How to read and understand your contracts

Contracts. Love them or loathe them – they are a crucial part of your business. Would you like to feel more confident about signing on the dotted line? You can, by putting into practice these simple steps.

Let’s start with a basic definition. A contract is a legally binding agreement. An agreement comes about through offer and acceptance. An agreement is legally binding if:
(1) There is an exchange of something between the parties that they both consider of value (known as ‘consideration’),
(2) the parties must have an intention to enter into legal relations, and have the capacity to contract
(3) the terms of the agreement are certain, complete and not made for illegal purposes. (1)

Agreements can be made verbally, although in any case of dispute it becomes much more challenging to prove what terms were agreed at the time of reaching the agreement. For the purpose of this article I will concentrate on written agreements.

Now that we have a working definition of a contract, let’s look at the practical side: what IS the contract? This is where it can get tricky, because any document, data or information that is referenced as part of the contract may be incorporated into the contract.

When you read your contracts, therefore, you must make sure that you have access to, and have read these additional parts to the contract if these are intended to be part of the contract, otherwise you may find yourself working on an incomplete understanding of the contract.

The Written Word

In business, we process a high volume of written information each day. Reports, specifications, instructions – some information may be quite complex.
Contracts are no different. They seek to convey specific information, including obligations and depending on the type of contract, specifications and milestones, which need to be stated in exact language.

Searching for meaning: contract analysis

In simple terms, contracts have four key components:
(1) Scope – WHAT is it about?
(2) Roles & Responsibilities – WHO does what?
(3) Performance – HOW will we know that the SCOPE has been fulfilled to satisfaction?
(4) Remedies – WHAT happens if something happens or doesn’t happen according to the terms of the contract? (2)

The Scope can often be found in a separate schedule called the Scope of Work or Statement of Work. Smaller contracts may provide descriptions in order forms or under headers along the lines of ‘Services’ or ‘Project’.

Roles and Responsibilities can be included in the Scope, but may also appear in the agreement itself. Look out for headers such as ‘Customer’s / Company’s Obligations’. You should be clear on your responsibilities as well as those of the other party. What is each of you expected to do?

Performance indicators – commonly found in the Scope – are essential. Have deliverables and milestones been documented and agreed? Are there any provisions for testing and acceptance criteria? If not, how and when will the parties know that the contract has been successfully concluded? What standards apply?

Finally, the agreement must have provisions for when things go wrong. These can be the normal elements of termination, unforeseen circumstances (force majeure), and insurance and indemnities, but will also need to look at other aspects. All contracts should have the facility for change – therefore look for the change control mechanism and make sure you understand it. You should also take a note of the the process for giving notice. Always write down the address & process details for notices keep them handy and up-to-date in the first section of your contract file.

Risk and Resources

Another way of identifying important matters in a contract is to read for clauses that require you to have processes and resources in place (active clauses) and for clauses that trigger actions and consequences if you don’t have or do something you were supposed to (passive clauses). (3)

Active Clauses

Examples of active clauses are those to do with your confidentiality & data protection obligations, or the actions you must take to ensure any sub-contractors you engage comply with your client’s policies and the terms of the contracts. Other examples are invoicing and change control procedures and notification processes. Active clauses typically require ongoing resource and monitoring, and you need to be sure before committing to the contract that you will be able to maintain the resource required for the lifetime of the contract.

Passive clauses

Passive clauses tend to come only into play when an obligation in the contract was not met. These are the so-called breach situations, and depending on the seriousness of the situation, a range of consequences may follow, including termination of the agreement as well as pursuit of damages.
Typical examples are intellectual property clauses, indemnity provisions and clauses dealing with limitation of liability.
Although the day-to-day management of these clauses may not be as resource hungry as the active clauses, they need your careful review and consideration, as breach may be costly.

Decision Time: Gain vs Risk

Now that you have analysed the contract (Scope, Roles & Responsibilities, Performance, Remedies) and know what resources (Active Clauses) you need to commit and where the likely risks are (Passive Clauses), it is time for checks and balances.
You should now be able to see where the key areas of risk and exposure in the contract are. These you now need to prioritise. Questions to ask are:
(1) What are the key issues?
(2) Who and/or what can stop you from (a) delivering your obligations; or (b) meeting your objectives?
(3) What is the likelihood of that happening?

A useful way of looking at risk and how to deal with it is in terms of the Four Ts of Risk:

4Ts

The 4 Ts of Risk

If both the risk and the probability of its happening are low, you may decide not to take any action. This is falls in the category of tolerating risk. Even so, you should continue to monitor the situation because future changes may mean the risk factor changes.
If the risk is higher, but the probability low, you can look at transferring the risk. This can be done by asking the other party to share part of the risk, or by taking out insurance.
If the risk is low, but the probability high, it may be sensible to look at treating risk through actions aimed at reducing the likelihood of the risk occurring or limiting its impact prior to occurrence.

Finally, where both risk and probability are high, it can be sensible to terminate the risk. Where you come across these in contract reviews, you may have to weigh up risk vs gain and decide whether you are willing to sign the contract in hand.

Can you see the wood for the trees?

Legal and contract management professionals are working towards greater clarity and simplicity in contracts. Even so, we are working with the written word, often to capture someone else’s ideas, and must frame these within the constraints of the law and commercial feasibility.
Take maps. A map is not the actual area, but a graphic representation, in scale, or the area it depicts. In like manner, a contract is not the actual object, but its constituent parts (Scope, Deliverables, Milestones) form a written description of what the object should look like once it is completed.
Whether written in plain English or dense legalese, it can take a bit of time to orient yourself in the world of contract analysis and feel confident to make the best possible decisions for your business. If you feel you would benefit from our assistance, you are more than welcome to contact us.

Cora Burke,
Director

References:

(1) Lexisnexis.com.libezproxy.open.ac.uk. (2016). Halsbury’s Laws of England: Consumer Credit Vol. 21 (2016) – (6) Applicable Principles of Contract Law. [online] Available at: http://www.lexisnexis.com.libezproxy.open.ac.uk/uk/legal/returnTo.do?returnToKey=20_T25248952105 [Accessed 20 Dec. 2016].

(2) Cummins, T., David, M. and Kawamoto, K. (2012). Contract and commercial management. 1st ed. Amersfoort: Van Haren Publishing, p.525-526.

(3) Cummins, T., David, M. and Kawamoto, K. (2012). Contract and commercial management. 1st ed. Amersfoort: Van Haren Publishing, p.522.

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Whether you are a small business owner, a law firm (or other private organisation), or public sector organisation, business agreements and their proper management are part and parcel of the day-to-day running of your business. As a specialist Contract & Commercial Management consultancy, we  believe it is essential that subject matter experts focus their time and effort on their area of expertise.

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