GUIDE TO CONTRACT DRAFTING: BUILDING BLOCKS (PART II)

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 key building blocks of contracts that appear in all professionally drafted contracts. Such provisions, referred to as the essential building blocks of a contract, inter alia include:

·??????Representations and Warranties

·??????Covenants

·??????Condition Precedent

·??????Contractual Remedies

This article is a continuation of Guide to Contract Drafting: Building Blocks (Part I) and shall deal with condition precedents and contractual remedies. For representations, warranties, and covenants the reader may refer to the first part of this article available at: https://www.dhirubhai.net/pulse/guide-contract-drafting-building-blocks-part-i-bahram-khan/.

Conditions Precedent

Conditions precedent are terms in a contract which requires certain circumstances to exist before a party to the contract is required to perform its obligations. A basic example can be discerned from the purchase of a computer: the seller shall only dispatch the computer to your home upon full payment being made. Similarly, in a joint venture agreement the parties may include a condition precedent that both parties shall have approved and undertaken all action required for the execution of the joint venture agreement. Please note that contracts which do not contain conditions precedent are effective immediately upon execution.

The non-existence of all circumstances by a set date (long stop date) for which a party is responsible through conditions precedent allows the other party to walk away from the agreement or terminate it. When drafting conditions precedent a lawyer should reduce the conditions precedent that their client will have to comply with whilst maximizing conditions precedent necessary to protect their client's interests that the other party must fulfil.

Disputes relating to conditions precedent usually arise in contracts where the conditions precedent are not fully satisfied upon execution. In such circumstances a delayed closing occurs. As an example, an acquisition agreement may inter alia include a condition precedent that the buyer obtains funding from banks by a set date (long stop date) for the purchase of the shares in the target company. Usually in such circumstances the seller’s counsel will want the inclusion of a covenant which requires the buyer to diligently pursue and use reasonable efforts to obtain the funding. Without the use of such covenant the buyer may simply choose not to approach the bank for funding and thereby cancel the transaction at will.

As required with other contractual provisions, it is essential to draft conditions precedent with precision and clarity without the use of subjective terms to prevent a party from arguing that a condition is not fulfilled. In a loan agreement, for example, the inclusion of a requirement that the financial health of the borrower is satisfactory to the lender as a condition precedent should be avoided. Similarly, in an acquisition agreement a condition precedent that no “adverse scenario” shall have occurred from the execution date till the closing date is a vague term which should be avoided. In the latter case, any downturn in the economy or other event that may be remotely categorized as an “adverse scenario” could be used to avoid closing of the transaction when convenient.

Conditions Precedent in Share Purchase Agreement

The form of conditions precedent incorporated in contract vary by the nature and peculiar circumstances of the contract. In a share purchase agreement usually the following conditions precedent are included as per the format below:

“The obligation of the Seller to transfer and the obligation of the Buyer to acquire the shares of the Target (“Sale Shares”) shall be subject to the fulfillment/satisfaction of the conditions precedent set forth below on or before [INSERT DATE] (“Long Stop Date”), unless otherwise waived by the Seller to the extent permissible under the law:

·?????Governmental Approval: The Buyer has lawfully obtained all governmental approvals and consents required from any governmental entity, or body, including the Competition Commission of Pakistan, for the purchase of the Sale Shares.

·?????No Restrictions: There are: (i) no laws, regulations, rules, directives, official notifications or decrees of any court that prohibit the closing of this Agreement; and (ii) no pending proceedings which may negatively affect the Target or the buyer’s ownership of the Target.

·?????Representations and Warranties: All representations and warranties made under this Agreement are true, accurate and correct up to and including the Closing Date.

·?????Covenants: The Seller is in full compliance with all of the covenants set forth in this Agreement.

Note to reader: In Share Purchase Agreements where the execution and closing dates are different the buyer usually insists on inclusion of covenants to restrict the seller and the target from undertaking any action that may impair the value of the target. Such restrictions inter alia include: (i) creating subsidiaries; (ii) incurring or prepaying debt; (iii) entering into material contracts; (iv) paying dividends; (iv) disposing of assets; (v) settling of litigation; (vi) amending constitutive documents and (vii) changing accounting practices.

·?????Purchase Price: The purchase price shall be equal to or less than the break up value of the Sale Shares as determined by a practicing chartered accountant in compliance with applicable law(s).

·?????Due Diligence: During the period between the Execution Date and the Closing Date there shall not have occurred any event that would prompt a significant or material change in the observations, findings and results of the due diligence conducted by the Buyer. In this regard the Sellers shall deliver to the Buyer, within seven (07) Business Days, any and all information as is requested by the Buyer to determine and confirm that no event has occurred which would cause a significant or material change in the observations, findings and results of the due diligence conducted by the Buyer.?

