Contract Review & Drafting – Rules One Should Know
A contract shall be structured in such a way that the purpose behind it is lawfully positioned, performed, and protected writes Siddharth Sangal.
An effective contract is not only a reflection of the parties’ intention to get into a legal relationship, but clearly lays out the respective obligations of the parties with necessary safeguards and efficacious remedies. Today’s world is economized by trade, domestic and international, and this trade is facilitated through contracts (domestic or international) entered into by the parties. A domestic contract is one where both the parties operate their business from the one and the same country, whereas an international contract is one where both the parties operate their business from two different countries. Accelerated globalization has almost removed the disparity of required terms between the domestic and international contracts, and thus, most of the corporates follow the same principles while drafting and/or reviewing the domestic and international contracts. This is, to an extent, evident and eased by standard terms provided by GAFTA, FOSFA, and Incoterms (1).
Even then, sloppy and careless drafting and/or review of contracts have hurt the corporates all over. A contract is not a compilation of standard terms, but a considerate replication of the understanding of the parties with regard to the purpose of the agreement, nature of services, form of performance, kind of consideration, and type of industry. So, the structure of the contract in general, the hierarchy and the construction of the terms will differ and depend on parties, purpose, services, industry, location, and law.
Having said the above, certain basic rules govern the drafting and/or review of contracts which keep on progressing with change in the law and practices. To ensure a successful contract, before initiating drafting and/or review of a contract, these questions shall be answered:
- Who has drafted or will draft/review the contract?
- What is the purpose of the contract?
- Whether it is a domestic or an international contract?
- Are all boilerplate terms effectively injected in the contract?
- Are all important terms carefully inserted in the contract?
- The construction of the contract – whether lengthy, bulky, or difficult to understand?
- Is there a correct arbitration clause in the contract?
While answering these questions, one must keep in mind the following:
Section A - Who has drafted or will draft/review the contract?
1. The skill, expertise, background, and experience of the person drafting and/or reviewing the contract are very important for the effective and successful execution of the contract. Most of the corporates designate this work to the respective departments, which may or may not comprise of experts [legal], but only technical assistance. The development and management of contracts with compliance of good, accepted and established practices is required for an effective speaking contract. In this regard, legal professionals are considered the safest bet for drafting and/or review of a contract, for they are not only well-versed with the applicable law but being a part of the day to day legal happenings even know the construction and interpretation of certain terms that call for disputes.
2. The one, who reviews the contract drafted by the other party, shall have knowledge of its own standard terms and practices. Most of the corporates, with the help of experts, formulate a check-list that guides the reviewer to ascertain whether the terms of the contract are in conformity or deviate with the check-list (standard terms and practices). It is the deviations which call for negotiations later on. Such check-list will be different for different kind of contracts and will be based on the role the party proposes to play in a contract. This kind of practice is best suited for confidentiality agreements, licensing agreements, work contracts, supplier contracts, and hotel related franchise or management agreements, among others.
3. In this way, by availing the services of the right person for drafting and/or review of a contract, a corporate not only secures its own interest in the contract but can even save huge amounts of money which might come into picture by way of a dispute resulting from careless or faulty drafting and/or review of the contract.
Section B - What is the purpose of the contract?
1. The purpose or the object of the contract is instrumental in the construction of the contract. The purpose defines the scope, design, and requirement of the terms to be included in the contract. For example: a franchise agreement shall have the terms related to duration of franchise, area restriction of franchise, royalty, and intellectual property etc.; a supplier agreement shall have the terms related to delivery of goods and services, price payment schedule, quality standards, indemnity, rejection and re-delivery of goods, and dispute resolution mechanism etc.; a confidentiality agreement shall have the terms related to definition of confidential information, duration of confidentiality, exceptions to confidentiality, and breach of confidentiality etc.; an arbitration agreement shall have the terms related to reference to arbitration, appointment of arbitrator(s), choice of arbitration law, and fees of arbitrator(s) etc.
