Unlike representations—statements of fact as of a specific point in time—covenants are ongoing promises by one party to take or not to take certain actions. Covenants can generally be divided into three categories: affirmative covenants—promises to take specified actions; negative covenants—promises not to take specified actions; and financial covenants—promises to maintain certain levels of financial condition or performance or not to take specific actions unless certain levels of financial condition or performance exist at the time.3 Negative covenants are also referred to as restrictive covenants, because they restrict or prohibit certain actions. (See section 9:3.3.) Broadly speaking, covenants are designed to ensure that a party receives the benefits that it bargained for in the operative provisions of the contract.
As a matter of usage, the parties’ primary obligations under the contract are not usually referred to as covenants, even though they are promises. Thus, a seller’s obligation to sell once all applicable conditions precedent have been satisfied is not typically referred to as a covenant.
In the example of a six-year lease of manufacturing equipment, the main objectives of the lessor are to ensure that the lessee pays the rent when due and returns the equipment at the termination of the lease. These will be the subject of the lease’s operative provisions. But the lessor will also want the lessee to maintain the leased assets, to maximize the value of the equipment when it is returned to the lessor. This is accomplished through the use of covenants that dictate what the lessee must do, and cannot do, with respect to the leased equipment.
A typical equipment lease will include covenants requiring the lessee to do, or not to do, the following (among others):
Each of these covenants is designed to help the lessor protect its residual interest in the leased equipment.
The lessor, in addition to its concern regarding the value of the equipment, will want to ensure that the lessee will be able to make the rent payments over the term of the lease. The lessor will have received financial information as to the lessee and required the lessee to make representations as to its financial condition. This provides the lessor with some comfort that the lessee can handle its lease payments at the outset of the lease, but doesn’t protect at all against the diminution over time of the lessee’s credit, its ability to meet its financial obligations.
Credit-related covenants restrict a party’s ability to engage in activities that may result in a worsening of its financial condition. These activities include the following:
Financial covenants, which require the covenanting party to periodically meet certain financial benchmarks, are also used to address credit concerns. These benchmarks are set at levels that are designed to create an "early warning signal" in the event the covenanting party is having financial difficulties.4
The general pattern for the negotiation of negative covenants is that Party A proposes a covenant that will restrict Party B’s activities. This draft covenant is relatively absolute as Party A’s preference would be to prohibit Party B entirely from engaging in the specified conduct. Party B then has the burden of proposing changes to the covenant that it believes are necessary to give it the flexibility to operate its business without the need to request consents or waivers from Party A.
The difference between crafting exceptions to representations and to covenants is like the difference between writing a newspaper article and writing science fiction: one deals with actual facts, while the other addresses potential facts. Ensuring that representations are correct requires only diligent fact gathering. Uncovering and disclosing all information that is called for by the representations is essentially a forensic exercise.5 On the other hand, the lawyer who must negotiate a covenant that restricts his client’s ability to incur debt for the next six years, for example, has a much more challenging task. First, the lawyer and his client must collectively consider all of the possible needs for debt over the term of the contract. Then, they must convince the other party of the need to build flexibility into the covenant to permit such debt. Last, they must draft the exceptions broadly enough to achieve their objective, taking into account that plans often change.
There are two basic types of covenant exceptions: carveouts and baskets.
A carveout gets its name because it has the function of removing, or carving out, part of the restriction created by the covenant. If the paradigm of a typical negative covenant is "thou shalt not do A through Z," the paradigm of a carveout is "but thou shalt be permitted to do ‘Y’." Here is an example of the use of a carveout:
The Borrower shall not sell any of its assets, except for the sale of obsolete equipment in the ordinary course of business.
A basket, on the other hand, is an exception that creates the right to deviate from the covenant’s restrictions by some specified amount (often expressed in dollars). The purpose of a basket is to give the restricted party a limited ability to deviate from a covenant’s restrictions. The above exception could be converted into a basket thus:
The Borrower shall not sell any of its assets, except for the sale of obsolete equipment in the ordinary course of business in an aggregate amount not to exceed $1,000,000.
Here, the restricted party’s ability to sell obsolete equipment is not open-ended. After the first
such sale for $200,000, for example, the party may only sell an additional $800,000 of obsolete equipment.
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The scope of a covenant can be limited or qualified in a few respects. The most important one is to create exceptions or to be specific regarding its scope. Two basic types of exceptions can be distinguished and will be addressed in this paragraph: carve-outs and baskets.
Carve-outs. A carve-out is formulated as an exception and functions as a removal, or carve-out, of part of the restriction imposed by the covenant. For example:
Borrower shall not sell any of its assets, except for any equipment that has reached its end-of-life status or a status of technical obsolescence.
Baskets. A basket, on the other hand, is an allowance that establishes the right to deviate from the covenant’s restrictions by some specified amount. The purpose of a basket is to give the restricted party a limited ability to deviate from a covenant’s restrictions. The above exception could be converted into a basket, as follows:
Borrower shall not sell any of its assets, except for any equipment that has reached its end-of-life status or a status of technical obsolescence up to an aggregate amount not exceeding EUR 15,000,000.
