly interested in not having its product adjudged to infringe the third party's patent. This clause makes it clear that the manufacturer has the right to defend againsst the infringement claim, whether or not the customer requests a defense.

5.9.6 Defense Cooperation Obligation

IF: An Indemnifying Party provides a Protected Person with a defense to a Covered Claim (whether or not requested by the Protected Person); THEN:

(1) The Protected Person must provide reasonable cooperation with the Indemnnifying Party and its counsel in the conduct of the defense, including for example providing all information reasonably requested by the Indemnifying Party or its counsel.

(2) Upon request by the Protected Person, the Indemnifying Party will pay, or reimburse the Protected Person for, all reasonable out-of-pocket expenses incurred by or on behalf of the Protected Person in providing such cooperation.

5.9.7 Control of Defense

(a) An Indemnifying Party is entitled to control any defense to a Covered Claim that it provides under this clause except as stated in sub­div­i­sion (b).

(b) If an Indemnifying Party does not provide a Protected Person with a defense to a Covered Claim as required by the Agreement, then: (1) the Protected Person may control its own defense; and (2) the Indemnifying Party must pay, or reimburse the Protected Person, for all reasonable expenses that the Protected Person incurs in the defense.

Comment

Obviously, if an Indemnifying Party doesn't "step up" to provide a defense, then the Protected Person should be able to control its own defense. But if the Indemnifying Party does provide a defense, then it should be able to control the defense — otherwise, the Protected Person's counsel — knowing that it would be the Indemnifying Party, not its client, that would eventually be paying the bills — could be tempted to put on an expensive, gold-plated defense.

5.9.8 Defense Counsel

A party controlling a defense against a Covered Claim (that is, the Indemnifying Party or the Protected Person, as the case may be) is to engage counsel of recognized standing, reasonably acceptable to the non-controlling party, to conduct the defense.

Comment

This language is necessarily vague, but it should serve as a warning that, say, a traffic-ticket lawyer would not necessarily be a sound choice to defend against, say, a bet-the-product-line patent infringement claim.

5.9.9 Separate Monitoring Counsel

A Protected Person, at its own expense, may engage separate counsel to monitor a defense provided by an Indemnifying Party; in such an event, the Indemnifying Party and Protected Person will each instruct their their respective counsel to provide reasonable cooperation with each other concerning the defense.

Comment

A protected party will sometimes want this provision because it doesn't want to rely completely on the legal counsel provided and paid by the indemnifying party.

  • Under legal ethics in the U.S. (and probably in many other jurisdictions as well), an attorney's loyalty is to the client, not to a third party that's paying the bills.
  • But in many cases, the indemnifying party will have its own legal counsel provide the defense for the protected party. The protected party, in turn, might well prefer to have its own regular counsel keeping an eye on the indemnifying party's legal counsel.

5.9.10 Defense-Counsel Conflict of Interest

IF: Reasonable minds could conclude that an Indemnifying Party's counsel has a conflict of interest that, under applicable ethics rules, would preclude the Indemnifying Party's counsel from representing the Protected Person in the defense of a Covered Claim; THEN: The Protected Person may in its sole discretion:

(1) assume control of the defense; and

(2) engage separate counsel for the defense, at the Indemnifying Party's expense.

Comment

The language, "if reasonable minds could conclude" (emphasis added) is intended to make sure that close calls go in favor of separate counsel.

5.9.11 Control of Settlement

(a) An Indemnifying Party may, at its own expense, settle a Covered Claim against a Protected Person as provided in this subdivision.

(b) Without the Protected Person's prior written consent, an Indemnifying Party must not settle a Covered Claim, and the Protected Person will not be bound by any purported settlement, on any terms that:

(1) restrict or place conditions on the Protected Person's activities if those activities would not reasonably be regarded as being otherwise unlawful; or

(2) require any action by the Protected Person, other than making one or more payments of money — funded in advance by or on behalf of the Indemnifying Party — to one or more third parties; or

(3) encumber any of the Protected Person's assets; or

(4) include (or require) any admission or public statement by the Protected Person; or

(5) call for the entry of a consent judgment inconsistent with any of subdivisions (1) through (4).

