GUIDE TO CONTRACT DRAFTING: BUILDING BLOCKS (PART I)

An enforceable contract serves as a cornerstone for a business's relationship with other parties. Whilst the fundamental concept of a contract, i.e. an agreement between parties, is straightforward, drafting a contract with precision and clarity that reflects the transaction that parties intend to execute may be more difficult than as it first appears. A well-drafted contract makes use of a number of legal structures to create the rights and obligations of the parties. Every lawyer drafting or reviewing contracts needs to be cognizant of the key building blocks of contracts that usually appear in all professionally drafted contracts. Such provisions inter alia include:

• Representations and Warranties
• Covenants
• Condition Precedent
• Contractual Remedies (including termination rights)

The building blocks are the backbone of contracts which when put together effectively reflect the parties’ commercial transaction. Please note that the building blocks referred to above do not deal with the operative clauses of a contract which principally deals with the core rights and obligations of the parties. As an example, the operative provisions in a contract for the sale of immovable property would cover the terms of the sale of the immovable property, its payment, and handing over of possession. Whilst a contract containing only the operative clauses would be enforceable there may be many unresolved/unaddressed issues. In the example of the sale of immovable property, it is possible that the property is subject to a lien or third party right which was not disclosed to the buyer. In such a case, whilst the seller may be liable for fraud or misrepresentation (based on the existence of an implied representation), for purposes of clarity it is best to avoid such issues by the correct usage of the building blocks. Had the contract included a representation and warranty by the seller that there are no liens or third party rights in the immovable property the seller would have been in clear breach of contract for which the buyer would have legal remedies.

This article is to be published in two parts: the first part shall deal with representations, warranties and covenants; whilst the second part shall deal with condition precedents and contractual remedies.

Representation and Warranties

During negotiations, parties make certain statements and promises to each other as an incentive to enter into an agreement. Such statements and promises come within the ambit of representations and warranties. Whilst there are similarities between representations and warranties there is a technical distinction between the two:

A “representation” is a statement concerning a fact at a particular point in time which is made for purposes of reliance. 

A “warranty” is a promise that a statement concerning a fact is correct.

Typically agreements club all such statements and promises as representations and warranties. The format usually followed is: “Party X represents and warrants to Party Y as follows”. It is essential that both the terms “represents” and “warrants” are included in a contract for purposes of precision. This is because it may be argued that the use of only one of the terms meant that only a representation or warranty was made which may have different legal consequences as the remedies available for a breach of a representation and a warranty are different (a topic for another article).

The fundamental purpose of making representations and warranties is to provide critical statements of facts at a particular point in time. Coming back to our example, during negotiations for the purchase of immovable property, the buyer may ask the seller to make a representation and warranty that there are no liens or third-party rights in respect of the immovable property. If the buyer refuses to make such a representation and warranty then the buyer may infer that there are liens or third party rights in respect of the property. As such the negotiations for inclusion of representations and warranties have the effect of revealing important facts which would otherwise not have been known. 

It is critical to note that representations and warranties function as a contractual risk allocation mechanism. If a representation or warranty is false, the party making it shall be responsible and may be liable to pay damages to the other party. Therefore, when drafting representations a lawyer should try reducing the representations made by her/his client or use qualifiers (detailed below). On the other hand, a lawyer representing a party who is receiving representations and warranties, should make the representations as wide and unqualified as possible.

Contract Qualifiers

When drafting representations and warranties, as with other contractual provisions, the drafters usually make use of qualifiers to restrict the scope of a representation and warranty. Two of the most frequently used qualifiers are materiality and knowledge qualifiers. These are both discussed below. 

Materiality qualifiers restrict a representation and warranty to concentrate on the most crucial facts which would otherwise be too absolute. As an example, in an acquisition agreement for a subsidiary the seller (parent company) may represent and warrant that “the target is materially in compliance under all agreements that it has entered into.” In such a case if the subsidiary entered into lease agreements for over 1,000 premises throughout Pakistan and the rent has not been paid for one month for a single premises the seller would not be held to be in breach of the representation and warranty made as it is not a material breach. If the materiality qualifier was absent, however, the seller would be in breach of contract, regardless of how minuscule the breach was. 

