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Published June 2010

Business Contracts 101: What Canadian Businesses Need to Know

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Drafting a business contract can seem like a daunting task. At best, contracts are time-consuming and at worst, they're packed with tedious legalese.

But they're an essential business tool. If drawn up properly, a contract can bring clarity and peace of mind. If not, your business's future and, ultimately, your life savings could be at risk.

The following guide highlights key information you need to know to protect yourself before signing on a contract's dotted line.

1. What is a contract?

A contract is a legally binding agreement between at least two parties for a specific purpose. You can think of a contract as a roadmap, showing you where you're headed in sometimes unfamiliar territory.

There are many types of business contracts, from those that involve money, such as sales contracts, to contracts that define a relationship, such as a confidentiality or non-compete agreement. (Since each has its own peculiarities, we'll focus on sales contracts in this article.)

Above all, you should put your contracts in writing. Oral contracts are, in fact, binding says Kate McGilvray, a partner in the Toronto office of Blake, Cassels & Graydon LLP, a business law firm. It's just trickier to prove who said what when there is a dispute with an oral contract.

2. What are your obligations?

At a fundamental level, your obligations depend on the terms of your contractual agreement.

Simply put, people are obliged to live up to the terms they agree to in a contract. In many cases, this will involve a vendor providing goods or services, usually by a set date, and the purchaser paying for the goods or services as agreed.

If a party fails to meet its obligation, that party risks breaching the contract. So, as obvious as it seems, you must be sure that you can meet all of your obligations before signing a contract. There may be no way to back out at a later date.

It is also vital that you understand the importance of enforcing your legal rights at the proper time. Under a legal principle known as "estoppel by laches," if you fail to do so, you quite likely will lose the right to bring an action against the other party at a later date. If you don't enforce a delivery date, for example, a contract continues under new terms and the original date no longer applies.

Bottom line? If you don't understand something going into a contract, it's really important to get clarification, says McGilvray. A lack of understanding of a contract's terms is not a valid reason to get out of a contract. It's critical that you read every contract you enter into and, if necessary, get legal advice.

3. How are contracts governed in Canada?

When you look at how contracts are governed in Canada, it's easy to become confused.

With a traffic violation, when a driver is pulled over for speeding, the police officer can point to the exact line of legislation that was broken. However, no such straightforward statute exists for contract law. Contract disputes are determined by prior court decisions, says Geoff Hall, a partner in the Toronto law office of McCarthy T├ętrault. "They sometimes require litigation to determine who is right," he says.

The challenge is that, in court, nothing is guaranteed.

"For a businessperson, litigation is pretty much a nightmare," says Hall. "It's horrendously expensive and its outcome is very difficult to predict." In many respects, it's this uncertainty that bothers businesspeople more than the cost, he says.

The unpredictability of human nature can play a big role in the final ruling. "People get nervous in the setting of a court," says Hall. "No matter how hard you try to prepare them, they may not perform well."

4. Overview of Canada's court systems

There are two basic systems of law in Canada: common and civil law.

Quebec follows the system of civil law. Wikipedia explains that the principle of principle of civil law is to provide all citizens with an accessible and written collection of the laws that apply to them and which judges must follow. Legislation, not past case precedents - previous decisions of judges - is used as the primary source of law.

In the rest of the country, the common law system is used, which relies heavily on precedents, widely known as case law.

"There are a few statutes that are relevant [to contracts], says Hall, "but for the most part, they're governed by case law." Interestingly, when he teaches an advanced contracts course at Osgoode Hall Law School in Toronto, he doesn't teach a single statute. "It's all contract law," he says.

Within the case law system, there is also a hierarchy in the courts. For example, a decision by the Supreme Court of Canada binds all courts in Canada. Similarly, a decision by the Ontario Court of Appeal governs all Ontario courts.

5. Things you should include in every contract

Contracts vary widely depending on the nature of the goods or services you are buying or selling. A good contract is detailed and provides a clear description of the exact goods or services to be provided.

To protect yourself, there are a few things you should be sure to include in every contract.

  • Parties to the contract. Include the legal names and addresses of all parties.
  • Scope. A clear, detailed description of the goods or services to be provided. Due dates are normally included here. Be as clear as possible; as we explain below, this is the one most commonly disputed parts of a contract.
  • Price and payment terms. Be sure to include not only the amount, but also when payment is due, the length of time the purchaser has to pay, and any interest charges that will be applied to late payments.
  • Responsibilities. Try to anticipate what could go wrong. For example, missing a deadline can have consequences.
  • Terms and conditions. This is where lawyers have a lot of fun. Typical things to include here are limitations of liability, terms for amending or terminating the contract, warranties and disclaimers.
  • Signatures. You will want to include the signature, typed name, and title of each signatory as well as the date signed for each signatory.

Remember, the more precise the wording of a contract is, the less open it will be to interpretation and dispute.

6. When should you hire a lawyer to draft or review a contract?

"Some contracts won't be worth the cost of having legal advice," says Hall. But for complicated matters, such as the sale of a business, legal advice can help you avoid future problems, he says. A lawyer can also point to nuances in language that you might misinterpret and later regret.

If you are a vendor, a good investment of your legal loonies would be to have a lawyer review your standard contract and help you add appropriate terms and conditions to protect yourself.

If you have liability insurance, your insurance company may be able to help you with the contract as well. To the insurance company, having a good contract is like having quality deadbolts on your doors. The tighter your contract terms are, the more protected you will be.