Similar baskets are found in the pre-closing covenants in share purchase agreements, where the purchaser requires the seller to obtain prior approval for certain types of transactions. The example shows that further distinguishing between the nature of the underlying transaction is helpful in finding a middle ground:
Except to the extent provided in a budget of Acquired Companies that has been fairly disclosed to or approved by Purchaser, Seller shall not permit Acquired Companies to do any of the following pending the Closing without the prior written approval of Purchaser (which approval shall not be unreasonably withheld or delayed):
(a) enter into an agreement or a series of related agreements which are in the ordinary course of business for an aggregate amount in excess of EUR 250,000;
(b) enter into an agreement or a series of related agreements which are not in the ordinary course of business for an aggregate amount in excess of EUR 50,000;
(c) enter into any abnormal or unusual agreements or commitments, including any which (i) are unlikely to become profitable, (ii) are of an unusually long-term nature or which cannot be terminated within 24 months, (iii) contain a payment term or potential liability exposure deviating significantly from Acquired Companies’ contracting policy as at the Signing Date, or (iv) would otherwise likely have a financial impact after the (initial) term of the contract;
(d) enter into any agreement in which a member of Seller’s Group has an interest.
Remedies for breach of a covenant. In most agreements that are subject to a European continental law, it is unnecessary to include a remedy in a covenant. Unlike in civil law jurisdictions, the default remedy under common law for breach of contract is that the harmed party is entitled to damages but not a priori to specific performance, which is an equitable remedy granted at the discretion of the court. In the European continental legal systems, the opposite applies (see paragraph 2.2(a)): by default, a party can ask for specific performance (and if that is not practicable or adequate, damages can be claimed). Because an entitlement to damages often does not protect the harmed party’s interests adequately, an agreement that is drafted in view of the law of a common law jurisdiction usually provides for specific remedies in the event of a breach of a covenant.
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That
Pesky Little Thing Called Fraud: An Examination of Buyers’ Insistence Upon (and Sellers’ Too
Ready Acceptance of ) Undefined “Fraud Carve-Outs” in Acquisition Agreements
Glenn D. West, 69(4): 1049-1080 (August 2014)
In those states that
have a high regard for the sanctity of contract, a wellcrafted waiver of reliance provision can effectively
eliminate the specter of a buyer’s post-closing fraud claim based upon alleged extra-contractual
representations of the seller or its agents. But undefined “fraud carveouts” continue to find their
way into acquisition agreements notwithstanding these otherwise well-crafted waiver of reliance provisions. An
undefined fraud carve-out threatens to undermine not only the waiver of reliance provision, but also the
contractual cap on indemnification that was otherwise stated to be the exclusive remedy for the representations
and warranties that were set forth in the contract. Practitioners continue to exhibit a limited appreciation of
the many meanings of the term “fraud” and the extent to which a generalized fraud carve-out can
potentially expand the universe of claims and remedies that can be brought outside the remedies specifically
bargained-for under the parties’ written agreement. Given the frequent insistence upon (and continued
acceptance by many of) undefined fraud carve-outs, and recent court decisions that bring the undefined fraud
carve-out issue into focus, this article will examine the various (and sometimes surprising) meanings of the
term “fraud”, and the resulting danger of generalized fraud carveouts, and will propose some
possible responses to the buyer who insists upon including the potentially problematic phrase “except in
the case of fraud” as an exception to the exclusive remedy provision of an acquisition agreement.
This term has several meanings. In the context of:
This term has a number of meanings. In the context of:
In the ADR world the term “carve-out” refers to an exception within an alternative. Arbitration is a popular alternative tocourt litigation, but contracting parties may not wish to commit all potential disputes to that forum. Frequently, negotiations over the choice for litigation or arbitration will lead contractual parties to draft a court litigation exception, or “carve-out”, within an arbitration clause. Advocates for such clauses argue that they provide for greater flexibility and customization of the dispute resolution process, however, as a number of recent court decisions show, the application of a “carve-out” can be prone to problems in practice. This piece considers some of those problems and potential solutions.
The “Carve-Out”
“Carve-out” provisions are frequently used to
distinguish claims regarding a certain subject matter, such as those concerning intellectual property, from
general commercial disputes. An arbitration clause that contains a “carve-out” may resemble the
following sample (“carve-out” language in bold):
“Any dispute arising out of or related to this Agreement shall be submitted to binding arbitration under the [specified rules (the “Rules”)] to be heard by a sole arbitrator appointed in accordance with the Rules, except for those causes of action brought in connection with the ownership or right to use [specified intellectual property] which shall be submitted to the exclusive jurisdiction of the courts of [specified jurisdiction].”
Other variations of “carve-outs” may see parties excepting to the jurisdiction of courts those actions brought for specific types of relief, such as injunctions, while requiring damage claims to be heard in arbitration.
Drafting a “Carve-Out” — Issues to Consider
Litigation over the intent
and meaning of a contractual dispute resolution clause exemplifies the phrase a “lose-lose
scenario”. The intended benefit of a detailed disputes clause is to provide all contractual parties with a
clear path to resolving their differences, but that value is lost and extra costs are incurred when contentions
arise over the scope and meaning of such provisions. Unfortunately, “carve-out” clauses have been
known to generate disputes of this kind, but a survey of available precedents suggests that much of that can be
avoided through careful drafting. The following points summarize some key takeaways drawn from recently
published decisions regarding disputes over “carve-out” provisions:
The opposite outcome occurred in the case of Archer and White Sales Inc. v. Henry Schein Inc.[ii] There, the litigation “carve-out” was, in the Fifth Circuit’s view, placed in a position within the clause so as to modify the delegation of authority to an arbitrator that would normally accrue under the language assigning to him or her any dispute to decide. Consequently, after much litigation, the Court proceeded to determine itself whether the matter was to be heard in court or in arbitration. [iii]
These cases highlight the fact that seemingly innocuous drafting choices can significantly impact the course of dispute resolution. If possible, it is best to anticipate, instead of litigate the “who decides” question by including express language in the clause to the effect that: “Any controversy or disagreement regarding whether a dispute (or claim within a dispute) arising pursuant to this clause is to be submitted to arbitration or to the designated court, shall be referred to [designate arbitrator or/ court] for a final determination.” [iv]
Conclusion
Ultimately, “carve-outs” may be a useful tool to resolve
difficult negotiations over an arbitration clause. Nevertheless, those seeking to draft an arbitration provision
containing a “carve-out” should be careful to include precise language to guard against unintended
outcomes.
