Effective Legalese for Maximizing Your Return on Contracts (ROC) – third in 4-part series

by Mauro Caputi, Consultant, Mainspring Consulting Group LLC and Raymond Averna, Esq., Principal Attorney in the law office of Raymond J. Averna, P.C. This article unpacks strategic advantage “legalese” can contribute towards the bottom-line value of an agreement if it is written correctly. Focusing on best practices of refining standard contract templates, authors reveal what might be the most important skill development in 21st century contract management. Let them walk you through the four-part litmus test of drafting comprehensible, clear, compliant, and complete contract language. Series Roundup from Mainspring Consulting Group:

The first article posted in the February issue, reviewed the three primary business pillars of success: Operational, Legal, and Financial.

The second, posted in the April issue, featured the Operational pillar and how organizations prepare, negotiate, execute, monitor, and analyze contracts efficiently.

This article will be followed by the final part of the series that will show how the Financial pillar contributes towards sustainable, long-term financial success.

READ ARTICLE A contract is an agreement between two or more parties. It sets forth the private law governing the parties’ relationships, specifically, the parties’ respective rights and obligations. It is vital to specify obligations clearly and consistently throughout the contract and ensure that rights are protected and obligations limited. Drafting the contract effectively is key. Our focus is about rights and obligations typically found in commercial contracts, and the best practices to consider when reviewing and refining standard contract templates. In fact, the process of trimming and consolidating templates is among one of the first exercises that we initiate for clients when they begin the Contracts Management process. We organize these according to Mainspring’s “The Four Cs of the ROC Legalese Effectiveness Model” as shown in Figure 1.

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• Comprehensible

– Terms and conditions that are easy to understand and improve the readability of contracts for business stakeholders to follow-through on their contractual commitments.

Comprehensible Clarity

Compliance-Ready

Completeness

THE FOUR-C’S OF THE

ROC LEGALESE

EFFECTIVENESS MODEL

• Compliance-Ready

– Terms and conditions that are consistent with regulatory requirements, internal policies, and enable transactions, especially financial incentives, to be easily enforced.

• Completeness

– Terms and conditions that anticipate and “foolproof” contracts for common business events such as organization restructurings, acquisitions or divestitures.

• Clarity

– Terms and conditions that provide clear and explicit direction and minimize ambiguity for addressing non-financial risks associated with business transactions.

Figure 1. The Four Cs of the ROC Legalese Effectiveness Model

ROC Legalese Model Defined Comprehensible: keep it simple

Ensure that the contract readability is high by drafting easy-to-understand text. Comprehensible

terms and conditions comprise the mechanics of contracts, not the content itself, because you

determine readability by style, sentence structure, diction, organization and formatting.

Readability is critical. Studies show the relationship between readability and contract interpretation. High readability levels correlate with higher interpretation levels. Improving contract readability reduces the risk of misinterpretation, increases the likelihood of compliance

with terms and conditions, which leads to stronger performing contracts.

Common pitfalls found in contracts1:

Compound Clauses combine multiple clauses into a single clause (e.g. Governing Law;

Venue; and Jurisdiction)

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Overlapping Clauses inconsistently combine clauses (e.g. (a) Entire Agreement;

Amendments and Waivers, (b) Entire Agreement; Waivers, and (c) Amendment and

Waivers)

Duplicate Clauses create redundancies in the agreement (e.g. Best Efforts and Further

Assurances in the Transaction, Covenants and Miscellaneous sections)

Inconsistent Organization of Clauses occurs when articles are inconsistently named

and grouped (e.g. Covenants, Covenants of the Buyer, Covenants of the Seller,

Additional Agreements, Additional Agreement and Covenants)

Inconsistent Location of Clauses occurs when a clause appears in different sections

of a document (e.g. an Amendment clause may appear in either the Miscellaneous or

the Termination section)

Rules for enhanced readability include:

Use short, simple, familiar words. Avoid jargon. Use culture-and-gender-neutral language. Use correct grammar, punctuation, and spelling. Use simple sentences, active voice, and present tense. Begin instructions in the imperative mode by starting sentences with an action verb. Use simple graphic elements such as bulleted lists and numbered steps to make

information visually accessible.”

