Vague terms in contracts and accuracy

Using vague terms in contracts may not be confused with drafting analytically and accuracy. ‘Accuracy’ requires not only the capability to distinguish legal, factual, accounting, procedural and legal-procedural concepts from each other. A capable lawyer should also identify the subtleties resulting from the negotiations. A skilled drafter translates this into precise and accurate wording, ties in those aspects that fill any unaddressed gaps, omits to clarify matters that were deliberately left vague and drafts analytically, applying McKinsey’s MECE principle.

Avoid vague terms? #

Rule and exception. The title of this paragraph – avoid vague terms – is a drafting principle with important exceptions. As a general principle, vagueness should be avoided, but many vague terms serve a useful purpose. As a general principle, a contract should be clear about the obligations of each party. However, clear obligations are not always agreeable. In such case, the principals may well work on the basis of a gentlemen’s agreement reflected by some vague wording of intention, materiality or reasonableness. Remember, however, that if an obligation is not clear, the strongest contracting party will have the benefit of the doubt as to whether it did perform duly.

Although contracts should be clear, many obligations are incapable of being defined in an all-embracing manner. For example, precise criteria may depend on extraneous uncertainties or the parties may be willing to assume clear (and even stricter) criteria only after a minimum level of mutual trust has been established. In such cases, it would be inevitable to use a vague term. It makes sense to elaborate on such vague terms by agreeing on conditions or milestones to achieve certainty at a later time and place.

Examples of vague or unspecified contract terms are the concepts of reasonableundue delaymaterialsubstantially and properly. It is probable that the concept of good faith is also such a vague term. Essentially, it introduces a standard of conduct which has yet to be defined, and reflects a call for ‘good-housekeeping-behaviour-but-not-too-much’. I disagree with this. Good faith is a subjective state of mind requiring due and sincere consideration.

Cultural difference. Generally, lawyers from jurisdictions with systematic codifications of the laws of obligations feel much more comfortable with vagueness than those from a common law jurisdiction. This may be explained by the fact that, by definition, codifications are built on vague terms that acquire their purpose in real life. Statutory references to materiality and reasonableness impose a balance of interests as well as a duty to explain. Similarly, in common law jurisdictions the individual freedom (and accordingly, the freedom of contract) may well prevail over vague (limiting) concepts such as good faith and fair dealing.

Several ‘vague terms’ are used in various typical contexts, but not always accurately. In this paragraph we will discuss a few aspects of the use of the terms reasonablematerialsubstantially and without undue delay.

Vague term: reasonable #

The most obvious example of vagueness is the word reasonable. It introduces an objective standard in the contract. The term reasonable places a limit on discretionary power or the effect of overly strict obligations. Where it limits the exercise of discretionary power, it requires that a party is able to explain its performance (or failure to perform as expected). Where the term reasonable is included with the aim of reducing the ‘harshness’ of strict contract clause, it introduces a common sense approach to the interpretation of what may normally be expected from a party’s performance. The standard of ‘reasonableness’ is one that is usually determined by reference to a well-informed third party with the same expertise acting under the same circumstances.

Party’s discretion. The opposite of reasonable would be the phrase at a party’s discretion or otherwise strict (and strictly enforced) criteria, although no performance and no exercise of power under a contract should be ‘unreasonable’ if it adversely affects the other party’s proper interests.
A typical manifestation of reasonableness is where a party would be provided the right to exercise its discretion in making a decision under a contract provision. The party who has the right to make a decision will want to be able to make it at its sole discretion. This way, whatever the party decides cannot be disputed by the other party. The other party will push for a standard of reasonableness, as it would give it the right to get an explanation and to discuss the other party’s decision.

DCFR. The Common Frame of Reference (a preliminary but official draft for preparing a future European Civil Code)[5] defines reasonable as:
a concept “to be objectively ascertained, having regard to the nature and purpose of what is being done, to the circumstances of the case and to any relevant usages and practices.”

Qualify the term? There is no need to provide for a qualification of reasonableness if a European law would be applicable. All European legal systems impose some standard of reasonableness on the contracting parties exercising their contractual rights. Nevertheless, contracting parties appreciate that a standard of reasonableness be introduced explicitly. This is also prudent in modern common law systems where the general principle of freedom of contract retains considerable support[6]. An example:

Customer shall reimburse Service Provider’s reasonable out-of-pocket expenses incurred in connection with the Services.

The term reasonable clarifies that there is a limit on reimbursable out-of-pocket expenses. It gives the Customer a point of departure for addressing excessive declarations. The Service Provider should be able to explain why the invoiced expenses were made and the explanation should somehow be understandable or reasonable. The explanation should fit in the parties’ and contractual subjective contexts and the actual circumstances. Because the Service Provider is dependent on the Principal’s decision, in hindsight, of its invoice, the Service Provider will be careful in incurring the expenses.

