Article: Demonstrating the Allocation of Risk

DEMONSTRATING THE ALLOCATION OF RISK

By Lenné Eidson Espenschied

Objective of this Presentation: To demonstrate pedagogy for drafting provisions to allocate risk.

Key Techniques:

· Start with provisions that favor the client.

· Draft to allocate the appropriate level of risk.

· Identify the range of risk.

One of my primary objectives is to teach students to apply traditional, think-like-a-lawyer, critical thinking skills to drafting projects, particularly with respect to the language they inherit. Critical thinking in drafting begins by considering why the existing language was included in the prior draft, whether it is relevant to the current transaction, and whether it appropriately allocates risk among the parties under the facts and circumstances presented. All three topics are covered in Contract Drafting, but this presentation will focus on pedagogy with respect to allocating risk.

1. Start with provisions that favor the client.

The first point I attempt to convey to my students is that a lawyer is ethically required to abide by the client’s decisions concerning the objectives of the representation and the means by which they are pursued. The language a lawyer creates should always advance these objectives. Virtually every sentence in a contract can be drafted so it favors one party or the other. Most provisions can also be drafted more neutrally, so the right or obligation is reciprocal. The objective here may be better stated in a negative manner: don’t start from a losing position!

It’s surprising how often in actual practice a client’s “standard form” actually favors the other party. For example, purchase agreements for goods and services routinely exclude the warranty of fitness for particular purpose, yet this UCC warranty only comes into effect when the seller is aware of the buyer’s intended use, and the buyer relies on the seller’s recommendation to purchase it. Why would a buyer who has relied on the seller’s advice that the product is appropriate for buyer’s purposes automaticallyexclude this warranty?[1] Sometimes, the parties negotiate to exclude the warranty, but too often it is excluded simply because the drafter inserted familiar language from another form without considering the raison d'être; namely, to exculpate seller from responsibility.

Clients differ in their approach to the bargaining process, and lawyers are obligated under the Model Rules of Professional Conduct to follow the client’s reasonable directives concerning the objectives of representation, within certain parameters.[2] Some clients prefer that all provisions be drafted as strongly as possible in their favor, while others prefer a more paternalistic, “I’m o.k., you’re o.k.,” approach where provisions are drafted in a more neutral manner that is considered equitable to both parties.

Documents should be drafted according to the client’s objectives, but in no event should the starting position be detrimental to the client’s interests. Where the client adopts a more paternalistic approach, the provision should be drafted so it is more neutral, but not in a manner that favors the other party. For example, an indemnification provision can be drafted so either party is required to indemnify the other, or so both parties undertake a reciprocal obligation to indemnify. Absent a compelling reason, it would be a losing position to draft an indemnification provision that requires the client to indemnify the other party without receiving a reciprocal promise.

A lawyer should be aware of the client’s philosophical approach to business relationships before drafting because the client’s policies should permeate every sentence. Some clients might take a different approach with different types of contracts, or when dealing with different business partners. For example, a company might adopt a more aggressive approach to protect its intellectual property rights, but the same company might adopt a more paternalistic approach in other types of agreements, or when its business partners are small businesses. The best way to learn the client’s objectives is to ask during the interview process. While lawyers can certainly offer advice and make recommendations, it is not ethically appropriate to ignore the client’s preferences or to substitute their own.

2. Draft to allocate risk.

The second point students should understand is that contracts serve to allocate risk among the parties to a transaction. For most contract provisions, there is an approach that allocates more risk to the party receiving assets, goods, or services; an approach that allocates more risk to the party providing them; and a range of possibilities between the extremes. The way a provision is drafted affects the level of risk and responsibility each party undertakes in the contract. Sometimes a single word or phrase can have an enormous impact. For example, insertion of the phrase “to the extent that” in an indemnification provision activates proximate cause limitations to reduce the indemnifying party’s risk.

Consider the following provisions. Notice how the risk shifts between the parties based on relatively small changes to the wording:

1. Seller shall deliver the goods on or before July 31.

2. Seller shall use best efforts to deliver the goods on or before July 31.

3. Seller shall use best efforts to deliver the goods on or before July 31. For purposes of this Agreement, “best efforts” means that Seller will obtain the goods on the open market and absorb any additional costs incurred to fulfill its delivery obligations on a timely basis.

