unit 1: overview of general contract principles - software... · overview of general contract...

© Central Law Training 2009 CLT/PLD0577A

1

UNIT 1:

Overview of General Contract Principles

Table of ContentsPage No.


2

Unit 1: Overview of General Contract Law Principles 3 Learning Objectives 3 1. Introduction 3 2. Contract Law Principles 4 3. Term Sheets 29 4. Pre-Contractual Liability 34 5. Frustration and Force Majeure 38 6. Breach of Contract 39 7. Limitation of Liability 42 8. Indemnities 58 9. Confidentiality 62

BTEC Paralegal Programme - Software and Unit 1 - Overview of General Technology Services Contracts Contract Law Principles


3

Unit 1Overview of General Contract Law Principles

Learning Outcomes

Learning Outcomes Assessment criteriaTo achieve this unit a learner must demonstrate the ability to:

1. Explore the contracting process

P1: Explain the elements of a contractP2: Understand the differences

between an offer and an invitation to treat

P3: Understand the postal acceptance rule

2. Analyse the concepts related to liability

P4: Explain what the term sheet is and identify the key provisions that should be included

P5: Understand the relationship between limitations of liability and the relevant legislative framework for ensuring reasonableness

P6: Redrafting a liability provision to ensure that indirect losses have been excluded appropriately and to ensure that direct losses have not been inadvertently excluded

P7: Understand the categories of loss which should not be capped or excluded

P8: Understand the importance of liquidated damages in certain circumstances

3. Demonstrate understanding of indemnities and the law of confidentiality

P9: Review a standard IP indemnity clause and redraft to protect a customer’s interests

P10: Understand the key provisions to be included in a confidentiality agreement

1. Introduction

There is little doubt that information technology agreements will come across your desk. Whether you deal with them on a daily basis or only occasionally, you need to know what to look for in order to anticipate possible troubles, cover key points and adequately protect your business. With the fast pace of evolving technology, IT contracting issues are constantly evolving too, you can’t afford to be left behind.



4

This programme aims to present the key inside secrets and information you need to effectively negotiate, draft and manage contracts for the most common types of Software and Technology Services Contracts, including software licensing, IT support, software development, systems integration and outsourcing.

Prior to looking at the specific software and technology contracts it is useful to have general understanding of contract law and related principles. Unit 1 is designed to give a brief “overview” of the contracting process and explain important concepts such as liability, indemnities and confidentiality.

This unit is intended to provide the “building blocks” for the remainder of the programme.

2. Contract Law Principles

2.1 Importance of contracts

Contracts are part of almost every business transaction, whether purchasing a box of diskettes or arranging for a services relationship which will last for years. The nature of a contract, and what is included in a contract (and what is not) is often poorly understood, even by sophisticated business people.

It is quite common to hear a business person say “we can do this deal without a contract”. What they almost certainly mean is that they feel that a formal, written contract is not necessary. There is often a misunderstanding that if there is simply a “deal” there are no legal issues involved, and hence no need for the expense of a lawyer. Whereas, if there is to be a formal written contract, then a lawyer has to be consulted.

Contrary to this view, even a “deal” can be a contract if it satisfies certain criteria, no matter what name the parties may give to their understanding. An “Agreement” or a “Licence” is a contract, but so too can be an accepted Purchase Order and a request to provide something over the telephone which has been agreed to. The problem with not seeking legal advice when negotiating and finalising contractual arrangements is that the commercial and business people “doing the deal” will have difficulty answering the following:

(a) do you actually know if there are legal obligations; and

(b) if so, do you know what those legal obligations are?

Contracts can take many different forms. The legal definition of a contract is probably very different from what a non-lawyer



5

would expect. A contract drawn up by a lawyer is most likely to:

(a) state who the parties are;

(b) have execution clauses where the representatives of each party sign; and

(c) be headed ‘Contract’, ‘Agreement’ or something similar.

All of the above will make it easily recognisable. Some less easily recognisable forms of contract might be an oral agreement, a contract constituted by an exchange of letters’, or even a combination of both. These informal types of contract are almost invariably indistinguishable in law from the formal documents created by lawyers, and every bit as binding.

There are as many different types of contract as there are different forms of human endeavour. Two transactions which have a similar result can actually be quite different depending upon the contracts which cover the different transactions. A supply of software, for instance, can be either by way of a sale or licence. However, in both cases the user ends up with a copy of the program to use on his or her computer.

Because of this, it is very important to understand the borderline between discussions, negotiations, the “selling” phase, all other preliminaries, and the binding contract. Even when the parties clearly understand the borderline between the preliminaries and committing to the contract, the parties must be clear about what is agreed so that their transaction does not end in dispute, regardless of whether a dispute ends in Court proceedings, as disputes are not a recommendation for future business.

The reason that lawyers, and others, are called upon to draw up formal agreements is to ensure that the terms of an agreement are certain, or as certain as may be possible in any transaction.

A contract should provide a framework for an entire transaction, to cover as many circumstances which may arise as possible. No contract can hope to cover all contingencies, but disputes can be largely avoided through well drafted contracts which at least provide for resolution of issues, even if they cannot foresee what those issues might be.



6

2.2 What is a contract?

A contract cannot be characterised by any one single form. A contract can be wholly oral or hundreds of pages long, detailing all conceivable contingencies. Contracts can also be in a mixture of forms, perhaps constituted by a series of letters together with some oral terms or a series of documents linked together by a “master agreement”.

The test of whether or not there is a contract between two or more parties depends upon the actions of the parties (including what they say and what they write). It does not necessarily depend on whether each party thinks that their dealings constitute a contract, provided the essential elements are present. Although it is always possible for the parties to expressly agree that their arrangement does not constitute a binding contract, perhaps pending a formal document being created. In the absence of any agreement that the arrangement is not binding and the following elements are present, there will be a binding contract:

(a) one party to the contract makes an offer;

(b) the other party to the contract accepts that offer;

(c) promises contained in the contract must be made for valuable consideration;

(d) the terms of the contract must be certain; and

(e) the parties must intend to create legal relations when they enter into the contract.

It should be noted that an online contract is just like any other contract. It has the same requirements for offer, acceptance, consideration, certainty of terms, and intention to be bound by the terms of the contract.