(c) For the avoidance of doubt, the Indemnifying Party's settlement of a Covered Claim may, in the Indemnifying Party's sole and unfettered discretion, include the entry of a consent judgment binding on the Protected Person; the Protected Person must agree to entry of the consent judgment if the consent judgment is not inconsistent with sub­div­i­sion (b).

Comment

Sub­div­i­sion (b): Some categories of insurance contract give the insurance carrier essentially-complete control over the settlement of third-party claims. That could cause problems for the protected person if the insurance carrier were to settle a claim but then try to recoup the settlement amount from the protected person. This could happen, for example, if a contractor's surety bond decided to settle a claim and then sued the contractor to recoup the settlement payment. See, e.g., Hanover Ins. Co. v. Northern Building Co., 891 F. Supp.2d 1019, 1026 (N.D. Ill. 2012) (granting summary judgment awarding damages and attorney fees to insurance company), aff'd, No. 13-2675 (7th Cir. May 8, 2014).

Sub­div­i­sion (c): This is a detailed example of a type of clause that is often found in indemnity- and defense obligations.

5.9.12 Settlement by Protected Person

IF: A Protected Person settles a Covered Claim without the Indemnifying Party's prior written consent; THEN: The settlement will have the effect of releasing the Indemnifying Party from any further defense- or indemnity obligation as to that claim UNLESS: The Indemnifying Party unreasonably withheld, delayed, or conditioned its consent to the settlement, in which case the Indemnifying Party is to be deemed to have given its consent to the settlement.

Comment

This protects the Indemnifying Party against the possibility that a Protected Person might decide, what the hell, let's agree to pay a big settlement; after all, it won't be our money.

5.9.13 Protected Person Admissions

(a) This subdivision applies during any time that the Indemnifying Party is entitled to control the defense against the claim.

(b) Without the Indemnifying Party's prior written consent, a Protected Person must not:

(1) make any non-factual admission or stipulation concerning a Covered Claim — for example, an admission that a third party's patent was valid and enforceable would be such a non-factual admission; nor

(2) waive any defense against a Covered Claim.

(c) A Protected Person is strongly encouraged to consult with the Indemnifying Party before making any factual admission or stipulation concerning a Covered Claim. (As a hypothetical example, an admission that, in calendar year 20XX, the Protected Person sold Y units of its Model ABC widget would be such a factual admission.)

(d) IF: A Protected Person makes an admission or waives a defense in violation of sub­div­i­sion (b); THEN: The Indemnifying Party will have no further obligation to that Protected Person, in respect of the claim in question, by way of either defense or indemnity.

Comment

Admissions and stipulations can greatly streamline litigation (and arbitration). And factual admissions should be made as required. But an infelicitous non-factual admission by a Protected Person could seriously screw up the defense.

5.9.14 Indemnity Offsets

(a) An Indemnifying Party, in determining the amount it owes under an indemnity obligation of the Agreement, may reduce that amount by the following amounts received by or on behalf of the Protected Person, if any:

(1) insurance proceeds in respect of the subject matter of the indemnity obligation; and

(2) contributions from another liable individual or organization (other than another Protected Person).

(b) For the avoidance of doubt, this provision is not to be interpreted as in itself limiting an Indemnifying Party's indemnity obligation to the amount of either insurance proceeds or of contributions from other liable individuals or organizations.

Comment

This provision is intended to prevent double-dipping by a protected party, which might recover some of its losses from other sources and yet still try to pry money out of an indemnifying party.

NOTE: If Alice is asked to indemnify Bob against any damages that Bob suffers as a result of Carol's actions, then Alice might want to consider laying some groundwork for her to sue Carol under the doctrine of subrogation.

5.9.15  ? Indemnity Payment Due Date

(a) IF: A Protected Person gives notice to the Indemnifying Party that an Indemnified Financial Obligation (i) is due or (ii) has been paid (in which case evidence of payment must accompany the notice); THEN: The Indemnifying Party must do the following no later than the Indemnity-Payment Due Date (namely, ten business days after written notice):

(1) pay each such Indemnified Financial Obligation directly to the individual or organization to which the Protected Person owes it, or

(2) reimburse the payer if the Indemnified Financial Obligation has already been paid by or on behalf of the Protected Person.

(b) Sub­div­i­sion (a) applies regardless whether applicable law would otherwise require the Protected Person itself to pay the Indemnified Financial Obligation first and then seek reimbursement from the Indemnifying Party.