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A contract usually provides for specific remedies in the event of a breach of a covenant (see section 2:5). A party that is entitled to performance of a covenant may also seek a judicial order of specific performance forcing the covenanting party to perform. Even if the parties agree to specific performance as a remedy, it will not always be available. The court always has the discretion not to grant equitable remedies such as specific performance. For example, specific performance is not available if the court determines that money damages are adequate.
The provisions specifying the requirements that must be satisfied before a party is obligated to perform under a contract or before a closing occurs are known as conditions precedent. The quintessential examples of conditions precedent are found in purchase agreements: the seller is not required to transfer the assets unless the buyer pays the purchase price, and the buyer is not obligated to pay the purchase price unless the seller transfers the assets. Conditions are often colloquially referred to as "outs," because a failure by one party to satisfy its conditions allows the other party to get out of the contract or terminate certain of its obligations. Conditions precedent vary widely, depending on the type of contract, although as is discussed in more detail below there are many that are fairly standard. In agreements that lead to a closing, the conditions precedent section dictates what documents must be delivered and what other actions must be taken at the closing.6
A condition precedent is a condition or an event that must occur before a right, claim, duty, or interests arises. Compare condition subsequent.
In a contract, a condition precedent is an event that must occur before the parties are obligated to perform. For example, an insurance contract may require the insurer to pay to rebuild the customer’s home if it is destroyed by fire during the policy period. The fire is a condition precedent. The fire must occur before the insurer is obligated to pay.
Courts prefer to interpret a clause in a contract as a promise rather than a condition precedent to avoid forfeiture. The Second Restatement of Contracts has dropped the term “condition precedent” and simply refers to it as “condition.”
In property, a condition precedent is an event at which the vesting of a property interest occurs. If the condition does not occur before a specified time, the condition fails, and the property interest does not vest.
In general, a condition is a term or requirement stated in a contract. Such a term can be drafted as a condition precedent or condition subsequent, among other things. A condition subsequent is an event or state of affairs that, if it occurs, will terminate one party’s obligation to the other.
For example, a contract might state something like: the client will pay for the haircut, unless the hairdresser does not perform the haircut. In this case, the client has a contractual duty to pay for the haircut, and this obligation will only end if the hairdresser does not perform. In other words, in order to prove that they are no longer bound, the client must prove that the haircut never occurred.
Related Terms:
A condition precedent is a clause in a given agreement that is required to trigger certain contract obligations. If you fail to satisfy a condition precedent to your contract, then it may allow the defendant (the breaching party) to shield themselves from liability — the defendant can reasonably argue that they did not actually commit breach by violating any contractual obligations. Simply put, the basis of their defense is that the contractual obligations did not trigger, and therefore, could not have been violated.
For example, suppose that you are a product manufacturer and you agree to a bulk purchase order contract with the buyer. The timely delivery of the goods in question is a “condition precedent” written into the contract — in other words, if you fail to deliver the goods in a timely manner (designated by a specific date and time in the contract), then the buyer’s obligation to perform their contract obligations and purchase/accept the goods will not trigger.
Now, you are several hours late for the delivery. The buyer refuses to accept the delivery and you sue for damages. The buyer may argue that they cannot be held liable as you failed to satisfy the condition precedent. You could, ostensibly, argue that your failure to satisfy the condition was immaterial, as the delay was minor and had no appreciable effect on the defendant’s business interests. In all likelihood, however, the buyer would be able to avoid liability for breach.
It’s worth noting that a breaching party cannot actively create the circumstances that lead to the condition precedent defense — basically, the breaching party cannot shield themselves from liability for your “failure to satisfy a condition precedent” if they engaged in activities that interfered with your ability to satisfy the condition precedent.
Let’s return to the previous delivery example for clarity.
Suppose that you were delayed in making the delivery of goods. The buyer attempts to avoid liability by arguing that you failed to satisfy the condition precedent of “timely delivery.” Further investigation reveals that the buyer actually wanted to terminate the contract, and intentionally interfered with your ability to make a timely delivery so that they could avoid liability for their eventual breach. Perhaps the buyer called you regularly and demanded that you alter and revise the items at-issue, thus delaying the timely manufacture and delivery of the goods.
Given those circumstances, the defendant would not be entitled to make use of the condition precedent defense.
Businesses need to know if they have entered a contract or if a condition has been fulfilled for a contractual obligation to become effective. That’s why it’s important that those tasked with negotiating and enforcing your commercial contracts know what is meant by a ‘condition precedent’, and what is required of your business or the other contracting party to fulfil the condition precedent.
A condition precedent is a condition of a contract which must be fulfilled for either the contract to be valid or certain contractual obligations to come into effect. As a result, it is vital that the parties to a contract understand what is meant and required by any conditions precedent and that they agree what will happen if such conditions are not satisfied. Failure to understand a condition precedent could result in a commercial dispute, so it’s best to take the time to understand condition precedents and how they could impact your specific contractual arrangements.
