Contract Drafting & This Book PDF

A Few Words About Contract Drafting and This Book 1.1 INTRODUCTION A well-drafted contract is elegant. Its language is clear and unambiguous, and its organization cohesive and thoughtful. But drafting a contract requires more than good writing and organizational skills. A drafter should have keen...

A Few Words About Contract Drafting and This Book 1.1 INTRODUCTION A well-drafted contract is elegant. Its language is clear and unambiguous, and its organization cohesive and thoughtful. But drafting a contract requires more than good writing and organizational skills. A drafter should have keen analytical skills; a superior ability to negotiate; a sophisticated understanding of business, the business deal, and the client’s business; a comprehensive knowledge of the law; and a discerning eye for details. It also helps to have formidable powers of concentration, physical stamina, mental acuity, tenacity, the ability to multitask, and a sense of humor. Finally, a drafter must enjoy working with colleagues to create a product—the contract. 1.2 WHAT DOES A CONTRACT DO? A contract establishes the terms of the parties’ relationship. It reflects their agreement as to the rules that will govern their transaction. The rules generally include the statements of facts that each party made that induced the other to enter the transaction; each party’s promises as to its future performance; each party’s rights; the events that must occur before each party is obligated to perform; each party’s discretionary authority; how the contract will end, including the events that constitute breach and the remedies for breach; and the general policies that govern the parties’ relationship. These rules are the parties’ private laws, which the courts will enforce, subject to public policy exceptions found in statutes and common law. Indeed, commentators speak of contracts as private law. They also refer to them as planning documents. Unlike litigation, which looks back in time, contracts look forward to the parties’ future relationship and reflect their joint plans. A contract also helps the parties to problem solve. Often parties will have the same goal but differ as to how to 45 resolve a specific business issue. A well-written contract can bridge this difference, giving each party enough of what it needs to agree to the contract. 1.3 WHAT ARE A CONTRACT’S GOALS? When drafting, you are trying to create a document that serves multiple purposes. Sometimes, you may not be able to accomplish all of them, but you should try. A well- written contract should do the following: Accurately memorialize the business deal. Be clear and unambiguous. Resolve problems pragmatically. Be sufficiently specific that the parties know their rights and obligations, but be flexible enough to cope with changed circumstances. Advance the client’s goals and reduce its risks. Give each side enough of what it needs so that each leaves the table feeling that it negotiated a good deal. Be drafted well enough that it never leaves the file drawer. Prevent litigation. 1.4 WHAT IS THE CONTEXT WITHIN WHICH CONTRACTS ARE DRAFTED? Most contracts are drafted in a different atmosphere from that in which litigators draft memoranda and briefs. Litigators are out to win. They want to defeat their adversaries in court; cooperation is not generally a big part of their playbook. But doing deals and drafting contracts differ from litigation. Neither party wants to give away the candy store, but each looks for a way to get the deal done. The argot of deal lawyers also differs from that of litigators. While litigators talk about their adversaries— those with whom they will battle through a war of words—deal lawyers and their clients talk about the other side or the principals. These phrases acknowledge that the parties are not aligned, but they are softer than adversaries and reflect a different relationship. The parties are competitive, but in the context of a cooperative venture.1 Each may be willing to walk away from the deal, but each has incentive to find a way to get the deal done. 1.5 DOES THIS BOOK COVER ALL KINDS OF CONTRACTS? This book focuses on the drafting of business contracts, not standard form consumer contracts. The scope of the phrase business contracts is intended to be broad and encompassing. It is intended to cover all negotiated 46 contracts, whatever the topic or dollar amount. Within its reach are contracts for the sale of a used car, the construction of an office tower, and a settlement agreement between litigating adversaries. It does not cover a standard form contract that a corporation puts to a consumer. The distinction matters because it affects a drafter’s contract drafting style and a contract’s substance. Today, most consumer contracts are drafted in plain English, a style of drafting in which simplicity and clarity prevail. This book will not teach you to draft in plain English. Instead, for business contracts, this book espouses a style of drafting that this author calls contemporary commercial drafting. It resembles plain English, but it is not the same. It draws on the principles of plain English and promotes clarity through, among other things, simpler language, shorter sentences, and formatting. It differs from plain English, however, in important ways. First, plain English drafters make their contracts more reader friendly by, for example, adopting an informal tone. Although the business world is more informal than it used to be (think business casual dress), it is hard to imagine a multimillion dollar contract between Apple and Intel in which Apple is referred to as we and Intel as you. But more important than tone is the approach to the contract’s substance. A plain English contract’s provisions are pared down to their bare essentials, while a business contract’s are hefty, retaining all provisions that might add value or protect against risk. Carl Felsenfeld, one of the first proponents of plain English, explained the difference between the two kinds of contracts as follows: The plain English movement requires a new drafting approach. Each provision [of a consumer contract] must be analyzed one at a time against the specific transaction and the type of protection required. Many of the traditional legal provisions may well be found essentially unnecessary. It is basic to this approach that one must regard drafting for a consumer transaction as quite different from drafting for a business transaction. … One does not yet, for example, see it taken seriously, in the teaching of contract law. Traditionally, [promissory] notes were not divided in this way and many of the carefully drafted provisions that cluttered up consumer documents, while important, perhaps even essential, to a business transaction really added very little to the typical consumer loan. … The point is that consumer drafting must be regarded as a separate process from business drafting. A legal principle derived from this, while perhaps extreme, does lead the way: “In a business transaction, if a risk can be perceived draft for it. In a consumer transaction, unless a risk seems likely, forget it.”2 1.6 WHY SHOULD YOU LEARN TO DRAFT IF YOU PLAN TO LITIGATE? If you plan to litigate, you should learn to draft for two reasons. First, you will regularly draft contracts as a litigator. Litigating parties settle more often than they go to trial. The settlement they reach is a business deal, just like any other, and it must be memorialized clearly and accurately. Failure to do so can lead to another dispute and further litigation. Second, knowing how to draft will make you a better litigator. Many of the cases that you litigate will grow out of contract disputes. To represent your client properly, you must be able to analyze a contract and its provisions. If you understand how and why a drafter wrote a provision in a specific 47 way, you will be able to craft more persuasive legal arguments. 1.7 WHAT WILL THIS BOOK TEACH YOU? This book will teach you how to write a contract and how to think about writing a contract. The first requires that you learn basic principles of contract drafting: For example, use recitals sparingly; limit the number of definitions; avoid ambiguity; do not use the false imperative; tabulate to promote clarity; and say the same thing the same way. Learning how to think about writing a contract will require you to learn how business people and their lawyers think about a transaction and the contract that memorializes it. Some of the questions that lawyers and their clients think about include the following: What are the client’s business goals? How can the contract frustrate or further those goals? What risks inhere in the transaction? What business issues does a provision raise and how can the drafting resolve them? Does a provision give the other side too much control? Do the representations and warranties allocate too much risk to the client? How can the drafter change a covenant’s standard of liability to reduce the client’s risk? Should a particular event result in a breach? What remedies are appropriate if a party breaches the contract? Asking and answering these and other questions are the fun part of contract drafting. They are what make you more than “a mere scrivener”—the ultimate insult to a contract drafter. 1.8 HOW IS THIS BOOK ORGANIZED? Part 1, composed of Chapters 1 through 4, provides the framework for the course. It introduces you to the building blocks of contracts: representations and warranties, covenants, rights, conditions, discretionary authority, and declarations. Part 1, however, does more than define these terms. It shows how and why a drafter chooses a specific contract concept. It does this by teaching you the analytic skill of translating the business deal into contract concepts. The translation skill is the analytic skill that deal lawyers use when drafting. It differs from that used in writing a persuasive document—whether a memorandum or a brief. Rather than applying the law to the facts, a deal lawyer translates the client’s business concerns (a deal lawyer’s facts) into contract concepts and then into contract provisions. By learning this skill in the beginning of the course, you will later be able to layer 48 knowledge of how to draft on top of a framework that has taught you what you are drafting. Part 2 begins with Chapter 5. That chapter provides an overview of Part 2 by introducing you to a contract’s parts. Preamble—name of agreement, date, and the parties. Recitals—why the parties are entering the contract. Words of agreement—statement that the parties agree to the provisions that follow. Definitions. Action sections—promise to perform the subject matter of the contract and monetary provisions. Other substantive business provisions. Endgame provisions—specific business provisions dealing with the contract’s end. General provisions—the “boilerplate” provisions. Signature lines. Schedules. Exhibits. This chapter also shows you how the contract concepts you learned in Chapters 3 and 4 are integrated into a contract’s parts. In the remainder of Part 2, Chapters 6 through 17, you will learn how to draft each of the listed parts. Some of this will entail learning detailed drafting rules, but much of it will require you to learn to think like a deal lawyer. Chapters 18 through 24, which compose Part 3, will teach you rules and techniques to enhance clarity and to avoid ambiguity. You will learn, among other things, about formatting, clarity through sentence structure, tabulation, and common causes of and cures for ambiguity. You will also learn how to draft formulas and provisions that use accounting concepts. Chapter 25, the only chapter in Part 4, will teach you how to look at a deal from the client’s business perspective and how to add value to a transaction by identifying business issues. In Part 5, Chapters 26 through 29, you will learn the drafting process, from organizing the initial contract to amending the signed agreement. You will also learn how to analyze and comment on a contract that another lawyer has drafted. Part 6, which consists of Chapter 30, addresses ethical issues unique to contract drafting. 