Here are a few contract-drafting tips derived from judicial decisions issued in the past few days:
Table of contents
- An exclusive-jurisdiction forum selection clause might accidentally negate an arbitration requirement
- A simple exclusion of consequential damages might still allow recovery of lost profits
- Do you even need a termination-for-breach clause?
- Be explicit about incorporation by reference
- Try explaining why your liquidated-damages clause is a reasonable approximation
- Your contract’s unrestricted unilateral-termination right might invalidate the arbitration clause
An exclusive-jurisdiction forum selection clause might accidentally negate an arbitration requirement
The case: Citigroup Global Markets Inc. v. All Children’s Hospital, Inc., No. 13 Civ. 8558 (S.D.N.Y. March 21, 2014) (Rakoff, J.).
A Florida customer of a securities brokerage initiated an arbitration proceeding against the broker, in Florida. It did so pursuant to the rules of the Financial Industry Regulatory Authority (“FINRA”).
In response, the broker filed a lawsuit against the customer in federal court in New York. The broker sought to prohibit the customer from continuing with the arbitration. The broker cited a forum-selection clause in the agreement between the broker and the customer; that clause required all disputes to be litigated (not arbitrated) in New York:
The parties agree that all actions and proceedings arising out of this Broker-Dealer Agreement or any of the transactions contemplated hereby shall be brought in a New York State Court or United States District Court, in each case the County of New York and, in connection with any such action or proceeding, submit to the jurisdiction of, and venue in, such County.
Judge Rakoff, following precedent from his colleagues in the Southern District of New York and from the Second Circuit court of appeals, had no trouble holding that this clause in the agreement trumped the “background” FINRA rules requiring arbitration:
The Court agrees with these three other decisions that the instant issue is governed by Applied Energetics, Inc. v. Newoak Capital Mkts., LLC, 645 F.3d 522 (2d Cir. 2011), which held that an agreement’s merger clause and a forum-selection clause that required adjudication operated to displace a previous or background agreement to arbitrate.
The agreement in Applied Energetics, like the Agreement at issue here, did not expressly prohibit arbitration or make any reference to arbitration. Instead, it provided that “[a]ny dispute arising out of this Agreement shall be adjudicated” in New York, id. at 523, and this broad and exclusive language distinguished it from the non-exclusive clause that had been read to complement a previous agreement to arbitrate in Bank Julius Baer & Co., Ltd. v. Waxfield Ltd., 424 F.3d 278, 282 (2d Cir. 2005) ….
(Emphasis and extra paragraphing added.)
Drafting tip: A drafter would do well to state expressly whether an exclusive forum-selection clause is intended to trump an arbitration clause. The Common Draft forum-selection clause, which in its basic form is non-exclusive, includes language to the effect that the forum selection does not negate any provision of the agreement requiring arbitration or other non-judicial dispute resolution procedure.
A simple exclusion of consequential damages might still allow recovery of lost profits
The case: Biotronik A.G. v. Conor Medsystems Ireland, Ltd., 2014 NY Slip Op 02101 (N.Y. March 27, 2014)
A manufacturer of a new type of coronary stent entered into an agreement designating another company as the manufacturer’s exclusive distributor of the stent in the United States and certain other countries. The agreement required the distributor to pay the manufacturer a percentage of the distributor’s net sales of the stent.
The agreement’s limitation of liability clause excluded consequential damages, among others: “Neither party shall be liable to the other for any indirect, special, consequential, incidental, or punitive damage with respect to any claim arising out of this agreement (including without limitation its performance or breach of this agreement) for any reason.”
At the time the parties entered into the agreement, the manufacturer had not yet obtained regulatory approval for the new stent in Europe or the United States. European approval ensued two years later, and the distributor began selling the new stent.
A year after that, however, the manufacturer was acquired by Johnson & Johnson. At the time, part of J&J’s product line was another stent that competed directly with the manufacturer’s new stent. A few months after that, the manufacturer discontinued its FDA trial of what was purportedly the new stent and issued a worldwide recall of the stent.