2.3 Form of the contract

In general, a contract does not have to be in writing. It can be formed orally or by the conduct of the parties. The Government proposed to make it clear that the fact that a contract is concluded over the Internet rather than on paper or in person does not affect its validity through the introduction of the Electronic Communications Act 2000 (ECA). The ECA is designed to reduce uncertainty surrounding electronic communications, and make it easier to use electronic technology to meet certain legal requirements.

Let us now examine each of the elements required for a contract to be formed.



7

2.4 Offer

An offer is a statement made by a person wishing to enter into a contract, by which he or she shows a willingness to enter into a binding contract. The person making an offer is known as the “offeror” and the person to whom the offer is addressed is known as the “offeree”.In order to be effective, an offer must be communicated to the intended offeree. Such communication may be to a specific individual or organisation, to a class of offerees or even to the world at large. See Carlill v Carbolic Smoke Ball Co [1891-94] All ER Rep 127.

Discussion Point – Carlill v Carbolic Smoke Ball Co [1893] 1 QB 256

The Carbolic Smoke Ball Co advertised that it would pay £100 to anybody who caught influenza after using its infallible preventative against that disease – a “smoke ball” – in the specified manner; the advertisement stated that the company had deposited £1,000 with its bankers as a show of faith.

Ms Carlill contracted influenza after using one of the smoke balls and sued for the £100 when Carbolic Smoke Ball Co refused to pay. She said that there was a contract constituted by the offer of £100 on the conditions laid out in the advertisement, provided she used the smoke ball.

In its efforts to avoid payment, amongst other things, the company said the advertising was merely exaggerated advertising, a “mere-puff” which no-one could seriously take as an offer in a contractual sense, and further, that since the “offer” was made to no particular person, but to the world at large, then it could not result in a contract between the company and any individual.

The Court held that there was a contract. By buying the smoke ball Ms Carlill accepted the offer made, even though it had been made at large. In addition, the advertising was clear and unequivocal, more than a “mere-puff”, it was an offer to be acted upon. Ms Carlill had fulfilled her side of the contract and used the smoke ball in the specified manner, and now the company had to perform its side of the contract It is clear from this example that the notion of contract can be far distant from that of a bargain struck in the marketplace between two traders, face to face.



8

2.5 Invitation to treat

The concept of an offer needs to be contrasted with what is known as an “invitation to treat”. An invitation to treat arises when a person invites others to make offers to him. This is best explained by means of an example. When a person goes into a supermarket, the goods on the shelves constitute an invitation to treat. This was decided in the case of Pharmaceutical Society of Great Britain v Boots Cash Chemists [1953] 1 All ER 482. The supermarket owner is inviting its customers to take the goods to the checkout and to make an offer to the supermarket owner to buy them. It is important to note that a binding contract is only made at the point at which the supermarket agrees to sell the goods to the customer. In this way, the supermarket owner is not making an offer to sell goods at a particular price (whilst the supermarket owner can refuse to sell the goods to a customer at the price indicated on them, it cannot sell them to the customer at a different price) nor to someone who is prohibited by law from purchasing those goods (for example, offering to sell alcohol to minors).

Further, the Courts have decided that goods displayed in a shop window also amount to an invitation to treat. See Fisher v Bell [1961] 1 QB 394 in which the Courts held that the display of a flick knife in a shop window was not an offer to sell the knife but only an invitation to treat. Accordingly no offence was committed by the shopkeeper.

It is important to contrast an invitation to treat with a “unilateral offer” which is an offer made by a person which is capable of acceptance by anybody complying with the requirements set out in the offer (for example, a person handing over a lost item in return for a reward). In order for there to be a unilateral offer, it must be clear that the person making the offer intended it to be capable of acceptance and to be bound by the consequences of that acceptance.The above distinction between an offer and an invitation to treat is particularly important in the online world. Most, if not all, commercial websites will be treated in the same way as a shop window. The goods or services marketed on them will amount to an invitation to treat. The importance from an ecommerce point of view can best be illustrated by means of an example:

In 1999 Argos ran into difficulties in relation to Sony television sets it was selling from its website. The televisions were being sold for £299.99. However, the price was rounded up on the site, but for some reason the decimal point was put in the wrong place giving a price of £3.00 as opposed to £300.00.



9

Not surprisingly, Argos was inundated with orders for the televisions.

Argos argued that its website amounted to the invitation to treat and as such it was up to Argos to decide whether to accept the offers made by potential customers. Argos declined to accept the offers. The wording of the acknowledgements sent out by the Argos website in response to the orders was crucial. The acknowledgement did not amount to an acceptance of the offers contained within the orders. Whilst the matter did not go to Court, it seems unlikely that Argos had entered into any legally binding agreements to sell television sets at £3.00.

However, this will not always be the case. If an order constitutes an offer, it is essential that any automated response makes it clear that it is only a holding reply and that acceptance will not take place until the goods or notification of acceptance have been sent to the customer.

Therefore, if a business is offering goods or services online, it is best practice for the business to ensure its advertisements constitute an invitation to treat (as distinct from an offer), because:

(a) the business may not be able to fill every order (but may specify “limited stocks” or “first 10 only”” if applicable);

(b) the business could make a mistake (for example, about the price);

(c) the business may need to control to whom it sells (for example, alcohol or cigarettes cannot be sold to anyone aged under 18); and

(d) some countries restrict what goods and services customers can purchase (for example, Nazi memorabilia cannot be sold in France or Germany).

The offeror may revoke his or her offer provided that he does so before his or her offer is accepted and he communicates the revocation to the offeree. Where a person has started to fulfil the acceptance requirements under a unilateral offer, the offeror cannot revoke the offer in relation to that person. An offeror may provide that the offer will expire after a fixed period and in any event an offer will no longer be capable of acceptance after a reasonable period has expired. An offer will come to an end once it has been accepted.



10

Task 1Access the “Conditions of Use and Sale” from the website of Amazon.co.uk. Identify and print out the clause in Amazon’s contract which states that its advertisements are an “invitation to treat” as opposed to an offer.

