If you own a business or a non-profit organization, I bet you have considered the following questions:
Have you ever been presented with a contract to sign, and you weren’t quite sure about the possible impact of one or two provisions? Maybe you wondered if a part of the contract might hurt your business down the road, but you didn’t want to rock the boat with that new client, vendor or investor, who presented the contract to you? In this article, I’ll be addressing several of the most common pitfalls in contracts, and how to address these potential problems, to decrease the chance of complications for you and your business.
Whether you are a small business owner, a small non-profit organization, or a social entrepreneur, I bet you have experienced (or hopefully will experience) the following situation:
You have been slaving away, working 12 to 14 hour days (and nights) on your vision. You’ve hustled, networked, marketed (perhaps gone social-media mad), and let everyone know about your company. Eventually, your hard work pays off, and you get some exciting news:
- A donor organization wants to invest in your non-profit’s vision! They (the donor) will have their lawyers send you a contract to sign (a formality, they assure you), before any funding or donations for your non-profit organization can begin…
- A well-established, larger corporation wants to buy your company’s new high-tech app, fashion line, e-book, skateboards, or whatever other cool creative things your business has produced. Are you interested? Of course you are! Their lawyers will send a contract, describing how, when and where you will deliver your goods or services to them…
- A bigger company puts a bid in on a service-industry job (construction, perhaps), and they want to have a teaming agreement with your green, clean-air friendly construction company! After being told that a teaming agreement is a form of a contract (not related to sports, per se), you receive an email, with a pdf of a long contract for your review
Whether your business, non-profit organization or social enterprise provides a service or product, promotes a social cause, or both, contracts are a necessary and vital part of any business owner’s existence. And yet, too often in my years as an attorney, I have seen some of the smartest, business-savvy people sign contracts, which put them at an extreme disadvantage in their business dealings. In this article, I’ll address these potential problems and discuss some possible alternative language and contractual terms, before signing any binding legal agreement. Lastly, I’ll explain why I used the karma reference in the title (it’s more than just a way to make a dry topic like contracts seem hip. I realize that contracts lack the sex appeal of criminal law or litigation, as we’re yet to see NBC make a “Law & Order: Special Contracts Unit” spin-off, or an ABC series about business contracts on prime time TV). Let’s take a look at three of the most common problems in contracts:
Pitfall #1. Vague language, concerning each party’s rights to, or ownership of, a product:
With the advent of technology, more businesses are selling products such as e-books, apps, and other cross-breeds of intellectual property and concrete products. Contracts around the sale, distribution and/or promotion of such tech products may involve a second party’s product and intellectual property as well. Quite often, a poorly written contract will gradually “mesh” the two parties’ products, by reference to a vague term such as “intellectual property” or “related materials,” without stating clearly which intellectual property belongs to which party.
For example, suppose your company, Cool-App Inc., is developing and selling an electronic book (an E-book), which talks about Cool-App’s applications and uses in the modern tech world. You are about to sign a contract with a second company, ABC Software Co., which owns marketing services and software – software that your company wants to use, to write, publish and market Cool-App’s E-book. Makes sense so far, right?
Let’s further suppose that the contract, drafted by the ABC Software Company, and given to your company (Cool-App) to sign, defines your E-book as a product, and as a form of intellectual property, in paragraph 2 of the contract. The contract also references the ABC software as a different type of product, used to promote your e-book, and may also define such software as a form of intellectual property, owned by ABC Software, in paragraph 3 of the contract. As you read through the pages of your agreement, you soon come to a section of the contract, maybe paragraph 18, (three pages later), which states the following:
Paragraph 18. Division of Revenues / Proceeds of Sales:
“ABC Software Company and Cool-App agree to split the proceeds of all sales of Cool-App’s E-book as follows: Cool-App will receive 40% of the proceeds of e-book sales, and ABC Software Company will receive 40% of the proceeds from sales. The remaining 20% of sales revenue will be set aside, and used to pay all marketing costs, for the promotion and marketing of the product, and the intellectual property and related materials associated therein.”