·?????Material Adverse Effect: there shall not have occurred any Material Adverse Effect between the Execution Date of this Agreement and the Closing Date, attributable to any action of the Seller or the Target.

·?????Officer’s Certificate: the Seller has delivered a certificate by one of its officers stating that the representations and warranties made under the Agreement are true, correct and accurate up to and including the Closing Date and that it has complied with all the covenants set forth in this Agreement.

·?????Securing Financing: the Buyer has adequately procured financing from the Bank on reasonable terms for the purpose of buying the Sale Shares under this Agreement.?

Consequences of Non-Fulfilment of Conditions Precedent

Conditions Precedent usually allow a party to walk away from the deal in the event that the prescribed conditions are not fulfilled. Please note, however, that non-fulfillment of conditions precedent does not always lead to termination. For example, the failure by the seller to provide the documents required for due diligence by the long stop date may not result in termination if the buyer decides to waive it, subject to a price adjustment. Alternatively the buyer may demand further concessions / other more favorable terms. The following are the possible outcomes in the event of non-fulfillment of all the conditions precedent:

·?????The contract is terminated.

·?????The closing date is extended to allow fulfilment of the condition precedent.

·?????The condition precedent is waived (possibly for more favorable terms).

·?????The condition precedent is changed to a covenant.?

Contractual Remedies

It is essential for a lawyer to draft remedial provisions in a contract and avoid reliance on case law and statutory remedies available which contain an element of uncertainty. Remedial provisions, especially in large transactions, set out in detail the remedies available to a party in the event that another is in breach of contract. It is important to bear in mind that whenever the parties have any dispute – usually concerning money – these are the provisions that lawyers refer to and which are oftentimes the source of litigation. Remedial provisions in a contract can be broadly categorized into two distinct categories: (i) triggers to a right of remedy; and (ii) the remedies available for a breach.

(i) Triggers to Remedies

A contentious aspect of remedial provisions are the triggering events that a lawyer must frame to categorize events that lead to remedial rights. It is important for drafter to ensure that the grounds that give the right to a party for remedies are drafted in a unambiguous manner. Generally, a breach of a contract which consists of a failure, without lawful excuse, to perform contractual obligations is a trigger for remedies. A breach of contract may take distinctive forms which may be categorized as: (i) outright refusal to perform; (ii) unsatisfactory/defective performance; and (iii) delayed performance.

Whilst it is easy to stipulate that a breach of the contract shall give rise to remedies, in reality, what constitutes a breach of a contract is an intricate and complex question, both legally and factually. As an example, in the case of a facility management agreement for a bus transport service under which one party provides management services, the party receiving the services may allege that the services provided were unsatisfactory and as such constitute a breach of contract and so refuses to pay. The party providing services, on the other hand, may argue that the other party is in breach of contract as it is not making payment. To avoid these disputes the drafter is to clearly set out, in as much detail as necessary, the specific grounds/triggers giving a party the right to remedies. In particular vague terms such as “satisfactory performance” should be avoided. A drafter should aim to set out what satisfactory performance mean/cover. As an example, in facility management agreements, remedial rights are given in the event that key performance indicators (“KPI”) are not met by the party providing management services. KPI failure events under the facility management agreement may inter alia include:

·?????Operating Hours: Failure to provide services for the full duration of the daily operations which are from 9:00 am to 9:00 pm Pakistan Standard Time.

·?????Maintenance: Failure to conduct regular maintenance for the machines and equipment at the facilities.

·?????Daily Report: Failure to provide a daily settlement reports (Note to reader: The daily report contains information regarding payable and receivable transactions generated).

·?????Misbehavior of Staff: Failure by the personnel to adhere to the Code of Conduct or any misbehavior with passengers. ??

·?????Security: Non-compliance with the security arrangements required under this Agreement.

Typically triggering of KPI failure events entitles the other party to liquidated damages (explained below) under contracts which are essentially pre-determined amounts to be payable for particular breaches/non-compliance of contracts.

In addition to breach of contract, there may be several other triggering events:

(i)???????????Judgments, orders or any decree being passed/entered against a party in excess of PKR [INSERT]/- which is/are not complied with by a party;

(ii)??????????Liquidation, bankruptcy, insolvency or winding up of a party;

(iii)????????Change of control of a party (tailored to the specific circumstances);

(iv)????????Change in the financial health/conditions of a party or credit rating (usually found in loan agreements); ?