The satisfaction of a condition precedent results in the contract or a certain obligation in the contract becoming valid and binding. However, a condition subsequent has the opposite effect. Where there is a condition subsequent a contract which is already valid, and binding will terminate if the condition subsequent is not satisfied.
If there is a breach of a condition precedent (that is, a failure to satisfy the condition) the contract or certain contractual obligations will not come into force. In some situations, failure to meet the condition precedent means there is no binding contract.
Normally, if a party breaches a term in a contract it will result in them being liable to pay damages to the non-breaching party. Where a contract has been breached, the contract will usually still be valid and binding and the commercial position of the parties under the contract will not change. The situation is to be contrasted where there is a suitably drafted condition precedent in a contract. For example:
The use of condition precedents is crucial if you are a contracting party and some matters are outside your control or power. That’s because ordinarily, a breach of contract would result in the non-breaching party bringing a claim for damages against the party in breach. A condition precedent can be used where the payment of damages would not adequately compensate the non-breaching party, or where failure to satisfy the condition precedent means that the contract would be irrelevant.
Conditions precedent come in various guises and can be used in many different types of contracts. Here are some examples of condition precedent:
Although the decision about whether to include a condition precedent in a commercial contract is a business decision, it’s crucial that the condition precedent is carefully drafted by your commercial solicitor and that your business understands exactly what is meant by the condition precedent and how it is triggered.
A number of factors need to be thought about and documented when dealing with conditions precedent. Poor or unclear contract drafting, or failure to include key components, can result in the courts having to decide what the parties intended. In the event of a commercial dispute leading to court litigation the court will consider the contract on a case-by-case basis, looking at the circumstances to determine if the parties intended the obligation to be either a condition precedent (breach of which would result in the contract having no effect) or a contractual term (breach of which would result in damages).
To reduce the risk of commercial disputes the wording in the contract must be both clear and certain about:
The use of the phrase ‘condition precedent’ is not strictly required in the contract for something to amount to a condition precedent, but considering case law it is usually advisable to include it. In addition, consistency throughout the document whenever a condition precedent is referred to is also key to minimising the risks of disputes over condition precedents.
It is important that the parties to the contract agree with the inclusion of a condition precedent condition in the contract and understand what is required of them and when as failure to satisfy a condition precedent can have profound consequences.
The main points to consider when using a condition precedent are:
The use of conditions precedent in a contract can be advantageous, particularly where the obligations are onerous or pivotal to the agreement. You should ask your commercial solicitor to carefully consider their use and the precise wording of each condition precedent to best protect your business interests.
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A simultaneous closing occurs when an agreement is executed and delivered at the same time that all of the conditions precedent to the effectiveness of the agreement are satisfied. When an agreement is executed and delivered, but the conditions precedent aren’t satisfied until later, a delayed closing is the result.
The main distinction between these two is that the conditions precedent relating to a delayed closing must be much more carefully negotiated than those that relate to a simultaneous closing. In a delayed closing, any element of uncertainty, discretion, subjectivity or ambiguity included in a condition precedent can give one party a basis to claim that a condition isn’t satisfied and walk away from the transaction. Consider a stock purchase agreement containing the following condition to the purchaser’s obligation to purchase:
The Seller shall have delivered to the Purchaser the Target’s financial statements for the quarter ending September 30, 2001, and such financial statements shall be satisfactory to the Purchaser in all respects.
This condition gives the purchaser the unilateral right not to close by asserting that it is not satisfied with the September numbers. Suppose that the purchaser wants out of the deal because the economy has suffered a downturn since the date that this stock purchase agreement was entered into, but there is no condition that gives the purchaser the right to get out of the transaction for that particular reason. The broadness of the condition precedent above relating to the financial statements could be used by the purchaser as its excuse not to close, even if the target’s numbers aren’t significantly disappointing.
What if, instead, the same condition were contained in an agreement that was being entered into by the parties at the same time that the closing was taking place? The seller’s lawyer should not care about the subjective nature of this condition. If the purchaser is not satisfied with target’s financial condition (or anything else, for that matter, including the economy) at the time of the closing, it has the unfettered right to walk away from the deal, because it hasn’t signed the agreement yet.
Why include conditions precedent at all if there is going to be a simultaneous closing? It is not a necessity, but it does serve two useful functions: while the agreement is being negotiated, it creates a roadmap as to what the parties expect at the closing, and it creates a permanent record of what occurred at the closing.
Conditions are often hotly negotiated because they potentially give one or both parties the ability to get out of the transaction. Each party will want to minimize the number of conditions that it must satisfy, and at the same time will want to impose conditions on the other party that satisfy its own business and legal concerns about the deal.
The conditions precedent section of a stock purchase agreement, for example, will start with language such as the following:
The Purchaser’s obligation to purchase the Shares shall be subject to the prior satisfaction of the following conditions precedent:
This will be followed by a list of all of the things that the purchaser requires in order to close, foremost among which will be the delivery of the shares being purchased. Others may be business oriented: for example, delivery of financial projections of the target company, and satisfactory interviews with the target’s suppliers. Some will relate to legal issues, such as evidence of the target’s corporate existence and delivery of legal opinions.
The obligation of the purchaser to purchase the stock will be subject to the prior satisfaction of each of the specified conditions. The seller’s failure to satisfy even one of the conditions will normally give the purchaser the legal right to walk away from the transaction. Agreements often require both parties to satisfy a set of conditions, so that either party is excused from performance in the event the other party fails to satisfy the conditions applicable to it. In other cases, only one party is required to satisfy conditions precedent in order to force the other party’s performance, the most notable among these being debt financing agreements, where the lender’s performance is merely the provision of money. It is all a matter of negotiation and custom.