49 Part 7, which consists of Chapter 31, contains additional exercises for you to work on. Part 8 contains the final chapter, Chapter 32. That chapter provides exemplars of well- drafted contracts and guided reading exercises. In addition, the exemplars will serve as precedents for some of the exercises you do for class. This book concludes with several exhibits. Each exhibit provides background on specific issues not appropriate for the body of the textbook. 1.9 STYLISTIC MATTERS As you read this book, you will see that some words and phrases are in bold and others in italics. Words or phrases in a bold font signal important terms, many of which are defined. Italics are used for three purposes: to signal contract language, to provide supplementary information, and to emphasize a word or phrase. You will also notice that the book uses two kinds of boxes to highlight contract language. Short provisions are inside shaded boxes. Successors and Assigns. This Agreement binds and benefits the parties and their respective permitted successors and assigns. When two or more provisions are within a shaded box, each is numbered to distinguish where one ends and the other begins. Longer provisions are inside an unshaded box—to show you how the provision would look on a contract page. This Noncompetition Agreement, dated March 16, 20XX, is between Attorney Staffing Acquisition Co., a Delaware corporation (the “Company”), and Maria Rodriguez (the “Executive”). Background 1. Attorney Staffing Inc., a Delaware corporation (the “Seller”), provides temporary lawyers to law firms in the greater Chicago area. 2. The Seller is selling substantially all of its assets to the Company in accordance with the Asset Acquisition Agreement, dated February 1, 20XX (the “Acquisition Agreement”). 3. The Executive is the sole stockholder of the Seller and its President. 4. The Executive has extensive knowledge of the Seller’s business, including its client base and pool of temporary lawyers. 5. It is a condition to the consummation of the Acquisition Agreement that the Executive enter into this Noncompetition Agreement. Accordingly, the parties agree as follows: 50  1.10 SOME FINAL WORDS This course is a lot of work. But it is a great deal of fun (or so my students have told me). You will be learning the quintessential deal-lawyering skills: You will be learning to think and draft like a lawyer. Have fun. 1. Settlement and divorce negotiations are two notorious exceptions. 2. Carl Felsenfeld, Language Simplification and Consumer Legal Forms, remarks made at program on simplified legal drafting, American Bar Association, New York City, Aug. 7, 1978, in F. Reed Dickerson, Materials on Legal Drafting 267 (2d ed., Little, Brown & Co. 1986). See also Carl Felsenfeld & Alan Siegel, Writing Contracts in Plain English 28-29 (West 1981). 51 The Building Blocks of Contracts: The Seven Contract Concepts 2.1 INTRODUCTION To draft a contract, you must use contract concepts. These concepts are the foundation of every contract, the building blocks that, when properly assembled, express the parties’ business deal. In this chapter, you will be introduced to those concepts. Once you understand why contract concepts are used in a specific way, you can learn how to assemble them to create a contract and how to express a contract provision clearly and unambiguously. Here are the seven contract concepts, which when integrated into a contract’s parts, result in a contract: Representations. Warranties. Covenants. Rights. Conditions. Discretionary authority. Declarations. You already know something about these concepts from your first-year contracts course. Now you will learn in more depth how deal lawyers use them. 2.2 CAPSULE DEFINITIONS These are quick definitions of the seven contract concepts. You will learn more about each of them in Chapters 3 and 4. A representation is a statement of a past or present fact, made as of a moment in time to induce a party to act. A warranty is a promise that if the statement in the representation is false, the maker of the statement 52 will indemnify the other party for any damages suffered because of the false statement. A covenant is a promise to do or not to do something. It creates a duty to perform. A right is the flipside of a covenant. A right entitles a party to the other party’s performance. A condition to an obligation is a state of facts that must exist before a party is obligated to perform. Discretionary authority gives a party a choice or permission to act. Sometimes the exercise of discretionary authority is subject to the satisfaction of a condition. A declaration is a fact as to which both parties agree, generally a definition or a policy for the management of the contract. Sometimes a declaration is subject to the satisfaction of a condition. 2.3 TRANSLATING THE BUSINESS DEAL INTO CONTRACT CONCEPTS Each contract concept serves a different business purpose and has different legal consequences. Accordingly, drafters choose from among these concepts when memorializing the business deal. The analytical skill of determining which contract concept best reflects the business deal is the translation skill; it requires the drafter to look at each specific agreement of the business deal and to translate it into contract concepts. Only then can a drafter memorialize the business deal in a contract provision. The analytical skill of translating the business deal into contract concepts fundamentally differs from the analytical skill that litigators use. Litigators take the law and apply it to the facts to create a persuasive argument. They then memorialize that argument in a brief or a memo or otherwise use it to sway another, be it the other party or the court. In this paradigm, litigators seek a certain legal result by working backward from the law to a static set of facts. For example, imagine that a driver is going 80 miles an hour and hits a pedestrian; the pedestrian dies, and his heirs bring a lawsuit against the driver. The legal issue is whether the driver was negligent. To determine this, a litigator looks at the components of the cause of action for negligence and then to see whether each of the components can be matched up with the facts. The law is applied to the facts. Depending on whom the litigator represents, the conclusion may vary. The analytical skill of deal lawyers stands this paradigm on its head. Deal lawyers start from the business deal. The terms of the business deal are the deal lawyer’s facts. The deal lawyer must then find the contract concepts that best reflect the business deal and use those concepts as the basis for drafting the contract provisions. Chapters 3 and 4 teach the translation skill by looking at each of the contract concepts and examining its role in an agreement. Although we will be using the purchase of a house as the factual basis of much of our discussion of contract concepts, these same concepts are the building blocks of all contracts. 53 54 Translating the Business Deal into Contract Concepts: Part 1 (Representations and Warranties & Covenants and Rights) 3.1 INTRODUCTION Before deal lawyers begin to draft, they learn the terms of the business deal. Those terms are the deal lawyer’s facts. The lawyer must then find the contract concepts that best reflect the business deal and use those concepts as the basis of drafting the contract provisions. This skill is known as translating the business deal into contract concepts, often referred to in its truncated form as the translation skill. It is the foundation of a deal lawyer’s professional expertise and ability to problem solve. Without it, negotiating and drafting are abstractions. By learning this skill first, you will be able to layer knowledge of how to draft on top of a framework that has taught you what you are drafting. This chapter and the next discuss the seven contract concepts in depth and demonstrate how to use them in a contract. This chapter deals with representations and warranties, then covenants and rights. Chapter 4 deals with conditions, discretionary authority, and declarations. As part of this discussion, you will learn not only the legal aspects of each contract concept, but also its business purpose. Chapter 4 ends with two appendices that summarize the material in Chapters 3 and 4. You can use them as a quick reference. 3.2 REPRESENTATIONS AND WARRANTIES 3.2.1 DEFINITIONS Imagine that Sally Seller has listed her house for sale and that Bob Buyer is interested in purchasing it. But before Bob agrees to buy the house, he wants to learn more about it. All that he knows now is that the house is a two-story Cape Cod painted brown. He asks Sally the following questions during a telephone call: When was the house built? How old is the roof? Do all the appliances work? Is the house wired for Internet and cable television and is the wiring functioning properly? Is there a swimming pool? Is there a swimming pool water heater? Does it use propane gas for fuel? 55  How much propane gas is in the tank? What color are the living room walls, and when were they last painted? How much property comes with the house? Sally responds to Bob by telling him the following: The house was built in 1953 along with other houses in the neighborhood. The roof is four years old. All the appliances are in excellent condition. The house is wired for Internet and cable television, and the wiring is functioning properly. Yes. A swimming pool is on the property. Yes. A swimming pool water heater is on the property, and it uses propane gas for fuel. The tank is exactly one-half full with propane gas. The living room’s walls are painted eggshell white and were painted one year ago. Sally mentions that she has been thinking of painting them a pale blue to coordinate with her furniture. The house is on a one-acre lot. After hearing Sally’s answers, Bob visits the house and immediately decides that it is perfect for him. He and Sally agree on a $200,000 purchase price. Bob then calls his lawyer and asks her to draw up the contract and to include within it the information that Sally has told him. He tells his lawyer that he relied on Sally’s answers when deciding to buy the house. How does the lawyer include the information in the contract? The answer is that she will use representations and warranties. A representation is a statement1 of a past or present fact2 as of a moment in time3 intended to induce reliance.4 56 Assume that Sally and Bob sign a contract today for the sale of the house and that in the contract Sally tells Bob the following: The roof is four years old. Sally’s statement is a representation. She made that statement (a statement) today (a moment in time). (Had she made the statement a year ago, the roof would have been three years old, and if she were to make the statement in a year, it would be five years old.) In addition, she made the statement to convince Bob to purchase the house (to induce reliance). The representation that the roof is four years old is a statement about a present fact. Sally also made representations with respect to facts concerning the past: The house was built in 1953 along with other houses in the neighborhood. Although a party can make representations with respect to present and past facts, it generally cannot do so with respect to future facts.5 Those are mere statements of opinion. Chapter 9 discusses this issue in more depth. For Bob to have a cause of action for fraudulent misrepresentation, also known as the tort of deceit, Sally must have known that her statement was false when she made it; Bob must have relied on Sally’s statement; and that reliance must have been justifiable.6 That is, Bob must not have known that Sally’s statement was