Commercial Contracts: Pitfalls of Boilerplate Clauses

By: Robert A. Burke

The use of boilerplate in commercial transactions can be a simple way for contracting parties to close business deals. However, the risks of using boilerplate provisions are exposed when disputes arise. This article addresses some of the more troubling provisions that find their way into standard commercial contracts.

We will touch on the following provisions:

• Recitals
• Governing Law
• Dispute Resolution (Mediation/Arbitration)
• Indemnification
• Liquidated Damages
• Merger Clauses

Recitals

Recitals are often used by parties to help identify the purpose of the agreement, the identity of the parties, and the reasons the parties have decided to enter into the agreement. Recitals can also be useful for explaining a complicated factual scenario that led to the contract.

A cautionary note on recitals: the parties need to determine if the recital will be part of the contract. There are two issues to identify here.

First, if the recital isn’t important enough to be specifically incorporated into the agreement, then why have it in the agreement?

Second, it’s typically wise to have the recital be part of the contract (and expressly state that it is part of the contract). This will make sure that the recital is admissible in interpreting the contract’s substantive provisions. This could also assure that the parties remove superfluous language.

Finally, a typical recital is the “statement of consideration”. The statement of consideration is not necessarily direct evidence that the agreement is supported by adequate consideration. However, if this language is in the agreement, most courts will recognize that there is a presumption that the agreement is supported by adequate consideration. Keep in mind, this presumption can be rebutted, and the contract could be deemed unenforceable for lack of consideration.

Governing Law

A choice of law provision is usually appropriate to include in most business transactions.  Without a valid choice of law provision, the courts will be left to determine the law of the state with the most significant relationship that will govern the enforcement of the agreement.

There is also a cautionary note on the use of choice of law provisions.  Namely, the chosen law is usually the state where the drafter’s office is located.  This is done without any regard for what impact the state’s law will have on the agreement.  Best practices dictate that you research the chosen jurisdiction’s laws before you include the provision.  If you have no idea why you are applying your state’s choice of law, don’t put it in the contract.

Dispute Resolution: Mediation and Arbitration

Dispute resolution provisions are an important part of any business transaction.  It’s prudent for the parties to decide at the start of a transaction what will happen if the transaction goes sour. The parties are free to provide for the adjudication of future disputes by inserting mandatory mediation and/or arbitration provisions in their agreements.

The American Arbitration Association, one of the larger dispute resolution organizations, has a number of draft provisions that can be used.  For example:

Any controversy or claim arising out of or relating to this contract, or the breach thereof, shall be settled by arbitration administered by the American Arbitration Association under its Commercial Arbitration Rules, and judgment on the award rendered by the arbitrators (s) may be entered in any court having jurisdiction thereof.

This provision covers many of the necessary elements of an arbitration clause:

• Any claim is covered by mandatory arbitration;
• It identifies the entity that is going to administer the arbitration;
• It describes the rules under which the arbitration will be decided; and
• It recognizes that any judgment arising out of the arbitration proceeding will be enforceable in a court.

The parties need to ascertain whether arbitration is the appropriate remedy for any dispute. This depends on the identity of the parties and the nature of the agreement.  Additionally, while it is presumed that arbitration is less expensive, this is not always the case. The parties typically will share in the cost of the arbitrator. In this regard, it’s not unusual for an arbitration clause to contain a provision that there will be a panel of three arbitrators. Having three arbitrators adjudicate a dispute is extraordinarily expensive and often cumbersome.

Additionally, there is no meaningful opportunity to appeal an arbitration award. An arbitration award will only be overturned if there is some sort of egregious unfairness in the arbitration process. The standard typically applied involves “fraud or corruption” (depending on the jurisdiction). It’s not enough if the arbitrator made evidentiary errors, incorrectly determined the facts or improperly applied the law. While there is finality in this result (and the avoidance of suffering through the costs and time delays of litigation in court) there is effectively little accountability for the arbitrator.

Before selecting an arbitration organization to administer any disputes, it’s important to understand the rules that the arbitrator will apply. The AAA is just one of many organizations in this country that will administer arbitration disputes. There are other organizations, as well, that administer arbitration disputes.

To the extent you’re going to have an arbitration provision in your agreement, it is useful to set forth the place that the arbitration will occur. This is especially important if the parties are from different jurisdictions.

Indemnification

A standard indemnification provision can provide for recognition of the parties’ obligations to compensate the other party for certain costs and expenses.