Comment

Not directly related, but of interest, is the litigation over reimbursement payments by British Petroleum (BP) in the wake of the loss of the Deepwater Horizon drilling rig at the Macondo oil well in the Gulf of Mexico; see generally the Wikipedia article on that topic.

Additional notes: Indemnities

What exactly is an "indemnity" obligation?

In many contracts, indemnity provisions are intensely-negotiated. As explained by a California appeals court:

Generally, indemnity is defined as an obligation of one party to [i] pay or [ii] satisfy the [x] loss or [y] damage incurred by another party.

A contractual indemnity provision may be drafted either[:]

  • to cover claims between the contracting parties themselves, or
  • to cover claims asserted by third parties.

Indemnity agreements are construed under the same rules which govern the interpretation of other contracts. Accordingly, the contract must be interpreted so as to give effect to the mutual intention of the parties.

The intention of the parties is to be ascertained from the clear and explicit language of the contract.

And, unless given some special meaning by the parties, the words of a contract are to be understood in their ordinary and popular sense.

In interpreting an express indemnity agreement, the courts look first to the words of the contract to determine the intended scope of the indemnity agreement.

Rideau v. Stewart Title of Cal., Inc., 235 Cal. App. 4th 1286, 1294, 185 Cal. Rptr. 3d 897 (2015) (interal quotation marks, alteration marks, and extensive citations omitted; extra paragraphing, bracketed numbering, and bullets added).

Caution: Is the indemnity obligation backed by enough money?

A right to be indemnified (like any other) might be worthless if the indemnifying party can't afford to do the needful. Consequently, a party wanting an indemnity commitment should consider negotiating backup sources of cash to support the indemnity obligation, commonly in the form of (for example) an insurance policy; a guaranty from a third party; an escrow; and/or a standby letter of credit (which of course is itself a form of guaranty).

Caution: Is an indemnity obligation a good idea?

Any party asked to agree to an indemnity obligation should think about it carefully. That's especially true if the indemnity obligation would apply regardless of the other party's own negligence or other "misconduct"; if you agree to that kind of obligation, in effect you've become the other party's insurance carrier.

Indemnity liability might be much more than plain breach-of-contract damages

Suppose that Alice agreed to indemnify Bob from all losses, damages, etc., arising from Alice's breach of contract (or breach of warranty or misrepresentation). That might open up Alice to far-greater liability than she would normally risk for a "garden variety" breach of contract. That's because, at least in Anglo-American jurisprudence:

  • Damages for breach of contract are generally limited to those that are foreseeable, and a non-breaching party will generally have a duty to mitigate its damages;
  • In contrast, liability for indemnity might not be subject to such a foreseeability limitation (although the case law is unclear on this point).

See generally:

An obligation to indemnify a party against its own fault might be unenforceable

In the interest of deterring negligent conduct, some jurisdictions entirely bar a party from being indemnified for the consequences of its own negligence. As the South Carolina supreme court explained:

The policy basis for the negligence rule is simple—barring indemnification when the indemnitee is at fault for the damages serves to deter negligent conduct in the future, for the indemnitee will know that the indemnification agreement will not save it from liability if it fails to act with due care.

Ashley II of Charleston, L.L.C. v. PCS Nitrogen, Inc., No. 27420, part II-A (S.C. July 23, 2014) (on certified question) (emphasis added). The supreme court held that the same rationale did not apply in cases of strict liability, because the same deterrent effect would not be present. See id.

Likewise, California Civil Code Section 1668 provides that "[a]ll contracts which have for their object, directly or indirectly, to exempt any one from responsibility for [i] his own fraud, or [ii] willful injury to the person or property of another, or [iii] violation of law, whether willful or negligent, are against the policy of the law." (Bracketed lettering added.) Such contracts are therefore void under section 1667(2).

In some jurisdictions, legislatures have enacted anti-indemnity statutes that, for certain types of contract, prohibit indemnity clauses that would shift the risk of Bob's own negligence onto Alice. Such indemnity clauses are often found in construction contracts, in which prime contractor Bob might require subcontractor Alice to indemnify him even against the consequences of Bob's own negligence. See, e.g., the Texas Anti-Indemnity Act, codified in Chapter 151 of the Texas Insurance Code. See also Foundation of the American Subcontractors Association, Inc., Anti-Indemnity Statutes in the 50 States (2013).