You also want to avoid what McGilvray calls the nasty "battle of the forms," where the vendor and purchaser volley documents with contradictory terms back and forth.

Clearly, each party would like to slant the agreement to its favour. During this negotiation, you need to consider how important the contract is to your business and whether you can live with its terms.

A contract, ultimately, should be so crystal clear that disputes are unlikely to arise.

7. What issues in a contract frequently give rise to dispute?

With contracts, there are many things that can go wrong, but the following areas tend to be particularly problematic:

Scope of work

When you buy products or services that do not have an exact specification, it's easy for parties to disagree about what was meant by the work outlined in the contract.

Consider this fictional, but all too possible, example:

A manufacturing company hires a design firm to work on its annual report and agrees to pay a flat fee of $10,000. It submits copy to the firm, work is well underway, then suddenly it produces new copy that needs to be used.

The design firm expects to be paid to include the new copy, as it will affect the already completed layout. The manufacturing company, however, says the work should be done for free as the contract does not specify that copy cannot be revised.

This is a classic case of what lawyers call "scope creep." Protect yourself by defining the scope of work in as much detail as possible and including limitations for things like the number of revisions permitted.

Limitation of liability

This refers to a cap on what each party is financially responsible for should a breach of contract occur.

For example, a home inspector's contract might specify that the inspector's liability is limited to his inspection fee-say $400. But his failure to identify a building flaw could lead to damage or repairs valued at substantially more.

"Those are the [kinds of] things you get into arguments over and you really want to look at," says McGilvray.

For instance, a damaged party might claim that it's unfair that this provision is in the contract, she says, or that it shouldn't have been buried in fine print. Or, with the home inspector example, the damaged party might argue that limitation of liability was never intended to apply because the inspector was grossly negligent and should have identified the building flaw.

To prevent such disputes, it's vital that you carefully review and understand your contract prior to signing it. "If there are provisions like this and you are in a position to bargain, cross them out or amend them," says McGilvray. "You should also understand that if a provision applies generically, it may come up in the context of an unforeseen circumstance, so try and think through all of the different scenarios before you enter into a contract."

Interpretation of a contract's terms

When it comes to contract terms, it is not uncommon for two parties to have completely different interpretations of what something means, usually with the interpretation strongly favouring each party's position.

Even something as specific as the meaning of "chicken" has been disputed.

Hall cites a 1960 lawsuit in New York State, Frigaliment Importing Co. v. B.N.S. International Sales Corp., in which a buyer of fresh frozen chicken took action against a seller. At issue was whether the word "chicken" in their contract referred only to high-quality young chickens or to any type of chicken, including stewing chickens. In the end, the buyer lost the case. "The court concluded that the narrower interpretation had not been proven so the broader one applied," says Hall.

Price

Disputes around price tend to arise not so much because someone hasn't paid, but because the cost of delivering a good or service rises unexpectedly due to an incident outside the vendor's control.

Here's a classic example of how price can come into question: Let's say you run an appliance store and enter into contract with another company to supply electric stoves at a fixed price. But then nickel (used in the manufacturing of stoves) increases in price and your supplier wants to raise his price.

Do you continue paying the original price and risk not having the stoves delivered or do you agree to the higher price?

"It all depends on how important that contract is to your business," says McGilvray. "If you need that supplier long-term, you might be willing to amend your contract."

Legally, the supplier is still obligated to supply stoves at the price specified in the contract. And what happens if they refuse? "You can sue them but suing can be expensive and time-consuming," says McGilvray. "What if there is no one else who can provide that type of stove and you have a requirement to sell the stoves to someone else? This is where other business considerations sometimes take precedence over the legal situation."

8. What should I do if a contract's terms change?

Put them in writing-whether it's a revised due date, a new price or an expansion of the scope of the work. Many contracts have a provision that stipulates amendments must be in writing. Even an email exchange may be valid, depending on the contract's provisions.

Remember, as mentioned above, you need to enforce contract terms when they are not met. If you know a term will be broken, such as a deadline, make sure you outline the new terms clearly and get both parties to agree in writing.

9. When can I terminate a contract?

Again, that depends on what your contract stipulates-and is another really important reason to have a written contract. (Oral contracts frequently don't take into account how to get out of the contract.)

Most contracts come to an end when the parties involved have met the contracts' obligations. But occasionally they must be terminated sooner. A contract may include a simple termination condition of 30-days' written notice and/or the following provisions:

  • Impossibility of performance. This occurs when the party(ies) is/are no longer able to meet the obligations of the contract. For instance, an entrepreneur hires a professional photographer to take photographs of his premises but the photographer passes away before she has taken the pictures.
  • Rescission. The contract is rescinded or deemed void due to specific circumstances. For example, a young man initially signed a contract but was later determined to be a minor which nullified the agreement.
  • Material breach of contract. This serious violation may result in one party suing the other for damages or to perform the obligations of the contract.
  • Anticipatory breach. This occurs when one party cancels the contract early in anticipation of the other party being unable to fulfil its obligations. In essence, the party anticipates that the other party will breach the contract and pre-empts the process, ending the contract on this basis. Be very careful before you try to use anticipatory breach as a basis for termination as the degree of negligence must be very high.

Final word:

Well-executed contracts are worth your time and careful attention. If a dispute arises, take time to reflect and get good legal advice before you commit to a course of action from which you can't turn back. Emotions may run high when a dispute occurs but court is extremely expensive, in terms of time, money and psychological costs. Over 90 per cent of cases are settled before they reach court, often with both parties feeling like they have lost.

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