2.6 Acceptance

Acceptance is the final and unqualified expression of assent by the offeree to the terms of the offer. In general:

(a) acceptance of an offer must be communicated to the offeror before a contract comes into existence; and

(b) a binding contract is formed at the time the offeror receives the acceptance.

Terms and conditions placed on acceptance

An offeror can state that acceptance has to be made within a certain time or in a particular manner. If these terms are not complied with, the acceptance is invalid. If an offeror does not state how an acceptance must be communicated, the offeree can use any communication method that is appropriate in the circumstances.

Communication of acceptance

Acceptance needs to be communicated to the offeror. There needs to be “an external manifestation of assent”. In other words, a word or action by the offeree that the law can regard as communication of the acceptance. Acceptance is usually communicated in writing or orally, but acceptance can be communicated by conduct.

Acceptance by conduct

An offer can be accepted by conduct if an action must be performed for the offer to be accepted and the offeree then performs that action. For example, an offer of a reward for a lost item is accepted (and the contract completed) if the offeree returns the lost item. In some contracts for the sale and licensing of computer software, the licence terms are accepted if the offeree removes the shrink-wrap plastic that surrounds the software.

Silence is not a communication of acceptance

An offeror cannot form a contract by specifying, for example, “If I don’t hear from you, I’ll assume you accept my offer”. The law does not recognise silence by an offeree as tacit communication of acceptance.



11

In one case (Felthouse v Bindley (1862) 11 CBNS 869; 142 ER 1037) a man offered to buy his nephew’s horse for £30 15s. In his letter, he stated, “If I hear no more about it, I consider the horse mine at that price”. The nephew did not reply to the letter.

Later, the nephew sold some of his stock by auction. The horse was sold inadvertently. The uncle tried to claim that the horse was his. However, the Court held that the nephew’s silence was not an acceptance of the uncle’s offer to buy the horse.

If silence could amount to tacit acceptance, offerees would find themselves bound by numerous contracts, because they failed to communicate their non-acceptance. Some companies send books or other goods to customers, stating that if they do not hear from the customer, they will assume the customer accepts the offer of the goods. If the customer does not respond, technically, there is no contract and so the customer is not obliged to return the goods or pay for them. (The company which sent the goods to the customer is relying on the customer not having knowledge of contract law).

Waiving the requirement for communication of acceptance

An offeror may waive the requirement for communication of acceptance. In effect, an offeror can say, “You can accept my offer if you want to, and if you do accept, you don’t have to tell me”. (This was in effect the situation in Carlill v Carbolic Smoke Ball Co [1892] 2 QB 484; [1893] 1 QB 256 (CA)).

Waiving the requirement for communication differs from saying silence is not acceptance. If the communication requirement has been waived, the offeree can enforce the contract against the offeror if the offer has been accepted. In contract, if the offeror states, “silence is consent” and receives no reply from the offeree, the offeror cannot enforce the contract that it had attempted to make.“Shrink wrap” licenses are an example of the offeror waiving the requirement for communication of acceptance (see under the heading “Shrink-wrap licenses”)

Postal acceptance

Acceptances sent through the post are treated differently from other communications of acceptance. Where an offer is made and accepted by letters sent through the post, the contract is formed the moment the letter accepting the offer is posted, even if it never reaches its destination (see Byrne v an Tienhoven (1880) 5 CPD 344, 348). This is the “postal acceptance rule”.



12

However, when dealing with instantaneous forms of communication such as telex (see Brinkibon Ltd v Stahag Stahl und Stahlwarenhandelsgesellschaft mbH [1983] 2 AC 34 (HL)) and fax (see Reese Bros Plastics Ltd v Hamon-Sobelco Aust Pty Ltd [1988] 5 BPR 11, 106), the Courts have held that an acceptance must be communicated to the offeror.

It is usual for commercial contracts to include specific clauses in relation to the giving and acceptance of notices under the contract as the rules in respect of postal acceptance and instantaneous communication will apply to all such notices between the parties. The contractual provisions will override both those rules. It is particularly important to include such provisions if the parties intend to communicate electronically as there are as yet no established rules for the time of dispatch and receipt of emails.

Acceptance online

The law is still developing around the issue of acceptance in the online environment. Some Courts have held that an online contract is formed when the offeree shows his or her acceptance in some way, for example by clicking an “I accept”. This type of contract is often referred to as a “click-wrap” contract

Counter-offer

Sometimes a party may purport to accept an offer, but in doing so may add additional terms, or remove terms, or alter the price. An acceptance that tries to change the terms of the original offer is not an acceptance, but a counter-offer. This often happens with agreements to sell land: the vendor prepares a contract for sale and purchase of a property and includes the price for which the vendor wants to sell the property. If the potential purchaser changes the price, to the price they hope to pay, this amounts to a counter-offer by the purchaser to the vendor (who may respond by accepting or rejecting the counter-offer, or making a counter-offer to the purchaser).

A counter-offer extinguishes the original offer. If the potential purchaser changes the price, the vendor can refuse to sell. The vendor is not obliged to then accept the amount for which the vendor originally offered to sell the property.

Revocation

If a person makes an offer to another but later changes his or her mind, they can revoke that offer. If an offer has been revoked, the offeree can no longer accept the offer and form



13

a contract with the offeror. Naturally, an offer may not be revoked if it has already been accepted.

A revocation must be communicated to the offeree; it is not enough for the offeror to just have a change of mind. In Byrne v Van Tienhoven (1880) 5CPD 344, Van Tienhoven (who was in Cardiff) posted a letter to Byrne (who was in New York), offering to sell 1,000 boxes of tinplates. The offer was sent on 1 October.

On the 8 October Van Tienhoven sent a letter revoking the offer. Byrne accepted the offer on 11 October by telegraphing Van Tienhoven and followed the telegraph with a letter on 15 October. On 20 October, Byrne received Van Tienhoven’s letter of revocation. The Court found that the acceptance of the offer was valid, because the revocation had not been communicated to Byrne before the offer was accepted.

2.7 Consideration

In order for there to be a binding agreement, there must be a consideration passing from each of the parties. Consideration has been defined by the Courts as “some right, interest, profit or benefit accruing to one party, or some forbearance, detriment, loss or responsibility given, suffered or undertaken by the other” (see Currie v Misa (1875) L.R. 10 Exch.153).