(v)??????????Any representation or warranty proving to be incorrect, when made or when reaffirmed;

(vi)????????A party being engaged in corrupt or fraudulent practices;

(vii)??????A party becoming blacklisted by the Government;

(viii)?????The creation of a charge or encumbrance on the assets of a party without the consent of the other party (usually found in loan agreements);

(ix)????????The liquidated damages cap being exceeded; and

(x)??????????Default or acceleration being declared under other agreements.

Remedial Rights?

The remedial rights under a contract are drafted to fit the particular circumstances, nature of the agreement, and the objectives of the parties. Whilst in certain contracts the remedies are basic and standard, in large complex transactions, often involving millions of dollars, the remedial provisions are highly negotiated.

The main remedial rights usually incorporated in contracts are inter alia the following:

(i)??????????Termination; ?

(ii)?????????Liquidated Damages;

(iii)????????Acceleration; and

(iv)????????Indemnification.?

Termination

Termination essentially results in all parties no longer being obligated to perform their obligations under a contract. The triggers usually incorporated in contracts which entitle a party to pursue termination are termination by: (i) mutual consent; (ii) completion of the duration of the contract?(without renewal); (iii) termination on the ground of material breach of contract; and (iv) incapacity or change of circumstances preventing the performance of contractual obligations.

It is imperative to mention that termination (unlike the statutory remedy of recission) does not have an impact on the liabilities/obligations of the parties that accrued prior to its termination. Therefore, where a lease agreement is terminated any due rent payable before termination is still payable. Additionally, the termination of a contract does not mean that the parties are no longer entitled to pursue other forms of remedies that may be available to them.

A termination clause should incorporate the procedural requirements for terminating contracts which inter alia includes the notice to be given to the other party, and opportunity to cure breach, if termination is initiated on grounds of breach of contract. Additionally, the contract should detail the steps to be taken post-termination which are to be tailored to the specific circumstances of the contract. As an example, a facility management agreement may require the operator to deliver information and records as may be reasonably necessary for the operation of the facility.

It is critical to clearly prescribe the grounds and procedure to be followed for termination as wrongful termination of contract may itself be a breach of contract and entitle the other party to remedies. ?

As a final note, termination is not an appropriate remedy in circumstances where substantial obligations by a party have already been performed. For example, the termination of a contract for purchase of immovable property on the ground of breach of representations and warranties discovered after the buyer made payment, i.e. after closing of the transaction, would not be useful.

Liquidated Damages

Liquidated damages provisions grant a right to a party to be paid a specific amount upon the triggering/occurrence of particular events. Examples of these include: (i) a severance payment to an employee under an employment agreement where the agreement is terminated without cause; (ii) payment of a sum where complete payment is not made by a set date under a purchase agreement; and (iii) a percentage amount payable in the event of failure to comply with the key performance indicators in a facility management agreement.?

A draft liquidated damages clause is provided below:

“If the Contractor: (i) fails to comply with any material provision of this Agreement; (ii) any event or circumstance occurs that would give the Employer a termination right under this Agreement; or (iii) the Contractor fails to comply with the Key Performance Indicators, (each a “Breach”) and the Contractor does not cure such breach within thirty days, the Contractor shall be liable to pay as liquidated damages (“Liquidated Damages”) an amount equal to PKR 20,000/- per each Breach per day for which the Breach has occurred or continued.”

Where a contract includes liquidated damages provisions the courts in Pakistan will only allow recovery of such amount as is a genuine estimate of harm likely to have been suffered.

Before elaborating on liquidated damages it is pertinent to look at the relevant sections under the Contract Act 1872 (“Contract Act”) for damages generally. Under section 73 of the Contract Act where a contract has been breached, the party who suffers by such breach is entitled to receive, from the party who has breached the contract, compensation for any loss or damage caused to him thereby. The Supreme Court of Pakistan (“Supreme Court”) in Kamran Construction (Pvt) Ltd vs. Nazir Talib [2010 SCMR 829] explained section 73 in the following terms:

“[A] party claiming damages suffered due to breach of contract must establish the contract, the breach thereof and the extent of damages. The onus is on the plaintiff [to prove breach and damages suffered as a result].”

Based on the above, as a general rule, for a party to claim damages such party must not only prove a breach of contract but also the loss occasioned. This is contrary to liquidated damages in which the triggering of an event entitles a party to a pre-determined amount, regardless of the actual loss suffered.