Does the failure to satisfy a condition precedent always result in a termination of the contract? It often does not—rather than terminating the contract, the party having the right to terminate may use it as a source of leverage to commence a new negotiation and extract concessions from the other party. For example, if the condition that isn’t satisfied is a requirement that a business being acquired have a minimum amount of cash flow during the three months prior to the closing, the buyer may insist that the purchase price be reduced in order for it to waive the condition and proceed with the acquisition.
Often a condition will be waived and the agreement rewritten to require that it be completed on a post-closing basis. This is often referred to as a post-closing condition—an inaccurate name, as a technical matter, because such a requirement is no longer a condition to performance. Instead, it has been converted into a covenant that one party must perform or else suffer the consequences for breach.
Different contracts call for different types of conditions with some conditions precedent being traditional for certain types of transactions. Other conditions will be required to address specific issues or concerns in the particular circumstances of one transaction. A party with a high degree of bargaining leverage may force its counterparty to jump through hoops by requiring the satisfaction of many conditions before it will close.
Some conditions that are seen more often than others include:
Many contracts provide for the satisfaction of conditions at a single time: the closing. For example, a private placement of equity securities will provide for issuance of the securities when all of the conditions precedent have been satisfied. Other contracts requiring performance on more than one occasion may have separate sets of conditions for each performance event. An example of this is a revolving credit agreement that permits multiple borrowings. These agreements will have a full set of closing conditions with respect to the initial borrowing or closing, and in addition a separate, usually shorter, set of conditions that must be satisfied by the borrower at the time of each borrowing. Many contracts provide that if all the conditions precedent to a party’s performance have not been satisfied or waived by a specified date (sometimes called a drop-dead date), that party can terminate the contract. Without such a mechanism, the party that must satisfy the conditions would be able to keep the contract alive indefinitely, waiting until the most advantageous time to close.
A bare bones contract could omit any discussion of what happens if the parties fail to perform in accordance with the terms of the contract. As every lawyer learned in law school, the aggrieved party could ask a court to fashion a remedy for breach based on statutory and case law. However, sophisticated commercial parties are generally reluctant to rely on a judge or a jury to do this, and for this reason many contracts have remedial provisions.
Remedial provisions have two elements: a description of the events that give rise to the right to a remedy, and the remedies themselves. As with the other building block provisions, these vary greatly based on the type of agreement in which they are contained, and are often tailored to the specifics of a transaction.
One of the primary purposes of remedy provisions is to address the failure of the parties to perform the operative provisions of a contract in accordance with their terms. The operative provisions represent the fundamental business deal between the parties; each party will want to have the ability to enforce the other side’s performance by having the contractual right to enforce remedies in the event of nonperformance. For example, take a commercial real estate management agreement under which one party agrees to manage a property owned by the other party in exchange for a management fee. The property owner will want to have the right to terminate the contract if the management company is not performing its duties satisfactorily, and the management company will want to be able to walk away if its fees aren’t being paid.
In addition, remedies are almost always provided in the event there is a breach of a representation. Representations facilitate the fact gathering and disclosure process, but this purpose would be significantly blunted if there were no remedy for false representations. Likewise, the inclusion of covenants in an agreement is considerably more useful if the contract spells out exactly what will happen if a covenant is breached. This way, the aggrieved party is not forced to seek judicial enforcement of the covenant by specific performance or a damage award.
A contract may also provide that events other than breaches by the parties trigger remedies under the contract. These are often things that are outside of the parties’ control and therefore are not appropriate for making the subject of affirmative or negative covenants. Some examples of such remedial events are:
The distinction between a covenant, the breach of which creates a remedial right, and a separate remedial event, is often a narrow one. The only difference between a covenant to maintain insurance and a remedial event occurring if insurance is not maintained is that a breach of the covenant may give rise to a claim for specific performance whereas the remedial event does not. Both would typically, however, give rise to the same remedies under a contract: the first as a result of the breach of a covenant and the second as a result of the occurrence of a remedial event. When a party is reluctant to covenant to something that it doesn’t have the power to control, the solution is to frame these points as remedial events rather than as covenants.
The remedies that are made available under a contract vary based on the type of agreement, the nature of the event giving rise to the remedy and the objectives of the parties. In some agreements the remedy provisions are highly negotiated; in others they are very standard and may not be subject to very much discussion. Some of the more typical provisions are discussed below.
Termination of the contract is one of the most common remedies, and results in neither party’s being required to continue performance under the contract (although in some cases the right of termination may be exercised together with other rights, such as the right to receive indemnification payments or liquidated damages). For this reason, termination is not a useful remedy where significant obligations under the contract have already been satisfied. Consider the situation where a purchaser of securities discovers after the closing that the seller breached its representations in the contract. At this point, the remedy of terminating the contract would be useless to the purchaser. On the other hand, if the purchaser discovered the breach of representations before the sale occurred, a right of termination would be very useful and entirely appropriate.
Sometimes a contract will permit a party to terminate certain obligations without terminating the entire contract. An example is a revolving credit agreement, under which a lender is required to make loans to the borrower from time to time. If the borrower defaults, the lender will be given the right to terminate its ongoing commitment to make additional loans, but exercise of this right by itself will not terminate other rights and obligations under the agreement.
