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Preface to contract interpretation guidelines

Thank you for downloading this e-book, Contract interpretation guidelines! The e-book discussescontract clauses that are typically found in article 1.2 of the larger types of agreement. The legal

concept of interpretation is also discussed and illustrated by reference to contract interpretation rules

in the Common Frame of Reference (a pan-European initiative aiming at converging differences

amongst European legal systems), as well as in the American Law Institutes Restatement, Second, of

Contracts. We hope the suggestions and best practices in this e-book help you improve your contract

drafting style.

If you like it, feel free to mail this e-book to your colleagues!

Note that both subject matters of this e-book are also included in the (hardcopy) book Drafting

contracts1 as paragraphs 2.2 and 7.2. If you wish to order a copy of the book, click on the cover pageof this e-book (or visit Kluwers webshop). You can find further information on the final page of this

book.

Willem Wiggers

Amsterdam, 26 October 2011

1 Willem J.H. Wiggers, Drafting contracts, Techniques, best practice rules and recommendations related to contractdrafting, Kluwer, 2011:http://shop.kluwer.nl/boeken_products/drafting-contracts/prod10178137.html.
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2. MATTERS OF STYLE AND LEGAL CULTURE

2.2 Some considerations on contract interpretation

A drafter should be well aware of the meaning that will be attributed to contract wording once it comes

to court proceedings. International legal cultures as well as some interpretation guidelines will be

discussed in the light of contract drafting and interpretation. The purpose of this paragraph is to

increase awareness of the background of different opinions and styles of contract drafting.

(a) Legal cultures and determinative interpretation factors

Three main legal traditions. Three approaches to legal practice can be distinguished, each

representing the characteristics of the legal culture behind it:

The Roman legal culture;

The Germanic legal tradition; and

most visibly impacting the size of a contract, the common law.

Other legal families. Also other cultures can be identified, such as the Scandinavian family, the

(former) socialist countries, Arab (or Islamic) legal culture, the Hindu tradition and various mixtures:

the Scottish and South African legal systems are somewhat of a mixture between common law and

civil law; Japanese law has been influenced by both U.S. common law and German law; Turkish law

by the Swiss codification of around 1900; Russian law by several European legal systems including

the Dutch re-codification of 19922.

Roman and Germanic traditions. In both legal cultures, courts will come to their decisions by

reverting to systematic codifications of the law (i.e. a civil or a commercial code), the meaning of which

is elaborated on in parliamentary materials, doctrinal opinions and case law. These codifications have

a rather abstract character, building on general principles such as good faith, reasonable, fair

dealing, justifiable, duty to co-operate, which are familiar tools for each lawyer. These principles

require that a party exercising its rights under a contract observes standards of proportionality and

subsidiary.

2 Many other classifications have been made (and their classification questioned). See Konrad Zweigert & Hein Ktz,Einfhrung in die Rechtsvergleichung, JCB Mohr Tbingen 1996, 3rd ed. and Reinhard Zimmermann & MathiasReimann, The Oxford Handbook of Comparative Law, Oxford U.P., 2006/2008, 1456 p.


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Willem Wiggers, Drafting contracts

Techniques, best practice rules and MMM

recommendations related to contract drafting MMM

Contract interpretation guidelines MMM

In the Roman and Germanic legal traditions, courts are not strictly bound to their precedents and,

exceptionally, even able to set aside unfair consequences of a law or regulation. Lawyers from

common law jurisdictions would probably reject such source of uncertainty about explicit provisions,

but the practical consequences are not as sweeping as it may seem. Remedies in case of breach of

contract are not limited and will typically include specific performance or an otherwise effective

remedy.

The two legal traditions are fundamentally different as regards contract interpretation (although the

difference may seem to be of a philosophical, academic nature rather than of practical meaning). In

the Roman legal culture, the rather subjectiveconsensus between the parties is determinative for the

scope and nature of the parties mutual obligations. This means that not the written contract but the

mental, common intentions are relevant and that a written agreement is rather a we lcomed (but

important) piece of evidence. In the Germanic legal tradition, an objective approach prevails in the

interpretation of contracts and legal acts: important is what, under the circumstances, a reasonable

and informed person in the same position would deem reflects most accurately how the parties are

bound. Also in this approach, the written contract is a good starting point. Efforts to articulate a

common core of European contract law resulted in the following general principle of contractinterpretation (CFR):

II. 8:101: General rules

(1) A contract is to be interpreted according to the common intention of the parties even if this differs from

the literal meaning of the words.

(2) If one party intended the contract, or a term or expression used in it, to have a particular meaning, and

at the time of the conclusion of the contract the other party was aware, or could reasonably be expected to

have been aware, of the first partys intention, the contract is to be interpreted in the way intended by the

first party.

(3) The contract is, however, to be interpreted according to the meaning which a reasonable person

would give to it:

(a) if an intention cannot be established under the preceding paragraphs; or

(b) if the question arises with a person, not being a party to the contract or a person who by law has no

better rights than such a party, who has reasonably and in good faith relied on the contracts apparent

meaning.