Measure your readability score By adhering to the rules and avoiding some of the common

pitfalls, you can raise the readability score of contracts. To measure the score research the free

online test websites or use the out-of-the-box feature in Microsoft Word 2010. You can find

readability formulas on Flesch formula, Dale-Chall, Gunning Fog, McLaughling SMOG.

Use common sense – simplify! Economist Alfred E. Kahn, a devotee of plain English, wrote

a message to his legal staff saying, “Every time you’re tempted to use ‘herein’ or ‘hereinabout’

or ‘hereinunder’ or, similarly, ‘therein,’ thereinabove’ or ‘thereinunder,’ and the corresponding

variants, try ‘here’ or ‘there’ or ‘above’ or ‘below,’ and see if it doesn’t make just as much

sense.”2

Clarity: minimize ambiguity Eliminate risk of ambiguity of the objectives, parameters and non-financial elements associated with the business arrangement. Examples of clarity in the contract are in the following two clauses, scope and grant: Scope – Be specific or risk embarrassing, costly results.

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Before drafting a contract, identify and structure the fundamental terms of the business relationship to create the basic parameters of the contract. This foundation upon which you establish the parties’ respective rights and obligations is the “scope” of the contract. The scope of goods or services sold must be sufficiently detailed in the contract, because substantial rights and obligations are derived from the sale of goods or services.

For example, consider the contract whereby a manufacturer sells semiconductors to a purchaser. Semiconductor manufacturers typically manufacture thousands of unique parts. Many are identical except for minor attributes. Specific legalese is essential.

An ambiguous or deficient description of the parts can confuse the parties as to which parts are actually the subject of the contract. This uncertainty can create unwanted obligations and accompanying liabilities to the manufacturer. For example, imagine the confusion that can arise with respect to the manufacturer’s obligations as to the following:

specifications with which the parts must comply date code of the parts

warranties with which the parts must comply

applicable lead time for the manufacture of the parts

applicable price of the parts packaging requirements

shipping terms

Consider, further, a distribution agreement. A party (distributor) purchases beverages from a supplier with the right to distribute them within a designated geographical territory. The distributor expects a detailed and clear description of the products including additional items within the definition of “products”, such as:

product line extensions enhanced products

additional brands of products to an existing brand family

new brands associated with the trade name of the supplier

On the other hand, a supplier may want to limit the definition of “products” and exclude the aforementioned items. But again, a deficient description of services to be rendered in a services contract can also result in an ambiguity of and with similar consequences. Grant. Under a contract, a party may “grant” a specific right to the other party , such as a right to:

distribute, market or promote a product

have a product manufactured or developed

license a particular product or intellectual property right

Because the grant of a right can form the fundamental basis of a contract, you must draft clearly and specifically the right granted, together with all its ancillary effects..

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Completeness Contract templates can include events occurring over the life of the agreement such as, reorganizations, growth through mergers and/or acquisitions, divestitures of business units, or downsizing. The agreements and the underlying relationships can “evolve” with the contracted parties without the need for amendments or new agreements for every event that occurs. The four sample clauses below illustrate this point: 1. Price increases. Price is the key term in both services and traditional product sales or purchases contracts. With the term, price, the ability to increase the price is inevitable, especially for a long-term contract or if the price of the goods or services is sensitive to the economic, market or other conditions. A supplier of goods will reserve its right to increase the prices of the goods sold under the contract. Indeed, the supplier’s ability to increase the price of the goods may be critical to maintain its standing in the market. However, this right, if unbridled, can victimize the purchaser to significant and unrealistic price increases, effectively blocking the purchaser from the market.