The remedy of acceleration is found primarily in debt financing agreements. The exercise by a lender of this right results in the indebtedness under the agreement being accelerated, i.e., becoming immediately due and payable by the borrower despite a later stated maturity date. A borrower rarely has the cash to repay the amount of a loan that becomes due as a result of acceleration. In addition, the existence of an acceleration often causes a number of other negative side effects: accountants will be unwilling to issue clean opinions on the borrower’s financial statements; defaults may be triggered under other agreements of the borrower as a result of cross-default provisions; trade credit may tighten or disappear; other debt of the borrower may be accelerated as a result of cross-acceleration provisions; if the borrower is a public company, it will have to publicly disclose that its debt has been accelerated. As a result, acceleration often has catastrophic consequences. Usually, the mere threat of acceleration is sufficient to cause the defaulting party to make significant concessions in exchange for the lender agreeing not to accelerate.
An agreement may provide that a party breaching its representations or covenants will be required to indemnify the other party for all costs, damages and losses incurred as a result of the breach. Indemnification would be an appropriate remedy for a purchaser of a manufacturing plant who discovers after the sale that the seller breached its representation that there was no hazardous waste contamination of the property. The seller would be required to reimburse the purchaser for remediation and related costs.
Liability under indemnification provisions is often limited by baskets, caps and termination provisions. If indemnification is not required for claims that are less than some specified dollar amount, that is referred to as a basket. A cap is a limitation on the maximum amount of payments that may be required under an indemnification provision. If the negotiated cap is ten million dollars, then the indemnitee may receive no more than that amount in total indemnification payments, even if its damages are greater. Indemnity clauses may also be subject to termination after a certain point in time. There are two variations on this: a cut-off of indemnification if the event giving rise to the indemnification claim arises after the cut-off date, and a cut-off if the claim is made after a certain date.
Liquidated damages clauses provide for one party to make a specified payment to the other party upon the occurrences of certain events. Examples include the following:
Case law suggests that liquidated damages may be characterized as an unenforceable penalty unless the actual amount of damages in the event of a breach would be difficult to compute and the amount of liquidated damages represents a good faith attempt to estimate the actual damages that may be suffered. Accordingly, liquidated damages provisions often recite that these elements are present—although a court is likely to look through any such conclusory statement to the underlying substance.
A common example of a liquidated damages provision is the make-whole provision found in certain financing agreements. Where a lender provides loans at a fixed (as opposed to floating) rate of interest, the financing agreement will often require an additional payment from the issuer if it prepays the loans prior to their stated maturity. Without this provision, a borrower would refinance every time interest rates decreased, and fixed-rate lenders would lose the benefit of their bargain—the right to receive a fixed rate of interest over a specified period of time. This payment is calculated by reference to the loss that the lender will suffer by being forced to reinvest at a lower yield than it was receiving on the prepaid loan.
The concept of materiality is often used to prevent a remedial provision from having too harsh an effect. For example, a stock purchase agreement may provide the purchaser with a right of termination in the event that the seller breaches any of its representations or covenants in any material respect. The inclusion of the last phrase limits the breaches giving rise to the purchaser’s right to terminate the agreement to those that are material. Assume that the seller had made a representation as to the amount of debt on the balance sheet of the company to be acquired. If the purchaser discovers that the total debt is $10,000,500 instead of the represented level of $10,000,000, the representation will be breached but not in a material respect. As a result, the purchaser will not be able to terminate the agreement. Of course, the question of what breaches are or are not material can become the subject of debate.
Grace periods are also used to protect against hair trigger remedial provisions: instead of being immediately available upon the occurrence of a breach of covenant or other event, a remedy will be available only after a specified period of time (the grace or cure period) has elapsed following the event. If the act or condition at issue is cured during the grace period, the remedy is never triggered. In some cases, the grace period doesn’t begin until the breaching party receives notice of the breach.
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This article was originally published on July 9, 2020 on ConsensusDocs. It is reprinted here with permission.
It is sometimes overlooked that clauses in contracts requiring performance are not treated the same in cases of breach. There is a distinct difference in construction contracts between clauses that are conditions and clauses that are covenants. This difference determines the remedy a party is entitled to receive upon breach of the obligation. To understand this difference, we must first identify how these clauses are defined.
Under generally accepted principles of contract law, the remedies for breaches of covenants and conditions are different. The remedies are as follows:
The classic law school case Jacob & Youngs, Inc. v. Kent [4] provides a good analysis of the distinction. After the completion of a home construction project, it was discovered that the home was constructed with nonconforming pipe. The owner demanded replacement of the pipe, notwithstanding the fact that there was no evidence that the nonconforming pipe was inferior in quality to the pipe specified in the contract. Judge Cardozo, who authored the majority opinion of the court, discussed the distinction between covenants and conditions (sometimes referring to covenants as “dependent promises”). He stated:
There will be harshness sometimes and oppression in the implication of a condition when the thing upon which labor has been expended is incapable of surrender because united to the land, and equity and reason in the implication of a like condition when the subject matter, if defective, is in shape to be returned. From the conclusion that promises may not be treated as dependent to the extent of their uttermost minutiae without a sacrifice of justice, the progress is a short one to the conclusion that they may not be so treated without a perversion of intention. . . . There will be no assumption of a purpose to visit venial faults with oppressive retribution. [5]
The court held that the failure to use the specified pipe was the breach of a covenant rather than a condition. Thus, the owner was not excused from paying for the work (i.e., “oppressive retribution”), but the payment could be reduced to reflect any reduction in value because of the use of the nonspecified pipe.
