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Contracts: They’re Meant to be Broken

Contracts: They’re Meant to be Broken


When growing up, there are two things my mother always told me: “Keep your promises” and “treat others the way you want to be treated”. I do my best to live by these sayings every day, and so do many of my clients. On a broader scale, these sayings provide us with moral values that build trust and generate cooperation within our communities.

However, trouble arises when adjusting from a moral lens to a legal lens; keeping promises can lead to problematic situations. The problem is many people view a contract as a personal promise: it’s not.

While promises should be kept, contracts are meant to be broken.

If you are familiar with my blogs and articles, you will know that I like to provide actual case studies to illustrate my point. However, when it comes to breaking contracts, real life examples are often messy and are likely to confuse the point I am intending to make; therefore, I’m going back to my law school roots and will use my favorite contract examples instead.

Case study: Henry the farmer

Henry is farmer who grows carrots. He has agreed that at the end of the season he’ll sell Wanda 100,000 carrots, however during the season Henry’s farm is flooded and the crop ruined – he no longer has carrots for Wanda.

If we treat a contract as a promise, you could argue Henry has broken his promise to Wanda and that could be viewed as morally wrong. Despite breaking a “promise”, most people would agree that the flood was beyond Henry’s control and therefore he’d done nothing wrong.

So who should have to pay for Henry’s bad luck, Henry or Wanda?

There are two options in this scenario:

1.       In order to keep his “promise” Henry could purchase 100,000 carrots elsewhere and then sell them on to Wanda. If he is able to buy these carrots for less than what Wanda is paying, then it could be a good outcome for both parties. However if Henry can’t find carrots for less than what Wanda is paying, he will be out of not only his crops and one year of growing, but also the difference in price.

2.       Henry could opt not to deliver anything, thus breaking his “promise”. In this scenario, Wanda has to find another carrot supplier. She may end up with a better deal than she had with Henry, but she might also end up with a worse deal – meaning she could be out the price difference.

So should Henry keep his promise? Before you say ‘yes’ and select option one, what if the result of keeping his promise is that Henry goes out of business – and his 50 employees lose their jobs?

Iron-clad contracts

When my clients ask me to draft a contract, they often use the phrase “iron-clad”. In short, this means they want a contract that the other party can’t get out of; in other words, they don’t want to get taken advantage of. If the iron-clad approach was applied to the aforementioned case study, Wanda would force Henry to keep his “promise” and deliver at all costs. This approach is actually the opposite of the path I prefer to take when drafting contracts: I draft the contract to be broken.

If you’re a Fortune 500 company, the iron-clad approach might work well. However, many of my clients are startups. The truth is, your contract is only as good as your ability to enforce it. For example, if Henry opts not to deliver the 100,000 carrots, Wanda may have damages – that is, the cost difference in obtaining the carrots elsewhere. An iron-clad contract may require Henry to cover that cost. However, the only way Wanda can get Henry to pay the damages or deliver the carrots is if she sues Henry and the court orders it. The issue here is this process could cost Wanda tens of thousands of dollars in total; on a small contract, these costs could amount to more than the damages, and therefore the attorney is the only real winner!

Rather than take an iron-clad approach, I prefer to draft “out clauses” into the contract. Ideally, there should be ways for both parties to get out of the contract in a defined way – allowing each party to make an informed decision. In Henry and Wanda’s case, this type of contract may allow Henry to back out of the contract when there are circumstances beyond his control (e.g. flooding).

In this scenario, the contract could potentially stipulate that:

1.       Henry is required to deliver as many carrots as he can salvage, but at a discount rate based on the percentage delivered. This could help balance any additional cost Wanda incurs obtaining the remaining carrots elsewhere.

2.       Henry pays a fraction of the difference in cost, helping to share the increased cost incurred by Wanda.

3.       Henry could reduce the price of his carrots the following year for Wanda.

The exact details of the clause aren’t important. Rather, it’s about setting the clause at a level that is high enough to encourage both parties to follow the contract even when things go wrong, but also low enough that neither party ends up back in the situation Henry found himself in.

While Henry’s case is extreme, a more common example is outlined below.

Case study: Nick the marketing guru

In my second case study, I’m going to talk about a service contract. Here is the scenario: Nick is a marketing guru, while Kora owns a product line. They agree that Nick will market Kora’s products for a year at a cost of $100,000.

Two months down the track, Nick receives an offer from Christina – she asks Nick to market her products for the next 10 months for $500,000. Nick only has time to market one of the two product lines himself.

So what should Nick do? The simple answer is that he should keep his “promise” to Kora – after all, he has a contract with her and only an offer from Christina. However, the answer to this situation isn’t all that simple. Suppose that Nick keeps his “promise” to Kora. This could mean that:

1.       Nick tries to do both product lines himself. He doesn’t want to break his “promise” to Kora, but the offer from Christina is too good to refuse: burning the midnight oil is perhaps worth it! However, the result is likely to be a lower quality of service for both clients.

2.       Nick takes on Christina’s product line and hires someone else to market Kora’s. The person he hires may or may not be a good fit for Kora’s products.

3.       Nick takes on Christina’s product line but hires someone else to market it so he can continue to personally market Kora’s. The person he hires may or may not be a good fit for Christina’s products.

4.       Nick could ask Kora to pay more for his service.

The unhappy vendor

The aforementioned situation is a business decision that needs to be made often by CEOs and account managers.

Firstly, let’s look at the question from Kora’s viewpoint. I often find that my clients reach out when – in this scenario – Nick asks Kora to pay more, Nick assigns someone else to market Kora’s products, or the work produced by Nick either slows or diminishes in quality. In these scenarios, my clients essentially want me to force Nick to do his job.

However, the reality is Nick will be unlikely to perform at the same level in these situations; he’s not going to walk away from a five times multiplier on his effort. At the end of the day, Kora probably doesn’t want a contractor who doesn’t want to work with her – she wants someone who will do their best and work hard to impress her with the view to securing more work. I’ve found that when you argue with a vendor regarding performance, the performance suffers more and both parties become bitter.

The reality is that in this situation, it’s better for both parties to just walk away. Contracts should be considered amoral, rather than a promise. If Nick wants to break his contract with Kora, he should be able to – ultimately, this is better for Kora as well.

That being said, while the contract should be drafted in such a way that it’s breakable, it should include penalties for doing so. I prefer to use positive rather than negative language, and therefore refer to this as “incentives to complete the contract”. As with the previous case study, it’s important that these incentives are enough to assist the harmed party to move on, but not so high as to force Nick to act in a way he does not desire.

It’s also important to remember that in this case study the situation can be reversed: Kora could lose a sales contract and no longer need Nick’s marketing services. In this case, Kora should be able to walk away.

Contracts should not be seen as promises: they should be drafted to facilitate breaking them should certain situations arise. When it comes to business, things don’t always go according to plan and a contract should reflect this – so long as it’s fair for both parties!