II. 8:102: Relevant matters

(1) In interpreting the contract, regard may be had, in particular, to:

(a) the circumstances in which it was concluded, including the preliminary negotiations;

(b) the conduct of the parties, even subsequent to the conclusion of the contract;

(c) the interpretation which has already been given by the parties to terms or expressions which are the

same as, or similar to, those used in the contract and the practices they have established betweenthemselves;

(d) the meaning commonly given to such terms or expressions in the branch of activity concerned and the

interpretation such terms or expressions may already have received;

(e) the nature and purpose of the contract;

(f) usages; and

(g) good faith and fair dealing.

(2) In a question with a person, not being a party to the contract or a person such as an assignee who by

law has no better rights than such a party, who has reasonably and in good faith relied on the contracts

apparent meaning, regard may be had to the circumstances mentioned in sub-paragraphs (a) to (c) above

only to the extent that those circumstances were known to, or could reasonably be expected to have been

known to, that person.


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The above CFR articles give a well-balanced principle of contract interpretation, which would even

encompass English law. It is fair to say that each European jurisdiction is somehow represented in the

expressed concepts and that none is contradicted. Note that the literal meaning of contractual words is

not necessarily decisive.

Common law. In the common law systems, vast codifications of private law have never beendeveloped or, at least, they never achieved an authority given to it on the European continent. For the

U.S., for example, codifications have been made for corporate law, partnership law, various types of

transactions in movable property (embodied in state codifications of the Uniform Commercial Code)

and federal topics such as competition law, intellectual property law, arbitration, securities laws and

regulations and bankruptcy law (Chapter 11). Subject matters that are not covered by these

codifications have often been developed in the common law (i.e. case law). Accordingly, legal

concepts such as mistake or set-off are based on court precedents. The influence of legal doctrine

is, at least in the U.S. state laws, very limited if relevant at all. To state that legal concepts such as

good faith and fair dealing can be excluded contractually is exaggerated, but to say that the typ ical

common law attorney is well able to appreciate its scope often contradicts practical experience.

Other than in the Roman and Germanic traditions, the default remedy in common law systems is

payment (in cash) of damages. Whether or not an injunction or specific performance may be awarded

may depend on the adjudicated court, except that parties can always contractually provide for

remedies.

Although this is not the place to elaborate on differences between legal systems, it may be helpful to

cite a few relevant provisions of the U.S. Restatement (Second) of Contracts3, an academic reflection

of the mainstream U.S. principles of contract law.

201. Whose meaning prevails

(1) Where the parties have attached the same meaning to a promise or agreement or a term thereof, it is

interpreted in accordance with that meaning.

(2) Where the parties have attached different meanings to a promise or agreement or a term thereof, it is

interpreted in accordance with the meaning attached by one of them if at the time the agreement was

made:

(a) that party did not know of any different meaning attached by the other, and the other knew the

meaning attached by the first party; or

(b) that party had no reason to know of any different meaning attached by the other, and the other had

reason to know the meaning attached by the first party.

(3) Except as stated in this Section, neither party is bound by the meaning attached by the other, even

though the result may be a failure of mutual assent.

202. Rules in aid of interpretation

(1) Words and other conduct are interpreted in the light of all the circumstances, and if the principal

purpose of the parties is ascertainable it is given great weight.

(2) A writing is interpreted as a whole, and all writings that are part of the same transaction are interpreted

together.

(3) Unless a different intention is manifested:

(a) where language has a generally prevailing meaning, it is interpreted in accordance with that meaning;

(b) technical terms and words of art are given their technical meaning when used in a transaction within

their technical field.

3 American Law Institute, Restatement (Second) of Contracts, 17 May 1978.


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(4) Where an agreement involves repeated occasions for performance by either party with knowledge of

the nature of the performance and opportunity for objection to it by the other, any course of performance

accepted or acquiesced in without objection is given great weight in the interpretation of the agreement.

(5) Wherever reasonable, the manifestations of intention of the parties to a promise or agreement are

interpreted as consistent with each other and with any relevant course of performance, course of dealing,

or usage of trade.

Of course, U.S. state laws may deviate on details, but the key message here is that the differences

with European contract laws are not as significant as it may seem.

(b) Statutory guidelines on contract interpretation

Lawyers like to provide certainty on how a contract must be (and will be) interpreted. For them, several

legislatures have provided guidelines for interpreting contracts (or legal acts). Despite the broad

consensus that such guidelines are not determinative for a case at hand and no more than some hintsfor a court, lawyers (and typically from other jurisdictions) have anticipated that the guidelines could

nevertheless be detrimental and should therefore be excluded explicitly.

Contra proferentem. The CFR provides guidelines for contract interpretation. This is in particular

consistent with the civil codes of France, Italy, Spain and Belgium4, albeit that all EU member states

apply such principles. The main interpretation principles have been stated in the previous paragraph;

another well-known one is:

II. 8:103: Interpretation against supplier of term or dominant party

(1) Where there is doubt about the meaning of a term not individually negotiated, an interpretation of the

term against the party who supplied it is to be preferred.

(2) Where there is doubt about the meaning of any other term, and that term has been established under

the dominant influence of one party, an interpretation of the term against that party is to be preferred.