The distributor sued the manufacturer for breach of contract. It sought damages for the lost profits it expected from its sale of the manufacturer’s new stent. The manufacturer argued, though — and the district court agreed — that the distributor’s claim for lost profits was barred by the agreement’s limitation of liability.
The Court of Appeals of New York (that state’s highest court) ruled otherwise, holding that for that particular contract, the distributor’s alleged loss of profits might constitute allowable direct damages, not excluded consequential damages:
The distinction between general and special contract damages is well defined, but its application to specific contracts and controversies is usually more elusive.
Lost profits may be either general or consequential damages, depending on whether the non-breaching party bargained for such profits and they are the direct and immediate fruits of the contract.
Otherwise, where the damages reflect a loss of profits on collateral business arrangements, they are only recoverable when (1) it is demonstrated with certainty that the damages have been caused by the breach, (2) the extent of the loss is capable of proof with reasonable certainty, and (3) it is established that the damages were fairly within the contemplation of the parties.
(Emphasis and extra pargraphing added, citations and internal quotation marks omitted).
Drafting tips: In the Common Draft provisions, the exclusion of consequential damages clause:
- expressly refers to “loss of profits from collateral business arrangements,” to make the scope of the limitation more clear; and
- does not exclude incidental damages.
Do you even need a termination-for-breach clause?
The case: Stevens Aviation, Inc. v. DynCorp Int’l LLC, No. 2011-202686 (S.C. March 26, 2014) (reversing court of appeals, and affirming trial court’s partial summary judgment that contract was an exclusive, requirements-type contract)
Many contracts include provisions allowing a party to terminate the agreement for material breach by the other party. Depending on the nature of the contract, though, a termination provision might be superfluous if the aggrieved party can simply stop sending work or orders to the breaching party.
For example, in a case involving whether a contract was a(n exclusive) requirements contract, the South Carolina supreme court noted that, if the contract did not create an exclusive relationship, then the contract’s termination provisions would not be needed:
The Subcontract’s termination provisions permit DynCorp to terminate the Subcontract if Stevens fails to perform despite receipt of cure notices. If the Subcontract is not a requirements contract, the termination provision would be superfluous. DynCorp would not need to issue cure notices or formally terminate the contract. DynCorp could effectively unilaterally terminate the contract at any time by choosing to not send additional aircraft to Stevens.
Id., slip op. at 9 (emphasis added).
Be explicit about incorporation by reference
The case: Stevens Aviation, Inc. v. DynCorp Int’l LLC, No. 2011-202686, slip op. at 9 (S.C. March 26, 2014) (reversing court of appeals, and affirming trial court’s partial summary judgment that contract was an exclusive, requirements-type contract):
A defense contractor entered into a “teaming agreement” with another company. The teaming agreement stated how the two companies would collaborate to pursue a defense contract to maintain certain U.S. Army aircraft.
The defense contractor was awarded the Army contract, and subsequently entered into a subcontract with the other company. The preamble of the subcontract referred to the parties’ previous teaming agreement, but it did not expressly state whether the teaming agreement was incorporated by reference:
WHEREAS, the parties entered into a Teaming Agreement . . . which identifies the roles and responsibilities of the parties as Prime and Subcontractor in a cooperative effort to perform the requirements of [the Army contract];
WHEREAS, this Subcontract supersedes all prior written or oral agreements between the parties, excluding the Proprietary Data Exchange Agreement . . . and constitutes the entire agreement between the parties with respect to this Subcontract.
(Well, this is awkward: The preamble included entire-agreement language, which was largely repeated in an integration clause, which violates the D.R.Y. [Don’t Repeat Yourself] guideline.)
