Properly reviewing a contract can save you a lot of money and frustration. So why do businesses and consumers treat contract review as an afterthought? Many do not understand the importance of reviewing business contracts. They believe that a simple handshake deal is good enough. Understanding contracts and their terms can make this process a lot more bearable.
This article will examine the core terms every business owner and executive should understand when reviewing a contract.
Note: This article is not a substitute for legal advice. This article only intends to inform the reader about some key terms in an agreement. Please contact an attorney if you have legal questions about negotiating or drafting a contract.
Understanding Commercial Terms
Commercial terms are arguably the most vital aspect of reviewing a contract. These terms dictate the “who, what, when, where,” and “how” of the agreement. Commercial terms are the backbone of the deal and are one of the first items reviewed when a dispute arises. Some of the key terms to be aware of include:
Pricing
This clause determines how much the product or service will cost. One consideration is whether the price will be paid in a lump sum or through installments. The pricing section can be as straightforward or as complex as needed. In some contracts, pricing may vary based on factors such as taxes or the cost of materials. Pricing clauses will sometimes contain language that adjusts pricing in the future as well.
Key Takeaway: Pricing terms not only discuss the price, but how payment will be made.
Invoices
The language that discusses how invoices and billing will be handled must be clear to minimize disputes. How long from receiving an invoice does a party have to pay? When is the invoice deemed received? How should disputes about an invoice be handled? These are all critical questions when reviewing invoice and billing terms.
Key Takeaway: Invoice terms provide guidance for billing disputes.
Shipping
If the contract is for products, how will they be delivered to the buyer? Who is responsible for arranging shipping? When is the shipment supposed to take place? Shipping provisions will often include Incoterms® such as Free On Board (FOB) or Free Carrier (FCA). It’s important to understand shipping terms so the parties know when and where the liability for handling the products has transferred from the seller to the buyer.
Key Takeaway: Shipping provisions determine who is responsible for shipping and where the destination will be.
Performance
A services agreement will detail where, when, and how the services will be performed. The scope of work is important so the contractor and the customer are on the same page about what needs to be done. In many contracts, milestones may also be included to gauge progress on the work. How to handle changes in work orders is another common topic.
Key Takeaway: Performance terms let the parties know how the work will be performed.
Term
A contract’s “term” provision explains how long the agreement will last. While some contracts have a set termination date, others may last indefinitely. Either way, this is an important item to cover in a contract. A dispute will likely arise if the parties have different thoughts on when the contract should end. If the parties want to be able to extend the contract, the mechanism for doing so needs to be communicated.
Key Takeaway: The Term provision sets the length of the contract.
Legal Terms
The most hated language in a contract tends to be the legal terms. These are the terms that people think are unnecessary or a trap. In reality, legal terms are usually included to provide clear rights and responsibilities for the parties. For example, a force majeure clause may feel unnecessary until a Hurricane causes the work to stop for a week.
Confidentiality
Most companies are protective of their operations. But doing business with others often means that information about how they do things must be revealed. We’ve discussed how an NDA or a confidentiality agreement offers some protection. Confidentiality provisions limit how confidential information can be used and shared. Note, however, that if the clause is too broad or vague, it might not be enforceable.
Key Takeaway: Confidentiality clauses lets the parties know what topics must be kept secret.
Force Majeure
If COVID taught us anything, it was to expect the unexpected. I’ve personally had contracts interrupted by floods, pandemics, and more. The force majeure clause is a way to excuse non-performance caused by factors beyond the party’s control. One thing to keep in mind is that this clause is often one-sided. For example, when the supplier is excused, but the buyer is still on the hook to pay.
Key Takeaway: Force Majeure clauses describe what happens to the agreement when disaster strikes.
Indemnification
This clause is a safety net if something goes wrong because of the other party’s actions. It lays out who is responsible for covering any damages, losses, or legal fees that might occur if a third party files a claim related to the work or the product.
For example, a tenant hires a contractor to install equipment in its office. The contractor makes a mistake and ends up causing damage. If the indemnification clause is solid, the tenant can hold the contractor responsible for fixing or compensating it for the damage.
However, parties must be cautious about how the indemnification is worded. Sometimes, these clauses can be sneaky. I have reviewed plenty of indemnification clauses that require one party to indemnify against the other party’s negligence! It’s common for a party to request that such indemnifications be mutual.
Key Takeaway: Indemnification clauses establish who is liable in certain situations.
Forum Selection and Choice of Laws
Many agreements will have forum selection and choice of law clauses.
Forum Selection: In the event of a dispute, this clause designates which courts would be the proper venue for the lawsuit. For example, if the forum selection clause states that the venue will be in Harris County, Texas. Then, a lawsuit related to the agreement would likely need to be filed in Harris County. Note that there are rare circumstances where forum selection will be overruled.
Choice of Laws: This provision allows the parties to dictate which state’s (or country’s) laws will apply to the agreement. So, let’s say the agreement states that it is subject to Texas law. In a breach of contract claim, the parties would use Texas law to determine if a breach occurred. Note that, like forum selection clauses, this provision can be set aside under particular (again, rare) circumstances.
Choice of laws and forum selection clauses are related but serve distinct purposes. In theory, you could have a forum selection clause different from the jurisdiction in the choice of laws provision. In practice, they are almost always in the same jurisdiction.
Key Takeaway: Forum selection and choice of laws allow parties to choose the applicable laws and jurisdiction.
Alternative Dispute Resolution (Arbitration or Mediation)
It’s no secret that litigation can require a lot of time, money, and patience. It’s no wonder that parties are increasingly looking at alternatives to litigation, such as mediation or arbitration. While these can be valuable tools, it is crucial to understand what they consist of and their limitations.
Mediation: This involves a neutral third party (the mediator) who will listen to both sides of the dispute. The mediator works with the parties to try to settle the dispute. Unlike an arbitrator, the mediator’s opinion is not binding until agreed to by the parties in a settlement agreement. Mediation tends to be more affordable and less contentious than litigation. The biggest drawback, however, is that there is no guarantee the parties will settle. Sometimes, they are just too far apart.
Arbitration: This is much more like a trial than mediation. The arbitrator (sometimes a panel of multiple arbitrators) will listen to arguments and review evidence related to the dispute. The panel will then render a binding judgment called an “award.” While arbitration can be cheaper than a trial, this is not always true. Costs can add up quickly, especially if much evidence or testimony is involved.
Arbitration and mediation can be a great alternative to trial under the right circumstances. However, parties would be wise to understand these options well before requiring them in an agreement.
Key Takeaway: Alternative Dispute Resolution clauses provide an alternative to litigation.
Breach
This clause details what will constitute a breach of the agreement. Sometimes, this provision outlines the difference between a material and a minor breach. Material breaches are typically a significant violation of the terms. Minor breaches, on the other hand, are usually much less significant. Many agreements offer a “cure” period where a party that commits a breach can remedy the breach. Like the indemnification provision, this clause is often very one-sided. This is especially true in leases.
Key Takeaway: Breach provisions outline what happens when someone breaks the agreement.
Reviewing a Contract Shouldn’t Be an Afterthought
I understand that companies don’t like to get bogged down in negotiating the language of a contract. In an ideal world, the parties would get the deal going as soon as possible, and everything would run smoothly. Unfortunately, sometimes the unexpected happens. The importance of reviewing business contracts cannot be stressed enough. Reviewing a contract carefully can help companies avoid serious headaches down the road. Having an understanding of the fundamental terms can make this much more manageable.
Of course, going it alone when negotiating a contract can be difficult. When in doubt, talk to an attorney.