Efficient contract drafting can protect the purchaser from unfair price increases, while still protecting the supplier from sudden spikes in costs, resulting from significant changes in market and economic conditions. For example, a purchaser of goods might agree to the supplier’s right to increase prices, providing the contract contains language that any price increase will…

be effective only after a a specific time elapses after the purchaser is given written notice of the price increase

be no higher than that price charged to other purchasers of the same goods in the purchaser’s geographical territory (and perhaps territories adjacent to that of purchaser’s)

specify whether or not other costs, such as taxes, shipping and insurance are included. 2. Transferability. In many instances, a services contract may be apply to the talents, experience and ability unique to only the party rendering the services. This means the recipient of the services would not want any third party to perform the services.. Typically, contracts prohibit the assignment of rights or delegation of duties, or at least, permit the same only with the other party’s reasonable consent. However, effective drafting can actually permit an assignment of rights or delegation of duties to a third party (the assignee), in certain well-defined circumstances, while still protecting the other party’s rights under the contract. Examples of proper drafting that permit assignments or delegations under certain circumstances are as follows: The proposed assignee…

is financially able to perform its obligations

has background and experience in the industry

is an affiliate of the party rendering the services

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…and the proposed assignment would not: materially change the duties of the recipient

increase the burden or risk imposed on the recipient

impair the recipient’s chance of obtaining return performance Clearly and effectively drafting these concepts can ensure more flexibility in the contract and yet, offer the same protection that the outright prohibition of assignments or delegations offer. 3. Liability. Perhaps the most discussed, negotiated and fought-over provisions of a contract are the liabilities of the performing party. The potential for unlimited liabilities can “chill” the performance of a party under the contract, expose such party to significant monetary or other damages, and can doom a performing party’s business and livelihood. Effective drafting of pertinent provisions of the contract, such as the warranty, limitation of damages and indemnification, can significantly limit a party’s potential liability.

Warranty. Typically, a performing party drafts a warranty for services to be performed or the goods to be sold or manufactured. From such party’s perspective, the warranty should always be specific and limited. For example, a manufacturer of a semiconductor might limit the warranty on a given part to conform to the manufacturer’s specification sheet. The warranty might further be limited to benefitting only the direct purchaser of the part (and not any other subsequent purchases or users). And the warranty is based on the specification sheet “ in effect at a particular point in time” (i.e., date of purchase, date of shipment), and is effective only for a limited time (i.e., twelve months after the date of shipment). Effective drafting would specifically exclude additional warranties in the contract, other than the one contained in the contract. Further, the contract should contain specific language disclaiming such warranties that might be implied under the laws of the jurisdiction applicable to the contract (e.g., warranties of merchantability and fitness for a particular purpose).

Limitation of Damages. The contract should also provide that if the warranty is breached, remedies are specified and limited. Such remedies might consist of a repair or replacement of the product, or where repair or replacement is not practical, then a refund of the price paid for that product. The performing party should consider adding a provision that waives the other party’s right to recover consequential damages. These include damages flowing directly from the act of the breaching party, but also from the consequences or results of the breach. These damages can include loss of profits or revenues, and can be staggering to the performing party. This waiver, therefore, is a critical and effective protection for the performing party.

Indemnification is a contractual agreement whereby one party agrees to compensate the other party’s loss monetarily. Provisions can be broad, requiring the compensating party to cover not only the aggrieved party’s direct loss, but also all claims, liabilities, damages and losses, including court costs, filing fees and attorney’s fees. Obviously,

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this provision can be a powerful contractual remedy for one party (the indemnified party), but correspondingly, an onerous obligation of the other (the indemnifying party). Effective drafting can significantly limit and reduce the “indemnifying” party’s obligations under the contract. For example, a party’s obligation to indemnify can be limited to only a particular breach, such as a breach of warranty. In that way, the party’s breach of any other provision of the contract would not lead to its indemnification obligations. Consider drafting a “carve out” from a party’s obligation to indemnify events, such as acts of the aggrieved party that may have caused its damages.

4. Termination Rights and renewal options. Most contracts have specific terms, sometimes with options for renewal. Even if a contract is mutually structured, negotiated and the parties begin a mutually beneficial, long-term relationship, circumstances can change, leading to a re-evaluation of the business relationship. That’s why you must consider provisions relating to termination rights. A party to a contract may identify the following events as constituting their rights to terminate the contract:

bankruptcy of the other party;

liquidation or dissolution of the other party;

felony conviction of the other party; revocation of suspension of the other party’s license (if one is required by the other party

in order to perform under the contract);

fraud on the part of the other party;

the other party’s breach of a material term under the contract.