Years later, the parties got into litigation. One of their disputes was about incorporation by reference:
- The trial court said yes, the teaming agreement was incorporated by reference into the subcontract;
- The appeals court disagreed, and said no, the teaming agreement was not incorporated by reference into the subcontract;
- The state supreme court held that it didn’t matter, because the ultimate answer was the same either way (that is, the subcontract required the government contractor to send all of the defined maintenance work to the subcontractor and not to others).
- The drafters of the subcontract could have saved their clients a lot of time and money in the litigation by clearly stating whether the parties’ prior teaming agreement was, or was not, incorporated by reference into the subcontract.
- The preamble of an agreement is not the place for an entire-agreement clause; the D.R.Y. (Don’t Repeat Yourself) guideline helps prevent accidental inconsistencies that can result when one provision is edited but the repetition of that provision isn’t.
Try explaining why your liquidated-damages clause is a reasonable approximation
The case: FPL Energy, LLC, v. TXU Portfolio Management Company, L.P., No. 11-0050 (Tex. March 21, 2014) (reversing court of appeals: liquidated-damages provision was unenforceable)
The Supreme Court of Texas reiterated its test for enforceability of liquidated-damages provisions: It emphasized that not only must actual damages be difficult to estimate, but also the agreed liquidated damages must be a reasonable forecast of the actual damage. If the two numbers end up being too far out of whack, then the liquidated-damages provision will be unenforceable as a penalty, which is just what happened in this complex case:
The basic principle underlying contract damages is compensation for losses sustained and no more; thus, we will not enforce punitive contractual damages provisions.
In Phillips v. Phillips, we acknowledged this principle and restated the two indispensable findings a court must make to enforce contractual damages provisions: (1) the harm caused by the breach is incapable or difficult of estimation, and (2) the amount of liquidated damages called for is a reasonable forecast of just compensation.
We evaluate both prongs of this test from the perspective of the parties at the time of contracting. …
[W]e recognized that, under this test, a liquidated damages provision may be unreasonable because the actual damages incurred were much less than the amount contracted for. A defendant making this assertion may be required to prove the amount of actual damages before a court can classify such a provision as an unenforceable penalty.
* * *
[W]hen there is an unbridgeable discrepancy between liquidated damages provisions as written and the unfortunate reality in application, we cannot enforce such provisions. … When the liquidated damages provisions operate with no rational relationship to actual damages, thus rendering the provisions unreasonable in light of actual damages, they are unenforceable.
Id. at part IIA, slip op. at 18-19, 23-24 (footnotes, citations, and internal quotation marks omitted; emphasis and extra paragraphing added).
- If drafting a liquidated-damages clause, don’t just recite “as liquidated damages and not as a penalty”; that won’t automatically save the clause. (A sewer by any other name would stink as badly.)
- Make a serious effort to develop a realistic approximation of the likely damages.
- Consider explaining, in the contract itself, perhaps in a footnote, the basis of the parties’ approximation of the likely damages.
Your contract’s unrestricted unilateral-termination right might invalidate the arbitration clause
The case: Lizalde v. Vista Quality Markets, Inc., No. 13-50015 (5th Cir. March 25, 2014) (reversing district court’s denial of employer’s motion to compel arbitration of employee’s claim for on-the-job injury):
A meat cutter sued his employer for injuries he sustained in a slip-and-fall accident on the job. The employer filed a motion to compel arbitration, which the trial court denied on grounds that the arbitration agreement supposedly was illusory because the employer had the right to terminate the arbitration agreement unilaterally at any time. (See the Common Draft commentary for a more-detailed discussion of the related issue of unilateral amendments.)
The appeals court reversed, holding that the employer’s unilateral-termination right was not illusory because a unilateral termination would not take place for ten days and would not affect existing claims See id. at part I, slip op. at 2 (internal quotation marks omitted, extra paragraphing and bullets added, alterations by the court); see also part IIIA, slip op. at 5 (citation omitted), citing In re Halliburton Co., 80 S.W.3d 566, 569-70 (Tex. 2002).