The Legal Side

Category: Government & Law
Published: July 2007

Learn about the importance proper contracts play in protecting you and your business.

In prior issues we discussed which form of business entity may be best for your company, how to develop a winning business plan, how to get financing, insurance issues, strategies to protect your company from business exposures and liabilities. Now lets talk about some basic contract principles which you will need to know.

Contracts define the relationship between the parties doing business. While an oral agreement can constitute a contract, the Uniform Commercial Code provides that a contract for the sale of goods over five hundred dollars is not enforceable unless there is some writing sufficient to indicate a contract between the parties (UCC 2-201[1]). This is often referred to as the "statute of frauds". As between merchants, the requirement can be satisfied if within a reasonable time a writing and confirmation of a contract is received and the party receiving it has reason to know of its contents and does not object within ten (10) days. Often times parties feel that there are other "understandings" between the parties which were part of the agreement. The Parole Evidence Rule (UCC 2-202) holds that a contract will be interpreted as the final expression of the agreement between the parties and may not be contradicted by evidence of any other agreement or understanding. Courts may allow the evidence of consistent additional terms based upon a course of dealing or usage of trade. However, the same cannot contradict or vary the terms of the original writing. The lesson, of course, is that whatever the arrangement, agreement or understanding is negotiated, if it is not set forth in writing, do not expect it to be enforced or to bind the other side.

When entering into the business world, you will be confronted with a host contracts from suppliers and companies with whom you want to do business. Those contracts will have "fine print" terms and conditions riddled throughout the document. They are there for a reason, mainly to limit your rights and remedies. They will be enforced unless the court determines them to be unconscionable, a very high standard. Moreover, you never want to be in the position of being in court and trying to argue unconsionability. Limits on warranties, transfer of risk of loss, limits on remedies for non-performance, interest rates, liquidated damages, advancement of payments, limitations on damages are but a few of the clauses which have to be studied very carefully. Really, you are far better served having an attorney review any kind of substantial contract to explain to you the depth and consequences of all this fine print. Then you have to weigh the risks that you are going to assume: Is it a clause or provision that you can live with or is it overburdensome? What is the likelihood that that clause or provision will actually come into play? What negotiating leverage do I have to modify that clause or provision. Is the benefit that I am going to enjoy by this contract worth the risks that I am undertaking?

As today's business environment becomes more sophisticated, so do the contracts. I was appalled a few months ago when I went to buy my son a bicycle and was presented with a purchase agreement whereby I was being asked to essentially sign away any legal rights or remedies I might have if there was ever an accident or defect with the bicycle. Sorry, but I thought that was just excessive: cannot even buy a bicycle nowadays without it being a big legal matter! I explained my dissatisfaction, left the bicycle at the cash register and went somewhere else. As a business owner, you may have to take the same approach, but you want to do it with cool judgment: weighing the risks, the benefits and the alternatives. Sometimes the benefit of the deal to your company thereby is worth the risk of a contract term that you do not like and cannot negotiate away. Sometimes it is not.

Certain rights and obligations cannot be contracted away. For example, when an owner or contractor gives an exclusive control of the work to a contractor or subcontractor, the common law right of indemnification always remains. There is a general rule that one cannot contractually make another responsible for one's own negligence. One can, however, contract to have another secure the necessary insurance for one's negligence. If you are going to be on someone else's insurance, you will need not only a certificate of insurance, but contract language which will afford you status as an additional insured on a primary and non-contributory basis on the other party's insurance policy. There policy also needs to have an endorsement which allows for the same.

For your own contracts, some clauses to keep in mind would include not only the payment terms but applicable interest and remedies for non-payment. I often recommend that the contract include a clause for binding arbitration which is typically much less complicated, less time consuming, and less expensive then having to go to court to deal with breach of contract issues.

Another consideration is whether you need any type of exclusivity language - granting exclusive rights or privileges. Additionally you may need confidentiality or language protecting your work product. What about failures of performance and remedies for the same? Do you want the contract to be assignable? Often overlooked is the time period for performance and whether time is of the essence. A contract cannot prevent inevitable business disagreements or failures of performance. Rather, it is giving you remedies when the same occurs.

Too often, however, business owners attempt to effectuate their own remedies when a dispute arises. By doing this, they actually may find themselves in breach of contract. An understanding of the Uniform Commercial Code concept of "substantial performance" is pivotal. If someone does not perform as exactly as they should, it does not give the other side the right to simply walk away from the contract. The Uniform Commercial Code may excuse performance where there has been an unforeseen contingency or where the majority of the contractual agreement has indeed been performed. The issue turns on whether the failure of performance goes to the very heart of the agreement or is incidental such that substituted performance (e.g., performing several days late) will be allowed. You cannot simply assume the incidental failures of performance, which can be corrected by substituted performance, automatically entitles you to cancel the contract. The law also imposes a duty of mitigation of damages. This is a concept that if you have been injured or wronged, you cannot simply sit back, do nothing and let the damages continue to tally. For example, if you have a contract to sell a perishable item and the other side breaches that contract, you have a duty to see if you can find another buyer (see UCC 2-703, 2-706). The Uniform Commercial Code does allow for liquidated damages (a set amount agreed upon by the parties in advance) but only an amount which is reasonable in light of the anticipated or actual harm caused by the breach (UCC 2-718). The Uniform Commercial Code allows a party to suspend its performance when the other party demonstrates an inability to perform or an intention not to perform (UCC 2-609). You can then demand adequate insurance of performance before going forward.

The key point is that even if you feel you are aggrieved, you have to be very careful about your response. It is far better to have an early consultation with an attorney to make sure that you are making the right decisions as compared to "self-help" remedies which can cause far more problems.

This article is for illustrative purposes only. You should consult your own attorney in any legal matters.