Even though the authoritativeness may be questioned, the Restatement (Second) of Contracts

explains that a similar principle applies in mainstream U.S. contract law:

206. Interpretation against the draftsman

In choosing among the reasonable meanings of a promise or agreement or a term thereof, that meaning is

generally preferred which operates against the party who supplies the words or from whom a writing

otherwise proceeds.

The lead-in of the first paragraph of Art. II.8:103 (and Restatement 206) typically refers to the

interpretation of general conditions rather than to ordinary course contracts. The second paragraph of

Art. II.8:103 emphasises this, where it introduces a preference in case any negotiations were mainly

determined by an economically strong party (vis--vis a weak counterparty). Despite this context

specific application, the principle has invited many drafters to include a provision express ing that the

parties reviewed and negotiated the entire contract in all its respects (and accordingly stating or

implying that no provision should be interpreted against the party who drafted it). Such approach fails

to address the real issue: the interpretation rule would first of all only apply to stipulations where there

is a (reasonable) doubt about the actual meaning of them. If there is no such doubt, the stipulation

4 Artt. 1156-1164 French and Belgian Code civil, artt. 1364-1371 Italian Codice civile, and artt. 1281-1289 SpanishCodigo civil.


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would be enforced. Whether such doubt could exist may well be measured against the main rule: for

instance, the fact that the parties are business people and advised by professionals who would be

keen to understand each oddly phrased provision. Secondly, the principle effectively says that where

two interpretations compete, the party who created the ambiguity should not have the benefit. The

phrase is to be preferredemphasises that the drafter may well explain why a certain meaning should

prevail (and win the interpretation discussion).

Similar arguments can be made about a dominant party who drafted a contract provision: such party

would insist on the inclusion of a particular provision, notably as regards disclaimers or limitation of

liabilities. In those cases, there may also be a hint of abuse of power, which is not supported by the

law. Art. II. 8:103 section (2) balances out this dominance: a dominant party should contractually

express its impositions carefully. Moreover, the provision may well be seen as the complement of

section (1), as it would likely apply to circumstances in which the dominant party even refused to talk

about an issue.

Drafting technique: introduce mutuality. The interpretation rules suggest that a very one-sided

contract may be highly susceptible of being interpreted against the drafter. A technique to diminish thisis to improve the sense of mutuality of the contract provisions. The most obvious example is probably

the confidentiality provision in most contracts: despite a clear one-party geared interest in continuing

confidentiality, typically, this provision is drafted to apply mutually. Well-known other examples of

mutuality are force majeure clauses: although the party that can be affected by an event of force

majeure is foreseeably only one of the two, the text of the provision often suggests fairness for both.

Rules prioritising interpretation. A few provisions of the CFR clarify that negotiation of a provision

increases its enforceability. This is understandable because the more comprehensive discussions

about the ins and outs of a provision were, all the more reluctant a court must be in attributing a

meaning, which is not at once apparent. Another important interpretation rule (Art. II. 8:106) is that

presumably a contract provision was given a meaning or intended effect. If a provision is ambiguous

or contains errors, the mere reliance on such ambiguity or error without further merit should not be

protected if another interpretation puts a meaning on it.

II. 8:104: Preference for negotiated terms

Terms which have been individually negotiated take preference over those which have not.

II. 8:105: Reference to contract as a whole

Terms and expressions are to be interpreted in the light of the whole contract in which they appear.

II. 8:106: Preference for interpretation which gives terms effect

An interpretation which renders the terms of the contract lawful, or effective, is to be preferred to one which

would not.

The Restatement (Second) of Contracts emphasises other aspects of contract interpretation.

Interesting enough, the written terms are not necessarily determinative:

203. Standards of preference in interpretation

In the interpretation of a promise or agreement or a term thereof, the following standards of preference are

generally applicable:

(a) an interpretation which gives a reasonable, lawful, and effective meaning to all the terms is preferred

to an interpretation which leaves a part unreasonable, unlawful, or of no effect;

(b) express terms are given greater weight than course of performance, course of dealing, and usage of

trade, course of performance is given greater weight than course of dealing or usage of trade, and course

of dealing is given greater weight than usage of trade;


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(c) specific terms and exact terms are given greater weight than general language;

(d) separately negotiated or added terms are given greater weight than standardized terms or other terms

not separately negotiated.

Altogether, the importance of one interpretation rule or another is yet a matter of judgement and is not

inevitably part of the reasoning a court gives. Where the principles revert to different standards, theiractual significance may well differ from country to country or even from judge to judge. Again, this

probably also appeals to cultural legal differences identified in the previous paragraph and discussed

in Weagrees weblog (post of 24 August 2009)5.

5 http://www.weagree.com/weblog-detail/44-cultural-differences--concepts-or-rules-.html
http://www.weagree.com/weblog-detail/44-cultural-differences--concepts-or-rules-.htmlhttp://www.weagree.com/weblog-detail/44-cultural-differences--concepts-or-rules-.htmlhttp://www.weagree.com/weblog-detail/44-cultural-differences--concepts-or-rules-.html


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Techniques, best practice rules and MMMMMM

recommendations related to contract drafting MMMMMM

Chapter 7 Definitions and interpretation guidelines MMMMMM

7. CONTRACT INTERPRETATION GUIDELINES

7.2 Interpretation guidelines for standard words and phrases

Many large agreements devote the second part of the interpretation article (where the first part

contains the defined terms and definitions) to commonly used phrases and address how certain

contract language is to be construed. (In such case, the header of article 1 is often renamed from

Definitionsinto Interpretation).

