Tips on Negotiation of Commercial Contracts
A formal contract, which defines the agreed terms and conditions between parties is an indispensable document in every commercial or business engagement. In Kenya, the general law on contract is the Law of Contract Act (Chapter 23 of the Laws of Kenya). This Act provides for the application of English law of contract in Kenya including the common law of England relating to contracts, as modified by the doctrines of equity.
Difference Between an Agreement versus Contract
The terms “agreement” and “contract” are often used interchangeably but technically they mean different things. A contract is an agreement giving rise to obligations which are enforced or recognised by law. An agreement may fall short of being an enforceable contract. For example, the law may require some contracts to be in writing. In such cases, an unwritten agreement between two parties will be unenforceable. Despite the foregoing, often times, enforceable written contracts are usually referred to as “agreements”. Therefore, the critical thing is to ensure that a contract or agreement contain all the essential elements for it to be enforceable.
Section 3 of the Law of Contract Act requires certain contracts, e.g. those dealing with the debt or disposition of land, to be in writing. The main reason why unwritten agreements aren’t usually enforceable is disagreements between the parties on what was actually agreed upon. With written contract, the parties can always refer to the terms and conditions of the contract to discern what was actually agreed upon between the parties.
Essential Elements of a Contract
In common law, there are 6 basic essentials to the creation of a contract: (1) offer; (ii) acceptance, (iii) agreement or meeting of minds; (iv) contractual intention; (v) legal capacity; and (iii) consideration.
Generally speaking, an agreement is reached when one party makes an offer, which is accepted by another party. Therefore, the first perquisite of a contract is that the parties should have reached an agreement, which is an objective test.
In contract law, consideration is an inducement given to enter into a contract that is sufficient to render the promise enforceable in the courts. Examples include property, money, employment, a promise to undertake an action or a promise to forbear or abstain from an action that the party would otherwise have the liberty to engage in (usually called forbearance). Therefore, technically to determine whether there is a consideration in a contract parties must have received a benefit, assumed an obligation or suffered a detriment or forbearance.
Generally speaking, a contract without a consideration is not enforceable unless where this is made as a deed. For example, if parties enter a contract under which one party is required to provide a good or service while the other is not required to provide anything of value, the contract lacks consideration. Without consideration, a contract is really just a gift or unilateral obligation between two parties. Example here include illusory promises (e.g. made in a blackmail situation where an obligation is uncertain), or gifts, or past performance (where a party try to establish contractual obligations retroactively).
In order for a contract to be enforceable, the law requires all individual who signed a contract to have “contractual capacity”, by which is meant minimum mental capacity to enter into an agreement. The law recognise three categories of persons who have no contractual capacity. These are: minors; individuals with psychological disabilities; and, intoxicated persons. Such individuals are presumed to not know what they are doing, and therefore a contract signed by them are void or liable to be set aside. For corporations, contracts may require to be signed by authorised person and in such cases, a contract signed by un authorised person may be unenforceable. For example, for a company, under the Companies Act, a contract must be signed by two directors, or one director or another authorised representative in a presence of a witness.
Where a contract is signed by a power of attorney, it is critical that this is valid and duly registered. Moreover, the donor should be alive as a power of attorney terminate automatically upon death.
Contract Life Cycle
Generally, the life cycle of a contract is unique depending on the type of contract and the parties involved. It also largely depends on the goods to be supplied or services to be performed under the contract as well as the completion timelines. For instance, some contracts are one-off or for a limited duration whereas others are for a number of months or years. Be that as it may, every contract has a life cycle. The life cycle of every contract begins with drafting of the agreement. This will be followed by the negotiation stage. On this stage, the parties will agree on the mutual terms and conditions or roles and responsibilities. This will, inter alia, usually cover the following:
- Contract price or consideration as well as payment terms;
- Contract Duration;
- Respective roles or obligations of the parties;
- What happen when one party breach the contract?
- What happens if an unforeseen circumstance arises?
- The governing law;
- What happens in the event of a legal dispute?
After negotiation stage, the contract will usually be approved and executed by both parties. This is normally follow by the handover stage where you will need to make sure that all stakeholders have what they need to manage the signed contract and that critical details like respective parties; roles and responsibilities and obligations as well critical timelines and contract milestones are well understood.
The handover stage is followed by the contract implementation stage, during which the contract will be performed or executed in accordance with its contractual terms and conditions. Here those managing the agreement will be expected to track and monitor important milestones and obligations. If either party breaches the contract, the life cycle will be disrupted, which could result in a breach of contract claim.
Generally, the last stages of contract life cycle are storage, retrieval and renewal or expiry.
