Understand the Contract Fundamentals
While companies use contracts every day (sometimes without even thinking twice about it), the law regarding contracts can be deceptively complex.
A contract is essentially any exchange of goods or services that is legally binding. While contracts can take many forms, and may not always be on paper, they need not be physical to have legal effect. You may be surprised to know that any contract made verbally, in writing, or even partially performed (like oral agreements leading up to the execution of a written contract), may be found to be legally binding if certain criteria are met.
Most contracts need to include three key elements to be legally binding regardless of their subject or whether they are oral or in writing:
The Offer
The offeror (the person making the offer) must make a definitive proposal to the offeree (the party accepting the offer). This proposal will include an offer and may include a time frame for acceptance.
For example, if I say to you "I’d like to buy your car for $5,000," this is an offer. Importantly, the offer is extended even if you don’t agree. You may say, however, "No, I’d sell it for $7,000" (which would not be a counter-offer, but a rejection).
The Acceptance
To accept the offer, the offeree must agree to the terms of the offer. This involves saying "yes, I accept," or communicating otherwise (for example , by counter-offering). If the offer specifies a time frame for acceptance and the offeree fails to do so during that time frame, the offer has been rejected.
The Offer and the Acceptance
In order for a binding contract to exist, the offeror and offeree must actually reach an agreement. When agreeing to the terms, the parties should consider the following:
The Consideration
The consideration is what is being exchanged. In our car example, the offeree is exchanging the car and title for $5,000 (the benefit). Therefore, the consideration is the car – if an accident or disaster occurs before the purchase, the other party cannot ask for the car as they have no consideration.
Nonetheless, in looking closely at the car, we see that the offers and acceptances may be slightly different. For instance, I may have offered to buy your car yesterday and you may have said "yes, sell it for $4,500." This could be considered a counter-offer, which is considered a rejection of the terms of the offer.
On the other hand, if you said, "yes, sell it for $3,000, but I will add in free car detailing services during the first three months," we again have a modified acceptance. This would be considered a counter-offer, but the offeree has now modified the consideration. There is considered to be a missing element of acceptance because there is an offer (car detailing services), but no acceptance of the terms of that offer (including its value).
Identify Key Terms and Provisions
It is all too common to gloss over contract language in the rush to sign on the dotted line. Let’s face it, many contracts are incomprehensible to the lay person. The typical contract is a hodgepodge of rules, restrictions, obligations, waivers, and protections written in "lawyer-speak" with little regard to what it means to the reader. Instead of relying upon your yearly review with the company lawyer to remind you of what you signed, or worse yet, when you need a lawyer to remind you and try to negotiate a way out of a liability, it is a smart move to get acquainted with some of the most commonly used contract terms.
These definitions are not intended to be exhaustive or legal advice, but are designed to inform you of terms commonly included in contracts and how to identify them if you should have need of legal assistance.
Here are a few of the most common contract terms that are important to recognize: Termination Clauses: A termination clause outlines the circumstances under which a party may terminate the contract. The parties should identify when, how, and for what reasons the contract may be terminated, i.e., "for cause" or "for convenience." In the event of a breach of an agreement, the injured party may have grounds for terminating the contract. Practically, one example of when a party is likely to terminate a contract includes instances where a party fails to meet a critical deadline within a contract, such as experimentation or testing clause obligations. Another example is a change of control or ownership of a company; in such an instance, it is important to be aware of whether a contract contains a change of control provision to determine whether a party may execute its termination rights if the company is sold or merged, or otherwise undergoes a change of control.
Indemnification, and limitations of: A limitation of liability clause is used to establish up front the risk that each party is willing to bear and limits the liability to a specified dollar figure. An indemnification clause generally requires one party to bear the risk for certain liabilities and potentially requires that party to pay for any costs associated with third-party claims. It may not be acceptable then for the party with the deep pocket to be indemnified for its own breach of the agreement. An indemnity provision can also be drafted to exclude certain types of damages from the indemnification obligation. For example, with an indemnification obligation, a party may seek to exclude indirect, special, consequential or punitive damages from its indemnification obligations. A contractual indemnification clause usually requires the indemnifying party (the party responsible for the indemnified loss) to defend the indemnified party against certain claims for which the indemnified party is entitled to indemnification. An indemnity provision with a duty to defend may obligate a party to appoint and pay a legal defense team for the indemnified party.
