If you have an agreement to do or not do something, and something of some value has been given in exchange for it, then you likely have a contract. Given the dense legalese used in many contracts, they can feel as clear as mud on an initial reading. As a result, you often may not learn about major exposures for your organization in these agreements until something goes wrong. While you may have legal recourse against the other party at that point, you could spend tens of thousands of dollars litigating an uncertain outcome. Instead, you should take the time up front to better understand and identify the pitfalls hidden in your contract. Then, work with the other side to proactively balance those out before moving forward.
In its simplest form, the contract review process involves thoroughly reading and understanding the contract in order to: 1) ensure all required business terms are present and accurate; and 2) identify and address loopholes and pitfalls to make sure you are protected once the contract is signed. Overall, the process is designed to make sure that the contracts you enter into are fair to both parties.
Unfortunately, avoiding loopholes can be trickier than it sounds as attorneys do not typically prepare contracts with empathy for the contracting parties on the other side. To the contrary, they are engaged by their clients to prepare contracts that are largely designed to protect their own interests. In the end, the contract form will likely contain one-sided clauses with a cornucopia of boilerplate language written in legalese, resulting in a business relationship that is anything but fair.
The following list outlines 12 key areas of significant risk in a contract and some of the main pitfalls you should watch for. This can help form the starting point of a thorough contract review process, reducing risk in your third-party and vendor relationships down the road.
1. Term Length
Look out for excessive or undefined term lengths. Contracts typically should not last forever, so it is important to make sure there is a clearly defined bookend in place stipulating how long the contract is intended to be in effect. Renewal provisions are often included, and you should make sure you understand these to avoid being unnecessarily locked into a contract you want to escape.
2. Prices and Quantities
Are the pricing and/or quantity terms transparent? It is important that the prices and quantities of goods and services being provided are spelled out in the contract. One side should not have the ability to raise or lower prices or quantities absent some countervailing check or consent from the other side. In addition, if the contract language points to prices and quantities found in an attached exhibit or schedule, make sure the exhibit or schedule exists. If it does not, make sure one is added.
3. Unilateral Powers
Following from the first two items, one party may be allowed to unilaterally terminate the contract or increase prices automatically. There are plenty of other areas in the contract where unilateral powers may exist, and these should be quickly identified, assessed and balanced to avoid undertaking unnecessary risks in the business relationship.
4. Invoicing and Payment
Review whether your contract requires payment “upon receipt of invoice” or “within X days of the invoice date,” especially if interest and late payment penalties are included in the payment terms. The former means your payment is immediately due, so what happens if your accounts payable department issues payments on a biweekly or other basis? With the latter, consider that you may not actually receive the invoice until well after the deadline for reasons out of your control. To fix this issue, consider revising the language to “within X days of receipt of the invoice.”
5. Risk of Loss
For a product purchaser or supplier, risk of loss is especially important. What is the specific delivery point being contemplated by the parties? Pay attention, as you may be blindsided by cost allocation and risk of loss of the goods being shifted to you at the wrong place while in transit. Risk of loss provisions may be hidden in the fine print in standard vendor or customer terms, so make sure to include these as part of the contract review process.
6. Representations and Warranties
Some contractual counterparts are required to provide assurances that the products or services being provided will comply with applicable laws and industry standards, among other things. However, beware of one-sided or overbroad guarantees, representations and/or warranties that are included in the contract. For example, is the contract requiring you to guarantee 100% on-time deliveries? If so, and this is something you cannot possibly accomplish, then you should revise this language.
7. Audit and Inspection Rights
While publicly held businesses have legal obligations to disclose certain financial and other information, most privately held businesses have no such compliance requirements. However, your contract may allow the other side unfettered access to audit and inspect your financial and accounting records on a regular basis, and to conduct regular inspections of your facilities. You may not be comfortable extending such expansive rights, so remove or dilute these rights as necessary.
8. Confidentiality
During the course of your contract, you may wind up providing certain confidential business information to the other side. For example, if you are supplying goods, you may have certain patents, trademarks, trade secrets and other protectable interests that could potentially be compromised without some sort of protection. However, your contract may not contain any such provision or requirement, or worse yet, the confidentiality requirements may be non-mutual and only protect the other side’s information. Make sure your confidentiality interests are adequately protected.
9. Insurance Requirements
Hopefully, you have purchased insurance to protect your business in the event of loss. Those insurance premiums are not cheap, and there may be business reasons that led you to purchase the levels of insurance that you did. The contract you signed may require you to procure even more insurance, and at levels that may ultimately be cost-prohibitive relative to the business relationship. Push back on any onerous or impossible insurance requirements, and be sure to negotiate these requirements prior to signing.
10. Indemnification
Let’s say your business counterpart does something wrong while performing its obligations under the contract, and an affected third-party winds up suing you as a result. Your first instinct would be to tender that claim to the counterpart, requiring that you be indemnified for any losses incurred. That is, until you discover your contract only has one-sided indemnification language—i.e., you are required to pay the other side’s losses to the extent of third-party claims arising out of your wrongdoing, but the other side has no such obligation. Any indemnification obligations in a contract should be mutual and balanced.
11. Limitation of Damages
If you purchase products from a supplier under an ongoing contract for resale to your customers and those products somehow fail or are otherwise compromised, your customers may seek recourse against you, or they may stop doing business with you altogether. You may have claims against the supplier under the contract for at least some of these losses. However, limitation of damages language in the contract may cap the supplier’s overall exposure at some nominal sum that does not come anywhere close to compensating you for such losses. Identify and negotiate such language in your contracts prior to any claims materializing.
12. Dispute Resolution
No one enters into a contract with the goal of getting into litigation. It does happen, however, and in the event that legal action needs to be taken, the contract will typically stipulate where a lawsuit must be filed. You may find yourself blindsided by having to pursue recovery against the other side in their own backyard three time zones away, in a jurisdiction that may not be as favorable to your interests. Dispute resolution provisions can vary widely across contract scenarios, even incorporating mediation and arbitration in lieu of litigation. Your contract should align with your appetite and expectations in the event of a potential breach by the other side.