Vague term: material #

Background. The concept of materiality is used to qualify phrases that would otherwise be too strict. It is often used in conditions precedent and warranties. Obviously, it takes out of the scope of the phrase various immaterial elements.
The qualification material balances out the straightforward wording against the potential result if no qualification of materiality was used. Like reasonableness, the scope of a materiality qualification would be determined by the party who carries the benefit of the related contract provision. This is usually the stronger contracting party. For example, if the completion of a transaction is subject to a condition precedent that no material adverse change has taken place in respect of the Target Company, any doubt about the materiality of adverse changes in the Target Company’s business will be used by the strongest party to the transaction. (Often, the fulfilment of a condition precedent triggers renegotiation of the contract terms rather than a mere termination of the transaction as a whole. This is because in reality, the conditionality is often included to allocate risks rather than giving a party a right to walk although this may well be a legitimate effect.)

Not. Materiality qualifications are often inappropriately used:

Borrower has not violated any material laws or regula­tions.
Q: What about persistent traffic speed violations by employees of the Borrower during work time?
Borrower has not violated any laws or regulations in any material respect.
Q: What is material?

Yes. A proper use would be:

Borrower has not violated any laws or regulations in a manner that must reasonably be expected to have a material adverse effect on Borrower’s business or financial condition.

If a party to an agreement defines materiality by reference to an amount, be very keen that all references to material are capable of meeting the threshold.

Vague term: substantially #

The vague term substantially is often used to allow for some minimal deviations after entering into an agreement. In major M&A-transactions, various affiliated contracts will be in an ‘agreed form’ on the signing date, ready to be entered into on the closing date of that transaction. An example of such ‘agreed form’ is often defined as:

Patent Licence Agreement means the patent licence agreement substantially in the form attached as Schedule X.

Effect. The effect of the qualification ‘substantially in the form’ is that a party might impose small modifications of a rather immaterial nature on the other party, requiring that such other party should not unreasonably reject such modifications. These may be desirable to fit the final contract terms to developments during the intermediate period between signing and closing or because (immaterial) inaccuracies were discovered whilst preparing the closing. Substantially then implies that any proposed change may be rejected by the other party if it touches upon the material aspects of the contract. The Vienna Convention on the international sale of goods (art. 19 par. 3) illustrates what may be considered material to (accepting an offer to conclude) a contract:

…terms relating, among other things, to the price, payment, quality and quantity of the goods, place and time of delivery, extent of one party’s liability to the other or the settlement of disputes are considered to alter the terms of the offer materially.

Usage (2)Substantially is also used in meet-or-release and most-favoured-customer clauses: pursuant to such contract provisions, a buyer may require price adjustments if the same goods or services can be sourced from a third party on terms and conditions which are substantially the same (or reasonably similar) to those from the seller. A meet-or-release provision would entitle the buyer to terminate the supply of goods or services if the seller elects not to meet the terms and conditions. A most-favoured-customer provision would entitle the buyer to be charged the lowest price offered by the seller to its other customers (and sometimes even to the lowest price available in the market). Needless to say that the enforcement of this most-favoured-customer provision should be secured by a right to audit the seller’s books or require an audited best-price-confirmation letter.

Vague term: without undue delay #

Many contract provisions remain silent on the precise period of time within which something has to happen. The alternative for immediate or prompt action, acting upon the occurrence of an event or acting within 30 days after a notice was received, is to allow that an action must be undertaken without undue delay.

Why? There may be many reasons for using without undue delay:

  • the event triggering an obligation (or a right) to act is itself vague;
  • it is not foreseeable how much time will be needed in order to take the required (or allowed) action effectively and efficiently, though adequate preparation will be desirable in any case;
  • when a triggering event occurs, there will probably be no urgency to act immediately, in which case thoughtless action, merely to prevent contractual rights from lapsing, should be discouraged (but the opposite may also be true);
  • not providing any limitation in time creates too much uncertainty.

Think analytically and draft ‘MECE’ #

One of the complications of the drafting principle to be ‘accurate’ is a drafter’s tendency to be exhaustive or to ascertain that the concept is well-covered. An important guideline for improving your accuracy (and accordingly your confidence that you did a good job) is to think analytically and draft conceptually, in McKinsey’s terminology[1], ‘MECE’ (mutually exclusive, collectively exhaustive) or, in French philosophical terms, ‘cartesianic’.

MECE and cartesianic mean that, consistent with the ideas of Descartes, the drafter cuts the greater contractual concepts into understandable pieces in respect of which he or she is convinced that those pieces are all the pieces, because they leave no gaps and do not overlap.

McKinsey’s MECE principle. The two related concepts of ‘mutually exclusive, collectively exhaustive’ can be explained as follows: a description of acts or events is ‘collectively exhaustive‘ if no other act or event is conceivable. In contract drafting terms it means that describing a course of action is collectively exhaustive if all variants are caught (under the addressed conditions or circumstances).