In a contract for the sale of goods, it is relatively straight forward. One party provides the goods and the other makes a payment for them. However, contract law does not regulate whether the parties have made a good bargain. In other words, the consideration given by each party need not be of equal value.

However, it must be sufficient in that it must be real and of some value. It does not matter if the value is negligible. Although, it should be noted that any value may impact on the level of damages which can be claimed in the event of breach of contract.

An important point to note is that consideration must not be past. The consideration to be provided by each party must be something which they will give, do or forgo in the future. For example, if a person makes a donation to a charity on Monday, then that payment cannot be used as consideration for a contract entered into on the Wednesday with the charity for the supply of goods or services. However, if a person undertakes on Monday to make a donation in consideration of the charity performing some service on Wednesday, then a binding contract may be made.



14

If a person is under an existing obligation to make a payment, that payment cannot be used as consideration for a further contract. This raises interesting issues in relation to the release of debts. If a person to whom money is owed agrees to accept the payment of a lesser sum from the debtor in full satisfaction of the loan, then in the absence of any other consideration, there is no binding agreement and the remainder of the debt can be recovered at a later date.

This rule seems harsh on the face of it and does not make commercial sense. However, there are ways around this issue. For example, the part payment of the debt on a date earlier than it would otherwise be due is good consideration (see the rule in Pinnel’s case (1602) 5 Co rep 117a, Moore KB 677). The parties can enter into a deed of release of the debt. A deed is an agreement which is in writing, signed by the parties in the presence of witnesses and is delivered. The document must be clearly identifiable as a deed on the face of it. If the formalities are met, then a binding agreement will have been entered into as there is no need for there to be any consideration.

The equitable doctrine of promissory estoppel is also relevant. Where one party to a contract makes a promise not to enforce its rights under a contract and the other party relies on that promise to its detriment, then it would be inequitable for the first party to subsequently renege on its promise and seek to enforce its rights. The promise not to enforce must have been clear and unambiguous. Further, the doctrine works as a defence only and cannot be used to found an action to enforce a right under a contract or to cure a lack of consideration.

2.8 Certainty of terms

Even if parties intend to be bound contractually, their intention can be defeated by vague or uncertain provisions. This problem can be so serious as to make an entire contract void for “uncertainty”, not just a particular obligation, if it concerns something fundamental. Again, this decision must be made by the Court on the facts existing as at the date of entry into the contract.

This issue places many contracts where the absence of agreed specifications or statement of work is a common occurrence in a most difficult position. How can the Court determine what the enforceable obligations of the parties at the date of the contract are, when the parties have not agreed themselves?

An “agreement to agree” is one example of a contract in which the obligation is too vague, or alternatively so devoid of substance, that the obligation cannot be regarded as binding.



15

An obligation to negotiate, or do anything else (such as to review a document) “in good faith” is also uncertain of being enforceable.

Discussion Point – Coal Cliff Collieries Pty Ltd v Sijehama Pty Ltd (1991) 24 NSWLR1

The parties entered into negotiations for a joint venture and agreed upon a “heads of agreement” which provided for the creation and execution of a full joint venture agreement as follows:

“This document will serve to record the terms and conditions subject to and upon which Coal Cliff Collieries Pty Ltd, Sijehama and Bulli Main [another party] agree to associate themselves in an unincorporated joint Venture.

The parties shall forthwith proceed in good faith to consult together upon the formulation of a more comprehensive and detailed joint venture agreement (and any associated Agreements) which when approved and executed will take the place of these heads of agreement, but the action of the parties in so consulting and in negotiating on fresh and additional terms shall not in the meantime in any way prejudice the full and binding effect of what is now agreed.”

After numerous drafts of joint venture documents were discussed and rejected, over a period of 4 years, Coal Cliff Collieries withdrew from the process altogether. Was Coal Cliff in breach of a binding contract to negotiate? If so, how long did it have to continue with such negotiations? The Court at first instances determined that Coal Cliff Collieries was at fault, and awarded $1.2 million in damages representing the cost of the whole process of negotiation (it could not award damages for the expected profit from the contract under negotiation because no contract was agreed). The Court of Appeal found the “agreement” no agreement at all, and allowed the appeal.

On the other hand, the Courts will always do their best to give meaning to what is obviously intended to be a binding contract, if that is possible. It is always desirable, therefore to at least establish a procedure which is likely to lead to a certain result.

When is the intention of the parties important, if it is not reflected in the words?

From the above, it will also be clear that the interpretation of the meaning of a contract must be made based upon the circumstances when it was made. Technically speaking, one cannot look at what happened after the moment the contract



16

was entered in order to aid in its interpretation, as tempting as that may be when the terms of the contract are not clear.

In this regard, it should be noted that the conduct of the parties after entering into the contract cannot be relevant to explain, let alone add to, the terms of the contract. In GEC Marconi Systems Pty Limited v BHP Information Technology Pty Limited [2003] FCA 50 (Finn J), a case concerning the development of an IT system over a long period which involved constant changes to a specification, Finn J drew attention to the difficulty that this can cause in the case of a large scale procurement contract.

It is almost inevitable in these sorts of contracts that the requirements of the customer and other aspects of the relationship of the parties will change during the course of the contract. Finn J suggested that perhaps a Court should be able to look at the conduct of the parties after the commencement of the contract when interpreting what the parties intended.

Most importantly, it is not the role of a Court to help one party or the other achieve its objectives with the contract. The role of the Court is to interpret what is there. First and foremost, a Court will hold the parties to the bargain expressed in the clear words of the contract.

However, if faced with an ambiguous, unclear or apparently incomplete contract, a Court may take into account a finding of what both parties intended, if it can be satisfied of what that is, either:

(a) for the purposes of interpretation of the express terms; or(b) for the purposes of a finding of an implied term of the

contract, which we will consider further below.

For reasons made clear below, never rely on a Court to fix up an inadequacy in your contract.

Task 2Assume in August 2008 that your company has agreed a three year supply contract with Stationary Plus. Stationary Plus must supply your company’s branded stationary for the next 3 years with the price to be agreed two months before the start of each financial year (1st of April). It is October 2008 when your company’s office manager rings you (his legal adviser) in a panic because the existing branded stationary is running very low (business has been extremely good). He wants reassurance that he has a valid contract for the supply of new stationary. How would you respond?