Wait a minute – what is “the product” that is receiving that last 20% of the profits, for marketing and promotion? Does that remaining 20% of sales revenues go to your company, Cool-App, for marketing and promotion of your E-book? Or does the 20% get paid to ABC marketing software, to market and promote its software (wasn’t ABC’s software referred to as a “product” and as “intellectual property” in paragraph 3?) And what about the “intellectual property rights associated therein” or the “related materials” – does that statement refer to ABC Software Company’s intellectual property and related materials, or the intellectual property and related materials of your company’s e-book?
While you might assume that the 20% of sales proceeds devoted for marketing refers to marketing your company (Cool-App)’s E-book as “the product,” ABC software’s attorneys might have a very different argument in store. They might claim that the software being used for the book is the product, and the ABC software’s marketing materials are the “related materials” of the ABC software company. After all, didn’t ABC Software Company clearly state in paragraph 3 that their software was a product? If not resolved, this could put the parties into litigation (or before an arbitrator – which is an issue I’ll discuss in just a little bit).
The solution – clear language throughout the contract, to avoid such confusion:
Your company (Cool-App) and the other party (ABC Software) need to have specific language throughout the contract, explaining precisely what “the product” is, what “the related materials” are, and which “intellectual property rights” are associated with each of the two companies that are signing this contract (in this case, Cool-App and ABC software). Such clear language might help to prevent ABC Software Company from trying to grab that remaining 20% of the proceeds, while claiming (based on other vague language earlier on in the contract) that “the product” and “related materials” refers to ABC software.
A better contract might be one that more clearly defines each company’s product, intellectual property and related materials in the beginning paragraphs (paragraphs 2 and 3, for example), and then might reference these clear definitions throughout various paragraphs of the contract. For example: after clearly defining terms like “the product” “intellectual property” and “related materials” (perhaps in paragraphs 2 and 3 of the contract), paragraph 18 on the division of revenues might read as follows:
Paragraph 18. Division of Revenues / Proceeds of Sales: Better Written Clause of the Contract: (I’ll under-line and highlight the different language here).
“ABC Software Company and Cool-App agree to split the proceeds of all sales of Cool-App’s e-book as follows: Cool-App will receive 40% of the proceeds of e-book sales (e-book constituting “the product,” as defined in paragraph 2 of this contract; also referred to in the within contract as the “Cool-App Product”), and ABC software company will receive 40% of the proceeds from sales of “the product,” (the “Cool-App Product,” as defined in paragraph 2). The remaining 20% of sales revenue will be used to pay all marketing costs, for promoting and marketing the product (the Cool-App Product), and for promoting and marketing the intellectual property and related materials associated therein (with the Cool-App product).”
See the difference? It is important that the parties are clear, about which product (ABC’s software, or your company’s E-book) should be marketed, using the remaining 20% of the sales proceeds. (Note: if the ABC Software Company did not intend for the 20% of remaining sales proceeds to be used for your E-book’s marketing and promotion, well, that means that you and ABC Software have some negotiating to do). However, often, the smaller company (Cool-App) won’t want to “rock the boat,” and so they will sign the above contract, just as it was vaguely stated, only to find themselves in court later on (or in arbitration, which I’ll discuss in a moment), trying to determine which company’s product should be given the 20% of remaining revenues, for marketing and promotion.
The Karma Connection:
Much as in any other relationship that you have, clarity in communicating is likely to prevent conflicts, while vagueness and unspoken interpretations might lead to misunderstandings, conflict and clashing later on (anyone in a relationship has surely had this experience at one time or another).
It comes back to karma. In Buddhism, there is a precept about the importance of clarity around one’s speech, and about having clear intentions, right speech and right action. If one’s intentions are clear and honest, and if one acts on and communicates such clear / honest intentions, then their actions are more likely to have positive reactions in the world (good karma). However, if one’s intentions are vague, hidden, or not stated out of fear, then one’s actions (such as signing a vague contract) are likely to breed less positive reactions or consequences (such as the dispute and disagreement in the hypothetical above; bad karma). I don’t know what the Buddha’s view on attorneys was, but I like to think he would agree with me on the above statement.