4. Seller shall use commercially reasonable efforts to deliver the goods on or before July 31.

5. Seller will attempt to deliver the goods on or before July 31.

The risk allocation between buyer and seller varies in each of the examples given above. Relatively simple edits in the language shift the risk from the Seller in the first sentence to the Buyer in the last. In the first sentence, the Seller has more risk because in order to comply with the terms of the agreement, the goods have to be delivered by July 31 without exception.[3] The second example provides a small exception: the Seller will not breach the agreement if it uses best efforts but is unable to deliver the goods by July 31. The Seller still has the risk of ensuring that its efforts rise to the level of being “best efforts,” which can be a tough standard. “Best efforts”implies that the Seller will do anything within its power to see that the goods are delivered on or before July 31, which may be financially unfeasible. The third example whittles away from the Seller another small degree of risk because the term “best efforts” is defined within the contract. In the fourth example, the risk is shifting more towards the Buyer, because Seller is only obligated to use “commercially reasonable” efforts to deliver the goods, which means the Seller is not obligated to use efforts that are financially unfeasible. In the last example, the Buyer has assumed the risk because the Seller has only agreed to attempt to deliver by July 31, meaning that the Buyer will have no recourse if the Seller attempts but is unable to deliver the goods.

The drafter’s responsibility is to ensure that the client assumes the correct level of risk. While a buyer client may ultimately wind up accepting no more than an attempt at delivery by the seller as a result of negotiations, by no means should the negotiation process start at this position. This is a losing position because the buyer has absorbed all risks if the goods are not delivered.

The examples and exercises outlined below cultivate critical thinking skills by requiring students to analyze how seemingly minor changes in wording significantly affect the allocation of risk.

Exercise: Describe how the risk progressively shifts from one party to the other in these warranty provisions. What particular changes in wording affect the allocation of risk in each provision?

Warranties:

1. Warranty. Seller warrants that the goods will conform to buyer’s specifications.

2. Warranty. Seller warrants that the goods will conform in all material ways to buyer’s specifications.

3. Limited Warranty. Seller warrants that the goods are merchantable. Seller specifically disclaims the warranty of fitness for particular purpose.

4. Limited Warranty. Seller warrants that it will use commercially reasonable efforts to comply with the terms of this Agreement. Seller specifically disclaims all other warranties, including the warranty of merchantability and the warranty of fitness for particular purpose.

5. No Warranty. Seller disclaims all warranties under this Agreement, including the warranty of merchantability and the warranty of fitness for particular purpose.

Comments: In the first example, Seller has assumed a large risk for three reasons: first, this is a full warranty with no limitations, so UCC warranties of merchantability and fitness for particular purpose apply; second, there is no materiality limitation, so the goods must conform in every detail, not just in every material way; and third, because the buyer’s specifications are not defined and limited in the agreement. Presumably, the buyer may change its specifications from time to time during the term of the agreement, and the seller has absorbed the risk of conforming, no matter what those specifications may be. The Seller’s risk is reduced in the second example because a materiality limitation has been added. In the third example, Seller’s risk is reduced and buyer’s risk is increased because this is no longer a full warranty and the UCC warranty of fitness for particular purpose is disclaimed. In the fourth example, by disclaiming UCC warranties, the Seller has assumed no more than the degree of risk associated with using commercially reasonable efforts to comply with the terms of the Agreement, which allocates a much greater degree of risk for nonconforming goods to the Buyer. In the fifth example, Seller has disclaimed all warranties for the goods, which shifts the risk entirely to the buyer.

Exercise: Describe how the risk progressively shifts from one party to the other in these conditions of transfer provisions.

1. The Transferring Owner shall have delivered to the Company a written opinion of counsel for the Company substantially in the form attached to this Agreement as Schedule 14.1 that the Transfer will not result in a violation of applicable law.

2. The Transferring Owner shall have delivered to the Company a written opinion of counsel for the Company or of other counsel satisfactory to the Company substantially in the form attached to this Agreement as Schedule 14.1 that the Transfer will not result in a violation of applicable law.

3. The Transferring Owner shall have delivered to the Company a written opinion of counsel reasonably satisfactory to the Company that the Transfer will not result in a violation of applicable law.

4. The Transferring Owner shall have delivered to the Company a written opinion of counsel that the Transfer will not result in a violation of applicable law.

Comments: The transferring owner has a higher degree of risk in the first example, because counsel for the company is going to be highly protective of its client’s interests and the form attached is likely to be one-sided in advancing the Company’s rights. In the second example, the transferring owner may be able to obtain an opinion of counsel from its own representatives (if the Company deems them satisfactory), who will advocate the owner’s interests. In the third example, the owner may select its own counsel with approval of the Company, which now must be reasonable, and the legal threshold for the opinion has been lowered since the format for the opinion is not specified. In the fourth example, the owner may select its own counsel and the Company is bound by owner’s counsel’s opinion, which means the Company has been allocated a higher degree of risk.

