United States: Top Ten Mistakes When Drafting And Negotiating Contracts

Commercial litigation often occurs as a result of common and recurring mistakes that are made during the drafting and negotiation of contracts. As litigators and transactional attorneys, we (and our clients) often wish that we could turn-back-the-clock so that a provision or two could be added to resolve a contractual problem. Such daydreaming is particularly painful because commercial disputes frequently result in protracted and costly litigation.

Businesses that are conscious of the following top ten mistakes and seek to avoid making them will be less likely to face litigation. If suits are filed, the avoidance of these mistakes will enhance the likelihood of a favorable verdict or settlement.

Perhaps the most fundamental mistake made by businesses is failing to adequately investigate the persons or entities with whom a business intends to enter a contractual relationship. While most companies analyze whether a proposed deal is financially advantageous, a surprising number fail to adequately study their proposed business partners. Such investigations are important because they can provide early warning signs about the desirability of a proposed business partner, the likelihood that contractual obligations will be met and whether litigation is likely if disputes arise.

Pre-contract investigation should, at a minimum, include a credit search to determine the financial viability of a proposed partner and a litigation search, which may indicate how litigious the proposed business partner is, the nature and types of its past legal disputes and the likelihood of litigation if problems arise.

A litigation search should do more than merely identify the number of suits involving a potential business partner. It should focus on the nature and type of conduct that led to the litigation as well as the nature and reasonableness of the positions taken in the litigation. If your proposed partner has been difficult and unreasonable in the past, it may be a good indication of future conduct. Most contentious commercial litigation involves one or more parties who are frequent litigants.

Assuming that a proposed business partner appears to be reliable and reputable, the next step should be to conduct thorough due diligence. In some instances, businesses are so eager to "do the deal" that they perform hasty or inadequate due diligence.

While the pressure to complete a transaction may be so great that companies elect to take "calculated risks," there are real risks to circumventing due diligence. If a deal appears to be too good to be true, the need for due diligence is often even greater.

We realize that in some situations a complete and thorough due diligence is not feasible. For example, in large asset based transactions, it may be impossible or economically impractical to perform a complete investigation. When this occurs, a risk benefit analysis should be performed to decide the scope of due diligence. If thorough due diligence will not be performed, the parties should consider including provisions providing compensation if representations, warranties or other contractual assumptions later prove to be inaccurate.

Given society’s negative view of lawyers and the perceived cost of legal services, it is not surprising that companies often make the mistake of entering contracts without having them reviewed or approved by a lawyer.

The temptation to do so is greater when contracts "seem" simple and straight forward. However, the old adage that "things are rarely as simple as they seem" applies here. In most instances, paying a lawyer to briefly review a contract is an investment that more than pays for itself and, if nothing else, allows a company to identify the risks of proceeding without greater attorney involvement. In situations where companies enter the same type of transaction over and over again, the use and development of form contracts is appropriate as long as those agreements are drafted or approved by a lawyer, its use is not expanded to transactions other than those initially contemplated and the form is occasionally reviewed and evaluated in light of new laws and past performance and enforcement of the contract.

To ensure that contractual intent is achieved, contracts must contain well defined terms and unambiguous provisions.

Whenever a party seeks to avoid contractual obligations, their primary strategy is to identify contractual ambiguities. While it is impossible to entirely eliminate the risk that a party will assert that ambiguities exist, careful drafting avoids creating loopholes and increases the likelihood that contracts will be fulfilled and construed as intended.

While identifying the state law that will be used to construe a contract may seem formalistic and unnecessary, the failure to do so is a major mistake that can make contractual disputes more difficult and expensive to resolve.

Where contracts either involve parties from different states or interstate performance, the law used to govern and construe a contract may be uncertain. If litigation occurs and there is no choice of law provision, motion practice will probably occur involving a complex and highly fact specific interest analysis, which is often expensive and is particularly frustrating because the inclusion of such provisions is often uncontroversial.

In many instances, laws that can have a major impact on contractual interpretation vary from state to state and some jurisdictions have laws that, for public policy reasons, do not enforce certain types of contracts. For example, in Pennsylvania, agreements to indemnify and defend against "any and all claims" will not be construed to include a duty to indemnify and defend a party from their own negligence or culpable conduct. Similarly, in other states, a provision requiring a buyer to pay the legal fees of a seller prevailing in litigation is construed as also requiring the seller to pay the attorney’s fee of a successful buyer litigant. Parties who are unfamiliar with the laws selected to govern their contracts may be surprised to find out that their intent cannot be achieved due to the applicable law.