false. So, for example, if Bob purchases the house after his contractor inspects the roof and tells Bob that the roof is much older than four years, Bob cannot justifiably rely on Sally’s representation that the roof is four years old. Accordingly, Bob would not have a cause of action in tort for fraudulent misrepresentation as to the roof’s age. He might, however, have a separate cause of action for breach of warranty based on Sally’s statement in the representation about the roof’s age.7 Do not equate a statement in a representation with a representation. A representation is more than a bald statement of fact. It must be a past or present fact intended to induce the reliance of the person receiving the statement. As you proceed through this chapter, focus on the salient role of reliance in establishing the tort cause of action for breach of warranty. A warranty differs from a representation. A warranty is a promise by the maker of a statement that the statement is true.8 In the context of a contract with both representations and warranties, the statements referenced in the definition of warranty are those the maker made in the representation. Thus a warranty requires the 57 statement’s maker to pay damages to the statement’s recipient if the statement was false and the recipient damaged. The warranty acts as an indemnity.9 Generally, it does not matter whether the recipient knew the statement was false and did not rely on it. The critical question is not whether the buyer believed in the truth of the warranted information, as [the seller] would have it, but “whether [the buyer] believed [it] was purchasing the [seller’s] promise [as to its truth].”10 The dispute as to reliance’s role in a cause of action for breach of warranty stems from the oddity of its birth as a creature of tort law. English lawyers created warranties centuries ago to tackle the common law’s inflexibility. At the time, no contract-related writ permitted a plaintiff to sue the other side if it had not performed its obligations under the contract. The ever-inventive common law lawyers solved the problem by transforming nonperformance of a contract into a tort—an action of deceit that required reliance. Over time, a suit for breach of warranty became an action of assumpsit, a contract action.11 Nonetheless, through the centuries the contours of the cause of action remained uncertain and controversial. Warranty’s birth as a tort haunted it. American scholars extensively debated and analyzed warranties concerning the sale of goods during much of the twentieth century.12 Codification of the law of warranty concerning the sale of goods in the Uniform Sales Act, and subsequently in the Uniform Commercial Code, did little to quell the debate about whether reliance was a required element of a cause of action for breach of warranty.13 Outside the context of the sale of goods, academic writing about warranties appears nonexistent, despite the use of warranties in all kinds of commercial agreements (e.g., leases, licenses, and acquisition, credit, settlement, and entertainment agreements).14 The evolution of warranties outside the U.C.C. context pivots on the 1990 case of CBS Inc. v. Ziff-Davis Publishing Company. In that case, New York’s highest court held unequivocally that a warranty was contractual, and that reliance was not an element in a cause of action for its breach.15 (The Second Circuit has qualified the CBS decision by holding that a party waives its cause of action for breach of warranty if the party knows of a warranty’s falsity and does not explicitly preserve its rights.16 Nonetheless, the breadth of the CBS decision leaves open whether New York’s Court of Appeals would concur with the Second Circuit.17) Since the seminal CBS decision, the majority of courts addressing the issue of reliance have agreed with the CBS court and held that reliance is not an element of a cause of action for breach of warranty.18 In addition, courts have roundly criticized the small number of decisions holding to the contrary.19 Thus the modern view is that warranty has shed its tort origins20 and is a promise like any other in a contract.21 This book goes forth on that basis. (Because state Law governs this issue, be sure you know the law in the state whose law governs the transaction.) Chapter 9 discusses the consequences of this now bright-line distinction between representations and warranties. With this context, let’s return to our house purchase hypothetical. As stated previously, Bob would not have a 58 cause of action for misrepresentation with respect to the roof’s age because his contractor had told him that it was older than Sally represented. Nonetheless, because Sally also warranted the roof’s age, Bob would be able to sue for a breach of warranty post-closing—so long as he told Sally when they were closing that he was reserving his right to make a claim.22 Deal lawyers almost always negotiate for both representations and warranties.23 For example, in the house purchase agreement between Sally and Bob, the representations and warranties article would be introduced with the following language: The Seller represents and warrants to the Buyer as follows: By virtue of this one line, every statement in the sections that followed would be both a representation and a warranty. In the purchase agreement between Sally and Bob, Sally’s representations and warranties would resemble the following: Seller’s Representations and Warranties. The Seller represents and warrants to the Buyer as follows: (a) The house was built in 1953, along with the other houses in the neighborhood. (b) The roof is four years old. (c) All the appliances are in excellent condition. (d) The house is wired for Internet and cable television, and the wiring is functioning properly. (e) A swimming pool is on the property. (f) A swimming pool water heater is on the property, and it uses propane gas for fuel. The propane gas tank is on the property. (g) The tank is exactly one-half full with propane gas. (h) The living room’s walls are painted eggshell white and were painted one year ago. (i) The house is on a one-acre lot. Finally, when determining whether a party made a misrepresentation and breached a warranty, a statement’s truthfulness is always determined by comparing the statement to reality as of the moment in time when the statement was made, not when the determination of truthfulness is made.24 Therefore, Sally’s representation and warranty are truthful so long as the living room walls were painted eggshell white when she stated that they were that color. It would be irrelevant with respect to claims for misrepresentation and breach of warranty that she painted the walls pale blue after she made the representation in the contract for sale but 59 before she sold the house to Bob. Of course, the painting of the walls would not be irrelevant to Bob. But to obtain a remedy, he would need to rely on a cause of action other than misrepresentation and breach of warranty. He would need a covenant and perhaps a condition.25 3.2.2 REMEDIES Representations and warranties are common law concepts. As such, they carry with them common law remedies. The differences in these remedies can directly affect which cause of action is the most favorable for a plaintiff to plead. A party can make three types of misrepresentations: innocent,26 negligent,27 and fraudulent.28 A litigation alleging any of these misrepresentations is a suit in tort. Typically, innocent and negligent misrepresentations must be material to support a remedy.29 The law with respect to fraudulent misrepresentations depends on the jurisdiction. In some jurisdictions, a misrepresentation need not be material for it to constitute a fraudulent misrepresentation,30 while in others it must.31 If a misrepresentation is innocent or negligent, the usual remedies are avoidance and restitutionary recovery.32 Avoidance permits the injured party to unwind the contract.33 Both lawyers and courts often refer to it as rescission. Restitutionary recovery requires each party to return to the other what it received, either in kind or, if necessary, in money.34 A misrepresentation may also be fraudulent—a misstatement made with knowledge of its falsity (scienter).35 In this case, an injured party has a choice of remedies. First, it may void the contract and seek restitution,36 just as with innocent and negligent misrepresentations. Alternatively, it may affirm the contract, retain its benefits, and sue for damages based on a claim of fraudulent misrepresentation,37 sometimes referred to as the tort of deceit. The injured party’s damages claim could also include punitive damages,38 which, of course, can be significantly larger than general damages. (Lawyers sometimes refer to affirming the contract as standing on the contract.) If an injured party decides to affirm the contract by suing for fraudulent misrepresentation, the measure of damages depends on which state’s law governs the contract. Most states use the benefit of the bargain measure of damages,39 with the minority using the out-of-pocket measure of damages.40 The benefit of the bargain measure of damages results in a higher damages award and is the measure of damages that a party generally receives on a contract breach. It is equal to the value that the property was represented to be minus the actual value. So, if the property was represented to be worth $10,000 but was actually only worth $3,000, the damages would be $7,000. 60 Out-of-pocket damages are equal to the amount the plaintiff paid for the property minus the actual value. Thus, if the plaintiff paid $5,000 for property that was only worth $3,000, it could recover only $2,000 in damages. The difference in recovery between the benefit of the bargain damages and out- of-pocket damages can be an important factor when a plaintiff decides whether to sue for fraudulent misrepresentation or breach of warranty. Specifically, if an injured party asserts a claim for breach of warranty, a contract claim, the remedy for that breach is full benefit of the bargain damages.41 Therefore, in a state that follows the out-ofpocket rule of damages for fraudulent misrepresentations, a plaintiff would probably be better off pursuing a breach of warranty claim, as its benefit of the bargain damages would be greater.42 A claim for fraud might become the preferable claim, however, if a plaintiff could successfully argue for punitive damages. The following chart summarizes the remedies associated with representations and warranties. In this discussion, false representations have been referred to as misrepresentations. Although some lawyers colloquially speak of breaches of representations, that terminology is incorrect. A breach is a violation of a promise. Because representations are not promises, they cannot be breached. Instead, a party makes misrepresentations. It is correct, however, to speak of breaches of warranties, as warranties are promises. 3.2.3 WHY A PARTY SHOULD RECEIVE BOTH REPRESENTATIONS AND WARRANTIES As the preceding sections have made clear, multiple benefits accrue to a party who receives both representations and warranties. To summarize, these benefits are the following: First, a party may void the contract and receive restitution only if that party receives representations. Second, a party may sue for punitive damages only by claiming a fraudulent misrepresentation. Third, if a party cannot prove justifiable reliance on a representation, that party can still sue for breach of warranty. 