Contract Lifecycle Management (CLM)
This is the process of tracking and managing every aspect of a contract for its performance, compliance, and other success factors through every stage of the contract lifecycle — from execution to renewal or expiration. The management process itself begins when a contract is proposed or requested and continues throughout the delivery of the promised good or service and into contract renewal. Having a robust CLM process is critical for business success and this helps an organizations maintain a disciplined approach to managing agreements, which can help mitigate risk and increase the likelihood that important contracts perform as intended. Needless to mention losing visibility of critical contracts and terms thereof can lead to various risks including missed deadlines, penalties, interest claims, delayed deliveries, overpayment for services, all of which will invariably impact your business operations and profit margins.
Here, we share some of the best tips which you can apply when negotiating a commercial or business contract.
“Give me six hours to chop down a tree and I will spend the first four sharpening the axe.” – Abraham Lincoln.
Before you start any negotiations to enter into a contract and sign off the contract, you should prepare yourself as appropriate, which include putting the requisite resources in place. You might also need to consult your lawyer and your technical team on risk identification and risk allocation. Proper preparation will help you avoid entering in lopsided deals, or contract with wrong counterparties and therefore militate against unwarranted disputes and resultant litigation.
Do you have authority to contract?
As alluded, before entering into negotiations to enter into a contract, you should always ensure that you have the requisite contractual capacity as well as the authority to contract. In many organisations, different persons, depending on the level of seniority, have authority to enter into different categories of contract, which may be based on function or value. In a corporate set up, although every director may have general authority to contract, the board may delegate this to the executive directors or the MD/CEO.
In this era of technology, contracts can also be implied from email correspondence. Therefore, care should be taken to ensure that unauthorized persons do not create binding contractual obligations for their organisations through such correspondence. On the part of good governance and risk mitigation, every organisation should have a clear policy on persons who are allowed to negotiate or enter into contracts on its behalf as well as contract workflow documents or policy setting out persons responsible for each aspect of contract life cycle or stage and the limits of their authority.
Care should also be taken to ensure that persons without authority are not presented to counter parties as having authority to bind their organisations. Where misrepresentations are made, court will be left to resolve resultant dispute and may easily imply a binding contract from such correspondence even where there was no intention to create a contract.
Does your Counterparty have authority?
You should ensure that you do not waste time entering into negotiation with person without property or with limited authority to contract. As indicated before, the lack or limitation of authority to contract is a major cause of disputes and such risks should be avoided at all cost.
Have you done your due diligence?
As a risk mitigation measure, it is indispensable to have proper due diligence on legal, technical and financial capacity to contract before entering into formal contract negotiations. This may also be extended to reputation due diligence which may lead to risks to your brand by associating with persons who have no integrity or otherwise involved in crimes. In addition, this should include talking to references or other customers of your counterparty as well as conducting market research on the other options that may be available from competitors of your counterparty.
If proper due diligence is not conducted, this may result in your wasting time and resources in pointless negotiations, reputational damage to your organisation, or even worse lead to your entering into a dubious or lopsided contracts that are not in the best interest of your organization.
Consider confidentiality and or non-circumvention
In commercial engagements, one of the conundrum that is required to be resolved is disclosure or sharing of commercially sensitive information concerning your business or innovation that your counter party requires to be disclosed in order to progress a transaction, whilst protecting your business interests. This dilemma can be resolved by having a well-crafted confidentiality and non-circumvention agreement executed between the parties.
A confidentiality agreement (also called privacy or a non-disclosure agreement (NDA)) is a legally binding contract in which a person or business (called receiving party) undertake to another (called the disclosing party) to treat sensitive information (normally called confidential information) as confidential and promises not to disclose it to third parties or profit from it without prior authorisation.
A business usually gives a confidentiality agreement to an employee or contractor to make sure its trade secrets or proprietary information remains private. A confidentiality agreement can also be used to protect disclosure of various types of information including intellectual property as well proprietary information such as strategic functions, marketing plans, production processes and other internal financial reports.
A non-circumvention agreement is used either where a person is working with another party for the first time, or where there is little trust between the parties, or both. The purpose of a non-circumvention (or non-circumvent) agreement is to prevent one or more parties in a business deal from being bypassed and deprived of full compensation for their efforts or involvement. Moreover, such an agreement ensures that the contacts or intellectual property that a business discloses to another party during negotiations will not be disclosed to a third party. By executing a non-circumvent agreement, certain parties (the restricted parties) covenant not to conspire with each other for purposes of cheating, defrauding or by-passing a third party (the protected party) from a common commercial project or undertaking.
What is your end goal?
“Begin with the End in Mind” – Rule No. 2 in the Franklin Covey’s book “7 Habits of Most Successful People”.
This rule is based on imagination, that is, the ability to envision in your mind what you cannot at present see with your physical eye. This is founded on the principle that all things are created twice. There is a mental (first) creation, and a physical (second) creation. The physical creation follows the mental, just as a house follows an architectural design.
