November 1, 2013

Decoding Legal Mumbo Jumbo

Why it’s so important to understand contracts


I often hear businesspeople refer to standard contract terms as “legal mumbo jumbo.” They grumble that certain terms are “just legalese” and are either unimportant or too difficult to decipher. Not so.

It is becoming increasingly common for vendors and customers to insist on preprinted or standardized contract terms. So this is a perfect opportunity for a very brief primer on contract language. 

Every clause and phrase in a standard, preprinted or custom-written contract is included for a reason. If you are not the drafter of those terms, it’s appropriate to assume they are probably not very favorable to you. 

Before we look at some important clauses you will find in most commercial contracts, it’s important to understand what a legally enforceable contract is. Such a document must meet four requirements: 

  1. The contracting parties have reached a mutual agreement on a valid offer; 
  2. The contracting parties are of age and sound mind—not usually an issue in a commercial contract; 
  3. The object or purpose of the contract is a lawful one (this too is not usually an issue, unless the contract contains clauses that violate other laws, like antitrust laws); and 
  4. The contract is supported by some consideration, meaning that each party promises to give up something it otherwise was not obligated to give up. (On this point, however, the courts will not normally inquire into whether a contract is financially fair to the parties involved.)

Courts generally will enforce any contract that meets these four basic requirements. The actual terms of the contract usually cannot be an issue. For example, the parties may agree for the purposes of a contract that “cats” will be defined as “dogs.” The issue will be whether those terms have been broken—whether one party has refused to call those cats “dogs.” 

One of the beauties of commercial contracts—or perils, depending on your point of view—is that the parties can voluntarily agree to any term or condition as long as the object or purpose of such a term is lawful. As a result, the parties have a great deal of freedom to define the scope of the obligations and responsibilities. 

For an unsuspecting party, the downside is that routine rules of commercial engagement (e.g., the usual credit or delivery terms) are trumped or superseded by any additional, more precise contract language. It may be industry custom to deliver a product in a certain way, for instance, but if the contract specifies a different way, that becomes the new rule for that business transaction.  

So it is crucial for each contracting party to understand every clause, or to find someone who does. 

Consider some classic examples of boilerplate clauses that have very defined and potentially harmful consequences:

The Choice of Forum Provision

Parties have the right to sue if there is a breach of contract. However, some parties figure that courts in certain districts, especially those in their home state, may be more favorable to them. It is therefore very important to make sure you are comfortable with a contract’s designated forum, or prepare to be stuck without a choice if you end up in court.

The Arbitration Provision

While arbitration—settling a matter outside of litigation—may be viewed as quicker and cheaper (though this is not always the case), it takes a jury out of the dispute. In addition, many perceive that arbitrators often “split the baby,” so even if one party has a solid case, it may be difficult to receive all that is asked for in the arbitration demand. Finally, you generally can’t appeal arbitration, and its rules of evidence are much different and looser than in standard court proceedings. So if an arbitrator issues a finding that misstates the law or the facts, it probably will still stand.

Liquidated Damages Provisions

With these clauses, the parties agree upfront what the damages will be from a breach of contract. But when they are decided before any potential dispute, the damages may be substantially smaller than what could have been received without such a clause.

Fee-Shifting Provisions

Typically in the United States, the “loser” does not pay the winning party’s litigation costs and attorneys’ fees. But contract terms can try to inflict the payment of attorneys’ fees on the loser as an added penalty. 

Consequential Damages

Ordinarily, the party that breaks the contract is required to pay damages, including any that are “reasonably foreseeable” from the breach. Yet many would prefer not to pay for such damages, which, for example, would include lost potential profits on the sale of the product that was not tendered under the contract terms. A “no consequential damages” provision eliminates that possibility. Just as important, this kind of damage limitation can encourage one party to break the contract, or pay little attention to it, knowing that the damage exposure has been minimized or eliminated. 

These are just a few of the many terms and conditions that can be included in standard commercial contracts. Those who do not write the contract, or do not retain counsel to explain the ramifications of its terms, must realize that, once they sign the contract, they are generally stuck with it. The lesson: No one should sign a document he or she doesn’t understand.  

When the other side refuses to negotiate terms, you have a choice. But at least with proper analysis you can be aware of potentially onerous terms and then behave with appropriate caution during the life of the contract.

Mark McCareins is a senior partner at Winston and Strawn LLP, based in Chicago, Illinois, and serves as general counsel of MSCI. He also is a senior lecturer in business and antitrust law at Northwestern University’s Kellogg Graduate School of Management.