Warranties and Representations: A party may warrant and represent several things, including representations about itself and representations about the future. For example, a company may represent that it has all corporate power and authority to conduct its business as currently conducted, including all government approvals necessary to conduct its business, and warranties that certain parties have valid and binding obligations regarding its contracts. A company may also represent and warrant that it will not file for bankruptcy or become the subject of an involuntary proceeding, that it is not in breach of any obligations under any agreement or instrument, and that there are no pending or threatened actions against it that could result in a material adverse change in its business.
At its most basic, a warranty is a promise or guarantee that something is true or will happen. Warranties become relevant when something promised turns out to be untrue. After a deal closes, one transactions’ party failure to comply with a warranty can trigger a claim for damages that can be resolved through litigation or arbitration.
Detect Ambiguities and Traps
The art of contract reading goes far beyond just understanding plain language and being able to translate legalese. Every contract has been carefully crafted to minimize the risk of unintended consequences. One of the essential aspects of effective contract reading is being able to spot ambiguities and potential red flags within a contract that may affect the enforceability and interpretation of the agreement.
A contract may be ambiguous even where the language is not expressly unclear. An ambiguity can be either a latent or patent ambiguity. A latent ambiguity is one that is not immediately apparent because it is not obvious on its face, but only becomes clear when viewed in the context of the entire agreement. Such an ambiguity does not render a contract void on its face but warrants further review to address the court’s questions regarding intent.
A patent ambiguity, on the other hand, is one that is immediately apparent. For example, the use of the identical term "same" or "identical" in two different places in a contract without clarifying what is meant by that term. The courts are not required to guess at the parties’ true intention. Rather, ambiguous language is generally construed against the drafting party so as to carry out the reasonable expectations of the parties.
Another common source of ambiguity is when the contract fails to contain sufficient definitions for all relevant terms, leaving important concepts open to interpretation. For example, the absence of clear language defining the term "immediate" could lead to uncertainty in knowing how quickly a party is required to act. A list of key definitions should be included to help explain the simplest terms, assuming that it enhances the contract’s clarity. On the flip side, an excessive number of definitions, or overly complicated definitions, may cause ambiguity. The key to a good list is to only include necessary and clear terms.
Poorly drafted contracts or those that contain vague terms can affect enforcement. Some potential red flags include:
Examine Important Obligations and Duties
Next, you will want to analyze the obligations and responsibilities of each party. Who is doing what? The answers to these questions are usually on the first couple pages of the contract. Those two or three paragraph, introductory sections tend to tend to include a lot of information about the parties and what they are doing. If you find that the parties are not clearly delineated, you won’t be able to determine obligations later. You may need to read many contracts to figure out what language the drafters of each contract use, so that you can clearly define the obligations, time of performance, and other terms.
In most cases, you will want to have a separate section for each party. If you are working with a simple contract, such as an NDA, you might only be working with two parties, but even with just two parties, it’s a good idea to have them delineated.
Also, you will want to be clear about who is doing what, when they are doing it, and the amount and timing of consideration.
Be clear that one party’s obligations do not become another party’s obligations, even if they would on their face be similar. For example, "Party A must supply ten widgets to Party B on September 1st" should not have the assumption that generated in Party A’s mind that "if Party A does not supply its ten widgets to Party B by Sept. 1st, Party C must supply ten widgets to Party B by Sept. 1st." If it is the intent that Party C will be responsible for performance should Party A not perform, then that should be well-documented in the contract. Otherwise, it should under the contract that Party C has no obligation to do Party A’s performance.