Pitfall #2.Dispute Resolution Clauses That Are Biased, or Place Unfair Cost Burdens On The Smaller Business Or Entity:
Most business owners enter into a contract with another party, with expectations of positive, beneficial and profitable outcomes for all parties involved. Quite often, that is exactly what happens. However, if a vendor, a buyer, or a client of yours breaches a contract with your company or non-profit – or if your business is accused of a breach of contract– then you might find yourself revisiting a section of your contract that you may have overlooked the importance of: the Arbitration / Alternative Dispute Resolution Clause. Many (but not all) contracts contain a provision, whereby the parties agree to binding arbitration of their disputes (instead of going through the lengthy and expensive process of the court system). With binding arbitration (unlike mediation), the arbitrator’s decision is final. It may not be reviewed or overturned by a court, except in very limited circumstances, such as when fraud or misuse of power has been involved. While the pros and cons of binding arbitration might make for another article, let’s address your contract with its Binding Arbitration Clause, for now.
A Common Arbitration Clause:
Usually, the party drafting the arbitration clause in the contract states language to the effect that, in order to avoid the expenses and delays that accompany litigation, the parties agree that any controversy, dispute or disagreement arising out of or related to the contract will be settled by binding and final arbitration. The clause might further give the arbitrator the power to order that the parties perform a specific action or promise under the contract (known as equitable relief). However, be wary of any contract that either (a) fails to specify which party chooses the arbitrator, (b) lets the party drafting the contract select the arbitrator, or (c) automatically defers any dispute resolution to a third-party arbitration group, such as the American Arbitration Association, without either party having any input into the selection process, for choosing or objecting to an arbitrator.
(a) Problematic Arbitration Clause #1: Where is Your Say?
Nearly any contract where the other party is drafting the contract, and gets to select the arbitrator is usually problematic: they (the drafting party, or their attorneys) are most likely to choose or select an arbitrator that they have used previously and repeatedly – and who has ruled favorably to them — on a number of occasions. Remember that if you are dealing with a much larger organization – like a bank or a large corporation – the chances are that they have arbitrated hundreds of matters over the course of many years. Thus, if that party gets to choose the arbitrator in a dispute with you over the contract, then that arbitrator / decision-maker’s “neutrality” may likely be seriously compromised (even if it should not be, in theory).
(b) Problematic Arbitration Clause #2: Silence On How An Arbitrator Is Selected, Or Deference To An Arbitrator, Where You Lack Input or Options:
The same risk of having a biased arbitrator can occur, if the contract is either (a) silent on the issue of how an arbitrator is selected , or (b) defers to a commonly used arbitration group – such as the American Arbitration Association, or a well-known private arbitration / dispute resolution company. It’s not that there’s anything wrong with either of the above entities, but rather, the problem lies in the potential for bias: the more frequently the other party may have appeared before an arbitrator, the more likely it is that they have curried favor of some sort, and might well be within the good graces of the arbitrator that is deciding the fate of your dispute with the other contracting party.
Possible Solutions To Increase The Likelihood Of A More Neutral Arbitrator:
If your contract contains an arbitration clause, there are several ways to increase your chances of obtaining a neutral arbitrator (and, hopefully, a fair resolution of disputes that might be arbitrated). These suggestions include the following:
1. Joint Selection Of An Arbitrator:
One possible option is to suggest a provision be written into the contract (as part of the Arbitration Clause), whereby each party submits to one another the names of two or three arbitrators, and then the two parties narrow down the options, until they can agree on an arbitrator (or a pool of arbitrators) that both are happy with if a dispute should arise. This pool of arbitrators (from which one will be selected) can be written into the parties’ arbitration clause.
2. A Veto Clause:
Another option is for the contract’s parties to have a provision written into the arbitration clause, whereby, in the event of an arbitration that goes before a previously selected arbitration organization (such as the American Arbitration Association [AAA], or a private paid Alternative Dispute Resolution [ADR] group), each party can have one veto to the arbitrator who is appointed to hear your dispute (note that, in some states, some divisions of the AAA allow the parties to veto an arbitrator who is appointed, while other states might not). Such a veto clause in your contract will allow each party to do some background research on the arbitrator that is selected. Limiting the veto to only one time further serves to prevent either side from being overly fussy, as they may not know who the next arbitrator selected is going to be (or which side that next arbitrator might lean in favor of.
