The Building Blocks of Drafting Contracts

Contents:

1. Chapter 1: Introduction

2. Chapter 2: The Basics of the Contract: The Building Blocks

3. Chapter 3: The Principles of Effective Drafting

Chapter 1

Introduction

I. Role of Contracts:

The entire world of human transactions are based on Agreements, the nations were built on the foundation of written constitutions, which are nothing but a contract between the citizens among themselves to create a government to rule themselves. The agreements range from multilateral treaties between countries to govern their relationships, to a simple sale deed between two individuals. Every relationship is governed by rules, sometimes these rules are express, sometimes they are implied, but the whole world is a complex web of reward and deterrence based on the rules of contracts, either express or implied. In the world of 21st century, there are increasing complexity in commercial transactions, therefore every new entrant to the legal profession and every person associated with commercial transactions must understand the building blocks of contracts.

The contracts are recorded instruments in which the rights, duties, obligations, and responsibilities of each party is properly defined. The Role of a lawyer is to draw up a contract which reflects the true intentions of the parties, and therefore we chose the language to be very specific which does not mean any other thing but the true intention of the parties.

A contract creates a private body of law between its parties. Each party has the legal right to enforce the obligations and restrictions that the other party has agreed to. Many of the provisions of a complicated agreement go well beyond what the parties consider the "business deal," and, as a result, some people are prone to disregard these provisions as legal boilerplate. It is the responsibility of the lawyer to ensure that the client understands the impact that the contract will have on its business and its business relationships.

A well written contract has no place for ambiguity and it saves a lot of money by negating the chances of litigation. It provides a clear law that both the parties have to adhere.

In this book we will not go into the prevailing laws relating to contracts, rather we will try to understand the dynamics of drafting of contracts and what are the consequences of writing a contract with only slight variations in language. Most of us already know the law of offer, acceptance, and consideration, but our education system is more focused towards creating litigation lawyers, than a transactional lawyer, therefore many new lawyers struggle to understand the mechanics of drafting a good contract, and this book seeks to fill the gap of that training.

II. Drafting of Contracts:

The writing of contracts is an entirely different type of writing. The purpose of writing of contract is to record the meeting of minds of the parties with perfect precision. The contract is not is an expository writing to provide information or to persuade reader but the purpose of writing contracts is to record a transaction in a manner which cannot be interpreted in any other way than reflecting the real intention of the parties.

A lawyer has to analyze the transaction and raise all the potential issues that may arise at the time of execution or in the future, and educate the client and record everything in the contract itself to prevent any chances of litigation in future. The main aim of a well written contract is to prevent litigation, and therefore, a lawyer has to think about all the possible consequences of every action under the contract.

III. Scope of This Book:

This book:

· introduces the reader with the basic elements of all contracts (the "building blocks") and their functions;

· describes the lawyer’s function in the drafting and negotiating process;

· examines specific drafting skills;

· discusses some of the provisions typically found in most contracts.

Chapter 2

The Basics of the Contract: The Building Blocks

I. Introduction:

The building blocks of contracts are very important provisions of a contract. The building blocks serve the same purpose in all the contracts, irrespective of its subject matter and operative provisions.

The building blocks of contract are as follows:

a. Representation and Warranties

b. Covenants

c. Conditions Precedent

d. Remedial Provisions

e. Definitions

The building block further elaborates the provisions of the operative parts of the contract. Suppose we have a contract of sale of real estate property, the operative part of that contract would be description of the property, calculations of price, and the process of transferring of the property, the contract will be complete and enforceable even if only these provisions are included in the contract. But there are various contingencies that may arise, and which may give rise to a potential litigation like there was fault in the property that was not informed by the seller to the buyer, or the seller has damaged the property before the closing, what happens if the seller does not provide help to the buyer in transferring the property. These are the kinds of issues that are addressed in the building block provisions—representations and warranties, covenants, conditions precedent, remedial provisions and definitions.