61  Fourth, if a state follows the out-of-pocket rule for damages for fraudulent misrepresentations, a party can still recover the greater benefit of the bargain damages by suing for breach of warranty. Fifth, a breach of warranty claim may be easier to prove than a fraudulent misrepresentation claim. As noted earlier, to prove fraudulent misrepresentation, a plaintiff must demonstrate scienter, that the defendant knowingly made a false representation.43 As proving a party’s state of mind can be difficult, a breach of warranty claim, which has no such requirement, may be the easier claim to win.44 3.2.4 RISK ALLOCATION Each representation and warranty establishes a standard of liability. If a statement is false—if the statement does not reflect reality—then the standard has not been met and the party making the statement is subject to liability. By establishing standards of liability, representations and warranties serve an important business purpose. They are a risk allocation mechanism. This means that the degree of risk that each party assumes with respect to a statement varies depending on how broadly or narrowly the statement is drafted. Recall that Sally told Bob that the propane gas tank was exactly one-half full. That is a precise statement. It is posited as an absolute, without any kind of wiggle room. It is a flat representation. It is a high-risk statement for Sally because if she is even a little wrong, Bob has a cause of action for misrepresentation and breach of warranty. He might not have a claim for a great deal of money, but he could certainly bring a nuisance suit and hope for a quick settlement/price reduction. Sally could have reduced her risk by making a less precise statement. She could have made a qualified representation. For example, she could have said, “[T]he tank is approximately half-filled.” Then if the propane gas tank had been less than one-half its capacity, Sally might still have been able to contend that her statement was true. Her risk of having made a false statement would have been reduced. Bob, however, would have assumed a greater risk with respect to Sally’s statement about the amount of fuel in the tank. Originally, Bob would have had a cause of action if the tank was even a little less than half full. Now, in order to prove a misrepresentation and breach of warranty, Bob must argue what approximately means. The risk allocation has shifted more of the risk to Bob.45 To see how risk allocation works in a more sophisticated context, imagine that you are general counsel of a $100 million company that is selling all of its shares in a wholly owned subsidiary (the Target). Your current task is to negotiate the no litigation representation and warranty that appears in the stock purchase agreement.46 You know the statement needs to be qualified. But how? Immediately following this paragraph are five versions of a no litigation representation and warranty. The first version is the language in the agreement. The subsequent versions represent the evolution of your thinking with respect to what kind of qualifications would be appropriate. Read all of the versions and see if you can explain how each version changes the risk allocation. 62 Version 1 No Litigation. No litigation is pending or threatened against the Target. Version 2 No Litigation. Except as stated in Schedule 3.14, no litigation is pending or threatened against the Target. Version 3 No Litigation. Except as stated in Schedule 3.14, no litigation is pending or, to the Seller’s knowledge, threatened against the Target. Version 4 No Litigation. Except as stated in Schedule 3.14, no litigation is pending or, to the knowledge of any of the Seller’s officers, threatened against the Target. Version 5 No Litigation. Except as stated in Schedule 3.14, no litigation is pending or, to the knowledge of any of the Seller’s three executive officers, threatened against the Target. For the purpose of this representation and warranty, “knowledge” means, cumulatively, (a) each executive officer’s actual knowledge; and (b) the knowledge that each executive officer would have had after a diligent investigation. Again, Version 1 is how the representation and warranty appears in the stock purchase agreement. It is a flat representation and warranty. You immediately recognize its most obvious flaw: It is false. Virtually every company has some litigation, and the Target is no exception. If the representation and warranty is not changed, the Seller is at great risk because it knows that the statement is false. A cause of action for misrepresentation could allege fraud. Therefore, the first qualification is that the representation and warranty must indicate pending litigations. The typical way to do this is to list them on a disclosure schedule and then to refer to the schedule in the representation and warranty. Version 2 does this. For a more detailed discussion of schedules, see § 5.10. The easy part is now over. On further review, you see that the representation and warranty actually makes two statements: one about pending litigation and the other about threatened litigation. At first, you do not see this as a concern as the disclosure schedule can qualify the representation and warranty not only with respect to pending litigation, but also with respect to known, threatened litigation. But what if the Seller does not know of an existing, threatened litigation against the Target? Perhaps someone is claiming that a product malfunctioned and intends to sue. It is an unknown, threatened litigation. After concluding that this is an unfair risk for the Seller to assume, you ask the Buyer’s counsel for a knowledge qualification with respect to 63 unknown, threatened litigation.47 He acquiesces, and the representation and warranty is redrafted as set forth in Version 3.48 While the form of the Version 3 representation and warranty decreases the Seller’s risk of liability, it increases the Buyer’s risk. Because the Seller is no longer making a representation and warranty about unknown, threatened litigation, the Buyer will have no cause of action if unknown, threatened litigation against the Target actually exists. Version 4 addresses the problem of what constitutes the Seller’s knowledge. In the hypothetical, the Seller is a corporation, a juridical entity formed when its certificate of incorporation was filed with the appropriate governmental authority. As it is not a living, breathing human being, what constitutes its knowledge is not immediately apparent. Is it the knowledge of the company’s managers, or the knowledge of everyone from the president to the employees on the shop floor? From your perspective as general counsel (to put words in your mouth), it undoubtedly is an unfair risk for the Seller to be liable for the knowledge of every company employee. Accordingly, you request that the representation and warranty be further qualified so that the Seller is responsible only for its officers’ knowledge.49 With this change, the Seller no longer takes a risk as to the knowledge of an employee on the shop floor. However, the Seller’s decrease in risk means that the Buyer’s risk has commensurately increased. If an employee on the shop floor, in fact, knows of a threatened litigation, the Buyer will have no cause of action against the Seller because its representation and warranty is true: No officer knew. Thus, should the threatened litigation turn into an actual litigation and result in an award of damages, the Buyer would be obligated to pay it. At this point, you are on a roll. You decide that even knowledge of any of the Seller’s officers is too great a risk. Therefore, you go to the well again and ask the Buyer’s counsel to change the qualification so that it reads knowledge of any of the Seller’s three executive officers. This is the language in the first sentence of Version 5. At this point, however, the Buyer’s counsel says: “Enough. If knowledge is limited to three executive officers, they could walk around with blinders on doing their best to acquire no knowledge of threatened litigation. This is too much risk for the Buyer to assume.” The Buyer’s counsel instead proposes to define knowledge as the aggregate actual knowledge of each of the executive officers and their imputed knowledge; that is, the knowledge each executive would have had if the executive had performed a diligent inquiry. This is the compromise language in the remainder of Version 5. The Seller has limited its risk to the knowledge of the three executive officers, while, concurrently, the Buyer has eliminated its risk of the executive officers’ intentional oblivion. Understanding the impact of risk allocation is essential to fulfilling your role as a counselor. Clients too often misunderstand the purpose of representations and warranties and think that the time spent negotiating them is mere wordsmithing.50 By explaining to a client that the wording of the representations and warranties can affect potential liability, you have explained that money is on the table, something that clients readily understand. 64  3.3 COVENANTS 3.3.1 DEFINITIONS AND USES OF COVENANTS We will first look at covenants in the context of the sale of Sally’s house to Bob and then in other contexts. Imagine that after Sally and Bob have agreed to a price, Bob tells Sally that he cannot immediately purchase the house as he first needs to obtain a mortgage. A delayed closing is acceptable to Sally, and they agree to close the sale on the last day of the next month. This delay creates a gap period between the signing of the purchase contract and the closing.51 (A closing is when parties exchange the agreed performances. Typically, closings occur only in acquisitions and financings. In an acquisition, it would be the day the seller transfers its property to the buyer, and the buyer pays the seller; in a financing, it would be the day the bank makes the loan to the borrower, and the borrower agrees to repay it.) As Bob and Sally finalize their agreement, Bob tells Sally that he is concerned about what will happen to the house during the gap period. Specifically, he does not want the living room walls painted, and he wants to make sure that the propane gas tank is at least one-third full with propane gas when he moves in on the closing date. Sally agrees. To incorporate Sally’s agreement into the purchase contract, the lawyers use covenants, called promises in the argot of Restatement (Second) of Contracts.52 A covenant is a promise to do or not to do something.53 It creates a duty to perform if a contract has been formed.54 The duty to perform is sometimes called an obligation.55 In the purchase agreement between Sally and Bob, the covenants will resemble the following: Seller’s Covenants. The Seller (a) shall not paint the walls between the signing and the Closing; and (b) shall cause the propane gas tank to be at least one-third full with propane gas on the Closing Date. Although the need for these covenants in the purchase agreement arose because of the gap period between signing and closing, covenants are used in multiple other contexts. One of the most important is in the subject matter performance provision. In this provision, each side covenants to the other that it will perform the main subject matter of the contract. So, in our house contract hypothetical, the main subject matter of the contract is the purpose and sale of the house. The subject matter performance provision would be stated as follows: At the Closing, the Seller shall sell the house to the Buyer, and the Buyer shall buy the house from the Seller. The following timelines of an acquisition agreement and a license agreement show how covenants can be used at difficult stages in a transaction. 