Due the harsh difference in remedies as noted by Judge Cardoza, conditions are often interpreted as covenants to avoid forfeiture — the surrendering of the right to receive payment over “venial faults.” Since failure to satisfy a condition would prevent a contractor from recovering for work that it performed under the contract, courts may prefer to treat contractual obligations as covenants rather than conditions. [6] This is particularly true when a benefit has been conferred on the owner and nonpayment would be considered inequitable and akin to a forfeiture. As a generally accepted maxim of jurisprudence, equity abhors a forfeiture:
Forfeitures are not favored by the courts, and if an agreement can be reasonably interpreted so as to avoid a forfeiture, it is the duty of the court to avoid it. The burden is upon the party claiming a forfeiture to show that such was the unmistakable intention of the instrument. “A contract is not to be construed to provide a forfeiture unless no other interpretation is reasonably possible.” [7]
A common area where conditions are interpreted as covenants are notice provisions. In California, for instance, notice provisions in contracts can be interpreted as covenants rather than conditions to avoid forfeiture of a contractor’s claim. [8] When the notice requirement is found to be a covenant, the owner is entitled to recover, as an offset against the contractor’s claim, whatever damages the owner actually suffered from not receiving timely notice. [9]
The policy behind treating conditions as covenants is to interpret the contracting parties’ intentions to avoid unusual or inequitable results, to avoid forfeitures, and to avoid placing one party at the mercy of the other. [10] Courts have found that a provision in a contract for forfeiture of any damages for noncompliance with provisions relating to the filing of the claims must be strictly construed against that entity for whose benefit the clause was inserted. [11]
For example, in D. A. Parrish & Sons v. County Sanitation District, [12] the contract required written notice of a claim within 10 days after discovering the factual basis for the claim, and it provided: “The Contractor’s failure to notify the Owner within such ten (10) day period shall be deemed a waiver and relinquishment of any such claim against the Owner.” In refusing to enforce this forfeiture, the court held, “[A] forfeiture clause, such as this, will not only be strictly construed but has been interpreted by this court not to apply to claims arising from breaches of the contract caused by the other party.”
Outside of California, other jurisdictions also interpret notice provisions to avoid forfeiture. Sometimes courts will find that the government entity received “constructive notice,” thereby satisfying the notice condition in the contract. For example, in Welding, Inc. v. Bland County Service Authority, [13] a court found that mention of the claim issues in the progress meeting minutes was found to satisfy the notice requirement. Also, some courts will find that the notice would serve no useful function in the context of the case and therefore would not be considered a condition of the contract. [14]
There are some jurisdictions, however, that will not treat conditions as covenants in an effort to avoid forfeiture. For example, Stone Forest Industries, Inc. v. United States [15] involved a dispute arising out of contracts entered into with the U.S. Forest Service. Each of the contracts contained a provision stating that the purchaser shall file claims against the U.S. Forest Service within certain time limits and that “[f]ailure by Purchaser to submit a claim within these time limits shall relinquish the United States from any and all obligations whatsoever arising under said contract or portions thereof.” [16] The court held that this was “clearly a condition” because “the time limitation is clearly ‘an event, not certain to occur, which must occur . . . before performance under a contract becomes due.’” [17] Additionally, the court held that the time limitation “is not a covenant, as plaintiffs argue, because it does not create a right or duty in and of itself.” [18] The court found that, because the time limitation provision was a condition, and not a covenant, compliance with the time limitation was required before plaintiffs could enforce their refund rights under the contract.
Thus, due to the distinct differences in remedies in breaches of conditions and covenants, provisions in contracts that might be construed as conditions requiring forfeiture should be examined closely with an eye to the law of the contract’s jurisdiction and any equitable principles that may cause courts discomfort in enforcing
Liquidated damages provisions are common in construction contracts to guard against damages that the owner or a contractor might suffer if a project is delayed beyond the completion date set forth in the contract. These provisions appear in both public and private construction contracts. Oftentimes, the owner of a construction project will include a liquidated damages provision in the prime contract with the general contractor. The provision might state, for example, that if the project is delayed beyond the required completion date, the owner may assess against the general contractor liquidated damages in the amount of $1,000.00 per day until the project is complete. The general contractor, in turn, will likely include a similar clause in its subcontracts passing along the risk of liquidated damages to its subcontractors if delays to the completion of the project are caused by the acts or omissions of the subcontractor.
Liquidated damages provisions are helpful because they establish the damages for construction delays at the outset of the project and eliminate the need to prove actual damages. The party whom the liquidated damages clause benefits need only prove that the performing party delayed completion of the project to be entitled to recover the amount of damages listed in the contract. In the absence of a liquidated damages provision, to recover damages for delay, an owner or contractor has to prove both that the contractor delayed the project and the actual damages that were caused by the delay. Demonstrating actual damages is a difficult task that requires detailed proof that ties the loss to the period of undue delay with reasonable certainty. Thus, being able to rely on liquidated damages for delay provision can be quite useful.
Liquidated damages clauses are generally enforceable, but most courts will not enforce a liquidated damages provision if (1) it constitutes a penalty as opposed to a reasonable estimate of the actual damages likely to be incurred due to delay, or (2) the party benefitting from the liquidated damages clause is responsible for a portion of the delay to completion of the project and the contract does not provide for apportionment of damages in the case of mutual delays.
North Carolina courts recognize a two-pronged test for determining whether liquidated damages are enforceable or constitute a penalty: (1) the damages from the breach of contract must be difficult to ascertain as of the time the parties entered the contract; and (2) the amount of damages stipulated must either be a reasonable estimate of the damages which would probably be caused by a breach or reasonably proportionate to the damages actually caused by the breach. If the party disputing liquidated damages can prove either that actual damages were not difficult to ascertain or that the liquidated damages were not a reasonable estimate of actual damages and were not reasonably proportionate to the actual damages, the liquidated damages provision will not be enforced.