As mentioned above, courts will only allow recovery where the amount pre-determined is a genuine estimate of the harm/loss likely to have been suffered. Section 74 of the Contract Act provides that where:

(i)???????????a contract has been breached; and

(ii)??????????the contract provides an amount to be paid for such breach or if the contract contains a penalty for such breach

the non-breaching party is entitled to reasonable compensation from the breaching party (regardless of whether actual damage or loss is proved).

Whilst what amounts to reasonable compensation is difficult to ascertain, the superior courts have indicated that all factors and circumstances surrounding a particular breach is to be considered in determining what “reasonable compensation” is. As an example, in Province of West Pakistan vs. Messers Mistri Patel & Co [1969 PLD Supreme Court 80] a contract, between the Government of Sindh and a company, for the purchase of rice contained a clause that imposed liquidated damages of five percent of the value of the goods in case of failure by the company to lift the goods by the stipulated date. The company was not able to lift the goods and the Government of Sindh filed a suit for damages. The Supreme Court, however, refused to award damages worth five percent of the value of the goods. The Supreme Court reasoned that there is a distinction between liquidated damages (as being a genuine pre-estimate of damages agreed upon by the parties) and penalty (as a stipulation in terrorem) and that the latter (penalty) is not enforceable.

The heading or nomenclature used in a contract is not relevant in determining whether a provision is a genuine estimation of the harm likely to be suffered as a result of a breach or a penalty. Guidance on the distinction between the two is provided in Ramalinga Adaviar vs. Meenakshisundaram Pillai [85 Ind Cas 261] in which the Madras High Court noted:

“If, in making provision for breach of contract, the [contract] stipulates… [in the event of breach] for such compensation as the court would deem reasonable… there is no penalty... But if, on the other hand, the court would… [conclude] that the stipulation was put in not by way of reasonable compensation… but in order that by reason of its burdensome or oppressive character, it may operate in terrorum over the promisor so as to drive him to fulfil the contract, then the stipulation is one by way of penalty.”

The Supreme Court in Khanzada Muhammad Abdul Haq Khan Khattak & Co vs. WAPDA through Chairman WAPDA [1991 SCMR 1436] in this regard noted:

“Where the court considers that the amount mentioned in the contract as liquidated damages is oppressive, or highly penal in nature, the court may refrain from granting such amount and itself determine the amount which is reasonable…”

For a detailed commentary and analysis on liquidated damages the reader is advised to refer to the following article authored by Hassan Raza:

https://sahsol.lums.edu.pk/law-journal/liquidated-damages-%E2%80%93-common-law-versus-pakistan-law#:~:text=Therefore%2C%20as%20of%20today%2C%20if,of%20the%20pre%2Destimated%20amount.

Acceleration

Acceleration, typically found in credit agreements, essentially allows the lender the right to demand full payment of all outstanding amounts under the agreement on the occurrence of particular events such as breach of financial covenants. Acceleration has disastrous effects as the borrower rarely has the funds available to immediately pay the lender. The lender will typically not use the right of acceleration but rather use it as a threat to extract concessions from the borrower or to obtain greater control over the borrower so as to restrict its activities to secure its financial health and thereby ensure that its interests are secured.

A draft acceleration sample clause is provided below:

“Acceleration: In the case of an Event of Default, as specified under this agreement, with respect to the Company or any Guarantor of the Company, all outstanding Loans shall become due and payable immediately without further action or notice, unless a waiver is provided by the Lender.”

Indemnification

An indemnification provision in a contract essentially protects a party from liability by providing an undertaking by the indemnifying party to compensate the indemnified party from third party claims as a result of either (i) a breach of the contract or (ii) breach of any law by the indemnifying party. As an example, a distribution agreement, under which a distributor agrees to distribute a suppliers product, may contain an indemnification clause which protects the distributor from third party claims if such claims are as a result of breach of the contract or any law by the supplier. In the event that the distributor distributes products which infringe the intellectual property of a third party, the distributor shall have the right of compensation for any damages or liabilities imposed upon it as a result of a breach of the contract or any illegality on the part of the supplier. In this regard, the distribution agreement is likely to contain a representation and warranty which provides that the supplier is the lawful owner of the intellectual property in the products and that this distribution agreement shall not result in any material breach of law.

A draft indemnification sample clause is provided below:?

“Indemnification: Each Party (“Indemnifying Party”) shall defend, indemnify and hold harmless the other Parties’ officers, shareholders, managers, members, employees and agents (each an “Indemnified Party”) from and against any and all claims, actions, damages, losses, obligations, liabilities, recoveries or deficiencies, costs and expenses that the Indemnified Party may incur, suffer or bring and which, directly or indirectly relate to any breach of this Agreement by the Indemnifying Party.”

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.