The "express negligence rule" might impose conspicuousness requirements for some indemnity obligations

Less restrictively than the outright ban just discussed: In some jurisdictions the "express-negligence rule" precludes enforcement of a contract provision requiring Bob to indemnify Alice for the consequences of Alice's own negligence unless the contract provision is both express and conspicuous. See, e.g., Crawford v. Weather Shield Mfg. Inc., 44 Cal. 4th 541, 552 (2008); Dresser Industries v. Page Petroleum, Inc., 853 S.W.2d 505, 508 (Tex. 1993) (conspicuousness requirement); Ethyl Corp. v. Daniel Constr. Co., 725 S.W.2d 705, 708 (Tex. 1987) (express-negligence doctrine). See generally, e.g., Byron F. Egan, Indemnification in M&A Transactions for Strict Liability or Indemnitee Negligence: The Express Negligence Doctrine (JW.com 2014).

Caution: Will a contractual indemnity be excluded from the indemnifying party's insurance coverage?

Any party that is asked to agree to indemnify another party should consider checking whether its applicable insurance policies exclude coverage for indemnity obligations. This was an issue in Ewing Constr. Co. v. Amerisure Ins. Co., 420 S.W.3d 30 (Tex. 2014), which is discussed in this blog post by insurance agent Randy Maniloff.

Stories (in development)
Particular scope-of-indemnity language

A lease agreement for retail space contained an indemnity provision. The indemnity provision required the retailer to indemnify the landlord against, among other things, "any [losses, etc.] caused by injuries to persons or property while in, on or about [the retail premises] …." An employee of the retalier became sick while working in vacant retail space in the building, which the landlord had allowed the retailer to use for temporary storage after flooding. The employee sued the landlord, which cross-sued the retailer on the indemnity provision. The state supreme court held that the indemnity provision did not apply. Once Upon a Time, LLC v. Chappelle Properties, LLC, No. 1141052 (Ala. May 27, 2016) (reversing and remanding trial court's denial of retailer's motion for summary judgment).

Additional reading
Indemnity: Exercises (in development)
Indemnity: Basic questions
  1. How does an indemnity relate to a warranty?
  2. IF FALSE, EXPLAIN WHY: IF: Alice agrees to indemnify Bob against damage arising from occurrence of Event X; THEN: This reduces the risk to the parties associated with the (possible) occurrence of Event X. (CAUTION: Read this carefully.)
  3. IF FALSE, EXPLAIN WHY: An indemnity obligation allocates at least some of the financial risk of Event X.
  4. IF FALSE, EXPLAIN WHY: The following is an acceptable conventional phrasing: Alice hereby indemnifies Bob against any damage Bob might incur if it rains tomorrow.
Indemnities: Duty to defend

SUGGESTED READING:

FACTS: Suppose that:

  • You draft an indemnity obligation that does not expressly require the subcontractor to defend your client, the general contractor, from claims, but merely obligates the subcontractor to indemnify the general contractor.
  • An employee of the subcontractor writes a letter to the general contractor, asserting a claim. Assume for this purpose that the employee's claim comes within the scope of the subcontractor's indemnity obligation.
  • The general contractor forwards the employee's letter to the subcontractor and demands that the subcontractor engage outside counsel to investigate the claim.

QUESTIONS:

  1. Must the subcontractor engage outside counsel for the general contractor?
  2. Would your answer be different if all of this were taking place in Los Angeles instead of Houston? Cite the relevant authority.
Indemnity exercise: The spontaneously-combusting widgets

FACTS:

  1. Alice manufactures electronic widgets. Each widget has a battery that is sealed into the widget and not replaceable.
  2. Bob manufactures electronic gadgets that include electronic widgets.
  3. Bob enters into a contract with Alice to buy electronic widgets from her.
  4. The contract includes, among other provisions:
    • a warranty that the widgets do not contain any defects in design or manufacture;
    • a provision requiring Alice to indemnify Bob against any harm Bob suffers from defects in the widgets; and
    • an exclusion of incidental- and consequential damages.
  5. Bob takes delivery of a large quantity of Alice's widgets and stores them in an appropriate storage room.
  6. In the storage room, the batteries in several of Alice's widgets spontaneously catch fire, resulting in major damage and causing significant "down time" for Bob's gadget-manufacturing operations. (Think: Hoverboards.)
  7. Citing the indemnity provision, Bob demands that Alice reimburse him for the cost of:
    • repairs;
    • replacement of the damaged contents of the storage room;
    • the travel expenses that Bob incurred in going to China and India to check out alternative sources of widgets;
    • the profits that Bob lost from the manufacturing down time.