Exercise: Describe how risk progressively shifts from one party to the other in the following grant of rights provisions.

1. Licensor grants Company all intellectual property rights in the Software.

2. Licensor grants Company the right to use the Software and all rights appurtenant to use of the Software, including the right to modify the Software and the right to create derivative works.

3. Licensor grants Company the right to use the Software in any manner consistent with the terms of this Agreement.

4. Licensor grants Company the right to use the Software for the specific purposes described in this Agreement. Except as stated in this Agreement, no other rights are granted by Licensor to Company.

Comments: Risk allocation shifts from the Licensor to the Company in these examples as the specific rights granted are progressively narrowed. Company has less risk when broader rights are granted, but Licensor has less risk as more intellectual property rights are retained.

Exercise: Describe how risk progressively shifts from one party to the other in the following assignment provisions.

1. Seller may not assign any rights or duties under this Agreement.

2. Seller may not assign any rights or duties under this Agreement without the consent of Buyer, which consent may be withheld for any reason or no reason.

3. Seller may not assign any rights or duties under this Agreement without the consent of Buyer, which consent may not be unreasonably withheld.

4. Neither party may assign any rights or duties under this Agreement without written consent of the other party.

5. Neither party may assign any rights or duties under this Agreement except to a parent, affiliate or subsidiary or except to a successor in interest in the event of a change in control.

Comments: Seller’s risk shifts from not being able to assign in any event, to not being able to assign without Buyer’s consent, to not being able to assign without REASONABLE consent. Note that in the first three examples, Buyer is free to assign under common law principles because no restrictions against Buyer’s assignment have been included. The fourth and fifth examples impose a mutual restriction. Risk is lowered for the potential assignor in the fifth example which specific, permitted instances where assignment is automatically allowed, but the non-assigning party’s risk increases because it will not be able to veto the assignment in these situations. From these mutual provisions, the next step would be a provision that prohibits BUYER’s assigning without Seller’s reasonable consent.

3. Identify the range of risk.

The biggest challenge for the new drafter is to determine the parameters of the range of risk for each contractual obligation. In other words, when“marking up” a document to fit the current transaction, how does the new drafter determine whether a provision is neutral or whether it favors one of the parties over the other? Where does this particular provision fall in the overall range of risk as currently written? Does it advance the client’s interests, or is it more favorable to the other party? If the client prefers a more aggressive approach, how does the new drafter determine whether the provision is one-sided enough or whether it needs to be tightened up?

To some extent, this knowledge is gained through experience, which is why it is called the “practice” of law, and why partners’billing rates are substantially higher than new associates’ rates. For the diligent, however, some sources exist that can help identify the range of risk. The best source for identifying the range of risk for a particular provision is an experienced mentor. If a reliable mentor is not available, the next best source is the law firm’s or law department’s form files. Try to find a contract where the firm represented the buyer and compare it to a contract where the firm represented the seller. The final forms most likely have been heavily negotiated, so the best source is the first draft submitted to opposing counsel, if the firm drafted the contract, or the first revision, if the firm reviewed an initial draft prepared by opposing counsel. Study the revisions requested by counsel for each party and observe how experienced lawyers have fine-tuned the language to shift risk from one party to the other.

Although experienced drafters usually avoid them, some form books are well written and often include forms labeled as to which party they favor, like this: “Software License Favoring Licensee.”[4] Sometimes, form books are annotated with a running commentary as to why each provision is phrased a certain way, with alternative language included. By comparing forms favoring a licensee and a licensor side by side, for example, a new drafter can begin to identify the range of risk for each provision.

Exercise: How is risk allocated among the parties under the following provision? What words would you change to shift more risk to the Representative? What words would you change to shift more risk to the Company?

9.1 Indemnification by Representative. Representative shall indemnify Company from any and all claims, damages or lawsuits (including reasonable attorneys’ fees) arising out of or related to Representative’s:

a. Fraud, misrepresentation or negligence regarding any of the Products, services or orders solicited; or

b. Violation of any applicable law or governmental regulation.

Comments: It’s relatively easy to analyze a collection of provisions printed side by side; a much more challenging endeavor to determine where a single provision might fit when the range is unspecified. This exercise takes students to the next level of critical thinking by requiring them to analyze which party is favored under the provision as written, and what modifications they would need to make to shift the risk towards one party or the other. This provision transfers liability from Company to Representative only in very limited circumstances. It allocates less risk to Company than NO indemnification provision at all but its coverage is very limited. Company’s risk would be lowered, and hence, Representative’s risk increased, if a. and b. were omitted and general language added after “Representative’s” on the third line.