3. The Third Arbitrator:
A third possibility is to have both parties draft an arbitration clause, whereby each party selects an arbitrator, and then those two arbitrators select a third arbitrator. The third arbitrator decides the outcome of any potential disputes that may arise under the contract. This method allows for each party’s interests to be represented, as each party is choosing an arbitrator whose background they know and trust. The idea is that, if each party is comfortable with the person that they selected as an arbitrator, then the party will trust their choice to likely select an arbitrator who is fair and unbiased as well.
While there is no guarantee on how an arbitrator will rule – and no sure-fire way to guarantee that an arbitrator is 100% neutral – it does empower your company to have some say, in the selection of the arbitrator – the very person who will cast a judicially binding decision, about your contractual dispute with the other party.
Pitfall #3: Indemnity Clauses That Ask You To Fully Reimburse The Other Party For Any Liability That They Incur, Even if That Party, And Not You, Are Found to Be At Fault:
Many contracts contain an “indemnification clause” – essentially a provision in a contract under which one party (let’s say party A), commits to compensate the other (party B), or to compensate a third party, for any harm, liability, or losses / damages arising out of the contract (this can be a clause that is mutual, where each party agrees to indemnify the other). This provision applies, for example, when an damages have been awarded by a court to a third person or entity, against the party that you’re signing a contract with, and then you (or your business) must compensate the other party that you signed the contract with.
To be clear, I don’t believe that the very existence of an indemnity clause is, by itself, unreasonable (in fact, if the clause covers both parties, it can work to your company or non-profit organization’s benefit). However, I would caution any business or non-profit to be weary of an indemnity clause that asks you or your business to compensate the other party (or to compensate some third-party), regardless of whether the other party is found to be at fault, and if no liability is assessed to you at all. If this sounds confusing, perhaps an example will best illustrate this point. Let’s take a look at one type of indemnity clause, which I’ve seen in numerous contracts, followed by a better drafted version, which I’ll put forth, below.
Suppose your business is a socially conscious company, which manufactures shampoos and hair products that are safe for the environment (let’s call your business “Green Hair Care”). You’re about to sign a contract with a chain of salons (called “Savvy Salons”), selling them your newest product (a new organic, environmentally healthy shampoo), for use with the Salon’s customers. Suppose the Salon chain (Savvy Salons) sends you a contract, with the following language:
“To the extent limited by applicable law, Green Hair Care (your company) agrees to indemnify and hold harmless Savvy Salons (the other party), and any of its affiliates or subsidiaries, and all of its directors, officers, agents, contractors, volunteers and employees, from any and all claims, or liabilities, including, but not limited to, injury, death and/or damage to property, which may arise from Savvy Salon’s use of Green Hair Care’s products, pursuant to this Agreement.”
Clearly, this clause is problematic for two reasons: (1) it is unilateral – it only protects the other party, and not your company, and (2) there is no exception listed, for situations where the other party is grossly negligent, or has been found solely responsible for the damages incurred. For example, suppose one of Savvy Salon’s hairdressers comes to work drunk and high, and ends up leaving your organic shampoo in her client’s hair for an hour longer than directed (causing some burns to the person’s scalp). Let’s further suppose that the injured customer sues your company (Green Hair Care, for manufacturing the shampoo), the Salon (Savvy Salons), and the individual hairdresser in question (Sheila). In this example, the harm caused is solely due to the Salon’s negligent and/or Sheila’s reckless conduct. Yet, under this indemnification clause, even if a jury finds no liability against your company (Green Hair Care), and placed all fault and damages on the other party (Savvy Salons and their hairdresser), you and/or your company would still be on the hook, for reimbursing the Salon for any and all damages awarded in a lawsuit! This would be true under the above written indemnification clause, even if, clearly, your shampoo was not the reason for the injuries caused!
