The importance of contracts

Put simply, a contract is an enforceable agreement between two parties. Contracts do not have to be written down in order to be legally enforceable; an oral promise can also be binding. However, relying only on a long-standing relationship and a handshake is an unnecessarily high-risk strategy. Greater legal – and commercial - protections are afforded by well-drafted, written contracts, tailored to the specific arrangement being formalised.

Commercial considerations

A well-drafted, written contract provides certainty, clarity, and protects parties’ interests if problems arise down the line. The specifics of what the contract covers can be identified (for example through a scope of services clause or schedule of goods), and each party’s obligations and rights expressly stated. A written contract can also ensure that agreed procedures are in place should one party fail to comply with the terms of the contract, or if the parties are unable to perform their obligations due to unforeseen circumstances.

The COVID-19 pandemic and its impact on trade exemplified how instrumental a well-drafted contract can be to a company’s commercial resilience. Contracts that provided “get-out” clauses for situations such as a pandemic meant parties could terminate an agreement without being in breach of their obligations. If a party is in breach of contract, it can be liable to pay costs and/or damages to the other party. It might also incur legal fees if the parties cannot reach a settlement and the dispute goes to court.

More generally, if a dispute arises out of a contract and the contract is not written down, the parties could face the often difficult and protracted task of proving: (a) that a legally binding contract existed between the parties, and (b) what their obligations/rights were under the contract. Where there is no written agreement, the law can be less certain, and it will ultimately be one party’s word against the other’s.

The value of a contract

Contracts can be valuable assets to a company and should be managed as such. In particular, a company should know which of its contracts are ‘material’ (i.e. worth 10% or more of its turnover) and what its obligations are under such contracts. This is particularly important where a share sale is envisaged but should be borne in mind even before the contract is entered into.

By way of example, a contract might contain a “change of control” clause. This provision gives a party enhanced protection if the controlling shareholding of the other party is transferred. Often, the party who is not subject to a change in ownership will have the right to terminate the contract in the event of a change of control of the other party. If a material contract contains this right to terminate, it can be a red flag to prospective buyers because there is a risk that a major customer will terminate its contract with the company upon the transfer of that company.

In the best-case scenario, the sale process would be slowed down while the customer’s consent (i.e. the party with the right to terminate upon change of control) is obtained. If consent is not given, a prospective buyer could use this as leverage to negotiate a lower purchase price - since it is taking on the risk of losing a material contract – or seek to include an indemnity in the sale agreement.

A company should be alive to these issues and should ensure it understands its position in light of a prospective sale. Then, it can take appropriate steps to communicate with suppliers and/or customers and minimise risk.

Before entering into a contract, a company should consult a specialist legal team. Firstly, there is no such thing as a “one size fits all” contract, and each context – be it employment, consultancy, supply chain, consumer law, or data protection – will warrant different considerations and legal requirements. Secondly, interpreting a legal contract is not always as straightforward as it might appear. Some clauses might be drafted in such a way that implies certain obligations, or that omits protections that a company might wish to benefit from. When executed well, a binding, legal agreement can be a company’s greatest asset. However, when executed poorly, it can leave a company open to undue risk and liabilities.

If you have any queries about any of the above or would like to discuss anything further, please get in contact with me or a member of the Family Business Team.