Inclusion of a choice of law provision should not be a knee jerk decision to merely identify the law of the home state. Instead, the choice of law decision should be made after considering both the contractual intent and the proposed jurisdiction’s laws.

In some instances, companies are reluctant to raise issues like defaults, opportunities to cure and termination because they worry that doing so will cause their business partners to have second thoughts about entering the contract. However, these types of provisions are important ways to promote performance and avoid litigation. If notice of potential breaches and opportunities to cure are required, parties that might otherwise litigate are forced to attempt to work out their differences.

Another important benefit of these provisions is that they can require alleged contractual breaches to be raised and addressed when they first arise and not after problems fester and damages escalate.

Contracts should also include provisions that define how long an agreement will remain in force and how and when the agreement might be renewed or terminated. An early termination provision is often desirable so there is an escape route if undesirable circumstances occur. Absent such provisions, a business unhappy with contractual performance will have little or no other recourse and could conceivably be forced to live with a contract that fails to achieve its goals.

Potential business partners should also specify the damages that can be awarded if material breaches occur.

Some business partners may be unwilling to assume the risk of certain damages. When this occurs, parties can include provisions either limiting recovery to a certain dollar amount (which sometimes can be the contract price), or barring collection of certain damages, e.g. consequential.

These clauses help insure that companies do not assume unnecessary risks or liabilities. Moreover, by limiting possible damage recoveries, these clauses may reduce the risk of litigation.

The parties should also limit evidence that can be used to construe a contract and the circumstances under which an agreement can be changed after execution. Typically, provisions are included stating that the written contract is a final expression of the parties and that the agreement supersedes all other prior communications and understandings and that any modifications must be by a written and signed amendment.

These provisions make it more difficult to argue that there were side agreements or other understandings. Moreover, such provisions make it harder to argue that agreements were later modified by subsequent performance or conduct.

Parties entering contracts should also consider and address where and how disputes will be resolved. First, they should decide if disputes will be litigated in court or in some alternative forum such as arbitration. They should also decide where a case or dispute will be tried or arbitrated, which can be important particularly when the contracting parties are located far away from each other. A party with the "home court advantage" may not only be more likely to prevail, but also will likely have to spend less to prosecute or defend its case. Another consideration is that a potential litigant who will be forced to travel great distances may be less inclined to insist that disputes be adjudicated.

The final and often most serious mistake that businesses make is that they merely file a contract in a cabinet and then proceed to "do business." Having gone through the time and effort to draft and negotiate a detailed agreement establishing their rights and obligations, companies too often ignore the contract and only consult it when severe problems arise. By failing to establish procedures to monitor performance, companies may unwittingly breach their contracts or may waive the right to insist that their business partners fulfill their obligations.

Executed contracts should be forwarded to the managers and employees responsible for performance. Similarly, individuals should be assigned to insure that their business partners fulfill their responsibilities. These people should understand the agreement and should be explicitly told what to do if problems arise. If personnel changes occur, companies should have procedures to insure that the new managers or employees are similarly educated about the contract. Finally, companies should verify that its managers and employees are fulfilling the requirements of the contract. It is often not enough to merely send a detailed letter or memorandum establishing procedures. Instead, companies should regularly check to insure that protocols are followed. Needless to say, companies that establish and later ignore their own internal audit procedures will face difficult problems when litigation ensues.

When parties enter contracts, they expect that their goals will be achieved. That expectation alone is not likely to be achieved if companies rely solely upon the cooperative spirit that often exists at the onset of a relationship. Instead, agreements should fully reflect their expectations and the common mistakes set forth above should be avoided. If this occurs, it is less likely that parties will find themselves involved in commercial litigation.

David Ira Rosenbaum is a partner at the law firm of Rawle & Henderson LLP in the Philadelphia office and is the Chair of the Commercial Litigation and Transactions Practice Group. David has extensive experience litigating complex product liability and commercial matters and holds an appointment of Adjunct Professor of Law at Temple University's School of Law.

David regularly represents corporate clients in both transactions and complex commercial litigation involving breach of contract, restrictive covenants, commercial mortgages/ personal guarantees and copyright/ trademark violations.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.