A standard indemnification provision can read as follows:

[Buyer/Seller/Mutual] Indemnification. Subject to the terms and conditions set forth herein, [Buyer/Seller/each party] (“Indemnified Party”) shall indemnify, [hold harmless,] and defend [Seller/Buyer/the other party] and its officers, directors, employees, agents, affiliates, successors and permitted assigns (collectively, “Indemnified Party”) against any and all losses, damages, liabilities, deficiencies, claims, actions, judgments, settlements, interest, awards, penalties, fines, costs, or expenses of whatever kind, including [reasonable] attorneys’ fees, that are [incurred by Indemnified Party/awarded against Indemnified Party [in a final [non-appealable] judgment]] (collectively, “Losses”), [arising out of] any third-party claim alleging:[1]

The parties to the agreement have the option of making the indemnification provision mutual or unilateral. It’s not unusual, depending on the type of commercial transaction, for the parties to have different indemnification responsibilities. Specifically, the transaction can be set up where only one party indemnifies the other.

The indemnification provisions can apply to direct claims or third-party claims. Direct claims are claims that one of the parties to the contract will have as against the other party. The indemnification provision should clearly set forth that the indemnification is to cover only “direct claims” if that is the intent.

Third-Party claims are claims that an unknown or identified third-party may have against the indemnified party. Standard indemnification clauses are typically interpreted to cover the indemnification of third-party claims.

Another drafting error that parties make is failing to recognize the full extent of the indemnification provision. For example, the indemnification provision (in order to be complete) must provide that the provision requires the indemnifying party to “indemnify, defend and hold harmless”.

Finally, the indemnifying party’s obligation can be limited by the agreement. Specifically, the indemnifying party can limit its indemnity obligation by:

• Negotiating to qualify certain provisions, for example, by using

-reasonableness to qualify attorneys’ fees;

-gross negligence to qualify the indemnifying party’s acts and omissions; or

• Limiting the indemnity obligation to cover only claims arising in certain jurisdictions.
• Limiting the definition of the Indemnified Party. For example, sellers often refuse to include the buyer’s customers as indemnified parties, since the losses and liabilities suffered by customers are often only partly attributable to the seller’s actions.
• Limiting the indemnity obligation to losses and liabilities that are not covered by:

-insurance proceeds received by the indemnified party; and

-tax benefits received by the indemnified party.

• Replacing the nexus phrase “arising out of” with the narrower:

-caused by;

-resulting from;

-solely resulting from; or

-to the extent they arise out of.[2]

Liquidated Damages

Liquidated damage clauses anticipate the amount of loss or attempt to set caps on the types of damages that may be recovered. Liquidated damages clauses are generally enforceable unless they are determined to be a penalty. (This is not to be confused with a limitation of remedies). Liquidated damages provisions are a means by which the parties may apportion the risk. It’s not necessary that these liquidated damages provisions be reciprocal.

Liquidated damages provisions receive different treatment depending on the jurisdiction. In this regard, it’s critical to understand the governing law of the jurisdiction at issue before drafting the liquid damages provision. (See II, above). The parties need to have a clear understanding as to the definition of the types of damages that could be at issue:

• Compensatory damages;
• Actual damages;
• General damages;
• Special damages;
• Consequential damages;
• Damages recoverable under the UCC;
• Lost profits; and
• Punitive damages

It’s important for the parties to not overreach with respect to drafting a limitation of damages provision and risk a determination that the agreement is unconscionable or fails of its essential purpose.

Merger Clause

The merger clause, similar to the recital provisions, is an important way for the parties to define the agreement. For example, an agreement may provide that:

This agreement, together with all exhibits referenced herein, constitutes the entire agreement between the parties in relation to the subject matter of this agreement and supersedes all prior agreements, understandings and commitments, whether oral or in writing, between the parties.

This is the most basic type of merger clause. Merger clauses can also provide express representations that no other promises or inducements have been made by the parties in agreeing to execute the agreement “and that the parties are not relying upon any statement or representation of any other party.”

The merger clause should also address the manner in which future amendments and/or modifications will be accepted. Specifically, the agreement could provide that:

This agreement may not be amended or modified in any manner except by a written document signed by both parties that expressly amends this agreement.

Accordingly, the basics of any merger clause will include:

• a definition of the agreement;
• an express exclusion of reliance;
• a representation that the parties have conducted their own due diligence and relied solely upon their own due diligence; and
• address the manner in which future amendments and modifications will be accepted.

Robert A. Burke is a Partner in the Litigation Department at MacElree Harvey, focusing on complex commercial and estate litigation. With extensive trial and appellate experience across federal, state, and international courts, Bob has a strong track record in resolving partnership disputes, trust and estate conflicts, and intellectual property matters.