2. The purpose, if illegal or opposed to public policy will render the contract void. The purpose of a contract is said to be illegal if it is against any law for the time being in force, or it is fraudulent in nature. For example:
a. An agreement in restraint of marriage is void (2).
b. An agreement by which any one is restrained from exercising lawful profession, trade or business of any kind is void (3). Though this has exceptions, but such exceptions have to be exercised judiciously and reasonably.
c. A proper agreement for transfer of immovable property (sale deed etc.) is a valid contract, but if such contract is made with intent to defeat the creditors of the transferor then it is voidable at the option of such creditor (4).
d. In an agreement for formation of a company, the name of the proposed company is very important. Such name shall not be unlawful or immoral or against public policy. For example: The company name cannot be "Prostitutes Ltd." or "The Rape, Inc." so, where A and B enter into an agreement to form a company C, the name of which itself is immoral or barred by law – such an agreement cannot take effect.
e. An agreement to commit a crime is void. For example: A enters into an agreement with B to kill C for a consideration of Rs. X. Such an agreement is illegal and void.
3. Thus, it is imperative that before drafting and/or review of a contract the purpose of such contract is examined.
Section C - Whether it is a domestic or an international contract?
1. Although, with each passing day the terms of the domestic and international contracts are finding common ground, nonetheless, the geographical nature of the contract may attract some different construction of both. Where a domestic contract attracts certain fixed language for boilerplate clauses, an international contract attracts some ground work which may include serious negotiations. While drafting and/or review of an international contract, specific attention/modification shall be given to the following clauses:
a. Language: The parties shall decide upon the language that controls the contract. For example: A, a Chinese entity enters into a contract with B, an American company will both want to control the transactions arising out of the contract in their own native languages, and so, it will be important to arrive at a mutually decided language and inserted into the contract.
b. Location of Performance: Parties belonging to different countries shall clearly word out the terms with regard to performance of the contract and the services contained therein. Certain other clauses too may be inserted or modified depending upon the location of performance of a contract. For example: A, an American company enters into a contract with B, a Pakistani entity and the location of performance of contract is Pakistan. In such a case, certain other clauses like security and confidentiality of information, force majeure, and governing law etc. shall be suitably constructed.
c. Payment Currency: Different countries have different currency and so it is advisable to insert in the contract the currency in which payment shall be made. In other words, regard has to be given to the current exchange price and it is best to mention in the contract itself the exchange price, desired payment and the applicable currency – to avoid any future differences or disputes. For example: A, an American entity enters into a contract with B, another American company. A has its office branch in India and the performance of the contract has to be achieved by A’s Indian office in India. B has a subsidiary in India, which has to make payment to A’s Indian office. In such a case, where A and B agree to define the consideration of the contract in American Dollars ($), it is also important to agree and insert in the contract the exchange price per $ in Indian Rupees i.e. it shall be clearly written in the contract that 1$ = Rs. X for payment purposes. This is because the rate of rupee per dollar changes every day, and a party may stand to lose due to this uncertainty. For example: If the consideration of the contract is $3000, and the parties agree that 1$ = Rs. 45 for payment purposes, then the payment to be made under the contract shall be Rs. 135000 irrespective of the exchange price of dollar per rupee at the relevant time.
d. Governing Law: Each party will try to impose its country’s law into the contract. This could be challenging for both the parties, but a consensus has to be drawn in arriving at the governing law of the contract. In most cases, preference is given to the law of the country where the contract is to be performed. This is also the reason why some corporates prefer to do business only in those countries where they already have an office branch or a sister concern. In other cases, a small fish simply gives in to the demands of the large fish. Here, it is required of the person drafting and/or reviewing the contract to shell out the pros and cons of accepting the other country’s law as the governing law. For example: Where the contract refers any dispute to arbitration, it is important to confirm whether the countries of both the parties to the contract are reciprocating countries for the purposes of the enforcement of the arbitral award. Where they are not reciprocating countries, an enforceable award in one country will just have evidentiary value in the other without any direct enforceability rights.
Contracts that are silent on the governing law, any dispute is then guided by the accepted principles which are:
a. The place where the contract is made;
b. The object of the contract;
c. The place where the contract is to be performed substantially; and
d. The place of business of the parties
e. Court Jurisdiction: Usually the country who’s law is the agreed governing law; its courts only have the jurisdiction to entertain the disputes arising out of the contract. Nonetheless, it is important for the parties of two different countries to know which appropriate court to approach in case of a dispute. Reference to arbitration is an exception where the parties can decide a particular country as location of the arbitral tribunal but chose the arbitration law of some other country to govern the arbitral proceedings.
2. Thus, domestic and international contracts may influence the drafting and/or review of the contract to a great deal.
Section D - Are all boilerplate terms effectively injected in the contract?