QUESTIONS:

  1. EXPLAIN IF FALSE: Alice is not required to reimburse Bob because an indemnity provision covers claims by third parties against the protected party, not direct claims by the protected party against the indemnifying party.
  2. EXPLAIN IF FALSE: If Bob sues Alice for breach of her indemnity obligation, Alice can probably get Bob's claim for lost profits thrown out early (by moving for partial summary judgment) as barred by the contract's exclusion of consequential damages.
  3. EXPLAIN IF FALSE: If Alice had negotiated the indemnity provision to cover only third-party claims, the provision likely would be enforceable.
  4. EXPLAIN IF FALSE: Alice can probably get Bob's claim for travel expenses dismissed on partial summary judgment as barred by the contract's exclusion of incidental damages.
Exercise: Defense against indemnified claims
  1. FACTS:
    (A) Alice's contract with Bob obligates her to reimburse Bob for his attorney fees and expenses in defending against certain third-party claims.
    (B) A third party, Carol, brings such a claim against Bob — who hires Skadden Arps (a top NYC firm) to defend him against Carol's claim.
    (C) Alice has plenty of money to pay legal bills.
    QUESTION: Speculate about what incentives might motivate Skadden in conducting Bob's defense.
    QUESTION: Name two ways that Alice, during negotiation of her contract with Bob, could have limited her financial exposure to Bob's cost of defending against Carol's claim.
  2. MORE FACTS:
    (D) Alice's contract with Bob also requires her to indemnify Bob against any monetary awards resulting from such third-party claims.
    (E) Bob neglects to mention to either Alice or Skadden that Carol had filed her third-party claim weeks before, and that when Bob failed to file a timely answer, Carol moved for and obtained a default judgment for a large amount of money.
    QUESTION: Name two ways that Alice, during negotiation of her contract with Bob, could have limited her exposure to Bob's screw-up.
  3. ALTERNATE FACTS:
    (F) Alice's contract with Bob requires her to provide Bob with a defense, as opposed to reimbursing Bob for his defense expenses.
    (G) Alice engages her regular lawyer, Andy, to conduct Bob's defense against Carol's claim.
    (H) Bob finds that he and Andy don't get along so well.
    QUESTION: During negotiation of the contract, what sort of clause could Bob have asked to be included in the contract to protect him against this uncomfortable situation?
  4. ALTERNATE FACTS:
    (I) It turns out that Alice can't afford to pay Bob's legal bills for defending against Carol's claim.
    QUESTION: What if anything might Bob have done during contract negotiation to mitigate this problem?

5.10   Intellectual Property Ownership

5.10.1 IP Ownership Definitions

(a) This section 5.10 applies in any case in which the Agreement specifies that an individual or organization (the Owner is to own specified intellectual property (the Specified IP) that is or might be owned by another individual or organization (the Confirming Party).

(b) Each of the Owner's rights under this section 5.10 will pass to the Owner's successors and assigns, if any, in respect of the OWner's business relating to the Agreement.

Comment
Language notes

These definitions are designed to allow this form to be used by reference without having to customize it.

Sub­div­i­sion (b) takes into account that companies sometimes spin off divisions, do corporate reorganizations, etc.

Who should own the rights to IP developed under a services contract?

In my view, a buyer would take too short-term a view, and would be partially free-riding on past buyers' payments, if today's buyer insisted on owning "foreground" IP rights for IP that wasn't critical to its core business competitive position (it's a different analysis without that final qualifier). Here's why:

  1. The supplier has "background" IP available to offer precisely because yesterday's buyer paid the supplier to develop that background IP, thus reducing the total price that today's buyer must pay.
  2. It's therefore entirely reasonable for the supplier to insist that whatever foreground IP it develops for today's buyer must likewise be put into that supplier-managed pool of background IP assets.
  3. So, if today's buyer insists on owning that foreground IP anyway, then the price should go up dramatically — not least because of the future burden to the supplier of tracking which IP is available to it in the future as background IP.