Many people can spot a problematic indemnity clause, but don’t want to “rock the boat” with a big client, by refusing to sign the contract, or by seeking to have the clause taken out. One way to resolve this dilemma might be to propose an amendment to the clause, such as the following underlined and highlighted language:
“To the extent limited by applicable law, Green Hair Care (your company) agrees to indemnify and hold harmless Savvy Salons (the other party), and any of its affiliates or subsidiaries, and all of its directors, officers, agents, contractors, volunteers and employees, from any and all claims, or liabilities, including, but not limited to, injury, death and/or damage to property, which may arise from Savvy Salon’s use of Green Hair Care’s products, pursuant to this Agreement, except to the extent that such claims or liabilities are adjudicated to have arisen from the sole negligence, or from the gross negligence, willful action and/or inaction of the indemnified party (Savvy Salons), or its affiliates or subsidiaries.”
This suggestion seems reasonable – as you are asking the other party to accept responsibility, in the event that they are found to be solely responsible, or grossly at fault, for any damages that they incur.
Another more sound indemnification clause – one that would make the above addition more palatable for the other party as well — would be to make the above indemnification clause a mutual one. For example, a clause whereby Savvy Salons also agrees to further indemnify you and your company (Green Hair Care) for any awards or damages against Green Hair Care, so long as your company was not found by a court to be solely negligent, or grossly negligent and or willfully causing whatever harm occurs. Such an indemnification clause (also known as an indemnification / hold harmless clause) might look something like this:
“To the extent limited by applicable law, the parties (Green Hair Care and Savvy Salons) agree to indemnify and hold harmless the other party, and any of its affiliates or subsidiaries, and all of its directors, officers, agents, contractors, volunteers and employees, from any and all claims or liabilities, including, but not limited to, injury, death and/or damage to property, which may arise from the indemnifying parties’ performance of this Agreement, except to the extent that such claims or liabilities arise from the gross negligence or willful action or inaction of the other indemnified party or its affiliates or subsidiaries.”
Having a mutual indemnification clause – with exceptions where the party seeking indemnification (or compensation) has solely been found responsible for the harm caused – accords with the another Buddhist principle that I like: the do no harm precept – a precept taken in part from the Eightfold Path of Buddhism – and the idea of each party accepting responsibility for their actions. (Feel free to use this last bit of wisdom, if you are ever negotiating a contract with a Buddhist monk).
Suggestions That You Have An Attorney Review, Draft Or Negotiate Your Contracts:
As I noted in the beginning, contract law is not the sleekest or most titillating of topics. Indeed, the above was just a sampling of some of the complex issues that arise, when two parties seek to do business with one another, and formalize their dealings in a contract. A contract can help you or your business to seek redress, can protect your company or non-profit agency from unreasonable demands that you did not bargained for or agree to, and can further serve as a valuable tool for enforcing your rights, in the event that the other party fails to hold up their end of the bargain. However, one should be mindful of what it is that they are signing – or what type of contract they themselves are proposing – when entering into a contract on behalf of your business or non-profit.
Similarly, when drafting a contract, template contracts or forms downloaded from the Internet may fail to take into account the unique nature of a transaction, or might not be in accordance with the various laws, which vary from state to state. For this reason, it is suggested that you hire a competent, experienced and trustworthy attorney, to review and discuss any contracts with you, before you sign one on behalf of your business, non-profit agency, social enterprise, or company. That way, you can have a feeling of security, and a sense of peace in knowing that you and your company are better protected.
Eric Sarver, Esq. is an attorney with over sixteen years of experience practicing law — the past fourteen of which as the sole proprietor / principal at The Law Offices of Eric M. Sarver. Mr. Sarver’s practice areas include: labor and employment law, contracts, and business law, for small businesses, social entrepreneurs and non-profits. He is admitted to practice law in the State of New York, and in the federal courts, in the Eastern and Southern Districts of New York.For questions in New York State involving a specific contract, an employment law-related matter or other legal concerns that your business or non-profit is dealing with, feel free to contact Eric M. Sarver, Esq. at: Tel: 917-930-8684; E-mail:email@example.com; Web: www.sarver-law.com
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