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Drafting tip: Be sure there’s money somewhere to support the other side’s contract obligations

I’m in the middle of grading final exams from my Contract Drafting course at the University of Houston Law Center. One of the main questions involved marking up clauses from a hypothetical contract on behalf of a hypothetical client, ABC Corporation, that is negotiating with a counterparty, XYZ, Inc. I’ve noticed that a  couple of students suggested something along the lines of, “Let’s put in a clause requiring XYZ to indemnify ABC.”

The problem was, it was very much not clear from the facts that XYZ would have the money needed to comply with such an indemnity obligation. It’s reminiscent of the old economist joke whose punchline is “no problem, we’ll just assume we have a can-opener.”

The students in question apparently didn’t remember my lecture comments: For important obligations, try to  make sure someone, somewhere, has a pot of money that can be used to comply with contractual commitments, or at least to pay the damages resulting from breach of those commitments. That might be, for example:

  • an insurance policy, for example a liability policy; a completion bond, or a payment bond;
  • a third-party guaranty;
  • a letter of credit from a bank or other financial institution;
  • or even taking a security interest in collateral that could be seized and sold to raise funds if necessary.

On a related note, it’s also useful to try to include contractual obligations that will help reduce the risk of breach or of other problems. By analogy, homeowners can get a break on their insurance-policy costs if they install burglar alarms, smoke detectors, etc.; likewise, young drivers get an insurance discount if they take driver-ed training.

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