II. Representations and Warranties:

Representations and warranties are those statements were a party to the contract affirms or denies a statements of fact at a particular point of time. There is a minor difference between the Representations and Warranties, when there is no remedy provided in the contract for failure of representation or warranty; in that case if the representation given by one party fails then other party has the right to terminate the contract, whereby failure of warranty provides the other party the right to recover damages along with termination. When there is remedy of failure of representation and warranty is provided in the contract then there is no distinction between the terms. Generally representations and warranties are used for the same purpose of creating a list of facts that are important to the recipient’s business decision to enter into the transaction. The failure of a party’s representations to be true will result in the other party having rights and remedies under the contract.

Let’s take an example of a simple contract for the sale of building, the buyer would want to know that there are any problem in the sever line and water fittings. The buyer will do his due diligence to ensure that the building and all its equipments are in a sound state. However, it’s possible there had been an issue which was not discovered in the due diligence of the buyer. Therefore, the buyer would want the seller to make a representation that the building and all its equipments are in a sound state. The Seller provides the representation in the contract, then if there is any problem found in the building after the sale then buyer shall have a claim against the seller. If the buyer discovers before the closing that the representation is untrue, it would typically have the right to terminate the contract and walk away from the deal.

A. Allocation of Risk:

Representations have the function of allocating risk between the parties. Representations are based on the natural progression of the principle of caveat emptor. The party making the representation assumes the risk that if the representation is untrue, the other party will have a claim against it or some other remedy under the contract. The party being asked to make the representation may not have any better information on the subject matter of the representation than the party requesting it. But it may be forced to make the representation anyway, based on the principle that the recipient of the representation is entitled to some remedy if the fact being represented turns out to be false. Generally the seller is required to make representation for the soundness of the property to be sold, in this way the risk is allocated to the seller.

B. Categories of Representations:

There are primarily 3 categories, a representation fall into:

1. Representations as to the Contract Itself:

The first category includes representations that relate to the contract itself. The purpose of these representations (referred to here as "enforceability representations") is to provide assurance that the party making them has the contractual capacity and authority to enter into the agreement, and that the contract is legally enforceable and doesn’t result in a violation of law. The party asking for enforceability representations wants to ensure that the other party doesn’t have any technical defenses available to it, if the contract ever becomes the subject of litigation. These are standard representations and are rarely negotiated to any significant extent.

2. Subject Matter Representations:

The subject matter of the contract is the second category of representation. Generally subject matter representations are about the soundness and workability of the subject matter of contract.

A few examples are:

· A trademark license contains representations by the licensor that the trademark is properly registered and doesn’t infringe other trademarks.

· An asset sale agreement includes representations by the seller that the property to be transferred is not subject to any lien.

· A real estate lease contains representations by the lessor that it has not leased the same property to anyone else.

· A contract to rust-proof sheet metal contains representations by the contractor as to the quality of the materials used and the capacity of the provider’s plant to handle the contracted supply.

3. Representations about the Parties;

The third category of representations relate to the representations made about the parties for themselves. There are many contracts which require the parties to make representations about themselves, some examples are:

· Representation about good financial health to repay the loan in a loan agreement.

· Representation about the qualification and experience of candidate in an employment contract.

· Representations about the health condition of the insurance holder in a health insurance contract.

C. Exceptions to representations:

When the representations are negotiated, the situation arises when the parties have to make exceptions to the representations, some examples are:

· The borrower have no outstanding loans except the loan of 1 million $ from Bank of America.(Loan Contract)

· The Insurance holder does not have any health problems except the fact that he smokes cigarettes. (Life Insurance Contract)

D. Representation "Bringdowns"

Generally representations are made on the day of closing, but in some contracts the party have to make the representation again on a later date, such situations are termed as Representations brought down. For example in a contract for sale of assets were a part of property is to be transferred at a later date then the representations are brought down to that later date. In a revolving credit the borrower is required to maintain a net-worth throughout the term of the loan. The bringdown of representations is usually required at times when a significant event occurs under the contract.

