Contracts can be long and difficult to read. If you struggle to read through the terms and conditions of a website before clicking “I Accept”, you can imagine how much harder it would be to pore through tens (or even hundreds) of pages worth of provisions in a contract.
To make things worse, contracts can be extremely difficult to read as they can be filled with jargon (or as lawyers call it, “Legalese”).
Yet, contracts are essential to risk management. Your start-up’s survival depends heavily on how well you manage legal risks.
To help you cope with the overwhelming amount of content that may be contained in a contract, we set out in this article a description and explanation of the “Big 6” legal risk clauses – these clauses address the most material areas of risk in commercial contracts.
Legal risk clause 1: Liability clauses
There are 3 main types of liability clauses, namely “unlimited liability clauses”, “limited liability clauses” and “no liability clauses”.
“Unlimited liability clauses” set out scenarios where a party’s liability to its counterparties is unlimited. You need to ensure that the scenarios under which your liability is unlimited is kept to a minimum. Failure to do so could result in crippling losses for your business.
Typically, “unlimited liability clauses” cover the following scenarios:
● breaches of an extremely egregious nature; or
● scenarios stipulated under applicable law where a person’s liability is unlimited.
“Limited liability clauses” set out caps (or any other forms of limitations) on a party’s liability under various circumstances. When reviewing “limited liability clauses”, you should pay especial focus on the following areas:
● the levels of the liability caps/limits – are they too high/too low?
● exceptions to the liability caps/limits – are there any forms of liability that are not subject to the caps/limits, and should they nevertheless be subject to the caps/limits?
“No liability clauses” set out scenarios where a party’s liability to its counterparties is excluded. When reviewing “no liability clauses”, you should pay especial focus on the following areas:
● the scope of scenarios where liability is excluded – is the scope too wide/too narrow?
● indirect losses – while it is common for a contract to stipulate that parties exclude liability for ‘indirect losses’ (generally defined to mean losses that are remote and/or unforeseeable), does the contractual definition of ‘indirect losses” nevertheless encompass any forms of direct loss?
Legal risk clause 2: Representations/Warranties (“R/W”)
R/Ws are typically used by a contracting party where it:
● cannot ascertain a particular state of affairs with respect to its counterparty – under such circumstances, that contracting party may require its counterparty to provide a R/W in relation to that state of affairs; or
● requires further performance assurances from its counterparty with respect to the performance of certain obligations – the contracting party may request for the counterparty’s obligation to be elevated from a mere contractual obligation to a R/W.
So, what is the significance of R/Ws?
Where a party breaches its representation, the other party has the right to rescind the contract – this entails terminating the contract and restoring parties to their respective positions prior to their entry into the contract.
Where a party the breaches its warranty, the other party has the right to claim monetary damages against it.
Typically, commercial contracts stipulate that a party “represents and warrants” (i) a certain state of affairs, or (ii) that it will perform an obligation.
Where the party breaches such “representation and warranty”, the other party has the option to either rescind the contract, or claim monetary damages against the breaching party.
When reviewing the scope of R/Ws in a contract, you should examine the following:
● are the obligations covered by these R/Ws sufficiently important to be elevated to such a status?
● are you comfortable with providing the counterparty with its requested R/Ws?
Legal risk clause 3: Indemnities
An indemnity is a contractual obligation on a party to compensate its counterparty for losses that the counterparty may suffer as a result of the occurrence of certain events.
When reviewing indemnities in a contract, you should examine the following:
● the nature of the events that you are require to provide an indemnity for – as a general rule of thumb, you should not be providing indemnities for events that are beyond your control, or that occur due to no fault on your part;
● the extent of losses that you are required to indemnify – are the losses that you are required to indemnify potentially very high?
● who do you indemnify – does the indemnity apply only to the counterparty? Or does it extend to other persons such as the counterparty’s affiliates, shareholders and personnel?
Legal risk clause 4: Title/risk
Title/risk clauses are particularly applicable to supply of goods contracts. Whilst the concepts of “title” and “risk”, are often mentioned together in the same breath, they are actually different concepts.
“Title” relates to the legal rights of ownership. Where a clause state that a party has “title” in goods, it means that the party has the legal rights of ownership in relation to such goods. From a financial perspective, this could mean that these goods are “on your books” (colloquially speaking).
“Risk” on the other hand, relates to the bearing of risk in relation to loss of and/or damage to goods. Where a clause states that a party bear the “risk” in goods, it means that the party bears the risk of loss and/or damage in relation to such goods.
As both “title” and “risk” are separate and distinct concepts, it is not uncommon for “title” in goods to pass from one party to another without “risk” following suit, and vice versa.
In this regard, while reviewing “title/risk” clauses, you should examine the following:
● Does “title” in the goods pass? If so, is it even necessary for “title” to pass? – for example, a deliveryman may take possession of your goods for the purposes of delivering it to your recipient, but he should not have any legal rights of ownership in relation to your goods.
● When does “title” in the goods pass?
● Does “risk” in the goods pass? If so, are there any circumstances where “risk” in the goods passes back to the original party?
● When does “risk’ in the goods pass? – you should not take on any “risk” in goods if you are not even given a chance to ascertain their quantities and state.
Legal risk clause 5: Intellectual Property Rights (“IPR”)
Intellectual Property (“IP”) refers to “creations of the mind” – these include inventions, literary and artistic works, and symbols/names/images used in commerce.
While reviewing IPR clauses, you should examine the following:
● Are you required to represent/warrant that your provision of goods/services does not infringe upon the IPR of third parties? If so, are you prepared to do so?
● Has the counterparty granted you a licence over a sufficient amount of his/her IP, in order to enable you to (i) enjoy the full benefit of the contract and (ii) perform your contractual obligations?
● Do you get to own the IPR that you create during the duration of the contract?
Legal risk clause 6: termination
Whilst contracting parties have a right under general common law to terminate a contract if certain conditions are met, they typically do not rely solely on such general common law rights to terminate a contract.
Indeed, it may not be wise to do so, as it may be difficult to prove the existence of the conditions that give rise to such a right to terminate.
After all, general common law views termination as a draconian remedy, and the requirements that need to be fulfilled in order for a contracting party to the entitled to terminate under general common law may be stringent.
In this regard, it is common for parties to expressly stipulate additional grounds of termination in the contract as well.
While reviewing termination clauses, you should examine the following:
● Do parties have a right to terminate for convenience (i.e. terminate for no specific ground)? If so, what is the notice period for termination? The notice period for termination should not be too long or too short.
● Do parties have a right to terminate for cause (i.e. upon the occurrence of specific grounds)? If so, what are these grounds?
● What are your obligations upon the termination of the contract?
● What clauses survive (i.e. continue to remain in effect) the termination of the contract? How long do they survive for?
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We hope that this article has been helpful to you as a start-up trying to navigate the complicated (and often frustrating) realm of contracts.
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*The above content does not constitute, nor is it offered as, legal advice of any kind. GLS Solutions Pte Ltd is not a law firm and any support provided pursuant to this entity is not regulated legal advice or legal opinion.