The Oxford dictionary defines “Contingency” as “ . . . a future event or circumstance which is possible but cannot be predicted with certainty.”
Contingency provisions in contracts are clauses which allow a party to terminate the agreement in the event of the occurrence or non-occurrence of a specified (i.e., uncertain) event. Sometimes referred to as “outs”, contingencies give a party the right to terminate an agreement and walk away from a transaction, usually without liability, if the contingency is triggered.
For example, it's typical for a purchase agreement to include a financing contingency. This means that the transaction is contingent upon the buyer obtaining the necessary financing for the acquisition. If the buyer does not obtain the financing, then the buyer would have the right, pursuant to the contingency, to terminate the agreement.
Pro Tip: Contingency provisions are important aspects of a contract. This is so because a contingency can ultimately dictate whether the transaction proceeds to closing or terminates. Simply stated, if a contingency is triggered, the transaction is subject to termination (or other specified result) pursuant to its terms.
Its critical that contingencies are negotiated and drafted carefully. Its always wise to work with a qualified business attorney in negotiating and drafting your contracts. Contact Prime Legal Freelance for assistance with your commercial contracts. The initial consultation is FREE.
6 Tips For Using Contingency Provisions In Contracts
Below are six tips for parties to consider when contemplating use of contingencies.
1. What Types Of Contracts Use Contingencies?
Contingencies can be used in virtually any type of contract. Contingency provisions are often negotiated into M&A agreements (including asset purchase agreements, stock purchase agreements and merger agreements), real estate purchase agreements, leases, equipment agreements, investment agreements, management contracts, services agreements, manufacturing agreements, and many others.
Pro Tip: Seller's Perspective. Contingencies make a buyer's bid less favorable, in that an agreement which contains a contingency in buyer's favor is less certain (sometimes significantly less certain) to close than an agreement free of contingencies. However, in some cases, entering into an agreement albeit with contingencies is better for the seller than not entering into the agreement at all. A savvy seller will generally want any contingencies to be as narrowly tailored as possible, so that the contingency can not be used by the buyer to drag out the closing or as a guise to terminate the agreement for unrelated reasons.
Pro Tip: Buyer's Buyer's Perspective. If there are significant uncertainties surrounding a transaction, a buyer should think twice before executing the contract - unless relevant carefully crafted contingencies are included. Using contingencies is a great way for a buyer to "lock up" a deal, yet still have the flexibility to terminate if needed if the uncertainties are not resolved to the buyer's needs.
2. What Types Of Contingency Clauses Can Be Used In A Contract? How Many Contingencies Can Be Used?
There is generally no limit to the types or quantities of contingencies that can appear in a contract. It simply depends on the facts and circumstances surrounding the proposed transaction and the negotiation among the parties.
That said, its not uncommon for one or more of the following contingencies to be included in a commercial contract:
- Receipt of necessary financing for the acquisition (financing contingency)
- Receipt of Board of Director approval of the transaction (Board contingency)
- Receipt of shareholder approval of the transaction (shareholder contingency)
- Approval of due diligence in buyer's discretion (due diligence contingency)
- Receipt of governmental approvals necessary for the closing of the transaction (regulatory contingency)
- Receipt by buyer of the licenses or permits needed to operate the business (operational contingency)
- Receipt of consents or approvals to the transaction needed from third parties (consent contingency)
- Receipt of necessary rezoning of a parcel of real property (zoning contingency)
3. LOI Considerations Regarding Contingencies
When negotiating the letter of intent (LOI) for the transaction, the parties should consider whether contingencies may ultimately be needed in the definitive agreement. If a contingency will be needed, then it might make sense to address it in the LOI.
For instance, if a party knows that receipt of a particular third party consent will be needed to close the deal, then it might be appropriate for the LOI to reference that the definitive agreement will include a third party consent contingency. Doing so would eliminate the potential for surprise or disagreement on the topic later. Referencing any required contingencies in the LOI generally leads to a smoother and quicker negotiation of the definitive agreement, and can ultimately lead to a smoother closing.