Knowledge qualifiers restrict a representation and warranty such that the provision only covers what the concerned party “knows”. As an example, in an acquisition agreement for a subsidiary, the buyer may demand that a representation and warranty be made by the seller that the subsidiary is in compliance with all environmental laws. The seller may accept to make such representation and warranty subject to a knowledge qualifier: “To the best of its knowledge, the subsidiary is in compliance with all environmental laws.” In such a case if a chemical has been leaked, in breach of the environmental laws, and the seller was not aware of such leak, then the seller would not be held to be in breach of the representation. Without the use of the knowledge qualifier, the seller would have been in breach of contract in case a leak was found, regardless of whether the seller knew about such leak.

Categories of Representations and Warranties

Generally representations and warranties fall into the three categories, i.e. representations and warranties relating to: (i) the subject of the contract; (ii) enforceability of the contract; and (iii) the parties.

Subject Matter Representations and Warranties

Subject matter representations and warranties function as a guarantee that the parties receive what they agreed on, i.e. the subject matter of the contract. As an example, a contract for the purchase of food items from a wholesaler will contain representations and warranties stipulating that the food items are in good condition, safe for consumption and have not expired. In a share purchase agreement, on the other hand, representations and warranties relating to the description of the target and the shares to be acquired are made. In such a case sellers will typically inter alia make the following representations and warranties:

• Title to shares: The shares of the target have been duly authorized, lawfully issued, and fully paid up, and are owned by the sellers, without any encumbrances or charges.   
• Title to assets: The target has lawful title to all assets that it purports to own which are free and clear of any and all encumbrances.
• Capitalization: The authorized capital of the target is PKR [insert]/- divided into [insert] shares of PKR [insert] par value of which PKR [insert]/- divided into [insert] shares of PKR [insert] par value have been issued.
• Books and Records: The books of account of the target have been prepared in accordance with the applicable laws, are complete and accurate, and have been maintained with sound business practices.
• Tax:  The target has paid/withheld and accounted for all taxes accruing up to the closing date and submitted/filed the relevant documents to the authorities and has no outstanding, contingent or deferred tax liabilities.

Enforceability Representations and Warranties

These representations and warranties provide that the parties have the legal ability and power to enter into the contract, and that the contract is enforceable under law. For a party that is a corporate entity usually the following representations and warranties are inter alia made in most contracts:

• Enforceability: This agreement constitutes legal, valid and binding obligation of the party enforceable against it in accordance with this agreement’s terms, except to the extent that the enforceability thereof may be limited by applicable law(s). 
• Organization: It is a corporation duly organized, validly existing and in good standing under the laws of the Islamic Republic of Pakistan and has all requisite corporate power and authority to own its property and to carry on its business as it is now being conducted.
• Power and Authority: It has the corporate power and authority to execute and deliver this agreement and to carry out its terms; and the execution, delivery and performance of this agreement have been duly authorized by all necessary corporate action.
• No Conflict: The execution of this agreement shall not: (i) conflict with / contravene any contract to which it is a party; (ii) result in a breach of any provision of its constitutive documents; or (iii) result in breach of any law, legislation, regulation, rules, directives, official notifications or decree of any court.
• Necessary Action: All necessary action required to be duly taken by it to authorize the execution, delivery and performance of this agreement have been validly and lawfully taken.
• Governmental Approvals: Other than the consents and approval that have been lawfully obtained and which are in full force and effect, there are no consents or approvals that have to be obtained from any governmental entity or body.

Parties’ Representations and Warranties

In certain cases the nature of a contract may require that the parties make representations and warranties about themselves. Examples of these include loan agreements under which lenders usually require a corporate borrower to provide representations and warranties about its financial health. Another example can be found in merger and joint venture agreements in which the parties typically represent and warrant to each other that they are in material compliance with all applicable law(s) and that the information provided to each other is correct and accurate. 