(a) Standard words and phrases defined

This paragraph addresses these provisions and criticises how useful they are. In a European style

contract (but likely also in a U.S. style contract), none of these interpretation guidelines are crucial;only a few of them are somewhat useful; and most of them are redundant. Finally, a few of them even

disturb a reader by being exaggerated or legalese, or by addressing the obvious.

Written. Many contract provisions require a notice to be given in writing. The obvious intention of the

requirement is to require that a party is firm and accurate as regards its intentions. A party who needs

to notify an event of force majeure will prefer to do so informally rather than putting everyone on the

side of the other party in a position in which a formal response becomes inevitable (e.g. a firm and

final warning with a deadline for remedy). In joint ventures, informal communications between the

partners are the rule. A question that may arise is whether communications by e-mail or fax are in

writing (and satisfy the criterion provided in a contract clause). In view of modern practice, it would be

hard to argue that this is not the case, but avoiding any discussion may still be helpful:

A reference to a communication in writing shall be construed so as to include any

communication in the written form, whether by letter, fax or a scanned and signed document

sent by e-mail;

Singular and plural. Even though an agreement should be interpreted as a normal and reasonable

person would read it, some drafters believe that a normal and reasonable person could say (after

reading a contract provision that talks about one person required to do or omit something) that the

contract provision does not apply to cases where two or more persons would omit or do what is written

in it. They alone will need the following clause (for their comfort):


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A reference in this agreement to the singular includes the plural and vice versa.

Gender. This would allow a drafter to use gender-specific language in a contract without running the

risk of a court holding that, for example, use of only masculine pronouns in that contract excludes

corporations from the scope of certain provisions.

References to words importing one gender include both genders and the neuter.

Article and Section references. A meticulous contract drafter may refer to the articles and sections

of the agreement by adding of this Agreementor aboveor below, as the case may be, or hereof to

each such reference. There might theoretically be confusion about whether the reference may

accidentally point to a provision outside the body of the agreement. To ensure ( ) that this is only the

case for non-capitalised references include the following:

References to Articles, Sections, Annexes, and Schedules are references to articles or sections

of, or annexes or schedules to this Agreement.

Headings and captions. A drafter may sometimes want to ascertain that contractual provisions

cannot be summarised in the two or three words of an article heading or the caption immediately

preceding a contract section. Although it is difficult to argue that one party misunderstood a contract

clause because the caption or article heading gave it a certain meaning, the following clause would

attempt to diminish such argument:

Headings in this Agreement and captions to Sections are provided for convenience only and do

not affect its meaning.

Hereof, thereof, everywhereof. Dont even think about using the habit expressed in:

The words hereof, herein, hereunder; and herebyrefer to this Agreement as a whole and not to

any particular provision of this Agreement.

Amendments, supplements and addenda. A written amendment of an agreement will almost

inevitably state that as of such amendment, supplement or addendum the agreement needs to be

read in the amended, supplemented or extended manner. Some people feel more comfortable if the

agreement itself anticipates its amendment:

A reference to an agreement means that agreement as amended or supplemented, subject to

any restrictions on amendment in that agreement or any restrictions in such amendment or

supplement, as the case may be.

Applicable laws and regulations. When a party warrants that it is not in breach of a particular statute

or undertakes to continue acting in compliance with a particular act or regulation, the other party may

want to ascertain that such non-breach or compliance is measured against that statute, act or

regulation as it is in effect at the time in question. This provision would allow a drafter to accomplish


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that without adding as amended or supplementedor from time to timeafter each reference to such a

statute, act or regulation.

Except as provided otherwise, a reference to a statute or regulation means that statute or

regulation as amended or supplemented from time to time.

Times and time zones. In a multinational context it may be helpful to specify which time zone should

be referenced in case the parties failed to identify it.

Except as provided otherwise, a reference to a time of day is a reference to the time in

Amsterdam, the Netherlands.

Actions on non-business days. If a contract provision identifies several periods of time within which

a certain action needs to be taken, there is a possibility that such action will be required to be taken ata weekend or on a public holiday. The following provision creates an allowance for taking such action

on the immediately following business day.

If any date specified in this agreement as a date for taking action falls on a day that is not a

Business Day, then that action may be taken on the next Business Day.

Modified following adjusted clause. A similar provision, slightly more advanced, is the modified

following adjusted clause used in loan agreements.

If a payment under this Agreement is due on a day which is not a Business Day, the modified

following adjusted convention shall be applied such that the due date for that payment shall

instead be the next Business Day unless this day falls in the next calendar month, in which case

the due date for payment of such sum shall be the immediately preceding Business Day. During

any extension of the due date for payment of any principal amount under this Agreement,

interest is payable on that principal amount at the rate payable on the original due date.