When you roll a dice, it will inevitable show a 1, 2, 3, 4, 5 or 6 and they capture all possible outcomes exhaustively. ‘Mutually exclusive‘ are subject matters that exclude each other without any overlap. If you throw a coin, you can rest assured that the outcome is either heads or tails (yes, if you throw it in on the beach it might show the edge, which is why arguably the edge makes heads and tails collectively exhaustive, but still is mutually exclusive).

Descartes. The MECE-principle was probably identified by the 17th century philosopher and mathematician René Descartes. In his Discours de la méthode, and more elaborately in his Regulae ad directionem ingenii (i.e., rules on the direction of the mind), he restated a few principles to deduct, on the basis of a hypothesis, an explanation or description of any investigated problem. Traditionally, the French PhD-doctorate books are set up according to Descartes’ method. Descartes proposed that:

“if we are to understand a problem perfectly, we must free it from any superfluous conceptions, reduce it to the simplest terms, and by a process of enumeration, split it up into the smallest possible parts.”

Drafting technique. Now, let’s translate this into contract drafting. A draftsperson often deals with the question how to address a subject of discussion (or agreement) in such manner that the future will not show lacunas or reveal an interpretation that had not been put into the words by the parties. The task of a drafter is therefore to think analytically, to create a systematic structure, and to write logically. To identify the smallest possible parts, the drafter may revert to concepts such as:

  • substance vs. procedure
  • objective elements vs. subjective elements
  • content vs. form
  • cause vs. effects
  • a concept vs. manifestations of the concept
  • (chrono-) logical sequence: before and after delivery/closing

By converting these concepts into the case at hand, a drafter may establish a belief that the entire subject is captured into the contract. The trick is to draft conceptually rather than to list a concept’s manifestations (read more here).

Examples of improved accuracy #

Example 1. For example, in a contract for creating a piece of work, a drafter will probably address how and when delivery and acceptance of the piece of work takes place. Applicable statutes will probably provide that any shortcomings must be claimed “within a reasonable period of time” or “without undue delay” and that a claim assessment also takes into account the rules of the particular marketplace.

It may help to investigate how such deadlines actually work in the given context and provide for customised (i.e., precise) timeframes. A contract attempting to address the vagueness of such statutory provisions should align with the wording of the statutory provisions accurately, and deviate from them precisely. Likewise, such deviation is easier to accept by the other party. Also, if the deviation is at first sight incompatible with mandatory law, being precise may well justify the settlement of an uncertain element of such mandatory provision.

Example 2. A similar example can be found in share purchase agreements with a price adjustment mechanism. Typically, such mechanisms provide for strict timeframes within which a party must deliver (or respond to delivered) financial accounts. If the preparation is no more than the push of a button, a short period may well suit both parties’ interests, but if the work is much more complicated than producing quarterly or annual results (e.g., because the cut-off date is potentially a random day of the month), a longer period of time seems to be inevitable. Such informed proposal is easy to explain and probably very acceptable (and if the other party bluntly responds with a doubled or halved timeframe that may well be countered). The period desirable for reviewing financial statements delivered to a purchaser, on the other hand, requires that the purchaser becomes acquainted with the applied accounting principles, the way they are adopted in reality, as well as the reported facts and valuation assessments actually being true and accurate.

Example 3. For another example, if the contracting parties are unable to completely describe the desired end-result (‘content’), they may define milestones (‘procedure’) ascertaining that certain procedural steps will be taken in a pre-described manner, as this would enable each party to interfere at appropriate times and places. The quality of an end-result will certainly improve if the parties have established (and adhered to) a procedure ascertaining adequate evaluation.

If contract parties are unable to foresee all possible events of default or all circumstances in which very considerable damages may occur, it would probably be more appropriate to provide for notification procedures and subsequent obligations to cooperate, than to say that in case of Events A, B or C, the seller will indemnify the purchaser. The latter manifestations will frequently trigger liability-avoiding behaviour (often including passivity and hence even greater damages).

Example 4. For a final example, a services contract would address all compliance-related aspects of a service by addressing the desired service level, as well as the procedural aspects of a service (which standard of conduct the service provider must adhere to whilst performing the services).

The procedural aspects would ascertain that the agreed quality would not be achieved by non-compliant behaviour that cannot possibly be foreseen in the context of the service agreement (or even a reference to an exhaustive set of supporting principles).

[1] The MECE-principle (pronounce MEESEE, like in see me) is addressed in two bestsellers of Ethan Rasiel (McKinsey). Ethan M. Rasiel, The McKinsey way, McGraw-Hill 1999; and Ethan M. Rasiel and Paul N. Friga, The McKinsey mind, McGraw-Hill 2002 (both are translated into several languages).

 

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