1. Boilerplate clauses are the standard terms and conditions which a party inserts in almost all its contracts. These clauses could be assignment, governing law, arbitration, force majeure, severability, counterparts, entire agreement, termination, indemnity etc. Though standard, these clauses cannot be used mutatis mutandis in all contracts, and so, while drafting and/or review of a contract it is necessary to understand the usage of these clauses in the context of the contract. For example:
a. Termination could be contingent, without any reason or at convenience, with or without any limitation. Also, if the contract has a renewal clause then the wording of the termination clause will depend on it. A contract can be for a fixed tenure, evergreen, or renewable – all these have a bearing on the construction of the termination clause. Effects of termination form an essential part of the termination clause.
b. Indemnity clause could be an essential part of the contract or may be just included as boilerplate, but it has an important objective. In an indemnity clause, either or all parties agree to indemnify and hold harmless each other from all claims, losses, damage etc. arising out of the contract. The extent of indemnity may be limited or unlimited as the language of the clause suggests. Further, the indemnifier may cap its liability to a pre-determined maximum amount. Most contracts include this clause to indemnify the party from third party claims. An erroneous construction or a miss may take away the safeguard of the party to seek indemnity in case of losses or claims arising without fault. For example: A, a music director enters into a contract with B, a film producer to give music for a particular film. Once the music of the film is released, a pop-singer C files a suit for copyright infringement against B alleging that the music of a particular song in B’s film is lifted from C’s composition. As a result, B pays Rs. X to C as compensation. B can claim the amount of this compensation from A only if there is an “indemnity clause” in the contract between A and B. Smart drafting or reviewing will ensure that the indemnity clause includes attorney fees and expenses apart from losses and damages – this will entitle B to claim not only the amount of compensation but also the expenses of litigation, if any, B had with C.
2. Thus, even if the boilerplate clauses form a standard part of the contract, their careful drafting and/or review is of utmost importance to safeguard the interest of the parties.
Section E - Are all important terms carefully inserted in the contract?
1. Apart from the boilerplate clauses, there are various other terms which require deep introspection and interpretation. It is already discussed above how international contracts require certain additional terms. The purpose and the nature of the contract determine the terms essentials for that contract (refer to Section B 1. for examples).
2. The terms of the contract shall be clear with regard to:
a. Parties: Name and complete address of the parties.
b. Duration of the contract: Whether the contract is for a fixed term, or is renewable. If renewable, then how many times and for how many years in each time.
c. Payment of price: Whether it is contingent on delivery of goods/services or a particular date. The payment has to be one time or in installments? Payment to be made in which currency and mode i.e. by check, cash, draft, account transfer etc. For contracts related to complex or huge projects, it is advisable not to enter into fixed-price contracts because there are greater chances of hold, delay, fluctuation in prices of construction materials etc., and so, such unforeseen circumstances shall be taken care of.
d. Defect removal: In case one party fails to perform an obligation under the contract, is there any time provided for defect removal or rectification?
e. Payment of interest: If the work is not completed on time or the payment is not made in time, is there a provision for payment of interest on such defaulted amount? In construction or building contracts, there is usually a provision that where a customer defaults on payment of any installment or where the builder does not give possession to the customer on time, an interest provision is inserted to deal with such defaults.
f. Intellectual property: What is licensed, and to what extent? The purpose of such license, and the remedy in case of infringement?
g. Confidentiality: What is confidential, and what is not-confidential?
h. Territorial restriction: Is there any restriction as to the area for the operation of the contract? If yes, then the duration and exceptions, if any?
i. Implied and express warranties: Which party is responsible for what? This includes the obligation of any party to pay any taxes, fines etc. arising out of the contract.
3. Thus, it is important that all relevant terms suitable to the particular contract shall be included and constructed in a way so as to facilitate the purpose of the contract and the smooth completion of its performance by the parties.
Section F - The construction of the contract – whether lengthy, bulky, or difficult to understand?
1. A contract shall be clear, unambiguous, clean, and easy to read and understand.
2. It shall not be too bulky unless required for the need of a particular industry. For example: Hospitality related contracts and Government contracts are usually lengthy and bulky. An effort shall be made to see that the length of the contract does not kill the purpose of the contract.
3. The contract shall be to the point and unnecessary references or language shall be avoided, but it shall be structured in such a way so as to give solutions for all issues arising out of the transaction.
4. There shall not be repetitions in a contract. At the same time, the language of the terms shall not contradict each other. For example: A contract shall not have an arbitration clause along with another clause which gives exclusive rights to a civil court to exercise its jurisdiction over all disputes arising out of the contract.