17

What if there has been a “mistake”?

Sometimes, a party says that something was agreed, but due to a “mistake” it was omitted from the contract.

There are a couple of things wrong with this proposition, from a legal point of view.

First, the effect of the legal doctrine concerning mistake is that there was, and is, no contract at all. This does not always help the customer (the doctrine of frustration has the same effect), as the customer may then be liable for all work done on a time and materials basis.

Secondly, the doctrine of mistake requires that the alleged mistake goes to the “very root” of the contract – the whole reason the contract was entered – and must be shared by both parties entering into it.

Discussion Point – Great Peace Shipping Limited v Tsavliris (International) Limited [2002] EWCA Civ No. 1407 (14 October 2002)

Cape Providence was a ship which suffered severe structural damage in the South Indian Ocean. Tsavliris was engaged to offer salvage services. It would take nearly a week for its tug to reach the ship, and in the meantime there was a serious risk of the Cape Providence’s sinking with all hands. Tsavliris therefore looked for a merchant vessel nearby which could help, if necessary, with the crew’s evacuation. It was told by Ocean Routes (a weather forecasting service which also receives reports of ships’ locations) that Great Peace was the nearest boat. Armed with that information, Tsavliris and Great Peace’s managers contracted for it to provide evacuation services with a right to cancel. This however required payment of a cancellation fee equal to five days’ hire.

Once the contract was made, the parties then discovered that Great Peace was not the closest ship to Cape Providence. Instead of being 35 miles away, it was actually 410 miles away. Tsavliris contracted with a ship which passed the Cape Providence. Great Peace’s managers sought the cash under the contract. Tsavliris argued there was a common mistaken assumption of fact which rendered the service that would be provided if the contract were performed in accordance with its terms something different from performance that the parties contemplated.

The Court of Appeal decided that, while both parties did not know the precise location of the Great Peace in relation to Cape Providence, the Great peace could still have arrived in time to perform the contract. In other words, the common mistake did not



18

go to the very basis of the contract at all, which was to get a ship to do the rescue.

The Court of Appeal considered this finding was supported by the fact that contract was not cancelled when the mistake was discovered, but only when a closer ship was located. Tsavliris was ordered to pay the cancellation fee.

1. there must be a common assumption as to the existence of a state of affairs;

2. there must be no warranty by either party that that state of affairs exists;

3. the non-existence of the state of affairs must not be attributable to the fault of either party;

4. the non-existence of the state of affairs must render performance of the contract impossible;

5. the state of affairs may be the existence, or a vital attribute, of the consideration to be provided or circumstances which must subsist if performance of the contractual adventure is to be possible.

Indeed, the Court of Appeal found that the doctrine of mistake is based upon the same principles as those of frustration of contracts, namely that the whole purpose of the bargain being absent from the beginning, the contract was void from the beginning. Furthermore, the Court of Appeal dismissed as unsound over 50 years of jurisprudence in finding that a less fundamental mistake might be the basis of discretionary remedies in equity, based on the decision of Denning MR in Solle v Butcher [1950] 1 KB 671.

It should be noted that the fact that one party only is mistaken as to something about the contract, even something as fundamental as price or scope of service, does not entitle that party to “get out” of the contract, unless that party can establish that it was deceived by the other party. Clearly, the doctrine of “mistake” rarely helps fix a bad contract.

2.9 Intention to create legal relations

A binding agreement will only come into existence if both parties to the agreement have the necessary intention to create legal relations. This rule applies so as to exclude social and domestic arrangements from the ambit of contract law. Purely gratuitous promises do not give rise to binding contracts. A promise made by one friend to another in the pub to run in the London marathon is unlikely to be enforceable in a Court. However, a promise made by a professional athlete to a shoe



19

manufacturer to run in the London marathon in return for sponsorship most likely will be enforceable.

The rule in relation to intention to create legal relations is based on two rebuttable presumptions. In relation to domestic and social arrangements, it is presumed that there is no intention to create legal relations unless the contrary is shown. For example, where payment has been made.

In business and commercial transactions, it is presumed that there is an intention to create legal relations unless the contrary is shown. For example, a specific statement seeking to exclude legal enforcement such as making the document “subject to contract”.

2.10 Intention to form legal relations – “Heads of Agreement”, “Memoranda of Understanding” and “Letters of Intent”

Often, ordinary commercial transactions are ambivalent as to their contractual status. For example, are they intended to be binding so that failure of one party to perform will entitle the other to compensation of some kind or non-binding and merely expressions of good intentions? Among many other examples, documents titled “Heads of Agreement”, “Memoranda of Understanding”, “Letters of Intent” and “Letters of Comfort” are a frequent cause of confusion in this way, one party assuming they are non-binding expressions of “wishes” or statements of intention, the other being prepared to make commitments of resources or to third parties based upon them.

In fact, unless the document clearly states that it is intended to be a non-binding statement of intentions, and/or subject to finalisation of more comprehensive negotiations, legal documentation or other conditions, it is quite common for Courts to conclude that these represent or are evidence of a binding contract. In Edwards v Skyways Ltd [1964] 1 A11 ER 494, the parties recorded their intentions by saying that, in certain circumstances the defendant would make an “ex gratia” payment to the plaintiff. The defendant subsequently refused to make that payment, saying the words used indicated no intention to be bound, but the Court disagreed, saying the words were at worst ambiguous but otherwise showed a clear promise to pay the money in return for the plaintiff’s promise.

If, however, the Court decides that there was no intention to enter into binding contractual commitments, there is no amount of reliance upon the words of one of these non-



20

binding arrangements which can “convert” them into something binding, even if in writing.

Discussion Point – Rose and Frank v Crompton [1923] 2KB 261; reversed [1952] AC 455

The parties entered into a written agreement whereby the defendant agreed to supply the plaintiff with its products for the purpose of distribution and this arrangement continued for 6 years, the plaintiffs built up a substantial business in reliance upon their distribution rights. However, the original agreement contained a clause saying:

“This arrangement is not entered into nor is this memorandum written, as a formal or legal agreement, and shall not be subject to legal jurisdiction … but it is only a definite expression and record of the purpose and intention of the parties concerned, to which they each honourably pledge themselves.”