5.10.2 Work Made for Hire

To the maximum extent permitted by law, the Specified IP is to be considered a work made for hire whose author or inventor is the Owner.

Comment

Under U.S. copyright law, a contract can't designate a work of authorship as a work made for hire merely by saying so, because the work of authorship itself must meet specific statutory requirements. See generally the Reading Notes on this subject..

As to (U.S.) patents, the concept of work made for hire doesn't really apply. But an individual inventor who is employed, even without an invention-assignment agreement, might be under an implied obligation to assign her ownership rights in her invention to her employer if she (1) is subject to an employment agreement requiring her to do so; (2) was hired to invent; and/or (3) was "set to experimenting" by the employer with the invention being a result. In addition, her employer might have "shop rights" to use the invention if the inventor used the employer's time and/or resources in making the invention. See generally the Reading Notes on this subject.

5.10.3 Assignment of IP

The Confirming Party hereby irrevocably assigns to the Owner and its successors and assigns all right, title, interest, and property, anywhere in the world, in and to the Specified IP (to the extent that the Specified IP is not eligible to be a work made for hire under section 5.10.2), together with:

(1) any and all original, continuation, continuation-in-part, divisional, reissue, foreign-counterpart, or other patent applications for the Specified IP, no matter when filed;

(2) any and all patents issuing on each patent application described in sub­div­i­sion (1);

(3) the right to claim priority in, to, or from any patent application described in sub­div­i­sion (1) or any patent described in sub­div­i­sion (2);

(4) any and all registrations for, and any and all applications to register, the copyright or trademark rights (if any) in the Specified IP;

(5) any other intellectual property rights, of whatever nature, in the Specified IP, together with any applications for, or issued registrations for, the same; and

(6) the right to recover, and to bring proceedings to recover, damages and/or obtain other remedies in respect of infringement or misappropriation of any item listed in any of items (1) through (5), whether the infringement or misappropriation was committed before or after the date of the Agreement.

Comment

This provision is phrased as a present assignment – as opposed to a promise to assign at some unspecified point in the future — with the intent of avoiding a timing problem of the kind that resulted in Stanford University's being unable to assert a patent that it owned (or so it had thought). See Bd. of Trs. of the Leland Stanford Junior Univ. v. Roche Molecular Sys., Inc., 583 F.3d 832 (Fed. Cir. 2009), aff'd as to a different issue, 563 U.S. __, 131 S. Ct. 2188, 2194-95 (2011).

5.10.4 IP Ownership Documents

(a) Whenever so requested by the Owner from time to time, for no additional compensation, the Confirming Party will cause one or more Vesting Documents (as defined below, and as provided by the Owner at the Owner's expense) to be:

(1) signed;

(2) acknowledged or sworn to before a notary public or comparable official (if applicable); and

(3) delivered to the Owner for filing with appropriate authorities in the Owner's sole discretion and at the Owner's expense.

(b) Vesting Document refers to any of the following:

(1) patent applications and trademark- and copyright-registration applications as described in section 5.10.3(1) and (4);

(2) assignments of patents, patent applications, copyrights, trademark rights, and other intellectual-property rights;

(3) any other document that may be reasonably requested by the Owner to help the Owner or its nominee to:

(A) fully and effectively vest, in the Owner, the rights assigned by the Agreement;

(B) formally register the Owner’s title in the same with relevant government offices; and

(C) enjoy the full and exclusive benefit of those rights, including without limitation the Owner's (i) taking action against infringers and (ii) defending against challenges to the validity of the rights assigned by the Agreement.

Comment

Another "belt and suspenders" variation would be to state that "(1) it's a work for hire; (2) if it's not, you hereby assign the copyright to us; (3) and if that doesn't work, you hereby give us a perpetual paid-up license." Fred von Lohmann, comment on a posting at copyright scholar William Patry's blog.

See also 5.10.5. Backup IP License.

5.10.5 Backup IP License

To the extent (if any) that, by law, any moral rights or other intellectual property rights in Specified IP cannot be assigned to the Owner, the Confirming Party hereby grants to the Owner and its successors and assigns a perpetual, irrevocable, worldwide, royalty-free, fully-transferable license under all such non-assignable rights.

Comment

This is an anchor-to-windward provision.

see generally the Wikipedia entry on moral rights.