5. The contract shall be adequately titled so as to give the reader a preliminary sense of the object of the agreement. For example: Confidentiality Agreement, License Agreement, Technical Services Agreement, Arbitration Agreement, Hotel Operating Agreement etc.
6. As far as possible, the terms in a contract shall be adequately and appropriately titled and also numbered into sections and sub-sections, articles and sub-articles, or just plain numbers and sub-numbers. This will help the parties not only to identify the clauses with their titles, but also to refer them with the help of their numbering.
7. Special caution shall be taken in using defined terms, and undefined words shall not be inserted in capital letters.
8. Every contract shall go under proof-reading and/or review by an expert before final execution.
Section G - Is there a correct arbitration clause in the contract?
1. In today’s world, almost all contracts include a clause to refer the disputes to an arbitrator for adjudication. The idea behind such an inclination is to avoid the substantive rules, processes and delay involved in courts. The arbitration provision not only provides an effective, binding and efficacious remedy to the parties but even gives them freedom to decide on the appointment of the arbitrator, location of arbitration, law (rules) to follow, and the say in arbitral proceedings. So, it is equally important to draft and/or review the arbitration clause in its true perspective.
2. The arbitration clause shall be constructed in such a way that it reflects a clear intention to settle disputes by means of arbitration. As per Indian law on arbitration (5), an arbitration clause which forms part of the contract is treated as an agreement independent of the other terms of the contract i.e. it survives even if the contract frustrates or expires, and so, the arbitration clause shall in itself be sufficient to answer all questions with regard to the institution of arbitration.
3. The arbitration clause shall clearly provide the composition of the arbitral tribunal (6), the time for appointment, the location of arbitration, the language in which arbitral proceedings will be conducted, and the arbitration law that shall be followed by the arbitral tribunal.
4. There shall be a clear reference of disputes to arbitration. It shall be noted that the use of phrases "disputes under the contract" and "disputes arising out of the contract" will change the scope of the arbitration. The earlier will limit the scope whereas the latter will increase the scope to include all disputes arising out of the contract.
5. Special care shall be taken while using any word or phrase in the arbitration clause. Use of phrases "unless otherwise provided in the contract" and "except where otherwise provided in the contract" shall be effectively used where the intention is to limit the applicability of arbitration.
6. The arbitration clause shall use such language which envisages the claims that are arbitral. Criminal matters, fines and custodial sentences are some claims that are out of the arbitral claims. Thus, the arbitration clause shall be drafted and/or reviewed in the light of the intention of the parties for reference of disputes. It shall be complete and not evasive
To conclude, a carefully drafted and/or reviewed contract not only saves substantial manpower and hours but even results in the growth of the corporates. A contract is a mirror of the corporates’ horizon, modernity, awareness and its interest in the economy and fulfillment of the trade. A corporate shall never hesitate to approach or rope in experts to draft and/or review all of their contracts and negotiations. Some investment in contract management has the potential to save lot of money and embarrassment, and assure lot of protection and advancement to corporates.
|SIDDHARTH SANGAL is a Corporate Counsel and Attorney, Supreme Court of India.
|(1) GAFTA: The Grain and Feed Trade Association (GAFTA) is a London based trade organization consisting of professionals, operators, traders and transporters in the international grain trade; FOSFA: The Federation of Oils, Seeds and Fats Associations (FOSFA) is a professional international contract issuing and arbitral body concerned exclusively with the world trade in oilseeds, oils and fats with over 960 members in 78 countries. These members include producers and processors, shippers and dealers, traders, brokers and agents, superintendents, analysts, ship-owners, and others providing services to traders; Incoterms: Export transactions generally involve international sales contracts, whose clarity of terms is crucial to avoiding disputes between parties. To ensure consistent interpretation, the International Chamber of Commerce created a set of standard trade "Incoterms". Incoterms cover "Who does what / who pays for what / when risk in the goods passes from seller to buyer/when delivery occurs, as well as issues such as insurance, export and import clearance and the division of other costs pertaining to the delivery of goods".
(2) Refer to section 26 of the Indian Contract Act, 1872.
(3) Refer to section 27 of the Indian Contract Act, 1872.
(4) Refer to section 53 of The Transfer of Property Act, 1882.
(5) Refer to section 16 (a) of the Arbitration and Conciliation Act, 1996.
(6) Refer to section 10 Arbitration and Conciliation Act, 1996. The number of arbitrators shall not be an even number.