The Notary. A person who is qualitate quacareful and continuously in search of a maximum level of

security, is a notary. In order to prevent a notarial deed not being able to be executed due to the

notary being appointed personally (and him/her being absent on the desired date of execution), the

following clause provides for a discretionary right of substitution:

A reference to the Notary must be construed as a reference to the person named in this

Agreement as civil law notary or, if applicable, any other civil law notary working with [notary

firm name] and any of their deputies;

Person. Particularly in U.S. style contracts, it seems, the drafter may want to ascertain that a

reference to a person includes such persons assignees (or other successors in title). In legal systems

where a right of ownership transfers in its entirety, the following clause is redundant:

A reference to any Person is to be construed to include that Persons successors and assigns.


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As discussed in paragraph 2.2(b), a party might fear that a court will say that the contract is not a

negotiated agreement but rather a set of general terms and conditions (the interpretation of which

could potentially be scrutinised and interpreted against the drafter). The following may be included toreduce such risk:

Each party has participated in negotiating and drafting this agreement, so if an ambiguity or a

question of intent or interpretation arises, this agreement is to be construed as if the parties had

drafted it jointly, as opposed to being construed against a party because it was responsible for

drafting one or more provisions of this agreement.

(b) Subsidiaries and Affiliates

Subsidiaries. Although European company directives have defined the concept of a companys

subsidiary(and an affiliate) in clear terms, often large transaction agreements nevertheless provide for

a contractual definition. A common definition that meets the EU directives definition:

a company is a Subsidiary of another company, its Holding Company, if that other company

is a shareholder of it and:

(a) controls alone, pursuant to an agreement with other shareholders, a majority of the voting

rights in it; or

(b) has the right to nominate, appoint or remove a majority of its management team or board

of directors,

or if it is a Subsidiary of a company which itself is a Subsidiary of that other company.

Affiliates. Alternatively (e.g. because the EU member states company laws reveal a great variety of

possible corporate management structures), a more compact and less statutory terminology driven

definition may be preferred. Also, the concept may well be extended to sister companies and parent

companies:

Affiliate means, in relation to a person, any company or other entity, whether or not with legal

personality, which directly or indirectly controls, is controlled by or is under joint control with that

person. For this purpose, a person is deemed to control a company or entity if it (a) owns,

directly or indirectly, at least 50 percent of the capital of the other company, or (b) in the

absence of such ownership interest, substantially has the power to direct or cause the direction

of the management and set the policies of such company or entity.

In case of doubt, it is recommended to make the inclusion or exclusion of a certain entity explicit. This

is normal for M&A-agreements in respect of private equity investors or investment funds, if they act as

a 100 percent shareholder (i.e. since other portfolio investments may inadvertently be affected by a

broad definition). Also, the 50-percent-threshold may be heightened so as to exclude those joint


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ventures and participations in which the partner shareholder has a blocking vote (in other words,

where there is no 'control' in terms of accounting standards such as IFRS).

Note that within the scope of the contract between the parties the contractual definition of the term

Subsidiarywill prevail over a statutory definition. In other words: whilst using the same terminology a

contract drafter may well intend to apply a different concept. Therefore, do not attempt to correct the

other partys lawyer on the construction of a concept that also happens to be defined differently under

applicable law (unless you want to impose a different standard within the contractual scope). The key

question is typically whether a lower level of control over the other partys businesses may pe rmit that

business to benefit from the agreement or not (or, conversely, whether uncontrolled own entities

within a partys group structure are subject to contractual restrictions).

(c) Best endeavours and commercially reasonable efforts

Traditionally, legal systems distinguish between obligations to achieve a result and obligations to

make reasonable endeavours to achieve something (without necessarily accomplishing it). If a desired

result is not entirely within a contracting partys control, such party is probably willing to do its best but

not to guarantee the result. For an elaborate discussion of best effort provisions see Drafting

International Contractsby Marcel Fontaine and Filip De Ly6. Here, only a few highlights are given.

Best efforts varied. Other than best efforts, drafters also use phrases such as reasonable

endeavours, commercially reasonable efforts and good faith efforts. By implication, an obligation to

achieve a result is more onerous than any of its best efforts variants. Many lawyers believe that from

amongst the variants, best effortswould be the most onerous one; the promisor would be required to

do everything in its power to accomplish the goal, even if it leads to its insolvency, while other efforts

standards would be less onerous. Making the distinction at all implies that a party obliged to make

best effortsshould do everything that may reasonably be expected from it, but also things that cannot

reasonably be expected from it. This is probably not within the scope of either concept. A larger group

would probably reject such contrast of meanings and may even consider that the practical difference is

negligible. One thing is for sure, best effortscertainly does not mean second-best efforts.

Sufficient efforts? Best effortsand its variants are vague terms. The vagueness implies standards of

subsidiary and proportionality in what may or must be expected from the party concerned.

Occasionally, a party may be obliged to make efforts disproportionate to the benefits under the

contract. The vagueness also implies that determining whether a party has made sufficient efforts

depends on all facts and circumstances. The minimum standard would probably be that the party has

made a good faith effort to achieve the anticipated result. The Unidroit Principles7

give something to

hold on to:

6 Marcel Fontaine and Filip De Ly, Drafting International Contracts An analysis of contract clauses, reflecting thework of a truly international working group on international contracts (Groupe de travail contrats internationaux).