Covenants

Covenants are continuous agreements/promises made by a party to perform or abstain from taking certain actions. Covenants, in general, are intended to ensure that a party secures what it had bargained for under the contract's operative sections. Covenants may broadly be divided into three types: (i) affirmative covenants (promises to do certain actions); (ii) restrictive covenants (promises to not take certain actions); and (iii) financial covenants (promises that specified financial parameters will be maintained). While some drafters refer to covenants by categorizing covenants in the aforesaid manner, such nomenclature is not useful except in the context of complex agreements such as loan agreements where covenants are so categorized for ease of reference purposes.

Similar to representations and warranties, covenants allocate risk between the parties as a party that breaches its promise may be sued for damages. For drafting purposes, it is essential that a lawyer diligently examines all covenants. Generally lawyers should aim to keep the covenants made by their clients as narrow and as few as possible whilst ensuring that the party providing covenant to their clients are as broad and as detailed as possible. A red-flag that lawyers should be vigilant of is the inclusion of a covenant under which their client promise to do or not do something which is not in their discretion/control.

As an example, under a lease agreement the following covenants are typically provided:

Landlord’s Covenants

• Peaceful Possession: During the term of the lease the landlord shall not interfere with the tenant’s peaceful possession of the premises provided that the tenant is in material compliance with its obligations under this agreement (Restrictive Covenant).
• Maintenance and Repair: During the term of the lease the landlord shall keep the premises in good condition and carry out repairs, as and when necessary (Affirmative Covenant).

Tenant’s Covenants

·      Payment of Rent: During the term of the lease the tenant shall pay on or before the due date each month the monthly rental for the premises (Affirmative Covenant).

·      Inspection and Repair: Upon reasonable advance notice by the landlord, the tenant shall permit the landlord or the landlord’s agent to inspect the leased premises and carry out repairs if necessary (Affirmative Covenant).

·      Subletting and Assignment: The tenant shall not sublet the premises or assign this agreement without obtaining the written consent of the landlord (Restrictive Covenant).

·      Title to Premises: The tenant shall not in any circumstance deny the landlord’s legal title to the premises (Restrictive Covenant). 

Financial Covenants

Loan Agreements typically contain financial covenants under which the borrower is prohibited from taking certain actions that may deteriorate the borrower’s financial position. Such restrictions typically include prohibitions on incurrence of further debt, creation of liens, sale of assets etc. Whilst the aforesaid covenants may prevent actions that impair the creditworthiness of the borrower, it does not completely prevent a borrower’s financial performance from plummeting. Financial covenants are used to address this particular issue by providing that the borrower is to maintain certain financial parameters. The following arecommon financial covenants typically included in Loan Agreements:

EBITDA levels

EBITDA (earnings before interest, taxes, depreciation and amortization) is used as a measure of a company’s overall financial health. A minimum EBITDA level covenant requires the borrower to maintain a minimum EBITDA level the failure of which may lead to a party exercising its remedies which under a loan agreement may include acceleration.

Total Assets to Debt Ratio

The total debt to assets ratio measures the total amount of debt relative to assets owned by a company through which an assessment of the financial stability of a company may be made. A minimum total assets to debt ratio covenant requires the borrower to maintain a minimum total assets to debt ratio.

Interest Coverage Ratio

The interest coverage ratio is a debt and profitability ratio used to determine how easily a company can pay interest on its debt. This ratio is calculated by dividing a company’s EBITDA by its interest expense during a given period. A minimum interest coverage ratio covenant requires the borrower to maintain a minimum interest coverage ratio.

This article is for informational purposes only and does not constitute legal or professional advice and is not intended to and does not create or constitute an attorney-client relationship between the reader and the author.

The information provided herein may not be republished, sold, relied on, or be used, in any form, without the written consent of the author.

If you require assistance with drafting or enforcing a contract please feel free to reach out to me through email ([email protected]) or direct message on LinkedIn.