E. Survival of Representations:

There are various contracts in which the representation survives the closing date and become continuous. A survival clause means that the recipient of a representation continues to have the benefit of that representation after the closing, even after a month after the closing date a recipient of a representation discovers that the representation was false at the time when it was made; the recipient will have a remedy under the contract. The alternative to a survival clause is a provision that the representations merge, or terminate, at closing, which are generally the case in Real estate contracts.

III. Covenants:

A. Covenants are ongoing promises made by one party to take or not to take any particular actions. Covenants can be divided broadly into 3 categories:

a. affirmative covenants—promises to take specified actions;

b. negative covenants—promises not to take specified actions; and

c. financial covenants—promises to maintain certain levels of financial condition or performance or not to take specific actions unless certain levels of financial condition or performance exist at the time.

Covenants are generally made to ensure that a party receives the benefits that it bargained for in the operative provisions of the contract.

Example: The Lessor leasing his car and want to maintain the maximum possible market value of the car when the lease ends, this is accomplished through the use of covenants that dictate what the lessee must do, and cannot do, with respect to the leased car. The following covenants can be included:

· keep the car insured

· maintain the car in accordance with the manufacturer’s specifications

· operate the car in accordance with applicable laws

· not permit the creation of any liens on the car

· not sell or otherwise transfer the car

· permit the lessor to inspect the car

· use the car only for specified purposes

B. Exceptions of Covenants:

When the covenants are negotiated, both the parties are free to negotiate the exceptions of covenant as well. For example in the above example of car lease, there is a covenant to the effect that the Lessee must not sublease the car, but the lessee negotiates with the lessor and adds an exception to this clause by inserting the words “except to the persons who has good driving record and has the financial capability to indemnify the lessor in case of any damages, and such sub-lease can be for maximum duration of 6 hours.”

C. Types of Exceptions:

There are two basic types of covenant exceptions:

a. Carveouts: The function of carveout is to remove, or carve out, part of the restriction created by the covenant. If the paradigm of a typical negative covenant is "thou shalt not do A through C," the paradigm of a carveout is "but thou shalt be permitted to do ‘D’." For example in a loan contract, borrower shall not sell any of its assets, except for the sale of obsolete equipment in the ordinary course of business.

b. Baskets: Baskets are generally used to provide a limited right to the party to deviate from the covenant, which is generally expressed in amounts of money or quantity. Putting it in the above definition, a Basket clause would be “borrower shall not sell any of its assets, except for the sale of obsolete equipment in the ordinary course of business in an aggregate amount not exceeding 10,000 $”. Here the borrower’s right to sell the equipment is limited, if the borrower makes the first sale of 2,000 $, after that he can only sell for the remaining 8,000 $.

D. Remedies for Breach of a Covenant:

Most of the contracts usually provide for specific remedies in the event of a breach of a covenant and a party entitled to performance of a covenant may apply for a judicial order of specific performance forcing the defaulting party to perform its Covenant. Even if the parties agree to specific performance as a remedy, however, it is within the discretion of the court to grant or not to grant specific performance. If the court finds that money damages are adequate then it can deny the order of specific performance.

IV. Conditions Precedent:

The Conditions Precedents are those provisions in which certain requirements are specified that must be satisfied before a party is obligated to perform under a contract or before a closing occurs. For example; the seller is not required to transfer the assets unless the buyer pays the purchase price, and the buyer is not obligated to pay the purchase price unless the seller transfers the assets. If either party fails to satisfy the condition precedent, the other party shall have the right to walk out of the contract. When the contract is signed, delivered, and executed, but the condition precedent is not satisfied till a later date, then it may result in delayed closing of the contract.

A. Common Conditions:

There are many conditions which are common to certain types of contracts, but the lawyers are free to draft a condition to suit their peculiar circumstances. Some common conditions are:

· Incumbency certificate. This is a certificate signed by an officer of an entity attesting to the genuineness of the signatures of the officers that are signing the contract.

· No breach. Performance is not required if the other party has breached its covenants or representations in the contract.

· Bringdown of representations. Representations first made at signing may be required to be brought down at closing.

· Governmental approvals. If the transaction contemplated by the agreement requires a governmental approval, neither party will want to be obligated to close unless the approval is obtained.