This rule is also applicable in contract negotiation. It would be a sheer waste of time to enter into negotiations that are doomed to fail from the onset. Therefore, before engaging in any negotiations, you should be clear on your desired goals or objectives and your capabilities. As you walk back from the end, you should also have all the information, resources or inputs that would be required to achieve or produce the end product or the desired end or output. For instance, if you want to enter into the contract for the supply of goods, you should make sure that your manufacturer or supplier is able to meet the requisite technical and product specifications and that he has the requisite raw material to produce the contracted goods.
What is Irreducible Minimum Terms?
As far as this is practical, a contract should be on your terms. Moreover, you should not be desperate for a deal and therefore agree to enter into a contract at any price. In other words, before any negotiations you should be clear on what would be your important negotiating points as well as your irreducible minimum terms.
During negotiations for a contract, you should be clear on your objectives or otherwise distinguish the forest from the trees (be able to see the bigger picture). You should therefore not be bogged down discussing unimportant details and you can easily concede on this. Nevertheless, you should be clear on what is important as well as what is your irreducible minimum. For instance, you should not be over concerned with the price if this will translate into poor quality goods or a service that is below the required standards.
For instance, quantum of the product, time of delivery or price may be negotiable but other issues may not be, such as product specification or the environmental, social, governance (ESG) requirements in relating to sourcing of input required during the product manufacturing.
What are the Potential Risks?
There is no business engagement that has no risks. Therefore, each party to a commercial contract seeks to minimize its risk and maximize its reward or to manage the risks in a way that is acceptable to its business. Consequently, allocation of risk during contract negotiation creates an inherent tension between contracting parties.
The first step is for all risks in a contract to be assessed and highlighted. There should be a ‘fair and balanced’ risk allocation between the parties. The rationale for this is to ensure the best chance of successful and sustainable contractual arrangements for the mutual benefit of both parties. Generally, in order to achieve a fair and equitable allocation of the risks inherent in every contract, a risk should, inter alia, be allocated to a party if:
- the risk is within the party’s control;
- the party can transfer the risk to a third party through, for example, insurance, and it is most economically beneficial to deal with the risk in this fashion;
- the greater economic benefit of controlling the risk lies with the party in question; and
- to place the risk upon the party in question is in the interest of efficiency.
Generally, every risk should be allocated to a party who is best suited to control or take care of the it. As a business, you should guard against taking disproportionate risks. Again, you should carefully evaluate all risks and consider whether your business is willing to accept responsibility for them or if these are non-negotiable.
To make a contract a success, it is key for all risk to be identified and allocated between the parties in a fair and balanced manner. In addition, each party should adopt proper negotiation and risk management strategies. These include a combination of pre-contract negotiation due diligence (including vendor verification measures) and alertness during contract negotiations which could address risks. In addition, a party can use standard contracts and checklists to mitigate or negotiate risks that are inherent in certain contracts.
In addition, a party can use risk allocation provisions in order to mitigate, eliminate and shift the risks to the other party. These include: Conditions Precedent Clause, Warranties and Representations Clause; Payment Terms Clause; Late Penalty/Interest Clause; Indemnification Clause; Force Majeure Clause; Insurance Clause; Limitation of Liability Clause, No Set-off and Counterclaim Clauses, Severability Clause; Change of Law Clause; Product Warranties; Dispute Resolution Clause; Guarantee Clause; and Self- Executing Contractual Remedies.
Others key provisions that may be useful include: business interruption or disaster recovery clauses, non- Exclusivity clause, performance monitoring or audit as well as appropriate termination clause.
Do you need to enter into a Head of Terms Agreement?
A Head of Terms Agreement is also known as heads of agreement, letters of intent, memoranda of understanding or term sheets. This is prepared after initial negotiations, for purposes of setting out the agreed basic terms of a contract or a proposed contractual arrangement before the finer details are negotiated. Generally, the head of terms is usually not legally binding but is used to record the future intentions of parties in a proposed transaction without creating binding or enforceable obligations.
Unfortunately, many people do not employ head of terms agreements thinking that they are an unnecessary extra step in contract negotiation. Nevertheless, the usage of head of terms can help focus minds on the main terms of the deal, which is a highly useful start point and can help the parties summarize the key points in their proposed deal- especially while dealing with complex negotiations.
What is your Contract Review Cycle?
Lack of proper mechanisms of contract monitoring or review can ruin a business. Therefore, after successful negotiation of a commercial contract, you should set a cycle to monitor and review every contract. Most importantly, where necessary the contract should be reviewed or revised as the business relationship develops, supply and demand needs and the economic climate or risk matrix changes.
A review of a contract may culminate to a renegotiation of the terms thereof or kick in a termination clause that had been negotiated at the start of the contract. It is therefore critical that before adding any general or boiler plate clauses in a contract their implication on the vicissitude of the market and financial conditions should be considered.
Written by: Miriam MUGO