7 Unidroit Principles of International Commercial Contracts(2004).


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Art. 5.1.4Duty of best efforts

2. To the extent that an obligation of a party involves a duty of best efforts in the performance of an

activity, that party is bound to make such efforts as would be made by a reasonable person of the samekind in the same circumstances.

Art. 5.1.5 Determination of kind of duty involved

In determining the extent to which an obligation of a party involves a duty of best efforts in the performance

of an activity or a duty to achieve a specific result, regard shall be had, among other factors, to:

a) the way in which the obligation is expressed in the contract;

b) the contractual price and other terms of the contract;

c) the degree of risk normally involved in achieving the expected result;

d) the ability of the other party to influence the performance of the obligation.

Model clause. When I worked as an attorney-at-law (advocaat), I reworded this Unidroit principle as acontractual clause. The clause was later used in the law firms model corporate joint venture

agreement. Many years after leaving the firm, in an entirely different M&A-context, I received a mark-

up of a share purchase agreement prepared by another reputable Dutch law firm. It contained the

model clause exactly the way it was originally drafted.

Over the years, experience shows that a best effortsprovision must have teeth in order to ascertain

effectiveness beyond an otherwise relatively weak concept. The required improvement was a

clarification of the burden of proof, as well as making more explicit the scope of a partys duty to

explain and justify. In fact, to clarify what best efforts entail, the drafter should phrase it as an

obligation to achieve a result or link it to a contractual right to manage failure:

Where any obligation is qualified or phrased by reference to use reasonable endeavours, best

efforts or wording of a similar nature, it means the efforts that a person desirous of achieving a

result would use in similar circumstances to ensure that such result is achieved as expeditious

as possible. The Party under such an obligation shall, if a result aimed at is not achieved or

achieved after delay, upon the request of a Party explain in writing (a) the actions taken by it in

order to fulfill this obligation, (b) any choices made where two or more alternative courses of

action would have been reasonably appropriate, and (c) plausibly how any external factors

influenced its performance and the achieved result.

The efforts can be further strengthened by providing that either party may require that the efforts made

and explanations given shall be confirmed by an independent expert. In addition, the best efforts

provision can be extended such that, failing sufficient efforts, the expert (then acting as a binding

adviser) may determine which course of action a party should pursue in order to meet its obligation.

To make this more acceptable to the parties, the expert may be empowered to give such binding

advice only if the efforts made by that party are clearly insufficient or reasonably inadequate. An

experienced drafter will furthermore address the independence of the expert and its appointment and

allocate the related costs.


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(d) In the ordinary course of business

and consistent with past practice

Many M&A-agreements address the sellers or acquired companies behaviour during certain periods

of time. The transaction agreement either permits certain acts because they are in the ordinary course

of business, warrants that various acts have been conducted in the ordinary course, or requires that

an approval is obtained for certain acts outside the ordinary course. Accordingly, the purchaser would

be protected against unusual acts or omissions affecting the acquired com panies business or intrinsic

value, whilst the acquired companies are not burdened by unworkable approval requirements. For this

purpose, the transaction agreement refers to the ordinary course of business, to acts consistent with

past practiceor wording importing the same concept. Albeit that such standard of conduct implies a

vague term, it does achieve an appropriate objective standard of measurement.

Clauses in which the ordinary course test typically appears are in sellers warranties and the

covenants addressing the period between the transactions effective date (or signing) and completion.

For example:

Seller shall procure that pending Closing, Acquired Companies shall conduct business in all

material respects only in the ordinary course of business.

Sellers shall not permit Acquired Companies to do any of the following pending the Closing

without the prior written approval of Purchaser (which approval shall not be unreasonably

withheld or delayed):

(b) enter into an agreement or a series of related agreements that are not in the ordinary

course of business, for an aggregate amount in excess of EUR ____ ;

None of the Acquired Companies is a party to, or bound by:

(viii) any agreement or commitment relating to the disposition or acquisition of assets or any

interest in any business enterprise outside the ordinary course of business;

The difficulty is to define what is in the ordinary course of business (and what not). A drafting

technique to increase the likelihood that your description covers everything is to think MECE (see

Weagrees weblog post of 2 January 20108

). In defining the ordinary course, it makes sense to startwith what the Acquired Companies themselves believed was suitable in view of their size and the

workability of what operational personnel and staff had always considered efficient (at a time when

they did not anticipate the M&A transaction). This suggests a reference to such acquired companies

or sellers internal approval policies, as well as to the normal operations and acts of purchase

ordering. Alternatively, and in fact a strong argument for the purchaser during its negotiations, the SPA

could refer to the purchasers approval policies.