Of course, this was true when the agreement was entered into, and the parties had yet to get to know each other, but after 6 years (and one renewal/extension) was it still true when the defendant terminated the arrangement without warning, without giving the period of notice provided in the document? Yes, said the Courts; whether there is a binding contract must be determined at the date it is said to have been entered. The arrangement cannot “mature” into a binding contract over time. At the time the parties entered into this arrangement they had clearly expressed that no agreement was to be found. However, orders in place at the time of the termination, which had been accepted by the defendant, each constituted a separate contract and had to be honoured by the defendant.

The same principles will apply to any exchanges of correspondence or meetings, whether reduced to “Heads of Agreement”, “Memoranda of Undertaking” or “Letters of Intent”, but it is frequently these which leave the parties unsure of their legal status.

2.11 Privity

The general rule of privity of contract provides that a person cannot acquire rights, or be subjected to liabilities, arising under a contract to which he or she is not a party.

The Contracts (Rights of Third Parties) Act 1999 creates a statutory exception to this general rule. In some circumstances it allows a person on whom a benefit is to be conferred by a contract (the beneficiary) to enforce the promise to provide that benefit against the promisor, even if that beneficiary is



21

not a party to the contract. A beneficiary seeking to enforce a promise directly must establish that the:

(a) contact made a promise of a benefit;(b) beneficiary was sufficiently identified; and (c) promise was intended to create an obligation enforceable

by the beneficiary in the beneficiary’s own right.

For example, if a client and a service provider enter into an agreement for services and the service provider wishes to subcontract the provision of some of the services to a third party, then it will be in the client’s interest if the contract between the service provider and the subcontractor acknowledges that the client is a beneficiary under the subcontract and can enforce the subcontract in its own right. The subcontract could include the following words:

“This agreement [or specific clauses] is intended to be for the benefit, and is enforceable at the suit, of [insert name of third party], in terms of the Contracts (Rights of Third Parties) Act 1999.”

If a beneficiary brings an action to enforce a promise, the promisor may raise against the beneficiary any defence that would have been open to the promisor had the beneficiary been a party to the contract. The parties to a contact that confers a benefit on as third party may vary or discharge the contract at any time with the consent of the beneficiary.

Task 3Access a copy of The Contracts (Rights of Third Parties) Act 1999. You can access, using the search function access a copy from the Office of Public Sector Information (http://www.opsi.gov.uk/acts.htm). Identify the sections of that Act which states that a third party can enforce a term of the contract if:(1) the third party was sufficiently identified; and (2) promise was intended to create an obligation enforceable

by the third party in its own right.

2.12 Capacity

The parties to a contract must have the capacity to enter into a legally binding contract. Most companies will have capacity to enter into most contracts. However, the ability of a company to contract will depend upon its constitutional documents. The key provision used to be the main objects clause in a company’s memorandum of association, but with the widespread adoption of general objects clauses, this became less of an issue. However, capacity is still important when



22

dealing with minors (i.e. anyone under 18 years), statutory bodies or agencies and partnerships.

Any person over the age of 18 who is able to understand the consequences of his or her actions can enter into a binding contract. In addition, any entity with legal personality can enter into binding agreements. This includes companies, corporations and statutory bodies. There may be restrictions imposed either in the constitutional documents or by statute as to the type of contracts which such entities may enter into. In England and Wales, partnerships do not have a legal personality separate from the individual partners. This means that it is necessary to either enter into contract with all of the partners or with one or more partners on behalf of the partnership. The way in which contracts may be signed on behalf of a partnership and the identity of those who may sign on behalf of the partnership is usually set out in the relevant partnership deed.

2.13 Ostensible authority, agency & the power to enter contracts

People often assume that a contract cannot be formed on behalf of an organisation by a person who does not have the authority to do so. This is not a correct assumption.

A person may act legally through his or her agent. An agent may be a general agent for all purposes, or the agency may be limited to specific purposes. An agency need not be constituted by some formal documentation, but an agent may be appointed as such quite informally. An agency may arise as an incident to some other relationship, such as an employee acting in the course of employment, or a partner.

“Agency” and “agent”, like “partner” and “partnership” are terms of quite specific significance in the law, and should not be, as they often are, misused. An agent, whilst acting within his or her known, or if not precisely known ostensible, authority can bind the principle, for example, by entering into contracts. The agent is the principal, to all intents and purposes. Similarly, money received by an agent acting in the course of the agency is held on behalf of the principal. The agent has “fiduciary” obligations to account for money and other goods so received, and an agent acting with a conflict of interest, such as seeking or receiving commissions or margins without disclosure to the principal, can be acting illegally.

When an agent enters into a contract in the course of his or her agency, disclosing that he or she is doing so on behalf of a named principal, then the other party to the contract can look to the principal to perform the contract, for example,



23

pay the bills if that is what is required. The agent can be sued personally, but so long as acting within the scope of the agency, is entitled to back up, or “indemnified” by the principal. However, an agent acting outside the scope of the agency is personally liable. An agent who does not disclose the agency, or the identity of the principal, is also liable personally, but is entitled to be indemnified for all acts within the scope of the agency.

Confusion can arise from the misuse of these expressions. For example, is an advertising “agency”, or other “agencies” of this type (such as event organisers), an agent in law, and if so, for what purposes? Almost certainly, it is not, and most often the “agency” is in legal reality an independent contractor like any other.

Concerns can arise when an agency enters into media advertising commitments, or into contracts with actors, film crew, props, venue and equipment suppliers and other suppliers of goods and services. In the case of media bookings, it may well be acting as an agent, but if it is then it must account to the principal, the “client”, for any commissions or gifts received, unless the principal expressly waives this right.

In the case of the contracts entered into with other service providers, however, the habit of some advertising agencies to think that they have no personal obligation under the contracts is misguided. Often these commitments are simply obligations they must bear, and may charge back to the client as the client cannot be required to perform any obligations under them as the “agency” is personally liable. If the agency’s client reneges, the other party looks to the agency for payment. It is then for the agency to make its claim on the client, if it may.

