Let’s be clear – pitfalls of entering into commercial contracts
We have seen an increasing number of disputes concerning commercial contracts that have not accurately reflected the intentions of the parties.
Often it is trusting the other party to execute your wishes, or is down to misunderstandings compounded by ambiguous terms within a contract. Whatever the reason and whatever type of contract you are entering into, it is vital that the terms and intentions of both parties are clearly represented, as the consequences when this does not occur can be dire.
In 2002, a tech start-up was formed by three business associates. They were both the sole shareholders (SHDs) and directors of the company. In light of the upfront cost of the IT equipment needed, financial support was required. This was provided by an entrepreneur (E). The agreement was to provide financial support on an ongoing basis until the start-up was able to obtain regular finance from asset based lenders in the market.
The SHD’s entered into a loan agreement with E. As security for the loan, the SHDs were required to transfer their entire issued share capital in the company to E. It was agreed that the shares would be returned but only upon repayment of the loan. The SHD’s had no prior experience of entering into such an arrangement, nor did they obtain any legal advice, but trusted the E to ensure that the loan agreement reflected the agreed terms.
The start-up became successful over the coming years and the SHD’s sought the return of their shares on the basis that they calculated that the loan had been repaid. E disagreed and contended that the loan ran into many £millions and hence the shares would not be returned. The disagreement was compounded by the fact that the loan agreement was silent on the amount of the loan, or indeed what items of expenditure could be added to the loan. When the SHD’s voiced their concerns, they were dismissed as directors.
Whilst E made the SHD promises, the loan agreement did not reflect what was agreed or what the SHDs had intended. The SHD’s issued proceedings against E seeking to imply terms into the loan agreement and for a declaration that the loan had been repaid and the shares should be returned. The case settled and whilst the SHDs received a beneficial settlement, due to the wording of the loan agreement, they were unfortunately unlikely to recover their shareholding and so did not proceed to a risky trial.
This unfortunately is not an atypical case and is something we regularly see. It is particularly disheartening when it deals with the loss of a company that you have grown and nurtured. Lack of clarity within a contract, including silent elements, can have dire consequences.
How to avoid being unclear
Whilst there are no guarantees that disputes will not arise in the future, there are a number of steps that can be taken prior to the signing of commercial contracts to minimise the risk of a falling out at a later stage. We would always advise the following:
1. Keep a record of all pre-contract negotiations and discussions.
Where important points have been discussed and agreed, confirm these discussions in writing. We would also suggest keeping a note of any verbal discussions. This should be done immediately or as soon as possibly to ensure it is fresh in your mind. Note the time, date and attendees.
2. Make sure you explore all options available prior to entering into a binging contract.
In the example given above, the SHD’s did not approach any other financial institutions. They just assumed the rates would be prohibitive. Never assume. Always explore your options.
3. Where terms have been agreed, record the terms in “heads of terms of agreement” and get all parties to sign the “heads of terms”.
This document can then be used to draft the final contract.
Whilst legal action to settle a dispute over commercial agreements can be brought, and in some cases the courts may imply terms into a contract to reflect what the parties actually agreed, this is by no means certain and the costs of litigation are often high with no guarantee of success.
It is crucial that businesses ensure that all agreements entered into are worded clearly to reflect the intentions of both parties to avoid litigation where possible.