5.10.6 Employee IP Agreements

(a) The Confirming Party will ensure that its employees and subcontractors (if any) have signed written agreements sufficient to enable Customer to comply with its obligations under this section 5.10.

(b) This section 5.10.6 in itself neither authorizes nor prohibits the use of subcontractors by the Confirming Party.

Comment

An employee might not need a written agreement to cause the employee's work product to be owned by the employer (at least under U.S. law). See generally this annotated flowchart that I did a few years ago.

On the other hand a subcontractor likely would indeed need to sign such an agreement in order to transfer ownership to another party. The other party might be able to claim an implied license to use and further-develop the deliverable. See, e.g., Graham v. James, 144 F.3d 229 (2d Cir. 1998); Latour v. Columbia University, 12 F.Supp. 3d 658 (S.D.N.Y. 2014); Numbers Licensing LLC v. bVisual USA Inc., No. CV-09-65-EFS, 91 U.S.P.Q.2d 1946 (E.D. Wash. Jul. 15, 2009).

5.10.7 Joint IP Creation Ownership

(a) Joint IP Creation refers to any intellectual property that is invented, authored, or otherwise created or developed jointly by two or more Joint IP Creators, where:

(1) a Joint IP Creator is:

(A) an individual Signatory Party, or

(B) an employee or other individual associated with a non-individual Signatory Party,

(each such Signatory Party, a Joint IP Owner); and

(2) each Joint IP Owner is the beneficiary of an obligation, on the part of at least one Joint IP Creator, to assign that Joint IP Creator's interest in the intellectual property to that Joint IP Owner.

(b) The Joint IP Owners will own equal, undivided interests in each Joint IP Creation unless they expressly agree otherwise in writing.

Comment

Joint creation of intellectual property can occur, for example: • in services-type contracts; and • in collaboration agreements of various kinds, e.g., R&D joint-venture agreements. See generally this article about patent joint ownership and this article about copyright joint ownership.

Who is to own jointly-created IP will sometimes be a negotiation point.

5.10.8 Co-Owner Accounting Disclaimer

(a) Unless the Joint IP Owners expressly agree otherwise in writing, no Joint IP Owner that "uses" (as defined below) any Joint IP Creation is required to:

(1) share proceeds or profits from such use with any other Joint IP Owner; nor

(2) otherwise account to any other Joint IP Owner for such use.

(b) For purposes of sub­div­i­sion (a), the term use of a Joint IP Creation refers to any action that, if taken by any person other than a Joint IP Owner, would require a license under one or more intellectual-property rights in the Joint IP Creation.

Comment

Unless otherwise agreed, joint owners of the (U.S.) copyright in a work of authorship must account to each other for their respective uses of the work. In contrast, joint owners of a (U.S.) patent for an invention are not required to account to each other for their respective uses of the patented invention unless otherwise agreed.

5.11   Language for Written Communications

The Contract Language is to be used for:

(1) each written notice required or contemplated by this Agreement, including for example any notice of arbitration;

(2) all service of legal process in any Agreement-Related Dispute — if applicable law requires that service of process be made in another language, then a translation into the Contract Language of each other-language document so served is to be served with the other-language document; and

(3) except in cases of emergency, any other written communication made pursuant to the Agreement.

Comment

Requiring written communications to be in a specified language can prove useful in case of litigation, arbitration, or other dispute-related proceedings.

See also 9.15.  ? Language of the Agreement and 5.12.   Language Capability for Oral Communications and 5.11.   Language for Written Communications.

Sub­div­i­sion (1) has in mind the situation in CEEG (Shanghai) Solar Science & Tech. Co. v. LUMOS LLC, No. 15-1256 (10th Cir. Jul. 19, 2016), affirming No. 14-cv-03118 (D. Colo. May 29, 2015), discussed in the commentary to the master-agreement provision.

5.12   Language Capability for Oral Communications

(a) Each party is to maintain the capability of conducting routine business orally (e.g., in person or by telephone) in the Contract Language, whether through party personnel who can speak that language or through translators engaged at the party's expense.

(b) Sub­div­i­sion (a) does not limit any party's right to communicate orally in any other language when agreed to by the individuals involved and not a hindrance to the purpose of the Agreement.