65 Example 1 is the timeline of an acquisition agreement. As we have seen, in this type of transaction, the parties use covenants during the gap period to control the seller’s actions with respect to the subject matter of the contract (e.g., the house).56 However, an acquisition agreement also has covenants that are unrelated to the gap period. Some covenants, such as confidentiality provisions, apply both before and after closing. Other covenants apply only at closing; for example, the promise to pay the purchase price and the promise to transfer the assets (the subject matter performance covenants). And finally, some covenants apply only to the post- closing period. Indemnities and noncompetition provisions are classic examples. The timeline of a license agreement, Example 2, differs from the timeline of an acquisition agreement. The license agreement has no gap period. Its term begins and ends on agreed-on dates.57 Each party covenants to the other as to its behavior during the term. The licensee promises to use its commercially reasonable efforts to manufacture and market products using the trademark, to pay license fees, and to submit for approval a prototype of each product. In turn, the licensor promises not to license the trademark to anyone else, to defend the trademark, and to promptly approve or disapprove each prototype submitted for approval. Occasionally, covenants relate to the period after the term. For example, the contract will typically set out the parties’ obligations post-term with respect to any unsold inventory that the licensee owns at the end of the term. 3.3.2 DEGREES OF OBLIGATION In the same way that representations and warranties are a risk allocation mechanism, so too are covenants. The allocation manifests itself in terms of how absolute a party’s promises are. The business differences between the different ways of expressing a party’s obligations are degrees of obligation.58 Consider a transaction in which the buyer hopes to acquire a lease for property that the seller uses in its business operations. To effect this acquisition, the seller must assign its rights under the lease to the buyer, but the seller’s lease prohibits it from doing so. Therefore, the buyer insists that the seller must promise to obtain the landlord’s consent to the assignment. Review the following covenants and see if you can determine how the risk allocation shifts depending on the degree of the seller’s obligation.59 66 Version 1 Consents. The Seller shall obtain the consent of Landlord Corp. to the Seller’s assignment of the Lease to the Buyer. Version 2 Consents. The Seller shall use commercially reasonable efforts to obtain the consent of Landlord Corp. to the Seller’s assignment of the Lease to the Buyer. Version 3 Consents. The Seller shall use commercially reasonable efforts to obtain the consent of Landlord Corp. to the Seller’s assignment of the Lease to the Buyer. For purposes of this provision, the Seller is deemed to have used its commercially reasonable efforts if it offers Landlord Corp. at least $10,000 as an inducement to consent to the assignment. Version 4 Consents. The Seller shall request that Landlord Corp. consent to the Seller’s assignment of the Lease to the Buyer. Version 1 is the equivalent of a flat representation. It is the Seller’s absolute promise to obtain consent. The promise is dangerous for the Seller to make as it has no control over the outcome: Landlord Corp. has no obligation to consent, and it could just as easily refuse consent as grant it. Because the Seller has no control, it risks breaching the covenant. The Seller, therefore, wants to reduce its risk by reducing its degree of obligation. From the Buyer’s perspective, Version 1 is a terrific covenant. If the Seller obtains Landlord Corp.’s consent, the Buyer is in position immediately to continue the Seller’s business on the same premises. If the Buyer does not obtain consent, however, the Buyer should still come out whole as it has the right to sue for damages. If the current lease’s rent is under market value, the Buyer’s damages might be equal to the rent the Buyer would have to pay for comparable leased property minus the rent the Seller is paying under its lease. Versions 2 through 4 each change the Seller’s risk but in a different way. Version 2 does not require the Seller to obtain consent. Instead, the standard is that the Seller must have tried to obtain consent and must have used commercially reasonable efforts in that endeavor. That is, the Seller must do what the reasonable businessperson would do. This change substantially reduces the degree of the Seller’s obligation and, therefore, its risk. Now, the focus is on the degree of effort, rather than the result. So long as the Seller uses commercially reasonable efforts to obtain consent, the Buyer has no cause of action for breach if the consent is not obtained. Any difference between the cost of the existing lease and a new lease is for the Buyer’s account. The decrease in the Seller’s risk has shifted risk to the Buyer. From the Seller’s perspective, Version 2 is definitely better than Version 1. Nonetheless, the precise degree of 67 effort is vague. What does commercially reasonable efforts mean? How much money must the Seller spend to induce Landlord Corp. to grant consent?60 Version 3 directly addresses this issue by capping, at $10,000, the amount that the Seller needs to spend to comply with the covenant. The cap shifts risk to the Buyer. To see this more vividly, assume the Seller offers Landlord Corp. $10,000 to consent, but Landlord Corp. refuses to consent and demands $10,500. In this event, the Seller has performed its covenant and, therefore, is not in breach, even though it did not obtain consent. Accordingly, the Buyer is on the hook for any increased lease expense—even though a slightly increased payment to Landlord Corp. would have resulted in a consent. Finally, Version 4 eliminates the Seller’s obligation to obtain consent. Instead, the Seller must merely request that consent. Its degree of obligation is minimal, and the Buyer assumes almost all the risk with respect to the Seller’s failure to obtain consent. 3.3.3 REMEDIES In the same way that representations and warranties carry with them their own common law remedies, so too do covenants. In general, breach of a covenant entitles the injured party to sue for damages61 and, if the facts are appropriate, specific performance.62 The measure of damages is full benefit of the bargain damages. (If the breach is so material that it is a breach of the whole contract that cannot be cured, then a party may have a right to cancel as well as other remedies.63) If a party breaches a covenant, that party need not also have made a misrepresentation and breached a warranty. First, as is often the case, the party may not have made a representation and warranty on the same topic. Second, even if it has, the truthfulness of a representation and warranty is determined as of the time it was made. So, if a representation and warranty was true at the time that it was made, no misrepresentation or breach of warranty would occur just because the related covenant was breached. To put this in context, assume that, at the signing of the contract, Sally represents and warrants that the walls of the living room are eggshell white and covenants to maintain their color. Then, during the gap period, Sally decides that she wants blue walls for her last few weeks in the house, and she paints them. By doing so, Sally breaches her covenant not to paint the walls, giving Bob a cause of action for breach of the covenant. Bob will not, however, have a cause of action for misrepresentation or breach of warranty because the walls were eggshell white when Sally represented and warranted their color.64 3.4 RIGHTS A contract right flows from another party’s duty to perform; that is, it flows from a covenant. The person to whom the performance is owed has a right to that performance. Therefore, if there is a duty, there is a correlative right. More colloquially, the flip side of every duty is a right. Because of this relationship, a right’s business purpose is the same as a duty’s: to allocate risk by establishing standards of liability. Although a duty is generally expressed as a covenant for business and legal reasons, that duty can alternatively 68 be expressed as a right. For example: Version 1 Payment of Purchase Price. The Buyer shall pay the Seller $200,000 at Closing. (Drafted as the Buyer’s duty.) Version 2 Entitlement to Purchase Price. The Seller is entitled to be paid $200,000 at Closing. (Drafted as the Seller’s right.) In both examples, the Buyer must pay $200,000. The difference is the focus: the Buyer’s duty to pay versus the Seller’s right to payment. When determining whether a particular business point is a right, the correlative duty is not always immediately apparent. For example: Entitlement to Deposit. If the Buyer fails to close because it did not obtain financing, the Seller is entitled to keep the deposit. In this instance, the correlative duty would be the Buyer’s obligation not to seek return of the deposit.65 (The use of may here to indicate discretionary authority would be wrong. May indicates a choice between alternatives, but it’s hard to imagine a seller choosing to give the deposit back to a buyer.) A seller might be quite nonplussed to find it has discretionary authority as opposed to the absolute right. This is another example of is entitled being used to express a remedy. Some commentators might opt for may in these situations, but may insufficiently expresses the business deal. If clients are wronged, discretion doesn’t cut it. They want a right. 1. See Restatement (Second) of Contracts § 159 (1981) (Section 159 states that “[a] misrepresentation is an assertion that is not in accord with the facts.”). Turning the definition from a negative statement to a positive one, we obtain a definition of representation: a true assertion of fact. The Restatement uses assertion and statement synonymously. This textbook will use statement. 2. Id. at cmt. c (“[F]acts include past events as well as present circumstances but do not include future events.”); see Misrepresentation by Promisor of Real Intention as Misstatement of Existing Fact, 4 U. N.Y.U. L. Rev. 5, 5 (1926) (author not listed). (“Misrepresentations, in order to support an action in fraud, must, among other things, relate to a fact existing or past. Statements as to future events, merely promissory in character, are not actionable.”) (citations omitted; emphasis added). 3. Id. at cmt. c (“An assertion must relate to something that is a fact at the time the assertion is made in order to be a misrepresentation.”); see Spreitzer v. Hawkeye State Bank, 779 N.W.2d 726, 735 (Iowa 2009) (“[A] 69 representation must be false at the time it was made to support a claim of fraud, and a representation that was true cannot serve as the basis for a claim of fraud. … (citation omitted)”). 4. See Harold Cohn & Co., Inc. v. Harco Int’l, LLC, 804 A.2d 218, 223-224 (Conn. App. 2002). 5. See supra n. 2 and accompanying text. 6. See Restatement (Second) of Torts § 537 (1977) (“The recipient of a fraudulent misrepresentation can recover against its maker for pecuniary loss resulting from it if, but only if … (a) he relies on the misrepresentation in acting or refraining from action, and (b) his reliance is justifiable.”). See generally 37 Am. Jur. 2d Fraud and Deceit § 239 (2001) for a list of cases from multiple jurisdictions addressing the issue of justifiable reliance. 7. See S. Broad. Group, LLC v. Harco Int’l, LLC, 145 F. Supp. 2d 1316, 1321-1324 (M.D. Fla. 2001), aff’d, 49 Fed. Appx. 288 (11th Cir. 2002) (table); see also Shambaugh v. Lindsay, 445 N.E.2d 124, 125-127 (Ind. App. 1983). 8. See CBS Inc. v. Ziff-Davis Publg. Co., 554 N.Y.S.2d 449, 452-453 (1990). This is not the Uniform Commercial Code definition of a warranty, but the common law one on which this book will focus. 9. Metro. Coal Co. v. Howard, 155 F.2d 780, 784 (2d Cir. 1946) (Judge Learned Hand). 10. CBS Inc. v. Ziff-Davis Publg. Co., supra n. 8, at 453 (quoting Ainger v. Mich. Gen. Corp., 476 F. Supp. 1209, 1225 (S.D.N.Y.1979), aff’d, 632 F.2d 1025 (2d Cir. 1980)). 11. See generally James B. Ames, History of Assumpsit, 2 Harv. L. Rev. 1 (1888). 12. See e.g. James J. White, Freeing the Tortious Soul of Express Warranty Law, 72 Tul. L. Rev. 2089 (June 1998); George Gleason Bogert, Express Warranties in Sale of Goods, 33 Yale L. J. 14 (1923); Samuel Williston, What Constitutes an Express Warranty in the Law of Sales?, 21 Harv. L. Rev. 555 (1908); see also Thomas Williams Saunders, Warranties and Representations: Fraudulent Representations on the Sale of Personal Chattels, 10 W. Jurist 586 (1876) (discussing then contemporary English cases). 