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[1] Ms. Espenschied is the author of CONTRACT DRAFTING: Powerful Prose in Transactional Practice (ABA Fundamentals 2010) published by the American Bar Association. She is an Adjunct Professor at the University of Georgia School of Law where she teaches a popular course on Drafting for Business Transactions. Excerpts from CONTRACT DRAFTING used in this paper are reprinted with permission of the American Bar Association.

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[1] A buyer client may have made the decision that it would rather give up its UCC warranty rights in every purchase than to have to negotiate the provision on a case by case, but this should be based on an intentional decision of someone having appropriate authority, not on happenstance or ignorance.

[2] RULE 1.2 SCOPE OF REPRESENTATION
(a) A lawyer shall abide by a client's decisions concerning the objectives of representation, subject to paragraphs (c), (d) and (e), and shall consult with the client as to the means by which they are to be pursued. A lawyer shall abide by a client's decision whether to accept an offer of settlement of a matter. In a criminal case, the lawyer shall abide by the client's decision, after consultation with the lawyer, as to a plea to be entered, whether to waive jury trial and whether the client will testify.
(b) A lawyer's representation of a client, including representation by appointment, does not constitute an endorsement of the client's political, economic, social or moral views or activities.
(c) A lawyer may limit the objectives of the representation if the client consents after consultation.
(d) A lawyer shall not counsel a client to engage in conduct that the lawyer knows is criminal or fraudulent, nor knowingly assist a client in such conduct, but a lawyer may discuss the legal consequences of any proposed course of conduct with a client and may counsel or assist a client to make a good faith effort to determine the validity, scope, meaning or application of the law.
(e) When a lawyer knows that a client expects assistance not permitted by the rules of professional conduct or other law, the lawyer shall consult with the client regarding the relevant limitations on the lawyer's conduct.
The maximum penalty for a violation of this Rule is disbarment.
Comment
Scope of Representation
[1]Both lawyer and client have authority and responsibility in the objectives and means of representation. The client has ultimate authority to determine the purposes to be served by legal representation, within the limits imposed by law and the lawyer's professional obligations. Within those limits, a client also has a right to consult with the lawyer about the means to be used in pursuing those objectives. At the same time, a lawyer is not required to pursue objectives or employ means simply because a client may wish that the lawyer do so. A clear distinction between objectives and means sometimes cannot be drawn, and in many cases the client-lawyer relationship partakes of a joint undertaking. In questions of means, the lawyer should assume responsibility for technical and legal tactical issues, but should defer to the client regarding such questions as the expense to be incurred and concern for third persons who might be adversely affected.
[2] In a case in which the client appears to be suffering mental disability, the lawyer's duty to abide by the client's decisions is to be guided by reference to Rule 1.14: Client under a Disability.
Independence from Client's Views or Activities
[3] Legal representation should not be denied to people who are unable to afford legal services, or whose cause is controversial or the subject of popular disapproval. By the same token, representing a client does not constitute approval of the client's views or activities.
Services Limited in Objectives or Means
[4]The objectives or scope of services provided by a lawyer may be limited by agreement with the client or by the terms under which the lawyer's services are made available to the client. For example, a retainer may be for a specifically defined purpose. Representation provided through a legal aid agency may be subject to limitations on the types of cases the agency handles. When a lawyer has been retained by an insurer to represent an insured, the representation may be limited to matters covered by the insurance policy. The terms upon which representation is undertaken may exclude specific objectives or means. Such limitations may include objectives or means that the lawyer regards as repugnant or imprudent.
[5] An agreement concerning the scope of representation must accord with the Rules of Professional Conduct and other law. Thus, the client may not be asked to agree to representation so limited in scope as to violate Rule 1.1: Competence, or to surrender the right to terminate the lawyer's services or the right to settle litigation that the lawyer might wish to continue. The agreement should be in writing.

[3] For purposes of this discussion, we assume that time is of the essence of the agreement, although that is not the case for contracts for the sale of goods under the UCC, which applies a reasonableness standard. In some states, it is necessary to state in the agreement that time is of the essence if the parties intend it to be. For example, under O.C.G.A. § 13-2-2, time is not of the essence of the agreement, but the parties can so stipulate. This means that if the parties do not stipulate in the agreement that time is of the essence, delivery on August 1st or 2^nd would be satisfactory in most situations under “reasonableness” standards. This is the reason a “time is of the essence” clause is often included in the boilerplate.

[4] Look for form books that are subject-matter specific, but avoid form books that contain thousands of forms covering a multitude of legal practice areas.