Reviewing a Contract – 5 Key Terms to Consider

1. Order of Preference Clauses

Many times a contract will reference another contract within its terms and conditions. Examples include Service Agreements which can also include signed Statements of Work, signed Purchase Orders and other documents containing supplemental terms and conditions to a Service Agreement. When reviewing a contract that mentions, includes or incorporates the terms of another contract, the ‘order of preference’ clause in the contract will instruct the parties about which contract, and what specific contract terms, have priority in relation to each other. This clause is especially important to review when there is a dispute or disagreement between the parties and a question arises regarding the order in which several contracts, or certain specific contract terms, should be applied.

2. Governing Law

The ‘governing law’ clause instructs the parties about what laws govern the terms and conditions of a contract. Although the laws of the jurisdiction where the contract is performed can serve as the governing law, the parties are free to choose the laws of a particular state or country to govern their contractual relationship. For example, in international contracts it is typical for the laws of the State of New York to be chosen by the parties as the governing law of the contract even though the contract will be performed in another state or country other than New York. The choice of New York laws to govern the contract gives the parties confidence about what laws would be implemented in the event of a dispute between the contracting parties. However, this choice could also lead to significant unknown cost and expense if the parties are unfamiliar with New York laws and have no specific business in New York. For this reason it is important to review carefully the choice of the governing law of the contract prior to entering into any contractual relationship.

3. Subcontracting Provisions

It is common for a business to use subcontractors rather than employees to perform all or some portion of a contract. Before hiring a subcontractor, it is important to check the relevant contract to determine if there is a prohibition against subcontracting contained in the contract. Many contracts prohibit the use of subcontractors without the prior written consent and approval of all of the other parties to the contract. These clauses can sometimes give the non-subcontracting parties sole, subjective discretion to approve or disapprove of a particular subcontractor.

4. Non-Violation Clauses

Most contracts contain language requiring the parties to affirm and agree they each have not violated the terms and conditions of any contracts with unrelated third parties by entering into the current contract. Therefore, it is important to check carefully whether the contract being reviewed conflicts with the terms and conditions of any other contracts of the business. Due to the many different types of contracts entered into by a business there is a good chance that some of the terms and conditions of the different contracts will conflict with each other. If there are conflicts with previously signed agreements, then these conflicts may have already unintentionally caused a breach of the contract at hand, as well as the previously signed contracts, without any knowledge of such a breach occurring. In certain situations, the existence of a previous, continuing, non-remedied breach could make those specific contracts difficult or impossible to enforce in the future.

5. Indemnification

The allocation of risk between the parties is an essential function of any contract. By entering into a written contract the parties are generally attempting to allocate the risks, costs, expenses and uncertainties of a business relationship in the form of a written agreement between the parties. Many times these risks are unforeseen or unknown on the date the contract is formed. An indemnification clause is one method parties to a contract use to allocate unforeseen risk between the parties. An indemnification clause requires a party to pay for the costs, expenses and legal fees of the other party to the contract in the event of a legal claim filed against the other party which was caused by the indemnifying party. These clauses can require a party to contract to expend a considerable amount of funds, costs and expenses in defense of a third party legal claim. They should be reviewed carefully any time a contract is being reviewed to ensure the indemnification requirements are thoroughly understood by the parties.

LLC – Distribution of Non-Cash Assets – Deemed Distributions

In general, distributions of property other than cash from an LLC taxed as a partnership are tax-free to the members. This feature of an LLC is one reason why a business operating as an LLC may choose to be taxed as a partnership rather than a corporation.

There are five circumstances in which a distribution of property other than cash to an LLC member can trigger gain recognition for the LLC or an LLC member. A distribution of property to an LLC member that results in such member’s share of the profits or losses of the LLC to be reduced can result in one of the five circumstances where a member or LLC must recognize gain on a distribution of assets to a member.

I.R.C. Section 752 generally requires an LLC taxed as a partnership to determine the amount of liabilities that can be allocated to an LLC member for income tax purposes by reference to such member’s share of LLC profits or losses. Any reduction in an LLC member’s share of liabilities of the LLC is treated as a distribution of money, i.e. a “deemed distribution”, to such LLC member.

If the amount of the deemed distribution exceeds the LLC member’s tax basis in the member’s LLC membership interest, such member will recognize gain equal to the amount the deemed distribution of cash exceeds the member’s LLC membership interest tax basis.

LLC – Distribution of Non-Cash Assets -Marketable Securities

There are five circumstances in which a distribution of property other than cash to an LLC member can trigger gain recognition for the LLC or an LLC member. A distribution of ‘marketable securities’ to an LLC member can trigger one of the five circumstances where a member or LLC must recognize gain on a distribution of assets to a member.

In general, distributions of property other than cash from an LLC taxed as a partnership are tax-free to the members. This feature of an LLC is one reason why a business operating as an LLC may choose to be taxed as a partnership rather than a corporation.