V. Remedial Provisions:

Remedial provisions are those provisions of a contract which provides for remedies if either party fails to perform their part in accordance with the contract. Remedial provisions are divided into two categories: (a). description of the events that give rise to the right to a remedy, and (b). the remedies themselves.

For example, a commercial real estate management agreement under which one party agrees to manage a property owned by the other party in exchange for a management fee. The property owner will want to have the right to terminate the contract if the management company is not performing its duties satisfactorily, and the management company will want to be able to walk away if its fees aren’t being paid.

Some examples of such remedial events are:

· Change of control of a party, for example, due to a tender offer or a proxy contest

· Change in a party’s credit rating

· Judgments or orders being entered against a party

· Involuntary bankruptcy petitions being filed against a party

A. Types of Remedies:

Following are the types of remedies that are generally provided in a contract:

1. Termination: Termination means neither party’s being required to continue performance under the contract, sometimes the right of termination may be exercised together with other rights, such as the right to receive indemnification payments or liquidated damages.

Termination is the most common remedy in a contract.

2. Acceleration:

Acceleration is a common remedial provision provided in a debt contract; however, it can also be used in various other contracts. Acceleration means the liability of a party is accelerated to become immediately due by happening of certain occurrences. For example; depreciation in credit rating of the borrower shall amount in whole loan amount to immediately become due. This can also happen in case of defaults.

3. Indemnification:

Indemnification means the defaulting party shall be subjected to the obligation to indemnify and make good the loss suffered by the other party as a result of such default. The remedial provision of indemnification generally coexists with the other remedial provisions. Liability under indemnification provisions is often limited by baskets, caps and termination provisions. If indemnification is not required for claims that are less than some specified dollar amount, which is referred to as a basket. A cap is a limitation on the maximum amount of payments that may be required under an indemnification provision. If the negotiated cap is ten million dollars, then the indemnitee may receive no more than that amount in total indemnification payments, even if its damages are greater. Indemnity clauses may also be subject to termination after a certain point in time.

4. Liquidated Damages:

Liquidated damages clause is provided to make a provision of payment of a certain sum of money by the defaulting party to the other party on happening of certain occurrences. Some examples are:

· A severance payment under an employment agreement to an employee who is terminated other than for good cause.

· An equipment lease requiring the defaulting lessee to pay a lump sum calculated by estimating the decrease in rent that the lessor will receive upon releasing the property.

B. Softening Remedies:

Softening remedies are provided to negate the harshness of a remedial provision. For example, a stock purchase agreement may provide the purchaser with a right of termination in the event that the seller breaches any of its representations or covenants in any material respect. The inclusion of the last phrase limits the breaches giving rise to the purchaser’s right to terminate the agreement to those that are material. Assume that the seller had made a representation as to the amount of debt on the balance sheet of the company to be acquired. If the purchaser discovers that the total debt is $20,000,500 instead of the represented level of $20,000,000, the representation will be breached but not in a material respect. As a result, the purchaser will not be able to terminate the agreement. Of course, the question of what breaches are or are not material can become the subject of debate. Grace periods are also used to protect against hair trigger remedial provisions: instead of being immediately available upon the occurrence of a breach of covenant or other event, a remedy will be available only after a specified period of time (the grace or cure period) has elapsed following the event. If the act or condition at issue is cured during the grace period, the remedy is never triggered. In some cases, the grace period doesn’t begin until the breaching party receives notice of the breach.

VI. Definitions:

Precision is of paramount importance in a contract; the words in the contract should only reflect the meeting of minds of the parties and can’t be capable of more than one interpretation. There is no place for ambiguity in a contract. Definitions serve the function of removing ambiguity and restrain more than one interpretation by defining the terms used in the contract with precision. The process of defining important terms increases the likelihood not only that there has been a true meeting of the minds but that it was properly reflected in the agreement. In addition to this valuable function, the use of defined terms also engenders consistency and reduces unnecessary repetition.

