Avoiding contract disputes – Steps to take before entering a contract

We hear a lot in the financial press about the risks involved in failing to comply with the raft of legislation that currently regulates businesses. However, the greatest exposure most businesses have to litigation is through their relationships with other businesses and with their employees. It’s a matter of human nature that you are much more likely to argue with the people you deal with on a day-to-day basis than with a regulator.

There are lots of reasons to avoid getting into disputes with people: it’s expensive, it’s risky and it’s time consuming. Litigation is a very backward looking exercise and, litigators aside, very few people enjoy it. Most find it very stressful. Often by the time parties consult lawyers, they are deeply entrenched in the dispute and that means the options for moving forward are more limited. In avoiding disputes, prevention really is key.

With that in mind, this article looks at some common reasons that disputes arise and the steps you can take before entering into a contract to reduce the chance it will end in a dispute.

How do disputes arise?

Litigators get an interesting insight into how disputes arise. There are certainly some common patterns as follows:

• There is no contract between the parties – the parties have assumed they are on the same page about a transaction and don’t consider it necessary to enter into a written contract. This is more likely to occur when there is an ongoing business or personal relationship between the parties. There is a reluctance to think about what might go wrong.

• The contract doesn’t cover the event that has occurred – this often takes place where the parties have an overly optimistic view of what will occur and don’t rigorously consider other scenarios or what the parties’ rights will be if something goes wrong.

• The contract clause is ambiguous – disagreements are much more likely to occur, or escalate, where there is uncertainty about each party’s rights and obligations. If there’s more than one way of interpreting a contract, then it’s likely the parties will arrive at different interpretations which are most closely aligned with their commercial interests.

• There are vitiating factors – most commonly, this will take the form of some sort of claim of misleading and deceptive conduct or misrepresentation because one of the parties is unhappy with the bargain that has been struck between them.

The common factor in these scenarios is that there is an unforeseen event coupled with uncertainty about the parties’ obligations. If the parties have a contract that clearly spells out their rights and obligations, for the most part they will stick to it. Therefore, the best protection against disputes is to have an appropriately worded contract.

What should you do before entering into a contract?

The following steps are likely to assist in preventing problems down the track with the counterparty to any contracts you enter:

• Due diligence – complete due diligence on any party the business is intending to contract with, particularly if the contract will be long term or it has the potential to have a large impact on the business. It is advisable to explore:

– the track record and experience of the other party

– their financial standing

– their experience in undertaking similar contracts, and

– whether their key staff have appropriate qualifications and ability to manage the contract.

You are much more likely to get into a dispute with someone who is having difficulty meeting their obligations under the contract.

• Realistic price – be sure the price being paid under the contract is realistic. There’s an increased risk of the other party defaulting if the contract price is unrealistically low.

• Prepare for the negotiation – disputes primarily arise out of uncertainty. Prior to negotiating the contract with the other party, discuss and document with your own team what the business has learnt from other contracts or projects, what realistically could go wrong, and how those issues will be dealt with if they do arise. This should prepare you for the issues that will need to be negotiated with the other party.

• Scenario testing – look ahead and test some scenarios. What issues might arise that could have an impact on the contract and how will this affect the parties in terms of meeting their obligations? It might be third parties, the weather or the political environment that will have an impact on the performance of the contract.

• Identify commercial issues – the negotiation of a contract is an important stage where both parties to the contract need to identify all of the commercial issues between them which need to be resolved. Often, an inadequate amount of time is spent actually exploring what both parties require from the contract and how the parties will deal with the scenarios that might arise.

• Allocate risks – once you identify a risk, you need to consider how it will be dealt with by the contract. If the subject matter of the risk is important to your business, you might need to look for options which eliminate the risk.  Alternatively, you might retain the risk, but pass it onto your own customers. Another option is to share the risk between the two parties to the contract or transfer the risk to someone else, such as an insurer. There are no rights or wrongs about how you allocate the risk in the contract, but it should be clearly negotiated and agreed at the same time as the price and other essential terms of the contract are being discussed.

• Collaborative regimes – there are a number of dispute avoidance processes that can act as a circuit breaker and prevent a dispute between contractual parties from escalating into litigation. At an early stage in the negotiations, you should consider what collaborative regime can be designed and put in place between the parties to ensure the contract stays on track. These types of regimes are primarily aimed at maintaining the relationship between the parties so any issues that arise can be discussed in a non-confrontational way. You might agree on a formal process, such as team building, referral within the organisation, mutual evaluation, expert determination, mediation or arbitration as the agreed process the parties will undertake.

• Involve your lawyers early – many contracts are flawed because the lawyers didn’t have sufficient time to understand the deal or to negotiate the drafting of the terms with the other party’s solicitors. They are often pressured into signing off on a contract when the parties have “deal fatigue” or there are commercial pressures to get it signed.

• Make sure you understand the terms – the contract should be written in plain English and you should be able to read and understand the terms of the contract. If you don’t, the chances are that the counterparty also doesn’t understand what the term means and this could be a potential problem.

• Record important issues – if an issue is important to you, make sure it’s recorded in the contract. Keep in mind that evidence of representations and discussions that occur during the negotiations will probably be inadmissible. You therefore need to have any crucial information agreed and acknowledged in the written document.

Please contact us if you have any questions in relation to contract disputes. We can provide specialised legal advice in relation to contractual rights and obligations.

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