13. See generally White, supra n. 12, at 2094-2098; Sidney Kwestel, Freedom from Reliance: A Contract Approach to Express Warranty, 20 Suffolk U. L. Rev. 959 (Winter 1992). 14. The author found no mid- to late-20th century scholarly writing on warranties outside the U.C.C. context before the CBS decision. But proving the negative is, of course, problematic. After CBS, scholarly and practitioner writing on reliance’s role as an element in a cause of action for breach of warranty outside the U.C.C. context blossomed. See e.g. Bill Payne, Representations, Reliance & Remedies: The Legacy of Hendricks v. Callahan, 62 Bench & Bar Minn. 30 (Sept. 2005); Robert J. Johannes & Thomas A. Simonis, Buyer’s Pre- Closing Knowledge of Seller’s Breach of Warranty, 75 Wis. Law. 18 (July 2002); Sidney Kwestel, Express Warranty as Contractual—The Need for a Clear Approach, 53 Mercer L. Rev. 557 (Winter 2002); Matthew J. Duchemin, Whether Reliance on the Warranty is Required in a Common Law Action for Breach of an Express 70 Warranty?, 82 Marq. L. Rev. 689 (Spring 1999); Frank J. Wozniak, Purchaser’s Disbelief in, or Nonreliance upon., Express Warranties Made by Seller in Contract for Sale of Business as Precluding Action for Breach of Express Warranties, 7 A.L.R.5th 841 (1992). 15. CBS Inc. v. Ziff-Davis Publg. Co., supra n. 8. 16. See Galli v. Metz, 973 F.2d 145, 151 (2d Cir. 1992) (holding that where a buyer closes with full knowledge that the facts disclosed by the seller are not as warranted, the buyer may not sue on the breach of warranty, unless it expressly preserves the right to do so); Rogath v. Siebenmann, 129 F.3d 261, 264-265 (2d Cir. 1997) (requiring the express preservation of rights when the seller is the source of knowledge of the warranties’ falsity). 17. CBS Inc. v. Ziff-Davis Publg. Co., supra n. 8, at 454, *505-506, **1002 (“We see no reason why Ziff- Davis should be absolved from its warranty obligations under these circumstances. A holding that it should because CBS questioned the truth of the facts warranted would have the effect of depriving the express warranties of their only value to CBS—i.e., as continuing promises by Ziff-Davis to indemnify CBS if the facts warranted proved to be untrue (see Metropolitan Coal Co. v. Howard, supra, at 784). … Ironically, if Ziff- Davis’s position were adopted, it would have succeeded in pressing CBS to close despite CBS’s misgivings and, at the same time, would have succeeded in defeating CBS’s breach of warranties action because CBS harbored these identical misgivings.”) (emphasis in the original). 18. See Grupo Condumex, S.A. v. SPX Corp., 2008 WL 4372678 at *4 (No. 3:99CV7316, N.D. Ohio, Sept. 19, 2008) (“Declining to impose an obligation on a party claiming damages for breach of warranty to prove reliance on the warranty conforms to the current views of a majority of other jurisdictions. Mowbray v. Waste Mgmt. Holdings, Inc., 189 F.R.D. 194, 200 (D. Mass.); see Power Soak Sys. v. EMCO Holdings, Inc., 482 F. Supp. 2d 1125, 1134 (W.D. Mo. 2007) (‘The modern trend is that a buyer need not rely on a seller’s express warranty in order to recover for the seller’s subsequent breach of the express warranty.’); Southern Broadcast Group, LLC v. GEM Broadcasting, Inc., 145 F. Supp. 2d 1316, 1321-1324 (M.D. Fla. 2001) (citing cases applying Illinois, Pennsylvania, Connecticut, Montana, New York, New Mexico, Indiana, and Massachusetts law); Norcold Inc. v. Gateway Supply Co., 154 Ohio App. 3d 594, 601, 798 N.E.2d 618 (2003) (also recognizing that a ‘decisive majority of courts’ have held that reliance is not an element for claim of breach of warranty).”) 19. Cases holding to the contrary: Hendricks v. Callahan, 972 F.2d 190 (8th Cir. 1992) (applying Minnesota law); Land v. Roper Corp., 531 F.2d 445 (10th Cir. 1976) (applying Kansas law); Middleby Corp. v. Hussman, 1992 WL 220922 (N.D. 1ll. 1992) (applying Delaware law); Kazerouni v. De Satnick, 228 Cal. App. 3d 871 (2d Dist. 1991). Cases criticizing Hendricks and Land: Giuffrida v. Am. Family Brands, Inc., 1998 WL 196402 at *4 (E.D. Pa. Apr. 23, 1998); S. Broad. Group, LLC v. GEM Broad., Inc., 145 F. Supp. 2d 1316, 1321 (M.D. Fla. 2001); Mowbray v. Waste Mgt. Holdings, Inc., 189 F.R.D. 194, 200 (D. Mass. 1999). Case criticizing Middleby: Vigertone AG Prods., Inc. v. AG Prods. Inc., 316 F.3d 641, 649 (7th Cir. 2002) (Judge 71 Posner). Case distinguishing Kazerouni: Telephia v. Cuppy, 411 F. Supp. 2d 1178 (N.D. Cal. 2006). 20. CBS Inc. v. Ziff-Davis Publg. Co., supra n. 8, at 453, 503, 1001 (“This view of ‘reliance’—i.e., as requiring no more than reliance on the express warranty as being a part of the bargain between the parties —reflects the prevailing perception of an action for breach of express warranty as one that is no longer grounded in tort, but essentially in contract.”); see also Ainger v. Mich. Gen. Corp., 476 F. Supp. 1209, 1224-1225 (S.D.N.Y. 1979), aff’d, 632 F.2d 1025 (2d Cir. 1980) (“Transporting tort principles into contract law seems analytically unsound.”). 21. Glacier Gen. Assur. Co. v. Cas. Indem. Exch., 435 F. Supp. 855, 860 (D. Mont. 1977) (“The warranty is as much a part of the contract as any other part, and the right to damages on the breach depends on nothing more than the breach of warranty.”). 22. See supra nn. 16 and 17 and accompanying text. 23. Chapter 9 discusses situations when it might be appropriate to ask for just warranties. 24. See Union Bank v. Jones, 411 A.2d 1338, 1342 (Vt. 1980) and footnote 3 in this chapter. 25. See §§ 3.3 and 4.2. 26. See Bortz v. Noon, 729 A.2d 555, 563-564 (Pa. 1999); Restatement (Second) of Torts § 552C (1977) (misrepresentations in sales, rental, or exchange transactions). 27. See Liberty Mut. Ins. Co. v. Decking & Steel, Inc., 301 F. Supp. 2d 830, 834 (N.D. Ill. 2004); Restatement (Second) of Torts § 552 (1977) (information negligently supplied for the guidance of others). 28. See Skurnowicz v. Lucci, 798 A.2d 788, 793 (Pa. Super. 2002). 29. See Restatement (Second) of Contracts § 164 (1981). 30. See Sarvis v. Vt. State Colleges, 772 A.2d 494, 498 (Vt. 2001). Compare Restatement (Second) of Contracts § 164 (1981) (providing that a fraudulent misrepresentation need not be material to make it voidable) with Restatement (Second) of Torts § 538 (1977) (providing that reliance on a fraudulent representation is not justifiable unless the matter misrepresented is material). 31. See Skurnowicz v. Lucci, supra n. 28. 32. See Norton v. Poplos, 443 A.2d 1, 4-5 (Del. 1981) (innocent misrepresentation); Patch v. Arsenault, 653 A.2d 1079, 1081-1083 (N.H. 1995) (negligent misrepresentation). Damages have been awarded in cases of innocent and negligent misrepresentation. See Restatement (Second) of Torts §§ 552B and 552C (1977); see generally Dan B. Dobbs, Dobbs’ Law of Remedies vol. 2, § 9.2(2), 554-556 (2d ed., West 1993) [Dobbs’ Law of Remedies], 72 33. See Kavarco v. T.J.E., Inc., 478 A.2d 257, 261 (Conn. App. 1984); see generally E. Allan Farnsworth, Farnsworth on Contracts vol. 1, 495-496 (3d ed., Aspen Publishers 2004). 34. Farnsworth on Contracts, supra n. 33, at 499. Some cases hold that the injured party is also entitled to reliance damages. See In re Letterman, 799 F.2d 967, 974 (5th Cir. 1986). 35. See Bortz v. Noon, 729 A.2d 555, 560 (Pa. 1999). 36. See Smith v. Brown, 778 N.E.2d 490, 497 (Ind. App. 2002). 37. See Stebins v. Wells, 766 A.2d 369, 372 (R.I. 2001); A. Sangivanni & Sons v. F M. Floryan & Co., 262 A.2d 159, 163 (Conn. 1969) (“Fraud in the inducement of a contract ordinarily renders the contract merely voidable at the option of the defrauded party, who also has the choice of affirming the contract and suing for damages. … [in which event] the contract remains in force…”). 38. See generally Dobbs’ Law of Remedies vol. 2, § 9.2(5), 565-568. 39. See e.g. Lightning Litho, Inc. v. Danka Indus., Inc., 776 N.E.2d 1238, 1241-1242 (Ind. App. 2002). 40. See Reno v. Bull, 124 N.E. 144, 146 (N.Y. 1919). Some states follow neither rule exclusively, but instead have a more flexible approach that varies the damage award based on specific factors. See e.g. Selman v. Shirley, 85 P.2d 384, 393-394 (Or. 1938). 41. See Nunn v. Chem. Waste Mgt., Inc., 856 F.2d 1464, 1470 (10th Cir. 1988). 42. See Ainger v. Mich. Gen. Corp., supra n. 20, at 1233-1234. 43. See § 3.2.2 n. 35. 44. See W. Page Keeton, Dan B. Dobbs, Robert E. Keeton & David G. Owen, Prosser and Keeton on Torts § 107, 741 (5th ed. West 1984). 45. If this issue arose in the real world, the parties would most likely deal with it by a purchase price adjustment. It is used here to demonstrate risk allocation. 46. In an acquisition agreement, a no litigation representation and warranty details what litigation exists so that a buyer can determine if that litigation presents a significant risk to the business it is buying. Similar representations and warranties exist in other agreements. For example, in a license agreement, the licensor generally represents and warrants that there are no litigations challenging the licensor’s ownership of the trademark. 47. Another common qualification of representations and warranties is materiality. That qualifier is discussed in § 9.3 and is the subject of Exercise 9-1. 48. Agreeing to this qualification is so common that a buyer’s first draft often includes it. The parties do, however, often negotiate the definition of knowledge. 73 49. The qualification in Version 4 uses the phrase “to the knowledge of any of the Seller’s officers.” Thus, if any one or more of the Seller’s officers knows of any threatened litigation, that alone creates a misrepresentation and breach of warranty. If any were replaced with each, however, then all three of the Seller’s officers would have to know of the threatened litigation to cause a misrepresentation and breach of warranty. 50. Wordsmithing has a pejorative connotation. It suggests that a lawyer redrafts language for no substantive reason, wasting time and money. 51. A gap period between signing and closing is routine in acquisition transactions. It arises for multiple reasons. First, the buyer may need to obtain financing. Second, the parties may need to obtain consents to the transaction or to the transfer of particular assets. Finally, the buyer may want to perform due diligence if it did not previously do so. Due diligence is the corporate equivalent of test-driving a car before purchasing it. (To be sure that a target company is worth purchasing, the buyer-to-be examines, among other things, the seller’s contracts, equipment, and financial statements.) 52. Restatement (Second) of Contracts § 2(1). 53. Id. 54. Restatement (Second) of Contracts §§ 1 and 2 cmt. a. 55. Id. at § 1 cmt. b. 56. Buyers also give covenants, such as promising to obtain any necessary consents. 57. Sometimes the parties sign on a date before the term begins. The period between the signing and the beginning of the term differs from the gap periods in acquisition agreements. During the license agreement’s “gap period,” generally, no covenants must be performed or conditions satisfied. Instead, the delayed beginning of the term is for administrative ease, so that the term begins either on the first day of a month or immediately after one party’s relationship with a third party concludes. For example, a licensor and a licensee may negotiate and sign a license agreement in October, but the license term will not begin until January 1, the day after the licensor’s current arrangement with another licensee terminates. 58. I thank my former Fordham Law School colleague, Alan Shaw, for coining this most useful phrase, degrees of obligation. 59. These covenants are based on covenants that Alan Shaw drafted. 