Similarly, there is great danger in the common use in modern marketing of the word “partner”. “Partnership” is a burdensome legal obligation of joint responsibility for all the acts of the partners, and sharing in the returns of the common enterprise. Nothing could be further removed from the loose commercial linkages commonly nowadays referred to as “partnership” and it is dangerous when this word slips into legal documentation such as correspondence, advertising and contracts.



24

2.14 Invalid Contracts

Illegality

Contracts are invalid (and cannot be enforced) if they are illegal or against public policy (for example, a contract for one person to kill another).

Duress

In some circumstances, contracts can be made void if they were entered into by a person under duress or under the undue influence of another person. Duress is where one party uses some form of pressure to coerce the other into acting in a particular manner. Both the nature of coercion and the lack of consent are relevant. Undue influence occurs when a party to a transaction has the ability to influence the other and does so in an unconscionable manner which disadvantages that other party.

2.15 Interpreting the Contract

Whatever the form of contract, once it can be established that there is a contract it is important to establish what the terms of the contract are. Terms can be either express or implied. Express terms are the easier to deal with as they are those which the parties actually discussed and decided to include in the contract.

2.16 Express Terms

Where there is a written contract a Court will presume that the words contain the entire contract and are not to be varied by any oral terms. It is often a difficult question for a Court to decide whether a contract has been wholly reduced to writing, and therefore oral terms ought to be excluded, or whether the contract is intended to be partly oral and partly in writing. As with all such questions the answer can be sought only in the intention of the parties at the time of entering into the contract. Contracts drawn up by lawyers generally have an “entire agreement” or “merger” clause stating that there are no oral terms to ensure that only the written contract is relevant.

Thus where a contract has been formally drawn up, a Court will normally conclude that the words constitute the entire statement of the rights and duties of both parties and will not listen to evidence from either party as to what one of them thought was, or should have been, included (other than, perhaps, evidence as to the meaning of technical terms, or evidence as to a mutual mistake, or a printing “slip” in the contract). An important matter to be considered in deciding whether or



25

not oral terms form part of a contract is whether or not an oral statement has been followed by a reduction of the terms to writing. If they have, the written terms will generally be preferred in construing the contract. If for example, there is an oral statement that response times of an IT system will be no more than 5 seconds but a written contract specifically states that response time will be better than 8 seconds the supplier will be obliged to provide only 8 second response times.

It is extremely important to be aware of the difference between a term of a contract and a mere representation. Many a customer decides to acquire goods or services on the basis of promises from a salesperson that the goods or services will be able to accomplish some wonderful things, only to find when that does not happen there is no requirement in the contract that it do so. To form part of a contract both parties must have intended that a statement form part of the contract; it is not enough that they merely discussed it in coming to an agreement (although the law of “misrepresentation” referred to below, may provide some assistance).

If a contract is shown to be wholly in writing then the express terms of the contract are those which appear in the document.

If it has been established that a particular contract is partly oral and partly in writing it is then a difficult question to determine whether a particular oral statement is or is not a term of the contract or merely a representation. One of the important factors in deciding the question is the timing of the statement. A representation made in the early part of the negotiations and not repeated is unlikely to form part of the contract. On the other hand a representation made after the contract has been formed cannot possibly form part of the contract. An assertion by a supplier, made after some software has been delivered and paid for, that the software can perform a certain function will not form part of the contract.

2.17 What do the words mean?

In contractual disputes, the Court must objectively construe the terms of the agreement. As mentioned previously, it is not the role of a Court to help one party or the other achieve its objectives with the contract. The role of the Court is to interpret what is there. First and foremost, a Court will hold the parties to the bargain expressed in the clear words of the contract.

However, if faced with an ambiguous, unclear or apparently incomplete contract, a Court may take into account a finding of



26

what both parties intended, if it can be satisfied of what that is, either:

(a) for the purposes of interpretation of the express terms; or(b) for the purposes of a finding of an implied term of the

contract, which we will consider further below.

With regard to the former, the Court must ascertain the presumed intention of both parties when they agreed. Clearly, evidence of the context in which a contract was made may be very relevant in construing the words of that contract in this situation. The parol evidence rule, however, excludes the use of extrinsic evidence to interpret or imply terms which contradict the express terms of the language of a written agreement (This rule was first formulated in Goss v Lord Nugent (1833) 5 B & Ad 587 at 54-65). An exception to this rule arises only where the parties clearly intended their agreement to be affected by unwritten factors.

The House of Lords has indicated that evidence of the surrounding circumstances of a contract should be generally admissible when construing a written agreement (see ICS Ltd v West Bromwich BS [1998] 1 WLR 896).

2.18 Implied terms

Not surprisingly, a contract, whether written or oral, does not, perhaps cannot, expressly provide for every contingency. How often does it happen that, when the unexpected arises, the parties to a contract would say: “Well, had you asked us at the time what would happen if these circumstances were to arise, we would obviously have said …”

In such a case, Courts say that the unspoken assumption of the parties must be an implied term of the contract. By this it means, the law attempts to give commercial efficacy to everyday business transactions.

Such implied terms may arise in several ways, from industry practice, from the individual circumstances of a particular agreement, or by virtue of statutory regulation of commerce.

Implied Terms – Industry Practice

Perhaps an example of a term implied by virtue of industry practice may be found in most software development contracts. Most public relations or marketing contracts do not assign copyright, nor do they specifically license any materials created to the end user. Therefore it could be said, on a literal reading of the contract, that the user who is paying for the



27

development of the materials has neither copyright in them nor even a right to use. However, it will always be an implied term of such a contract that the user has a right to use the materials. The implied right to use the materials will probably not extend to grant others involved in marketing for the customer the right to make any necessary copies, but not necessarily anybody else.

In addition, many industries have certain accepted usages which are familiar to everyone in the industry. Provided both parties to the contract are in the same industry. These accepted usages are supposed to govern contracts which involve the supply of goods or services in the same industry and both parties to the contract are assumed to understand those terms and accept that they are part of the contract. For example, the concept of “project manager” is well understood, if somewhat difficult to define, and so it is not normally necessary to provide a definition in the contract. Also, there may be terms, in some cases very important terms, which are imported into the contract from the context.