You may also come across separate agreements that are linked together. When this happens, the contracts should be read in conjunction and as if they are one agreement, unless they are expressly denoted as separate agreements. Meaning, even if you have an NDA and a Service Agreement that reference each other and require mutual execution, they are still separate agreements unless otherwise denoted.
Another issue you may come across is conflicting provisions in a contract. When this happens, it is always best to follow the provisions that import the most procedural or substantive validity to the contract. In other words, what would a court be more likely to enforce? It is always important to know a bit about the applicable contract law to help you determine which provisions and clauses would likely be upheld by a court of competent jurisdiction.
Check Payment Terms and Schedule
Money makes the world go round and you need to know when and how you’re getting paid. The third thing I look for in a contract is payment terms and schedules. Although this may seem fairly straightforward, it can get confusing if not set out correctly. Remember, if something is missed, it is easier for someone else to pick up on it (e.g., party B versus party A). Depending on the type of contract you are entering into, the payment terms and schedules can differ greatly. They can also be set out separately or in the main body of the contract.
In the most basic form, pay attention to the following details:
Payment Terms
The first things you want to review are the payment terms. How long do you have to pay invoices? 30 days, 60 days or 90 days? There may also be a distinction between interim payments (1, 2 or 3 or upon completion of a particular phase of the work) for ongoing work. These can be by way of percentage (e.g., monthly schedule of values) or actual amount. These Types of payment schedules are common for construction contracts. You will want to speak to your accountant to determine whether you can live with the terms in the contract and what your options are to mitigate any cash flow issues (e.g., invoice factoring).
Payment Methods
The next thing to watch out for is how you get paid (i.e., the form of payment) . Do you get paid by certified cheque, electronic funds transfer or a bank draft? This can prove to be interesting when there is an issue with the payment. If an electronic funds transfer does not go through, there is no receipt versus a certified cheque, which you should at least be able to trace. This may seem like a silly provision, but it is important to know how you will be paid.
Timelines
In addition to the payment terms, other important provisions deal with timeliness. For example, when you get paid after work is completed (in the case of lump sum contracts). Another aspect of timelines is that time periods can be tied to how long you have to review something and advise the client. Further, a failure to keep to a schedule can be interpreted as a waiver in some instances.
What happens if you don’t get paid
Although it would be wonderful to say that you will always get paid on time, especially if the contract clearly outlines the payment terms, it is not required that you are always paid on time. How late you can be can depend on the contract and provincial/territorial legislation. What happens if you are late and do not get paid? Having a caveat in place may assist you in the interim. Depending on the type of contract, you may also be able to use a lien or arbitration to recover any outstanding fees.
Dispute Resolution and Governing Law
Dispute resolution clauses establish the procedures the parties will follow in resolving disputes. Some of the most frequently used methods include negotiation, mediation, arbitration, or litigation. Read this section of the contract carefully to ensure that you are comfortable with how disputes will be handled.
Governing law clauses specify which jurisdiction’s laws should be applied in a dispute. The location where any litigation should take place is sometimes also listed in this section. These two clauses are significant because they can determine not only where disputes will be resolved but also how substantive legal questions will be answered. Consideration of these clauses is especially important if you operate in multiple jurisdictions. It may make the most economic sense to resolve disputes with your main or most interested party in a single forum.
Final Review Before Executing
Before you finally affix your signature to the document, make sure to go through this checklist:
Erase any mental edits.
The contract should be a true reflection of your negotiations and discussions. Sometimes, out of habit, people make mental edits when reading through a contract. If you’ve agreed to a particular point and it’s not in the contract , let the other party know so that it can be included. You can always clarify in your signature line or in an addendum.
Check the signature lines.
The only person or people who can sign the contract to make it binding are those expressly identified as signing parties. This is typically the individuals’ signatures below their names but can also be a corporate officer. Still, you won’t want to sign the contract yourself unless you know for certain that you hold that title (i.e. sole proprietor), have that power of attorney, or have been given express permission to sign on behalf of that person. This will protect both you, and those you don’t have power of attorney over.