60. See e.g. Bloor v. Falstaff Brewing Corp., 601 F.2d 609 (2d Cir. 1979). 61. See generally Dobbs’ Law of Remedies vol. 3, § 12.2, 21-50. 62. See generally id. at § 12.8, 189-245. 74 63. See U.C.C. §§ 2-106(4), 2-612, 2-703 (2004). 64. See § 3.2.1. 65. See Chapter 10, Guideline 3 and § 12.1.2, pp. 176-178 for a further discussion of the drafting of rights in the context of endgame provisions. 75 Translating the Business Deal into Contract Concepts: Part 2 (Conditions, Discretionary Authority, and Declarations) 4.1 INTRODUCTION This chapter continues teaching you how to translate the business deal into contract concepts. It discusses conditions, discretionary authority, and declarations. 4.2 CONDITIONS TO OBLIGATIONS 4.2.1 THE BASICS Let’s continue with the Sally Seller/Bob Buyer house purchase hypothetical that we discussed in Chapter 3. After negotiating the purchase price, Bob tells Sally that he needs to obtain a mortgage and that the application process will take about six weeks. He also tells her that while he is quite confident that he will obtain the mortgage, he does not want to be obligated to buy the house if he cannot obtain it. Sally agrees. To establish the mortgage as a contractual prerequisite to Bob’s obligation to buy the house, the purchase contract will use a condition. A condition is a state of facts that must exist before a party is obligated to perform.1 If that state of facts does not exist, the obligation to perform is not triggered. Uncertainty is a hallmark of a condition. For a state of facts to be a condition, those facts cannot be certain to occur. Thus, the passage of time cannot be a condition because it will occur.2 Conditions may appear in any type of agreement. They are not limited to acquisition agreements. A condition is not a condition to the making of a covenant. Instead, a condition is a state of facts that must exist before a party must perform the obligation that flows from a covenant. Although many lawyers refer to a condition as a condition precedent, the Restatement (Second) of Contracts has eliminated the use of that term.3 Previously, a condition was labeled either a condition precedent or a condition subsequent. While a condition precedent was defined as a state of facts that had to exist before there was an obligation to perform, a condition subsequent was a state of facts that took away a preexisting obligation.4 As a lawyer could draft most provisions as either a condition precedent or a condition subsequent, distinguishing between the conditions was problematic. The difference, however, remained important because the type of condition determined which party had the evidentiary burden of proving the condition. The 76 Restatement has recharacterized the condition subsequent as the discharge of an obligation.5 So now, conditions precedent are referred to simply as conditions.6 In the contract between Bob and Sally, the condition to the obligation and the obligation to perform might look something like the following: If the Buyer obtains a mortgage, then the Buyer shall buy [is obligated to buy] the House. Obtaining the mortgage triggers Bob’s obligation to purchase. The condition to an obligation and the obligation need not be in the same sentence. They can be in different sections of the contract. But for every condition to an obligation, the contract must include an obligation. They are a matched pair. To decide whether a condition is the appropriate contract concept, determine if a relationship exists between two events and whether one must precede the other temporally. Try to fit the fact pattern into an if/then formulation. If this happens, then and only then is a party obligated to perform. If you can do that, draft a condition. When creating an if/then statement, the then clause should state who has the obligation to perform. Correct Mortgage. If the Buyer obtains a mortgage, the Buyer shall [is obligated to] purchase the House on the Closing Date. Do not craft the sentence so that it states what happens if the condition is not satisfied. Wrong Mortgage. If the Buyer does not obtain a mortgage, the Buyer is not obligated to purchase the House on the Closing Date. This formulation states the common law consequences of the failure to satisfy a condition, not the condition to an obligation and the obligation to be performed if the condition is satisfied. When you find a condition drafted in the negative, restructure it so that the then clause states that a party has an obligation to perform. The revised formulation clarifies who has an obligation and under what circumstances it is triggered. It will also facilitate the proper drafting of the contract provision. Because a right is the flip side of a covenant,7 parties can provide for a condition to the exercise of a right. Here is the same business term drafted first as a condition to an obligation, along with the obligation, and then as a condition to a right, along with the right. 77 Version 1 Painting of Bedroom. If the Seller paints the bedroom, the Buyer shall pay an additional $1,000 in purchase price. Version 2 Painting of Bedroom. If the Seller paints the bedroom, the Seller is entitled to an increase in purchase price of $1,000. Whether the language in the first version or the second is used, the result remains the same: no additional payment unless the bedroom is painted. Better drafting is to state the condition to the obligation. If the provision containing the right were challenged, a brief would need an extra section to clarify the relationship between covenants and rights. (First, how an entitlement (a right) is the flip side of a covenant and, second, why the contract provision does not even mention the party who has the obligation to perform.) 4.2.2 ONGOING CONDITIONS AND WALK-AWAY CONDITIONS Conditions can be divided into two subcategories, walk-away conditions and ongoing conditions. A condition’s category depends on the type of obligation that must be performed if the condition is satisfied. This book uses the terms ongoing conditions and walk-away conditions as a pedagogical aid; they are not technical contract law terms. A walk-away condition is a condition that must be satisfied before a party is obligated to perform its subject matter performance obligation. An ongoing condition is a condition that must be satisfied before a party is obligated to perform an obligation that is not a subject matter performance obligation. As Sections 5.4 and 8.2 explain in more depth, the subject matter performance provisions, generally speaking, are the covenants in which the parties promise to perform the main subject matter of the contract. Therefore, for example, in an acquisition agreement, where the main subject matter of the contract is the purchase and sale of the business, the subject matter performance provisions are the parties’ reciprocal promises to buy and sell that business. Similarly, in a lease where the main subject matter of the contract is the rental of specific premises, the subject matter performance provisions are the landlord’s promise to lease the premises to the tenant and the tenant’s reciprocal promise to rent the premises from the landlord. Walk-away conditions benefit a party who wants them satisfied before that party is obligated to perform its subject matter performance obligation. They are most frequently seen in acquisition and financing agreements. In contrast, ongoing conditions can appear in any kind of contract. We will return once again to our house 78 purchase hypothetical for an example. Let’s assume that the $200,000 purchase price for the house takes into account water damage to the living room ceiling resulting from a leaky roof. Not unreasonably, Bob worries that the leaks could cause extensive damage during the period between the signing and the closing. Therefore, he offers Sally the following deal: He will pay 110 percent of the cost of repairs if Sally has the roof repaired no later than ten business days after the contract’s signing. Sally agrees. Here’s the condition and the obligation. Roof Repair. If the Seller repairs the roof to the Buyer’s reasonable satisfaction no later than ten business days after the date of this Agreement’s signing, the Buyer shall pay the Seller at Closing (a) the Purchase Price plus (b) an amount equal to 110% of the cost of the repairs, as evidenced by receipts. In contract terms, Sally’s timely repair of the roof is a condition to Bob’s obligation to pay 110% of the cost of repairs as additional purchase price. Bob’s obligation to pay this additional purchase price is separate from his obligation to buy the house—his subject matter performance obligation. Therefore, the failure to satisfy the condition as to roof repairs affects only Bob’s obligation to pay the additional purchase price, not any other provision, including Bob’s subject matter performance promise to buy the house. Because the remainder of the contract provisions continue and have ongoing relevance, this condition is dubbed an ongoing condition. In contrast, Bob’s securing a mortgage is a walk-away condition. If he does not secure it, the condition is not satisfied, and Bob is not obligated to perform his subject matter performance obligation—the purchase of the house. Now, here is the tricky part: At this juncture, although not obligated to perform, Bob may choose whether to perform. Deal lawyers call this choice a walk-away right. Here are Bob’s options: 1. Bob may choose not to perform, that is, choose not to buy the house. That nonperformance would not be a breach because Bob had no obligation to purchase the house. The obligation to perform was never triggered by the satisfaction of the condition. 2. Bob may choose to perform by buying the house despite the absence of an obligation to purchase it. Why would he do so? The purchase of the house may ultimately be more important to him than the satisfaction of the condition. If Bob does buy the house,8 as a technical legal matter, he waives the failure to satisfy the condition. The choice is not contractual.9 It is the common law consequence of a failed walk-away condition. Accordingly, many agreements do not explicitly state that a party may choose whether to perform in these circumstances. 79 Nonetheless, the agreement may explicitly provide additional consequences that flow from the existence of the choice not to perform.10 For example, the agreement could automatically terminate. Alternatively, the agreement could give one or both parties the discretionary authority to terminate immediately, thereby permitting immediate termination, but not requiring it. By not requiring termination, the agreement extends the deadline by which the walk-away condition may be satisfied.11 Often, the agreement terminates automatically if the condition is not satisfied by the new deadline. The following diagram depicts the relationship between the satisfaction of a walk-away condition and the obligation to perform, on the one hand, and the failure to satisfy the walk-away condition and the choice whether to walk or perform, on the other hand. The rectangle represents the condition to the obligation to perform the subject matter performance provision. If the condition is satisfied (the left side of the diagram), the party must perform the subject matter performance obligation (the circle). If the condition is not satisfied (the right side of the diagram), the party has a choice (the triangle) that is the common law consequence of the failure to satisfy the condition. In this event, the party may choose to perform (ending up at the circle), or it may walk away, not perform, and not be in breach—despite its nonperformance. Again, the nonperformance is not a breach because the obligation to perform was never triggered. 