Definitions are included in agreements in one of two ways. Either terms are defined in a separate section or they are placed in the text itself, as in the following sentence:

The Seller shall not enter into agreements to sell any parcel of owned real property having a fair market value of $1 million or more ("Material Owned Property").

A. The Purpose of Definitions:

The purpose of Definitions is to provide a meaning to the words used repeatedly in the agreement and ensure that the contract is consistent as the terms defined are used in the same context and same meaning. Consider a real estate lease with both a representation and covenant dealing with the issue of encumbrances on the leased property. The landlord is required to represent as follows:

On the Closing Date, there are no liens, mortgages, encumbrances, easements or encroachments on the Leased Property.

Further on in the contract, the landlord makes this covenant:

Landlord shall not create, incur or permit to exist any security interest, lien, pledge or encumbrance on the Leased Property.

There are inconsistencies between these two provisions that are probably not intentional, but which could give rise to interpretation issues. The representation refers to easements and encroachments, whereas the covenant does not. If there were no easements or encroachments on the property at the time of closing (when the representation was made) but were subsequently created, is there no violation of the covenant because it fails to include these terms? Alternatively, can it be argued that the term "encumbrance" appearing in the covenant is intended to be broad enough to pick up things like easements and encroachments? If so, why were these words included in the representation? The obvious solution is to create a defined term for encumbrances that would be used in both provisions.

B. Avoid Substantive Requirements in Definitions:

Definitions section should only be used to define terms and one should avoid providing substantive provisions in definitions. Here is an example from a shareholders’ agreement:

"Purchase Agreement" means the Stock Purchase Agreement dated October 26, 2021 between Buyer and Seller, as amended, modified or supplemented from time to time, provided, that no such amendment may be entered into without each Shareholder’s consent.

Let’s assume it is now time to amend the purchase agreement, and the shareholders’ agreement is reviewed to determine whether consent of the shareholders is required. That the requirement is buried in the definition, and not included as a covenant, creates a greater likelihood that this requirement will be overlooked, because it is not where the reader would expect to see it. The guiding principle, once again, is to create a document that will be as easy to work with as possible.

Chapter 3

The Principles of Effective Drafting

I. Introduction:

Drafting of contracts is unique type of writing. Contract drafting is different from the expository writing which we have learnt in school or colleges, the purpose of expository writing is to provide information or to persuade a reader, but the contract is drafted for the purpose of recording the meeting of minds of two or more parties with precision. The primary audience for this writing is the parties and their counsel. The agreement may have additional readers, such as regulators, creditors and others interested in the contractual relationships and obligations of the parties. In the worst case, the ultimate audience will be a judge or a jury.

Let’s examine the differences between the two basic forms of legal writing. Here is a sentence from a brief by counsel to a plaintiff in a tortuous injury action:

The defendant have completely disregarded his duty to take care and allowed the hazardous substances to spill over the land of the plaintiff, resulted proximately and immediately in severe harm to the plaintiff.

The writer’s primary goal in these writings is to persuade the reader—the judge—that the position being conveyed is the correct one. Persuasion is more art than science. It requires that the writing is tailored to the reader, and may employ rhetorical devices and the creative use of language.

Now let’s take a well drafted contract provision:

This agreement shall terminate at 11:00 AM on September 29, 2021, unless before such time Buyer shall have delivered to Seller a formal order in the form of Exhibit C attached hereto.

Note that it accurately reflects the understanding of the parties and there are no rhetorical flourishes, no adjectives, no imprecise terms. Every word serves a precise purpose.

II. Precision:

Generally a contract is preceded by a long negotiation process, where each party agrees or disagrees to a lot of provisions, the lawyer has to review each communication and put every proposition into precise words. The precision sometimes becomes challenging for a lawyer. Let’s take an example of a machinery lease contract:

The Lessor, by notice to Lessee, may terminate this agreement, if Lessor asserts a breach by Lessee of the terms and conditions hereof, to the extent Lessor is given a reasonable time to cure such breach.