The party whose conduct leads to a termination of the contract, would like to be given a right and reasonable time to cure such conduct, at it relates to the breach of contract. You can draft this provision to include the requirement that a terminating party give the breaching party a detailed description, describing the nature of the breach and the corrective action needed to resolve the breach.

A more powerful right would be to terminate the contract for convenience (i.e., for any reason or no reason at all). This right does away with the need to establish a breach on the part of the other party. On the other hand, this right transforms the contract into an at-will agreement, terminable at any time.

Compliance-Ready Finally, contract templates that contain compliance-ready provisions must ensure that the deal structure or financial-related terms and conditions -- including financial incentives -- are enforceable and can be administered in a straightforward, efficient and effective manner. The following three clauses illustrate the point: 1. Performance Requirements. A party’s performance obligations under a contract may be

tied into a specific standard of performance. For example, a supplier may require that a purchaser or distributor meet certain objectives based on criteria, such as:

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purchasing a minimum quantity of products per year;

purchasing a minimum dollar value of products per year;

increasing certain percentages of the minimum quantity or dollar value of products purchased

mutually agreeing to a specified increase in the quantity or dollar value of products purchased and, or if the increase cannot be agreed to, then provide a default percentage or dollar value increase.

If a supplier or manufacturer imposes specific levels of achievements and standards of performance on the purchase or distributor, the contract will contain certain provisions for the preparation and implementation of annual business plans, which would provide for objectives concerning sales, marketing and distribution of the goods. These objectives typically include:

purchaser’s/distributor’s sales and promotion strategies investment commitments

sales and distribution goals

The purchaser or distributor would want the contract to include a provision providing “reasonable commercial efforts” to achieve sales and distribution goals instead of an obligation to actually achieve the stated goals. This significantly reduces the obligations (and potential liabilities) of the purchaser or distributor, since the failure to actually achieve the contractually agreed-to sales and distribution goals would not constitute a breach of contract, providing the purchaser or distributor at least used “reasonable commercial efforts to achieve such goals.” In addition, the contract could protect the purchaser or distributor by qualifying the obligation to achieve sales and distribution goals as being subject to “economic and market conditions” or events “beyond the control” of the purchaser or distributor. 2. On-Demand Capacity. In sales-of-goods contracts, purchasers are increasingly

demanding that the supplier guarantee a designated minimum quantity of products be readily available on demand to meet the purchasers’ requirements for goods as and when needed. These obligations are typically found in agreements called vendor-managed inventory, supplier managed inventory , just-in-time and buffer stock agreements. Although contracts vary, the concept is the same. The supplier will supply, in advance, a designated minimum quantity of products stored in a designated facility. The purchaser merely “pulls” the products when needed. Be aware that this arrangement can be filled with significant pitfalls for the purchaser so it is important that the contract includes the following precautions:

purchaser forecasts good faith anticipated demand for products; all products supplied are stored in supplier’s, not the purchaser’s, facility;

before the purchaser “pulls” products from storage, it issues its purchase order indicating the type and quantity of products demanded; the supplier then issues its acknowledgement (containing the supplier’s terms and conditions);

the supplier is allowed a reasonable lead time to replenish the quantity of goods pulled.;

the purchaser’s ability to demand an “upside” (a quantity of goods in excess of its original forecast) is limited to a specified percentage;

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once products have been placed in readily-available inventory, purchaser should be obligated to purchase all such products.

3. Post-Termination Obligations. While many contracts contain provisions addressing

termination rights, some contracts do not contain provisions relating to obligations of the parties that may or should continue after termination of the contract.