4.2.3 RELATIONSHIP BETWEEN CONDITIONS AND COVENANTS IN ACQUISITION AGREEMENTS AND FINANCINGS 80 Walk-away conditions and walk-away rights are sometimes related to a party’s performance of a covenant. This is particularly true in acquisitions and financings. We will use the house purchase as an example. Suppose the kitchen is a wreck, and Bob wants Sally to renovate it before the closing date. If Sally agrees to do the work, the parties can use both covenants and conditions to implement and memorialize their business deal. First, Sally can promise to renovate the kitchen before the closing date. Second, performance of that covenant can be a condition to Bob’s obligation to perform; that is, to buy the house. Obligation to Renovate the Kitchen. The Seller shall renovate the kitchen no later than the Closing Date. and Condition to Closing. It is a condition to the Buyer’s obligation to buy the House that the Seller must have performed her covenant to renovate the kitchen, as stated in Section X.12 Because the parties have used two provisions to implement their business deal, both provisions must be consulted to determine the consequences if Sally does not renovate the kitchen. Let’s assume that Sally never renovates the kitchen, thereby breaching her covenant. In that event, Bob has a cause of action for breach and may sue Sally for damages. But Bob has an additional remedy. The covenant breach means that the related condition was not satisfied. Therefore, on the closing date, Bob may choose whether to perform or walk away. No matter which of these actions he chooses, he retains his right to sue Sally for damages because she breached her covenant to renovate the kitchen. Two contract concepts were involved, so Bob has two sets of rights. Each contract concept exists independently of the other.13 Although satisfaction of a walk-away condition may rest on the performance of a covenant, it need not. A condition can be completely unrelated to any covenant. For example, Bob might quite reasonably insist that before closing he must have received a licensed engineer’s report stating that the house has no structural problems. It is a condition to the Buyer’s obligation to buy the House that the Buyer must have received a licensed engineer’s report stating the House has no structural damage. Securing the clean report would then be a walk-away condition, giving Bob a walkaway right if not satisfied. It would not, however, be based on Sally’s performance of a covenant. 4.2.4 RISK AVOCATION Parties use conditions in several ways to allocate risk. First, the agreement to include a condition is itself a risk allocation. By agreeing to a condition, the parties have agreed that the performing party has no duty to perform if the condition is not satisfied. Thus, the contract allocates the risk of the failure to satisfy the condition to the party who would have been entitled to performance. For example, if the parties have agreed that Bob is not obligated to purchase the house if he does not obtain a mortgage, Sally bears the risk that the condition 81 might not be satisfied. Second, parties allocate risk by choosing to frame a business issue as a condition rather than as a covenant. A classic example occurs in the insurance context where an insured must notify its insurer of a loss. Let’s assume that Bob purchases the house and that shortly afterward someone breaks in and steals his large- screen television. Bob reviews his homeowner’s insurance policy and discovers that the insurance company must receive notice of the loss no later than ten days after it occurs. Unfortunately, the notice Bob sends is received 12 days late. If the notice provision is a covenant, then Bob has breached the contract. In that event, the insurance company remains obligated to pay Bob for his loss, but it is entitled to damages, if any. For example, its damages might be the additional expense it incurs when it purchases the replacement television at full price, rather than at a sale that took place during the initial ten-day period. The result differs dramatically, however, if the provision is a condition. Then, if the notice is late, Bob fails to satisfy the condition to the insurance company’s obligation to perform. This failure means that the insurance company’s obligation to pay Bob is never triggered, and Bob forfeits his right to receive the insurance proceeds. Thus, the use of a condition places the risk of a late notice squarely on Bob, the homeowner. (Courts dislike forfeitures and regularly construe them as covenant provisions even though the language suggests that the provisions are conditions.14) Third, parties allocate risk by choosing the standard that establishes the state of facts that must exist before the obligation to perform arises. For example, assume that as a condition to Bob’s obligation to close, Sally’s lawyer must deliver an opinion addressing, among other things, environmental matters. That condition could be formulated in several ways. Here are three. (Note how even minor “drafting” revisions change the standard and shift risk.) Version 1 Opinion of Seller’s Counsel. The Seller’s lawyers must have delivered to the Buyer an opinion of counsel satisfactory to the Buyer. Version 2 Opinion of Seller’s Counsel. The Seller’s lawyers must have delivered to the Buyer an opinion of counsel reasonably satisfactory to the Buyer. Version 3 Opinion of Seller’s Counsel. The Seller’s lawyers must have delivered to the Buyer an opinion of counsel substantially in the form of Exhibit B. Version 1 is high risk for Sally as the standard of satisfactory to the Buyer seems to give Bob unfettered discretion in deciding whether the opinion is acceptable. Version 2 is somewhat less risky to Sally as it 82 constrains Bob’s determination. Here, the reasonable person standard of torts has been imported into the contract. The opinion must be reasonably satisfactory. Version 3 substantially reduces Sally’s risk as she and her lawyer will know what is required because they will have negotiated and agreed on the opinion that the lawyer must give. Fourth, parties allocate risk by deciding whose obligations are subject to the satisfaction of which conditions. For example, Bob may insist that before he is obligated to buy the house, he wants an appropriate test to conclude that the house’s water meets certain safety standards. To incorporate that requirement into the contract, the parties might use the following condition: Water Safety. It is a condition to the Buyer’s obligation to buy the House that the Buyer must have received test results that conclude that the House’s water is safe to use for all residential purposes. This condition would be a condition only to Bob’s obligation to close, not to Sally’s. The rationale is that the test is for Bob’s benefit only. It is part of his due diligence, part of his risk assessment. If the water is not satisfactory and he is willing to waive the failure of the condition, Sally should not be able to scuttle the deal by having a walk-away right. Although some conditions may be conditions for only one party, other conditions are conditions to both parties’ performance. A classic example in an acquisition agreement is receipt of specific governmental approvals. 4.3 DISCRETIONARY AUTHORITY Discretionary authority gives its holder a choice or permission to act.15 The holder may exercise that authority but is not required to do so. Once it does, the other party is bound by the holder’s decision. A person who has discretionary authority is sometimes said to have a privilege.16 The discretionary authority being discussed in this section is contractual discretionary authority. The parties have negotiated and agreed that one or both of them should have a choice under specific facts. It is not the same as the choice that a party has when there has been a failure to satisfy a condition to a subject matter performance obligation. That choice arises as a common law consequence of the unsatisfied condition, not through contractual agreement. As with the other contract concepts, a grant of discretionary authority allocates risk. It subjects the party without the discretion to the consequences of the actions of the party with the discretionary authority. The following provisions from Bob and Sally’s contract demonstrate how discretionary authority can be used: Example 1 Use of House. During the period between this Agreement’s signing and the Closing, the Seller may rent the House to one or more third parties. 83 Example 2 Notice. A party sending notice shall use one of the following methods of delivery, but may choose which method: registered mail, personal delivery, or overnight courier. In Example 1, Sally Seller has the absolute discretion to rent her house to anyone she chooses. In contrast, in Example 2, the parties have curtailed the exercise of discretion. There, the party giving notice may choose how to notify the other party, but it must be one of the previously agreed-on methods. The notifying party has discretion, but within limited parameters. A grant of discretionary authority often appears as an exception to a prohibition. The party exercising the discretion can be either the party prohibited from acting or the other party. Thus, the risk of how the discretionary authority is exercised depends on how a provision is drafted. In Versions 1 and 2 that follow, the house purchase agreement prohibits Bob from assigning his rights under the agreement but grants Sally the discretionary authority to consent to an assignment. Thus, these versions allocate to Bob the risk of how Sally will exercise her discretionary authority. In Version 1, Bob has the greater risk because the agreement imposes no constraints on how Sally may exercise her discretion. In contrast, in Version 2, the agreement limits Bob’s risk because it requires Sally to act reasonably.17 Version 3 differs from the other versions because now Bob has the discretionary authority. That authority is permission to assign, which Bob may exercise without constraint. It is an exception to the prohibition against assignment, and it allocates to Sally the risk of whether Bob will exercise his discretionary authority. Version 1 The Buyer shall not assign any of his rights under this Agreement without the Seller’s prior written consent. Version 2 The Buyer shall not assign any of his rights under this Agreement without the Seller’s prior written consent, which consent the Seller shall not unreasonably withhold. Version 3 The Buyer shall not assign any of his rights under this Agreement, except that he may assign his rights to his wife, Lara Raskin. The exercise of discretionary authority is often subject to a state of facts having first occurred. Here, the “condition” is a condition to discretionary authority. A condition to discretionary authority is a state of facts that must exist before a party may exercise its discretionary authority. 84 As with conditions to obligations, an if/then temporal sequence is a hallmark of conditions to discretionary authority. A classic example of the interplay between a condition and discretionary authority occurs in a loan agreement. Assume that to finance his purchase of the house, Bob takes out a loan and mortgages the house. In one of the later sections of the bank’s loan agreement, that agreement lists the events that constitute an Event of Default. It then provides what happens if one of those events occurs. Remedies. If an Event of Default occurs and is continuing, then the Bank may accelerate the Loan, foreclose on its security [Bob’s house]. … Here, the Bank has no authority to accelerate the Loan and to foreclose unless an Event of Default has occurred and is continuing.18 Once this state of facts exists, the Bank must decide whether it wishes to exercise its remedies. It need not; it has discretion. Alternatively, it could sue on the note, waive the default, or grant Bob extra time to comply with the loan covenant. A condition to discretionary authority allocates risk. Without the condition, the Bank could exercise its remedies at any time. Bob, of course, would find this unacceptable. By subjecting the exercise of remedies to the occu