The Lessor have made several phone calls to the lessee to purchase an insurance contract for the machinery, and lessee after getting that calls contacts and insurance company but there is some delay in the documentation which delayed the purchase of the insurance contract. To Lessor’s surprise, owner sends manager a written notice terminating the management contract. Each party calls its lawyer. Each lawyer separately advises its client that the following arguments may credibly be asserted by Lessor and would probably survive a motion for summary judgment:

· The phone conversations in which Lessor asserted that Lesse failed to comply with the contractual requirement to promptly make the repairs constituted the required notice of termination.

· Lessee is not entitled under the contract to the defense that it promptly contacted an Insurance company to purchase an insurance contract for the machinery.

· The period of time commencing on the date that Lessor first complained about the failure of Lessee to make the repairs and ending on the date that Lessor sent the notice of termination constitutes a reasonable cure period.

Although Lessee justifiably feels misused by Lessor, his lawyer advises him that a judge or jury could very well determine that the contract supports the action taken by owner. The result would have been different had the provision been drafted with more care:

If (a) Lessee breaches any of its obligations hereunder, (b) Lessor delivers a written notice to Lessee stating that it is a "Notice of Termination" which identifies such breach, and (c) Lessee fails to cure such breach within 30 days after the date of such notice, this Agreement shall terminate, provided, however, that if the cure of such breach reasonably requires the action or cooperation of a third party, no termination shall occur so long as Lessee is using its diligent efforts to cause such third party to act or cooperate.

Common instances of imprecision in a contract are:

A. Use of Antecedents:

The Drafting of contracts shall use minimal pronouns and everything should be referred by its name, even at the cost of departure from the general rules of the language. Sometimes the repetitions of terms may not appear good, but drafting of contracts is not the place to show your command on linguistics, but you have the job to correctly and precisely record the consensus of the parties.

B. Time References: The Time references in the contract have to be precise, for example if there is a clause for making payment, the time and date by when the payment should be made should be written with exactitude.

C. Legalese: Legalese is devised to communicate an idea in a word, which in plain English may require several words. The audiences of commercial contracts are sophisticated business people and lawyers, therefore, a lawyer should not hesitate in employing the best use of legalese that he has learnt in law school, but at the same time shall not use excessive legalese to make a simple provision unnecessarily complicated.

D. Conveyance Provisions: The conveyance provisions should contain every aspect of the property and precise description of property to be transferred. For example, a security interest isn’t created under Article 9 of the Uniform Commercial Code unless the agreement provides for a present grant of the security interest, and language effecting a conveyance of real property must comply with the relevant real estate law.

III. Simplicity:

The contract should be drafted by keeping every point as simple as possible. Simple provisions are easier to read and write and are less likely to be imprecise or unclear. Following are the ways in which the drafting contract can be kept simple:

A. Keeping Sentences Short: The old rule of keeping sentences short also apply with the drafting of contracts. Short sentences are easy to understand and make lasting impressions on the mind of the reader

B. Use the Active Voice: Another old rule which applies to drafting of contracts. Active voice are more clear than passive and a contract shall always be written in active voice.

C. Delete Unnecessary words: The Contract should be kept as short as possible, and only the words which are necessary and add to the meaning of the terms shall be kept. A contract is not meant to demonstrate the wide vocabulary of the writer, but it has to serve the purpose of being a charter of meeting of two minds.

D. Accretive Drafting: There are instances were a contract has to go through several rounds of negotiations and every time the other party adds something to it. Under those circumstances, it is best to use the devices of numbering and proviso to simplify the contract.

IV. Consistency:

The use of words in the contract shall be consistent, otherwise there may be confusion in its interpretations. For example; for making payments, there may be many words like (a) making payment from available funds; or (b)just make the payment of specified sum, in the first instance payment can be made in cash, but the second term is wider which allows payment by any method. Such terms should be kept consistent in every clause of the contract were it is referred to be precise and negate any chances of dispute.

V. Clarity:

The main objective of a contract drafter is to be absolutely clear in its terms. The contract should be easy to understand, of course the standards of audience who are sophisticated business people and lawyers should be kept in mind. A contract should not be such that a judge has to employ hours of his work to understand it. Clarity is the most important rule of drafting contracts.