8 http://www.weagree.com/weblog-detail/31-drafters-better-be-mece.html
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A properly drafted set of internal approval policies should obviously divide what the various non-

executive employees may or must do, from the unusual or significant acts that would require a

decision from management. Because M&A transactions are sometimes stalled because a seller is fedup with the cowboy-type of behaviour of the companies to whom it sells, an objective standard should

expressly set out the criteria of what is in the ordinary course of business, For example:

An action taken by a company will be deemed to have been taken in the ordinary course of

business only if:

(a) such action is consistent with the past practices of such company and is taken in the

ordinary course of the normal day-to-day operations of such company;

(b) such action is not required to be authorised by the managing board or general meeting of

shareholders of such company (or by any person or group of persons exercising similar

authority) and is not required to be specifically authorised by an affiliate of such company;and

(c) such action is similar in nature, magnitude and frequency to actions customarily taken,

without any authorisation by the managing board or general meeting of shareholders (or

by any person or group of persons exercising similar authority), in the ordinary course of

the normal day-to-day operations of other companies that are in the same line of

business.

Although uncommon, if the sold companies have adopted a written contract approval policy, it is

recommended to refer to such policy.

(e) On an arms length basis

The arms length principle expresses that a business relationship between two parties is entered into

against perfectly normal market prices and commonly negotiated terms and conditions. It refers to the

test applied by national tax authorities to satisfy themselves that the taxable entity does not avoid tax.

In inter-company relations it may be attractive to apply transfer pricing structures resulting in a tax-

optimised corporate structure that is most beneficial for the shareholders of the ultimate parent. In

many multinationals, the business people from the business groups or business units involved in such

an intra-company arrangement will indeed be tough in their negotiations. For an outsider, this is

sometimes surprisingly tough. Many national laws require the details of inter-company transactions to

be reflected in writing.

Practical use. The arms length principle is also required in the context of transactions that might not

be fully and fairly negotiated. For example, a purchaser of a company that will continue business with

the sellers group would like to ascertain that the company it acquires, conducts such bus iness on

terms and conditions that are perfectly sound. This is usually reflected in a warranty of the seller

stating that all transactions are on an arms length basis.


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If the warranty appears to be incorrect, the purchaser or acquired company should be entitled to

damages, being the difference between market prices and the transfer prices possibly subject to an

EBIT- or EBITDA-multiplier. Alternatively, the seller may be able to negotiate a covenant by virtue ofwhich all inter-company relationships terminate on completion date, with the exception only of certain

identified, agreed contracts.

Transfer pricing rules. To refer to the arm s length principle, a synopsis of the OECD principles on

transfer pricing may be of some help to the contract drafter9. Where any provision is qualified or

phrased by reference to an arms length basis or principle such qualification or reference shall mean:

the conditions which would be obtained between comparable, independent persons in

comparable transactions (taking into account the assets used, the responsibilities and risks

assumed and the division of benefits between the parties) and comparable circumstances

(taking into account the times and places of performance and the parties' business strategies),thereby providing the closest approximation of the workings of the open market.

The elements of the principle are self-explanatory. The reality of this principle may differ from country

to country depending on the attitude of the national tax authority. Likewise, the applicable tax regime

and local enforcement policies may well influence a companys decision to create a permanent

establishment in one country or another. But more appropriately, companies would use the principle in

their day-to-day practices such as by targeting employee bonus and other remuneration systems to

reduce the cost basis of their products, even at the expense of affiliated companies. Typically, this

results in a competitive environment in which all tendering suppliers attempt to achieve an optimum

price-quality ratio, sometimes allowing the benefits to third party suppliers.

(f) To the knowledge of

Sometimes, it is impossible to make a fully-fledged warranty in relation to (i) a fact or circumstance

being absent, (ii) the non-occurrence of an event, which is by its very nature unknown or uncertain, or

(iii) external events that can be influenced but not entirely.

Example 1: (no) technology infringment. It is often impossible to confirm that certain licenced

technology does not infringe upon third party intellectual property rights. (In fact, it is often more

realistic to acknowledge that a particular technology already existed at the moment that a particular

application for it was developed.) This is impossible for two reasons: first, establishing whether an

applied technology is already protected by a third party requires very extensive research into several

registers of intellectual property rights (whilst it is not readily clear how such search should be

conducted in order to be exhaustive and whilst the registries are abundant). Secondly, the third party

that may be in a position to claim infringement will often wait to see whether the infringing party is

successful before deciding whether making such claim is worth the effort. If it does, the licensee could

have chosen a technology and made considerable related investments, whereas the use of such

9 In fact, the synopsis closely follows the chapter outline of the authoritative loose leaf of OECD, Transfer PricingGuidelines for Multinational Enterprises and Tax Administrations, OECD Publishing 2001, 254 p.


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technology can then be stopped by the third party. For that reason, the licensee would seek protection

against loss of its investments and all that relates to it. Hence the inclusion of the following:

To the Knowledge of Licensor, the Licensed Technology does not infringe or make

unauthorised use of the Intellectual Property Rights of any third party.

Example 2: (no) defective product claims. Almost every supplier of products will continuously deal

with customer complaints and need to handle defects in its products or damages caused by

transportation or otherwise. A warranty in an M&A transaction that there is no litigation pending and

that no litigation is threatened against the company, could (depending on the type of business) be

incorrect. Hence the inclusion of the following, for example:

No written notification involving a claim against any of the Acquired Companies in excess of

EUR 500,000 has been received by or, to the Sellers Knowledge, threatened against theAcquired Companies or Seller in relation to any products sold or services provided by any of the

Acquired Companies.