Comment

This provision tries to balance: • the parties' interest in making sure they can communicate orally, against • the possible threat of legal action from employees claiming discrimination on the basis of national origin. See, e.g., Can You Require Employees to Speak Only English on the Job? (CBIA.com, undated).

See also 9.15.  ? Language of the Agreement and 5.11.   Language for Written Communications.

5.13   [Reserved: Liens]

5.14   Primary-Contact Designation

5.14.1 Designation Upon Written Request

(a) Upon a written request by any party, each party (each, a Designating Party) is to designate, in writing, and provide contact information for, one or more Primary-Contact Representatives.

(b) Each Primary-Contact Representative is to be an individual of appropriate seniority who is authorized by the Designating Party to act as a contact point on behalf of the Designating Party under the Agreement.

(c) Any such designation may:

(1) be by email;

(2) state limits on the authority of the Primary-Contact Representative;

(3) be amended in writing from time to time by any method permitted for the original designation; and/or

(4) be revoked in writing by any method permitted for the original designation.

Comment

Provisions like this are often seen in, e.g., services- and project agreements, where it can be important for parties to have designated points of contact.

In some circumstances, a party that designates a Primary-Contact Representative might want to restrict the representative's authority by so stating in its designation of the representative.

5.14.2 Binding Communications by Representatives

An oral communication from a Primary-Contact Representative to another Signatory Party will not be binding on the Designating Party; a written communication will be binding, and may be relied on by that other Signatory Party for any purpose relating to the Agreement, UNLESS:

(1) the communication exceeds a limitation on the Primary-Contact Representative's authority as stated in the Designating Party's most-recent written designation under sub­div­i­sion (1); or

(2) the communication itself clearly states that it is not intended to be binding.

Comment

This provision is intended to encourage written communications in the interest of trying to forestall future "he said, she said" disputes.

5.14.3 Communications by Other Party Personnel

Unless otherwise specified in the Agreement or in the written designation of a Primary Contact Representative, IF: An employee or other representative of a Designating Party, other than a Primary-Contract Representative of that party, purports to make a request or issue an instruction on behalf of the Designating Party; THEN: Other parties are not to consider the request or instruction to have been made on behalf of that Designating Party.

Comment

This provision addresses one of the major causes of "troubled" contracts, which is that is unauthorized people can make change requests that can lead to cost overruns and delays. See, e.g., Steve Olsen, Troubled contracts – why missing these steps may trip you up (IACCM.com 2015).

5.15   Site Visits & Network Access

5.15.1 Site-Visit Definitions

For purposes of this 5.15.   Site Visits & Network Access provision:

(a) Site, in respect of a party specified in the Agreement (each such party, a Host Party)), refers, as the case may be, to:

(1) any physical premises of that Host Party; and

(2) any computer system or network of that Host Party.

(b) Site Visit refers to the physical presence at such premises, and/or access to such a computer system or network, by another party (each, an Accessing Party) or any individual who is subject to the control of an Accessing Party (each, a Site Visitor).

Comment

Some drafters might want to make this a one-way provision so that only one party is a Hosting Party and the other an Accessing Party.

5.15.2 Site-Rules Compliance Obligation

Each Accessing Party will cause each of its Site Visitors to comply with such reasonable Site rules and policies as the Host Party may seasonably communicate in writing to the Accessing Party.

Comment

Customers' contract forms for providers of goods and services often include provisions along the lines of this clause.

These definitions recognize that these days "site visits" are sometimes virtual.

In many services-type agreements, the Host Party will be the customer, while the Accessing Party will be the services provider coming onto the customer's site or accessing the customer's computer network. (The same could be true of providers of goods if the provider's personnel will be, e.g., making deliveries at the customer's site, or if sales people will be making in-person calls at the customer's premises.)

In other types of agreement, it might be the other way around, e.g., with a customer's people coming onto a service provider's site for training, to have work done on vehicles or equipment, etc.

This provision doesn't require site rules to be communicated in writing, but obviously that might be advisable for proof purposes if no other reason.

5.15.3 Prohibition of Unlawful Discrimination

For the avoidance of doubt, a Host Party may not deny access to, or otherwise discriminate against, any Site Visitor for any reason prohibited by applicable law (for example, antidiscrimination or equal-opportunity law).

Comment

This provision helps give a visiting party some cover in the event of trouble.

5.15.4  ? Site Visit Indemnity Obligation