To protect the rights of the parties to the contract, consider drafting provisions that include the following:

the purchaser has the right to either exhaust its inventory of products or, obligate the supplier to re-purchase them, at the purchaser’s cost;

the purchaser has the right to continue purchasing products from the supplier for a time so that the supplier can support purchaser’s customer commitments;

the parties’ respective indemnification obligations should survive the termination of the contract, at least for a specified time;

a party’s obligations as to its use and disclosure of the other party’s confidential information should survive the termination of the contract, at least for a specified time.

Hopefully, the power and impact that “legalese” can have on the effectiveness of an agreement is made abundantly clear in these examples. Legalese is not just a cost of doing business to cover risk as is too often thought. Rather, legalese should be strategically viewed to maximize one’s Return on Contracts. Our last and final article will define and focus on the Financial pillar. Disclaimer: This article briefly explains the meaning and purpose for improving the effectiveness of commonly used contract terms. This article is provided for informational purposes only, and the above examples are not exclusive and are provided for illustrative purposes only. Therefore, this article is not intended, and should not be construed, to be legal advice of any kind. Each legal situation is different and is based, among other things, on the particular facts and circumstances applicable at the time and in the jurisdiction in question. Accordingly, you should consult with appropriate legal counsel regarding any issue for which legal advice may be desired or required. Please contact Mainspring Consulting Group and/or Raymond J. Averna, P.C. for more information.

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References

1. “Contract Readability – Part 2”, December 2010, by Kingsley Martin, http://contractanalysis.blogspot.com/2010/12/contract-readability-part-2.html

2. “Alfred E. Kahn, a Champion of Plain English in Economics” by Robert H. Frank, Sunday, January 09, 2011

3. Article 1 of 4: Failure to Manage Contracts is Costing Organizations Billions of Dollars Worldwide Each Year; February 2013 IACCM Newsletter

4. Article 2 of 4: Failure to Manage Contracts is Costing Organizations Billions of Dollars Worldwide Each Year; April 2013 IACCM Newsletter

ABOUT THE AUTHORS

Mauro Caputi, Partner for Mainspring Consulting Group LLC, has a 20-year background in Contracts

as both as a consultant and subject matter expert. This included supporting numerous clients with their

Contracts Management Programs. He has advised close to 50 clients on solutions, policy and process

design, and operational governance controls while also providing Delivery Management for global

enterprise-wide implementations of variety of Contracts Management applications involving over 20

countries, tens of thousands of users, and supporting millions of transactions annually. Mr. Caputi

received both his B.S. in Industrial Engineering, and M.B.A. from Columbia University. He currently

serves as Partner for Mainspring Consulting Group LLC.

Raymond J. Averna, Esq., Principal Attorney in the Law Office of Raymond J. Averna, P.C.has

extensive legal experience in corporate and business transactions, with an emphasis in manufacturing,

distribution and logistics. He has represented multi-national, national and regional companies across such

diverse industries as semiconductors, aerospace, pharmaceuticals, cosmetics, nutritional supplements,

food and beverage, HVAC and construction. Mr. Averna leverages his 25-plus year experience in legal

drafting in formulating and structuring clear, business-minded strategies to help companies achieve their

critical business objectives. Mr. Averna received his B.S. in Finance from St. John's University, J.D. from

St. John's University School of Law, and M.B.A. in Finance from New York University, Leonard Stern

School of Business.

Mainspring Consulting Group LLC is a boutique consulting services firm specializing in Contracts

Management. Mainspring provides three key services – Implementation, Managed Services and Analytics

– that revolve around optimizing the profitability or Return on ContractsTM

. Mainspring takes on the

administrative burden of contract management for clients and turns their contractual obligations into real

dollars.

Raymond J. Averna, P.C. is a law firm and Mainspring’s business partner dedicated to providing

strategic advice and counsel to national, regional and local companies in all phases of corporate

formation and operations, commercial transactions and general business matters. As a trusted business

advisor, the Firm provides strategic advice and counsel to corporate executives and senior corporate

managers on a variety of legal and business issues, such as supply and distribution relationships,

mergers and acquisitions, joint ventures, licensing, federal regulatory compliance, government contracts,

real estate sales and acquisitions, and general corporate and business matters.