To show that damages were not difficult to ascertain, the party opposing liquidate damages has to show that there was a clear, objective basis for measuring all aspects of the actual damages that might result from the breach. This is an extremely steep challenge in the context of liquidated damages for delays to construction projects. First, North Carolina courts give substantial weight to stipulations by the parties in the contract that damages are difficult to ascertain. Therefore, if the contract includes a clause stating that both parties agree the measure of damages that will result from project delays is difficult to ascertain, this will usually suffice to demonstrate that damages were in fact difficult to ascertain. Second, courts often find that damages are difficult to ascertain when the project at issue is complex or involves a large undertaking, as is often the case with construction projects. Lastly, delays in the completion of construction projects generally bring in to play many potential items of damages, including lost profits due to not opening the completed project on time, continued costs associated with operating other facilities that the project was meant to replace, increased costs of construction, etc. Thus, it is unlikely that the party opposing liquidated damages for delays on construction projects will be able to show that damages were not difficult to ascertain at the time of contracting.
To demonstrate that liquidated damages are not a reasonable estimate of actual damages and that they are unreasonably disproportionate to actual damages, the party opposing liquidated damages must show that there was no reasonable attempt to estimate damages prior to contracting and that liquidated damages are shockingly excessive when compared to the actual damages suffered and the overall value of the contract. As with the first prong, courts will generally defer to the parties if the parties stipulate that the amount of liquidated damages is a reasonable estimate of the damages that will likely result from delays to project completion. If such a stipulation exists, this will be difficult to overcome, so contractors and subcontractors should refuse to sign such a stipulation if you believe the amount of liquidated damages is unreasonable.
Next, because liquidated damages are meant to approximate actual damages, courts will consider whether the liquidated damages amount is based on a reasonable estimate of actual damages made by the owner or contractor, or whether the liquidated damages amount was simply a random arbitrary amount. Lastly, the court will look to whether liquidated damages are shockingly disproportionate to actual damages. Courts have held that liquidated damages twice the amount of actual damages were reasonably proportionate to actual damages. Thus, the party opposing liquidated damages will need to show that liquidated damages far exceed actual damages to succeed in having them ruled an unenforceable penalty.
In conclusion, contractors or subcontractors opposing liquidated damages for delays to construction projects face a difficult task in demonstrating that a liquidated damages clause is an unenforceable penalty. It is nearly impossible to show that delay damages were not difficult to ascertain at the time of contracting. However, if the contractor or subcontract can show that the liquidated damages amount was an arbitrary amount that far exceeded actual damages, a court may conclude that the liquidated damages constitute an unenforceable penalty. On the other hand, owners and contractors can likely avoid having liquidated damages for delay clauses overturned as unenforceable penalties if the liquidated damages amount reflects a sincere attempt to estimate actual damages and their contract includes stipulations that actual damages are difficult to ascertain and that the liquidated damages amount is a reasonable estimate of actual damages.
Under North Carolina law, it is clear that the party benefitting from a liquidated damages provision cannot recover liquidated damages if it is responsible for all of the delays to the project. In addition, North Carolina law states that liquidated damages are unenforceable if the party benefitting from the liquidated damages was itself responsible for a portion of the delays to project completion unless the contract contains a clause providing for apportionment (i.e. division) of liquidated damages in the case of mutual delays. This rule, which I'll refer to as the "Non-Apportionment Rule," was recognized by the North Carolina Supreme Court in 1967. Under the Non-Apportionment Rule, if the owner or contractor whom the liquidated damages clause benefits is responsible for any amount of the delays to project completion, they cannot recover liquidated damages unless the contract authorizes project delays to be apportioned between the parties so that liquidated damages can be assigned to the contractor or subcontractor based on the delays they are responsible for. In other words, an owner's or contractor's responsibility for a portion of the project delay can result in not being able to recover liquidated damages for delays caused by the performing party. Notably, there is a trend among other jurisdictions away from the Non-Apportionment Rule because some courts have found it to be overly harsh. North Carolina's Non-Apportionment Rule, however, has never been overruled and was applied by the North Carolina Court of Appeals as recently as 2007.
Based on the Non-Apportionment Rule, mutual delays can serve as a basis for complete avoidance of liquidated damages where the contract does not authorize apportionment of liquidated damages. Thus, parties seeking to avoid or enforce liquidated damages should be aware of the Non-Apportionment Rule. Owners or contractors seeking the benefit of liquidated damages provisions should consider including a provision in your contract for apportionment of liquidated damages in the case that both parties are responsible for delays (i.e. there are mutual or concurrent causes of delay). If an apportionment clause is included in the contract, the performing party should negotiate for any apportionment of delays to be administered by a neutral third party, so as to eliminate any bias in dividing the delays among the parties. If it is not included, the performing party should seek to prove mutual delays as an avenue to avoid liability. In either case, both parties should be sure to document and collect evidence of all delays which you contend the owner, contractor, or a subcontractor has caused to the project as you may need this evidence to either establish your right to liquidated damages or to escape or minimize your liability for liquidated damages.
In conclusion, liquidated damages clauses provide a helpful remedy to the party harmed by delay in circumstances where calculating actual delay damages is difficult. Liquidated damages, however, will not be enforced if they do not reflect a reasonable estimate of actual damages and are grossly excessive in comparison to actual damages. Additionally, unless the contract provides otherwise, liquidated damages for delays will not be enforced by the courts if the party seeking enforcement is responsible for some of the delay at issue. Participants in the construction industry should keep these issues in mind when negotiating and entering into construction contracts.