‘Marketable securities’ are financial instruments and foreign currencies that are actively traded on a public securities market. IRC Section 731(c) treats the distribution of marketable securities to an LLC member as a distribution of cash to the member in an amount equal to the fair market value of the securities.

Upon a distribution of marketable securities to an LLC member, the member will recognize gain equal to the amount the deemed cash received exceeds the member’s tax basis in their LLC membership interest.

Force Majeure: Terminate a Contract During COVID-19 Pandemic

Recently, due to the COVID-19 pandemic, many parties to a commercial contract have been unable to perform their contractual duties and obligations under the contract. As a result, they desire to terminate the contract or the contractual relationship.

If a party to a contract is unable to perform a required obligation under a contract there may be specific terms included in the contract directly addressing the failure to perform. These terms may excuse one or more of the parties from the required performance or may be invoked to terminate the contract.

One contract clause or term to look for in a contract which may terminate the contract without breaching the contract for non-performance is a ‘force majeure’ clause. This clause operates to terminate a contract, or excuse a party’s non-performance of a contract, upon certain defined events. These events generally include ‘acts of God’ such as a war, terror attack, hurricane, earthquake or other similar type of catastrophic event that is beyond the direct control of a party and which adversely affects that party’s ability to perform the contract.

A force majeure clause is only enforceable if the event described was ‘unforeseeable’ by the parties when they entered into the contract, and it’s scope and breadth is limited to only the specific events listed in the force majeure clause in the contract.

For example, the word ‘pandemic’ is required to be recited in the force majeure clause in the contract if a party is relying on the force majeure clause to terminate the contract during the recent COVID-19 pandemic. Also, the parties must not have foreseen or known about the COVID-19 pandemic when they entered into the contract. If the parties entered into the contract after the start of the COVID-19 pandemic, or during the pandemic, or at a time when they reasonably should have known about the pandemic, the force majeure clause is then unenforceable in relation to the COVID-19 pandemic.

Also, a force majeure clause is not enforceable unless it is ‘impossible’ for the party invoking the clause to perform as required under the contract. If there is any possibility of performance of the contract (even a very remote possibility), the force majeure clause will not excuse non-performance by the invoking party or will not serve to terminate the contractual relationship.

Due to the very limited circumstances in which a force majeure clause will excuse a party’s non-performance of their contractual duties or terminate a contract, the invoking party must give notice to the affected party under the contract as soon as possible after the force majeure event occurs. This notice will generally be met with a response from the affected party questioning the forseeability of the force majeure event and whether the performance of the contract duties are truly impossible.

Invoking a force majeure clause to terminate a contract is an inherently factual question which will be decided by the specific facts and circumstances surrounding the transaction and the parties to each contract. Invoking a force majeure clause may require a third-party decision maker such as a mediator, arbitrator or judge to determine if the terms of the force majeure clause are applicable to the situation.

Unless the facts of the situation clearly and specifically match the force majeure requirements in the contract, and the other requirements to enforce a force majeure clause under state laws are not in dispute between the contracting parties, invoking a force majeure clause to terminate a contract may not be the most effective or economical method to terminate the contract during the current COVID-19 pandemic.

LLC – Distribution of Non-Cash Property – Disguised Exchange

There are five circumstances in which a distribution of property other than cash to a member can trigger gain recognition to a member or LLC. A ‘disguised exchange’ transaction can trigger one of the five circumstances where a member or LLC must recognize gain on a distribution of assets to a member.

In general, distributions of property other than cash from an LLC taxed as a partnership are tax-free to the members. This feature of an LLC is one reason why a business operating as an LLC may choose to be taxed as a partnership rather than a corporation.

‘Disguised exchange’ transactions occur between members of an LLC when (1) a member contributes property to the LLC with a built in gain and that same property is distributed to a different member; or (2) a member contributes property with a built in gain to an LLC and the same member receives a distribution of different non-cash property from the LLC within 7 years of the initial property contribution.

IRC Section 704(c) and 737 prevent disguised exchange transactions between LLC members. Pursuant to Section 704(c), when a member contributes property to an LLC with a tax basis different from its fair market value the contributing member will be allocated the unrealized gain or loss upon the sale of the property. If the same property is distributed to another LLC member within 7 years of the initial property contribution, instead of being sold, Section 704 requires the contributing member be allocated the gain equal to the lesser of the remaining Section 704(c) gain that would be allocated to the partner if the property had been sold or the excess of the fair market value of the property over its tax basis.

IRC Section 737 prevents a disguised exchange transaction by requiring a member to recognize gain if an LLC member contributes non-cash property to an LLC that has a value in excess of the member’s basis, then receives a distribution of other property not contributed by that member within 7 years of the initial property contribution. The amount of gain will be the lesser of the remaining 704(c) gain and the excess of the fair market value of the distributed property over the adjusted basis of the receiving member’s membership interest.