Contracts 101: Part 3

The following is the third and final installment of our overview on how to read, draft and interpret contracts—specifically geared towards small business owners. Keep in mind that each of these clauses have their own nuances and can vary widely depending on the context of the agreement in which they are being used. Still, knowing the basics of each provision is a great starting point for you to manage your business relationships more effectively with clients and employees alike and will assist you in becoming more efficient in taking steps to proactively protect and further your company’s interests. 

Limitation of Liability 

Limitation of liability clauses cap the amount of money one party must pay the other if that party incurs losses due to a breach of contract or other certain events. This important contract clause can effectively mitigate the risk associated with an agreement and should always be read and negotiated carefully. Without such a clause, there is no financial limit on the damages a party can seek (whether or not it will be awarded is a different issue). Generally, New York courts will uphold limitation of liability clauses provided that they do not prohibit recovery for a party’s gross negligent or willful misconduct in the performance of the agreement. This is also the section where each party may exclude recovery for certain types of losses that might arise in the transaction. These are typically called “special”, “consequential” or “punitive” damages. While this section is often dense, do not skip reading and understanding it.

Confidentiality

A confidentiality clause explicitly defines the information to be kept confidential—effectively prohibiting the receiving party from disclosing it to any third party absent the express consent of the providing party. These clauses are commonly incorporated into employment contracts for new employees, independent contractor agreements, and licensing agreements. Keep in mind that occasionally it may be necessary to disclose confidential information. Each party to the contract commits to the standard of care to prevent disclosure of any information (e.g., commercially reasonable efforts, best efforts, etc.) and for how long this nondisclosure obligation lasts.  It will also indicate whether there are circumstances under which a party may disclose information without penalty. If you are trying to protect your confidential information, this is an important section to negotiate. 

Representations & Warranties

When you buy a new car, you go into the process carrying a number of basic assumptions such as: (1) the dealer has the right to sell you the vehicle; (2) the car is the make/model/condition that the seller claims it is; (3) the car performs as it was advertised; and (4) the dealer warrants that the product does not have any defects for a certain timeframe after the sale. These expectations are all premised on the seller’s representations, which are presentations of fact—either via words or conduct—intended to induce you to act by entering into a contract to buy the car. Similarly, the representations section in other commercial contracts will specifically set out the description of the goods/services to be delivered by way of the contractual agreement. Warranties are guarantees that a product will be free of defect and perform its intended role for a fixed time period, or that services will be provided at a certain level of care, among other things These warranties can either be express or implied. Express warranties are written into the contract; whereas implied warranties typically fall under the Uniform Commercial Code (UCC) which states that in all sales of goods there is an implied warranty that the goods have a fitness for a particular purpose (i.e., it will do the job it is sold to do). Note that express warranties are generally easier to be enforced judicially as opposed to implied warranties. 

Force Majeure

A force majeure clause is a contractual provision that relieves one or both parties from the performance of their duties when specified scenarios outside of anyone’s control take place that make performance inadvisable, commercially impracticable, illegal or impossible. This is also referred to as the “acts of God” clause. These fallback provisions are essential because without them, the parties to a contract are dependent on the not-so-merciful common law doctrines of “impracticability” and “frustration of purpose” --both of which are narrowly construed and thus rarely permit the entire excuse of obligation. When drafting a force majeure clause, the first step is to anticipate what type of circumstances will be covered, to include: natural disasters (hurricanes, floods, earthquakes, etc.), war, terrorism, civil disorder, labor strikes, fire, disease or medical epidemics, or disablement of transportation facilities that prevent or delay attendance by at least a fourth of the anticipated participants. Note that courts often interpret force majeure clauses narrowly meaning that only the specific occurrences explicitly stated in the contract will trigger the provision. This became a very contested clause in 2020 at the height of the pandemic as numerous businesses were unable to perform services due to governmental regulations. Often people have dismissed the importance of this clause, but those with well drafted ones were protected recently.

Independent Contractor

Independent contractor clauses set out the business relationship the contracting parties. Companies are rightfully concerned about one side claiming later they were hired as an employee and not as an independent contractor. This clause creates a record that the parties intended no employment relationship between the two. This is an especially important clause when contracting with an individual for a service. Otherwise, the hiring party may find themselves owing benefits, workers’ compensation, tax payments and the like.

Intellectual Property Rights

The intellectual property (IP) rights clause dictates the ownership of all intellectual property associated with the agreement. Is the IP owned by the purchaser? Jointly owned? Licensed? And, if licensed, what are the limitations on the use of the product or service? For example, creative professionals often do not sell the underlying rights to work performed, but do license the use of it for certain purposes. If the contract involves the creation of something, both parties need to be mindful of the IP rights and how they are allocated.

Restrictive Covenants

Employers typically include restrictive covenants in employment agreements, which fall under two main types: (1) non-solicitation; and (2) non-competition. A non-solicitation clause prevents employees from attempting to poach clients from their employer or soliciting fellow employees to leave their current positions. A non-competition clause functions to prohibit an employee from directly competing with an employer’s or former employer’s business operations. For example, a non-competition clause could bar an employee from engaging in a similar business within a certain geographical range and for a certain period of time after their employment. Note: in order to be enforceable, restrictive covenants must meet the two following requirements: (1) they utilize the least intrusive means to protect a legitimate business interest; and (2) they are clear and reasonable in terms of scope, restriction and duration. 

Assignments 

An assignment clause allows a party to effectively give away its obligations and rights under the agreement to another entity prior to the expiration of the contract. Accordingly, the assignee would be entitled to receive delivery of any associated assets and recoup all the benefits of the contract so long as they fulfill all obligations and requirements. Often a business owner doesn’t want a service provider to be able to assign its obligations under a contract, and a service provider doesn’t want a business owner to be able to assign its payment obligations under a contract.

Conclusion

As you can see, contracts are binding legal obligations that should be carefully read, negotiated and drafted. Mistakes in contracts can cost companies thousands of dollars; some mistakes can ruin businesses. A small business attorney is typically adept in crafting business contracts that make sense and are enforceable. 

We always caution against finding samples of agreements online and then copying and pasting parts. This only makes a Frankenstein-esque document that is hard to understand and harder still to enforce. When approaching contracts, remember this saying: Sometimes being casual leads to casualties.

Don’t be one of them. 

More on Contracts

Contracts 101: Part 1

Contracts 101: Part 2

Dangers of DIY