Penny Wise and Pound Foolish:

“Saving Costs” During Contract Formation Can Mean Big Litigation Bills Later

By Andrew M. Apfelberg, Rutter Hobbs & Davidoff

In today’s uncertain financial climate, many businesspeople have deliberately avoided involving their attorneys in the negotiation and documentation of deals. Reasons given have included, “Well, it is not that big of a transaction,” or, “It seems simple enough, so there is no need to consult with a lawyer.” But the real factor driving the decision to avoid legal involvement is one thing and one thing only: money.

While no one ever relishes the idea of paying a lawyer, the degree to which businesspeople are circumventing legal fees has dramatically increased during these less-than-booming economic times. For many middle-market companies, spending money to have a lawyer draft or review a business agreement is often perceived as a luxury that can be foregone when belts need to be tightened. Initially, eliminating $5,000 to $10,000 in legal fees sounds like a fantastic idea. However, what many businesspeople fail to consider is that they will inevitably have to deal with these agreements over the long-term and, without assistance from an attorney, significant fees can be incurred if a business deal goes south—ultimately costing a company thousands of dollars.

Take, for example, the example of Acme Skin Care Company*. In earlier, better economic times, Acme and Star Manufacturing Inc. signed an agreement drafted by Acme’s lawyer that explained Star’s relationship with Acme as an “exclusive supplier” of certain component elements of Acme’s products. After several years, a principal of Star met with Acme’s president to discuss the continuing relationship. By then, times were tougher financially, and in order to keep costs down Acme left its lawyer out of those discussions. Instead, in a private meeting with Star, Acme’s president hand-wrote what he believed to be a minor modification to the company’s original agreement with Star. Then, he and Star signed the handwritten “modification.”

After approximately one year, Acme’s relationship with Star began to sour. Star began demanding strict “compliance” with the “modification,” which Star asserted was a wholly separate deal. Acme decided to terminate its relationship with Star by providing 30 days notice as permitted under their original agreement. Star promptly filed suit, claiming the “modification” was a separate agreement for a fixed 10-year term with no provision allowing for early termination. Star claimed $10 million in damages, leaving Acme no choice but to defend the lawsuit. In the first few months of litigation alone, Acme spent more than $50,000 to defend against Star’s claims. Today, Acme’s counsel estimates that it will spend at least another $150,000 before the case is closed, with no guarantee of success.

So, how exactly did Acme get into this position? The problem lies with the actual wording of the “modification.” Read literally, that document—consisting of only five short paragraphs—said nothing about Acme’s prior agreement with Star and contained no mention of any right to terminate the relationship on 30 days notice or otherwise. On the other hand, it did mention a 10-year term and contained other language suggesting the “modification” was, in fact, a separate agreement.

Although Acme may have originally intended otherwise, the document read in a way that was favorable to Star, and, not surprisingly, Star then claimed that the document contained clear contract language that accurately stated the intention of the parties.

The difficulty for Acme in defending against Star was that California courts—and many state courts applying similar statutes—try to interpret contracts based solely on the written language contained in the document without looking to other evidence. The California Civil Code, for instance, provides that:

• The language of a contract is to govern its interpretation, if the language is clear and explicit, and does not involve an absurdity. §1638.
• When a contract is reduced to writing, the intention of the parties is to be ascertained by the writing alone, if possible; . . . §1639.

Most states adhere strictly to written terms in order to discourage situations like the one in which Acme now finds itself, where the document says one thing but the opposite party argues it means another. By holding parties to the apparent meaning of the specific words used in the document, the courts force parties during contract formation to express clearly and completely their intent in writing within the actual four corners of the document.

Does this mean that Acme stands no chance of success in the litigation with Star? No, there are additional rules of contract interpretation other than the “bare bones” rules. But the important lesson to be learned is that it has already cost Acme five to 10 times more to litigate its dispute with Star than it would have cost to have a lawyer simply draft or review the “modification” in the first place.

To avoid the kind of problem Acme now faces, a company must make sure that both parties clearly understand the general terms of a business transaction. The parties may even want to prepare an explicitly non-binding term sheet outlining the potential deal, before immediately hiring a lawyer.

Next, a company should discuss with the attorney, in detail, its relationship with the other party, explaining past history; identifying any prior agreements; explaining specific goals for the transaction and desired strategy for negotiation; and identifying each material term of the deal. After a formal contract is prepared, both sides must read it front to back, and word for word. A lawyer can then explain any difficult-to-understand terms and define words that may have legal significance beyond their typical, everyday meaning.

Above all, business executives must remember that if a deal goes south, they will be held to what the document actually says, and not to what they may have “meant” or “understood.” And if both parties involved decide later that they want to alter the deal, they must ensure that each change is put in writing and reviewed by a lawyer before it is signed.

As for costs, wouldn’t any savvy businessperson rather spend $5,000 now rather than $200,000 down the line?

* Company names have been changed to protect privacy

About the Author: Andrew M. Apfelberg is a corporate transactional attorney for privately held middle-market companies. He represents clients as their day-to-day general counsel and in significant transactions such as mergers and acquisitions, financings, joint ventures, licensing, entity formation, agreements between shareholders and the establishment of manufacturing facilities in Mexico. He is a partner of Rutter Hobbs & Davidoff Incorporated, a full service law firm in Century City (www.rutterhobbs.com). The firm provides comprehensive transactional and litigation services to companies, their principals and entrepreneurs. Apfelberg’s clients benefit from his strong business and finance background gained from working for investment banks prior to attending law school. This experience enables him to more effectively structure transactions and negotiate agreements to maximize the return to the client and increase the likelihood of getting the deal closed. He was awarded the most coveted AV rating through Martindale-Hubbell, and was selected as a “Super Lawyer” in the field of Business Law by Law & Politics in 2005, 2006, 2007, 2008 and 2009.

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2 Responses

  1. […] here: Penny Wise and Pound Foolish: By admin | category: av star | tags: agreement-drafted, av star, better-economic, […]

  2. If you hire a new lawyer, your new lawyer should take care of the process of getting your file from your former lawyer and getting any necessary substitution of counsel filed with the court.
    You can hire any lawyer you want, as long as they’re licensed to practice in the court where your case is pending, but hiring one near the courthouse can save you from having to pay for your lawyer’s travel time.

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