No court, arbitration, mediation or government proceedings involving a claim against any of the

Acquired Companies in excess of EUR 500,000 are pending against any of the Acquired

Companies. To the Seller's Knowledge, there are no facts or events that may give rise to any

such litigation or proceedings.

Example 3: (no) violations of laws or regulations . In an M&A transaction, a purchaser of a

business will likely require that the business is in full compliance with all applicable laws and

regulations, but in any event that it does not violate regulatory prohibitions. This may well be

impossible, even though it is understandable, because:

the scope of competition law has changed and extended over time (e.g. historically acceptable

business arrangements are currently unacceptable);

over the past decade, competition laws are being enforced much more actively and have

therefore become increasingly important (e.g. in-house lawyers have not been adequately

educated);

the acquired business has become a dominant market party (e.g. initially permitted exclusivity

or minimum purchase arrangements are now troublesome as a consequence of the success of

the business);

remedying non-compliance is impossible because the number and types of contracts are tooabundant and non-compliance is not recognised as a priority (i.e. the logistics required to

correct any non-compliance are lacking).

What the purchaser of the business would probably want to ascertain is that there are no gross

violations of laws and regulations: that there is a basic awareness of antitrust issues and that there are

no price fixing arrangements between competitors. Despite its complexity and the understandability of

a violation, no seller really wants to discuss this issue in detail. At the same time, a purchaser will not

accept generic and broadly phrased carve-outs. In this case, it makes sense to be more specific about

the scope of the warranty and distinguish its particular elements.


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In the above examples, instead of giving a straightforward warranty, a party can qualify a requested

warranty by stating that as far as it knows, what is being warranted is correct. This is typically

accomplished by the phrase To the best of Sellers knowledge, or a more succinct version To theSellers knowledge(knowledge is a constant and not a variable: it is either present or absent but not

to a certain extent or merely in a certain quality hence, the word bestis redundant).

If warranties are qualified to a partys knowledge, it makes sense to specify the scope of such

knowledge. For example:

A persons knowledge, awareness or words of similar import means the knowledge of Messrs.

Boukema and Wiggers who, after due and careful inquiry, have actual knowledge of the facts

and events in relation to or on the basis of which the relevant statement is made.

A specification of what a partys knowledge entails is important because the knowledge of anyemployee is already attributable to the employer, and therefore to the Seller. In particular, if the

acquired company employs a large number of employees it would be appropriate to identify the

relevant functions (e.g. the Acquired Companies president, chief executive, CFO, certain or all

financial controllers, chief development officer, production site directors) or to name the members of

senior management (including any staff members responsible for matters that are dealt with at group

level: patent attorneys, members of group financial and tax departments etc.).

Furthermore, a qualified partys knowledge still assumes that each and every case of infringement

would be reported to senior management. If it were not, the seller would be released from its warranty.

Therefore, the knowledge can be assumed to have been present if reasonable or due inquiry into the

business organisation would have revealed that a fact or event was present (or absent). As paragraph

8.3(c) explains, such inquiry should in all cases be made as part of the process of negotiating

warranties (and preparing disclosures). In any case, such inquiry implies an imputation of knowledge

against a standard of reasonableness and permits an objective assessment and judgement of what

should have been the case.


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This free e-book is a chapter of Willem J.H. Wiggers, Drafting contracts Techniques, best

practice rules and recommendations related to contract drafting, Kluwer 2011.

Drafting Contracts is an essential reference guide for in-house legal counsel and attorneys-at-law.

The book addresses all your contract drafting issues in a concise and structured manner. Drafting

Contractsdiscusses techniques for avoiding ambiguities and improving the readability of an

agreement and contains many best practice rules and recommendations relating to all aspects of

contract drafting. It provides a helpful insight into the common core of European legal systems and it

highlights key differences with U.S. legal practice.

Drafting Contractsaddresses:

dos and donts relating to drafting definitions, conditions precedent, covenants, warranties,

dispute resolution clauses and other miscellaneous (boilerplate) provisions

many examples of legalese and typical contract phrases

drafting style and legal culture

structure and presentation of agreements

how to upgrade your model contracts effectively and efficiently

aspects of implementing (automated) contract assembly software

This book discusses phrases such as for the avoidance of doubtand excluding its choice of law

principles; it explains why many miscellaneous clauses are redundant and further clarifies that in

witness whereofis common law language (and, if relevant at all, meaningless in civil lawjurisdictions).

Willem Wiggers has vast experience in international commercial transactions. After his research work

for which he visited several top legal institutes worldwide, Willem became an attorney-at-law

(advocaat) in the M&A practice of a premier European law firm, followed by interim assignments with

several major multinational companies. Willem is the owner of Weagree, a company that accelerates

contract drafting by providing model-contract-drafting services and a contract assembly software

application.

Published by Kluwer

To order the full printed book, click:

http://shop.kluwer.nl/boeken_products/drafting-contracts/prod10178137.html

ISBN 9789013092561

Copyright Willem Wiggers 2011
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