Ten bad business contract decisions Featured

8:00pm EDT August 26, 2007

Business contracts often fail to include specific terms that provide basic, fair protection to all parties involved. As a result, businesses expose themselves to unnecessary disputes that, even if they win, leave them less than whole. Including sensible protections will help the parties to a business contract avoid disputes, or shorten litigation should it arise.

Smart Business spoke with Neil Kenton “Ken” Alexander, a partner of Porter & Hedges LLP, to identify the most common shortcomings in business contracts.

What are the most frequent shortcomings in business contracts?

My top ten list includes: no default interest rate; no provision for attorneys’ fees and litigation expenses; reliance on oral agreements; no notice of claim provisions; inadequate dispute resolution provisions; poorly drafted insurance and indemnity obligations; absence of proper warranties; no well-considered damage limitations; failure to conduct a risk assessment; no qualification of contract counterparties. These defects appear often in everything from insurance policies to supply and service agreements to construction contracts.

What is the impact of these shortcomings?

Without proper provisions for interest rates on default, attorneys’ fees and litigation expenses, well-crafted insurance and indemnity obligations, and warranties, it is practically guaranteed that a business owner will be exposed to risks it did not want, or will not be kept whole if the contract counterparty breaches. If the contract is signed without good notice of claim or dispute resolution provisions, or without applying proper risk assessment or qualification of the parties, the innocent business owner may be drawn into an expensive, time-consuming legal battle.

Why are these defects so common?

Business people sometimes rely on contracts provided by a trade association, an industry group, a customer, supplier, or even a competitor that are not well-tailored to the situation. A big reason is complacency. Sometimes business owners focus on the good things they expect from a transaction, but do not carefully consider the bad things that may cost far more than the revenue from the contract. They get lulled to sleep by repeat business, or assume that a standard contract protects their interests.

How can business owners make sure their contracts protect their interests?

Two important steps happen before you ever speak to an attorney. First, consider the real-world risks that the contract poses for all parties, not just you. If it places a risk on a party who does not understand it, or cannot manage or insure it, the result likely is nonperformance and maybe a nasty lawsuit. Second, contracts rarely really fully protect you from a dishonest, incompetent, or under-financed contract counter-party, so qualification of the companies with which you do business is essential.

I recommend specifying an interest rate on past-due sums, because the law provides for interest substantially below what most business people regard as sufficient to cover the real cost and risk of delayed payment.

What contract matters especially deserve review by counsel?

Here are some key examples. Courts almost never award attorneys’ fees to the successful defendant, unless the contract says so. In other words, if the other contract party brings a meritless lawsuit against your company, you do not recover your attorneys’ fees. A more level playing field is created in many situations if the contract provides that the prevailing party will recover attorneys’ fees. There are also many other expenses of litigation that are not recoverable unless the contract says so.

I encourage my clients to think through whether they want their contracts to be subject to arbitration, jury trial, bench trial, or mandatory mediation. Arbitration is good for some contracts; it is lousy for others. If you pick arbitration, have some well-considered specifics about the kind of arbitration you want.

Lots of contracts that I see in litigation, especially standard form contracts, have poorly drafted insurance and indemnity provisions. Indemnity provisions are often under-inclusive, over-inclusive, unenforceable, or downright incomprehensible. If you cannot figure out what it means, do not expect a court interpretation that you will like. Indemnity and insurance provisions are not one size fits all.

Your contracts need to contemplate what damages each party is really on the hook for. Lost profits? Costs of delay? Only outof-pocket costs?

Lawyers are like doctors. A checkup with one who is qualified to deliver preventive care is vastly cheaper than dealing with a problem through surgery or litigation. Good counsel sophisticated in these matters will help you create contracts that make all parties happier and lower litigation risks. If you fear involving counsel will make negotiating a good deal with the other party more difficult, maybe it is time to look for new counsel.

NEIL KENTON ALEXANDER is a partner with Porter Hedges LLP. Reach him at kalexander@porterhedges.com. or (713) 226-6614.