Many businesses, especially smaller businesses, prepare their own contract forms for day-to-day transactions without the assistance of a lawyer. While this is often good enough for low-risk and low-value transactions, there are many potential pitfalls in this strategy.
From a lawyer’s perspective, the most important purpose of a written contract is to avoid disputes. A buyer and seller can agree by phone to sell a product for a certain price, and this can create a binding contract between them. If they later disagree about what the price was supposed to be, or what the delivery terms were supposed to be, or about losses arising due to a defect in the product, they may end up in court arguing about the terms of their deal, and neither side may be able to prove its position. The terms of a contract may also be of vital interest to a business’s accounting staff, to tax authorities when conducting an audit, or to regulatory authorities when conducting an investigation. A written contract will ideally explain the entire deal as clearly as possible to anyone who reads it.
Inconsistent Usage of Terminology
One of the most common and simple contract drafting errors is inconsistent usage of terminology. In the event of a dispute, any inconsistency creates an opening to argue about the intended meaning of a phrase or sentence. Some of the common mistakes along these lines include:
- Defining terms but using similar terms inconsistently, such as defining “this Agreement” and then referring to “this contract” or “the agreement created hereby.”
- Using terms such as “will,” “shall,” and “must” inconsistently.
- Failing to define potentially ambiguous terms such as “taxes,” “laws,” “intellectual property,” and “force majeure.”
- Using Incoterms without a reference to a specific version (or any version) of Incoterms.
Unclear Conditions and Procedures
A commercial transaction typically has certain defined steps. In the sale of a product, for example, there is typically payment, delivery, inspection, transfer of title, and after-service. Many contracts fail to clearly define how these steps impact each other, such as:
- Does the seller have to deliver if the buyer doesn’t pay, or vice versa? (Is delivery conditional upon payment, or is payment conditional upon delivery?)
- Does the product have to pass inspection before the buyer pays?
- When does title and risk of loss transfer?
- When does payment become final and non-refundable?
- Does a party have to do anything before claiming damages, claiming relief from liability, or commencing a lawsuit?
- Can the terms of the deal be changed while it is in progress?
Vague Quality/Performance Standards
Many contracts provide vague standards, or no standards, for quality of products or performance of services. For example:
- In one case well-known to American law students, two companies landed in court over a dispute over the meaning of the word “chicken,” and one party ended up with poorer-quality chicken than it initially bargained for.
- During the 2020 coronavirus pandemic, many institutions rushed to order large quantities of surgical masks from China, only to discover that many masks failed to meet basic quality standards.
- Many service contracts do not include clear standards for availability or response time, which may mean that customers are unable to recoup their losses when their provider has an outage.
Lawyers usually do not have enough technical or commercial knowledge to draft product and service specifications by themselves. Getting these “right” often requires coordination between lawyers and subject matter experts.
Indemnities and Liability Caps
Indemnities are extremely useful tools for allocating various kinds of risks among the parties to a contract, such as personal injury, IP infringement, and compliance violations. Liability limitations and caps are also extremely useful tools for limiting parties’ risks. However, these clauses often don’t play well in combination with each other. Common issues include:
- Providing an overlapping or inconsistent jumble of indemnities. For example, if seller indemnifies for product liability, and buyer indemnifies for personal injury to its employees, what about personal injury to an employee caused by the product?
- Providing an indemnity without securing the ability to control defense of the claim.
- Making an indemnity subject to a liability cap (this often makes the indemnity worthless if the liability cap is very low).
- Using a liability cap based on contract value when the contract value is unclear.
- In contracts governed by US state law, failing to write liability limitation language in conspicuous text (such as capital letters).
Failing to Account for Taxes
Unexpected tax and withholding obligations arise frequently in the business-to-business context, especially in cross-border transactions. Parties often account for these taxes through “gross-up” provisions that ensure a party receives a certain amount after withholding, or through tax indemnity clauses that shift tax burdens between the parties, but these clauses can have a major financial impact on a party who hasn’t fully considered their effect. Examples of taxes that may impact a contract include:
- Sales, consumption, and value-added taxes.
- Withholding taxes on payments of service fees, interest, and royalties.
- Import duties.
- Income taxes in different jurisdictions as a result of holding inventory or dispatching personnel.
Dysfunctional Governing Law and Dispute Resolution Clauses
Most contracts need to be drafted on the assumption that a disagreement, misunderstanding, or other problem will arise. In many cases, a party’s leverage in negotiating a resolution depends on what legal remedies they can fall back upon if negotiations fail. This can be particularly challenging in contracts where the parties are located in different countries. Common mistakes include:
- Omitting a dispute resolution clause where one is necessary (such as where the other party is in a country with inefficient courts).
- Using a dispute resolution clause that makes the contract unenforceable (such as arbitration when injunctive relief is necessary).
- Using an impractical dispute resolution clause (such as costly arbitration in a small-value contract).
- Referring to nonexistent governing law (such as “US law,” “UK law,” or “international law”).
- Referring to nonexistent courts or arbitration institutions.
Governing law and dispute resolution clauses are discussed further in this article.
Misuse of “One-Sided” Forms
Many contract forms are carefully drafted to be beneficial to one party and detrimental to the other. This is particularly common in the “fine print” of consumer contracts, purchase order terms, and other contracts that are rarely negotiated. Businesses have to be careful to pick forms and precedents that are reasonably favorable to their own position, which may not be obvious at first glance.
Accidentally Illegal Contracts
Illegal contracts are often unenforceable, and may give rise to legal penalties. Obviously, a contract to commit a murder or steal a painting would fall into this category, but a contract can be illegal in more subtle ways, such as:
- Charging an illegal rate of interest.
- Engaging in a regulated business without a license.
- In common law contracts, imposing penalties that are not reasonable estimates of actual damages.
- Violating export control or trade sanctions rules.