4. Why Have Contingencies In A Contract?
Including a contingency in a contract allows the parties to enter the agreement knowing that one party will have the right to terminate the agreement before closing if the specified event (i.e, the contingency) is triggered. Including a contingency can be very beneficial to the parties, because without it, one or both of the parties might otherwise be unwilling to enter into the agreement.
Example: Consider a prospective real estate buyer who is uncertain whether she will be able to rezone the subject parcel for her intended use. Without a rezoning contingency in the contract, the buyer would have two choices: (1) not enter the purchase agreement until the rezoning has occurred. This is risky, because if she is not under contract then the property might remain on the market and be at risk for being sold to someone else; or (2) enter the agreement despite the lack of correct zoning designation. This too would be risky, because if the correct zoning designation is not ultimately secured and the buyer is therefore forced to terminate the contract, she could be deemed in breech of the contract.
Thus, the third option--including a zoning contingency in the contract--would be highly beneficial in this scenario. Correctly worded and implemented, a zoning contingency would allow the buyer to enter the real estate purchase agreement (thus avoiding the risk of the property remaining on the market), while giving her the right to terminate the agreement without liability if the rezoning efforts were unsuccessful.
5. Examples of Contract Contingencies
Contingencies in contracts must be carefully written, in order to accomplish the intentions of the parties. A contingency clause which is too broad could have unanticipated consequences, in that it might allow a party to walk away from an agreement without liability for reasons beyond those which were intended. A contingency which is too narrow, on the other hand, could effectively force the parties to close on a deal which should not otherwise close, or subject a party to liability for not closing.
Example of Broadly-Worded Zoning Contingency (Favorable to Buyer). In the zoning example above, a broad buyer-friendly contingency would simply state that buyer's obligation to close the acquisition is contingent upon the buyer's receipt of the necessary rezoning as determined by buyer. In this example, aside from the implied covenant of good faith and fair dealing, there are essentially no parameters surrounding the extent of the buyer's efforts required to secure the needed rezoning and proceed to closing. As a result, the seller may very well have no legal grounds to complain about the buyers rezoning efforts - or the lack thereof.
Example of Narrowly-Worded Zoning Contingency (Favorable to Seller). A narrowly tailored seller-friendly contingency, on the other hand, could include any or all of the following requirements, milestones and parameters: (i) the specific dates by which the buyer must submit her rezoning applications; (ii) a clear description of the level of effort and steps that the buyer must take to effect the rezoning; (iii) identification of the particular rezoning designation needed; (iv) obligations to keep seller apprised of the rezoning status; and (v) a deadline by which the buyer must terminate the agreement.
By adding requirements, milestones and parameters, the buyer's obligations are much more specifically defined, and the contingency is therefore much less susceptible of abuse. In the seller-favorable example above, the buyer is on a short leash and must be able to demonstrate progress and milestones. If the buyer fails to take the required steps, the seller is more likely to have grounds to challenge the buyer from a legal standpoint, and the transaction overall may have a higher likelihood of closing.
6. Focus On The Details
As is always the case with contracts, the devil is in the details. The mere existence of a contingency may or may not be sufficient to meet the needs of the parties. Careful negotiation and meticulous drafting is crucial to ensure that the contingency provision meets the needs and expectations of the parties.
A qualified business or real estate attorney can assist in negotiating, understanding and drafting contingency provisions, and in guiding a party on effectively carrying out its obligations under the agreement.
Contact the Law Office of Jennifer M. Settles today for assistance with your contracts. We can be reached at 602-617-3938, or on the Contact Form on our website, www.jsettleslaw.com
Jennifer M. Settles, Esq. is a corporate lawyer at the Law Office of Jennifer M. Settles. She advises clients on M&A transactions, commercial contracts, real estate matters, financing transactions and corporate law. To schedule a free consultation, please call 602-617-3938, or email us through our Contact Form.
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