Implied terms – Implications by Statue

Terms can also be implied in contracts by statute. In many cases, these are merely intended to codify the general law. For example, terms implied by Sale of Goods Acts 1979 (as amended by the Sale and Supply of Goods Act 1994) which imposes on every contract of sale of goods and services implied warranties as to:(a) ownership of the goods being sold;

(b) fitness of the goods and services for the purposes for which sold (if made known to the seller, whether expressly or by implication – for example, if the seller knows very well what the goods will be used for, because it is obvious from the goods, such as magnetic media, or because of the seller’s knowledge of the buyer’s business) if the buyer relied on the skill and judgment of the seller;

(c) general “satisfactory quality” of the goods and services, meaning fitness to be sold at all;

(d) “quiet possession” of the goods and that the buyer will get title “free from encumbrances” – practice it is almost always sufficient to rely upon the condition as to ownership and possession without having to deal with these two implied warranties;

(e) conformity with description, or sample, where goods or services have been sold in that manner.

Such warranties were implied into contracts for the sale of goods by the Courts well before their being enshrined in statute, but, just as in the general law, the Sale of Goods laws



28

have generally allowed these terms to be excluded or modified by express agreement, which they often are.

Task 4Access a copy of the Sale of Goods Acts 1979. You can access, using the search function a copy from the Office of Public Sector Information (http://www.opsi.gov.uk/acts.htm) Identify the sections of that Act which address the following points:(1) The supplier has the right to sell the goods.(2) The buyer will enjoy quiet possession of the goods.(3) Where goods are sold by description, the goods will

correspond with that description.(4) The goods are of “satisfactory quality”.

Implied Terms – Terms Implied by the Courts

As we have discussed previously, unless a statute otherwise imposes a term into a contract which is not there, a term will only be implied into a contract if it is clear, makes business sense, and was obviously intended by both parties to be there right from the beginning, on the day the contract was signed.

The difficulty with all “implied terms” is that invariably they are only mentioned when the parties are in dispute, at which time it is virtually impossible to get agreement either as to the existence of the terms (except when imposed by statute) or as to their meaning.

For this reason, it is generally considered safer by lawyers to define expressly and in writing agreement as to as many issues, or potential issues, as possible, and to exclude all other terms. For example, lawyers will often include a specific “force majeure” (something that happens that is out of the control of the parties to the contract) clause in a contract much more favourable to one of the parties than the general law.

It is for this reason that the “boilerplate clauses” (standard or common clauses)at the end of a contract should always be carefully examined by the parties. Except where required to do so by statute, the Courts will never imply a term contradictory to any matter expressly agreed to by the parties, and will do so only cautiously if the parties have expressly agreed that all implied terms are excluded absolutely.

2.19 Inferring a contract form the parties’ conduct

Where there is no documented agreement, it is still possible for a valid contract to be inferred from the parties’ conduct. The same formation tests need to be applied regardless of whether you are looking at a written or an oral contract.



29

Often, oral contracts are found to exist where the parties have commenced performing their obligations on the reasonable assumption that they have made a contract. For example, if there is no documented agreement, but the parties have met the tests set out previously (and, as often happens, the parties may have gone further, and performed the arrangements for example, commenced supplying and using goods) a Court would be likely to find that a contract (in some form) exists and they may also apply some other legal principles (such as estoppel) where parties have relied on the conduct of others.

The real problem with oral contracts is that it is often difficult to know what the terms of the contract are, and they may need to be pieced together by looking at the parties’ conduct. For this reason, it is far more certain to have a written contract which sets out the precise terms that the parties have agreed to.

Task 5Consider the following fact scenario. Jim is considering buying a security system for his home from 24x7 Security Systems. 24x7 Security Systems advises Jim that the security system still operates even if the mains electricity supply is cut off. 24x7 Security Systems genuinely believes this to be true and a week later Jim signs a contract for 24x7 Security Systems to install the system. The contract makes no mention of what would happen if the electricity supply fails. During the week of installation the 24x7 Security Systems representative discovers that the system will not operate during a power cut but, having forgotten that he ever discussed the matter with Jim, doesn’t say anything more about it. Having paid £3,000 for the system, Jim’s house is broken into two weeks later during a power cut and £10,000 worth of art is stolen. There are other security systems on the market which are not dependent on the mains supply but all cost over £5,000.

Advise Jim whether the statement made by the representative of 24x7 Security Systems could be considered a misrepresentation or could be considered as a term of the contract between Jim and 24x7 Security Systems.

3. Term Sheets

3.1 Introduction and terminology

Given that the time and effort required to draft, negotiate and finalise a full and comprehensive commercial contract, can be considerable, parties often like to use a “term sheet” to set out the commercial and legal provisions which the parties have agreed to.



30

Unfortunately, the terminology describing these documents is somewhat confusing. For instance, the wording “term sheets”, “letters of intent”, “memorandum of understanding”, “heads of agreements”, “letters of comfort”, all are used (to name a few). There is not anything particularly scientific about the terminology. Often the names are used interchangeably. Whatever the term used, the crucial distinction is whether the document is intended to be binding or non-binding. For the purposes of this unit, the document shall be referred to as term sheets.

3.2 Are term sheets binding contracts?

One of the most common questions clients ask their lawyers about term sheets is whether they are binding or not. The truth is, sometimes they are binding contracts, sometimes they are not and sometimes it is difficult to tell (which is a situation that you do not want to be in).

The difficulty with term sheets, memorandums of understanding and the like is that the terms are often uncertain. It may not be clear whether the document is intended to be:(a) a binding statement of the agreement that has been

reached by the parties; or(b) merely a non binding preliminary document recording the

terms of a proposed agreement.

3.3 Be clear about whether a term sheet is binding or not

When you are drafting term sheets, it is important to be clear about what the purpose of your term sheet is and whether you want the term sheet to be binding.If: (a) you have not worked out all material terms of the deal; or(b) the term sheet is subject to further negotiation; or (c) the term sheet is not intended to be binding, you should include a statement in the document to this effect, such as that it is “not binding on the parties and is subject to contract”. It is important to note that even this statement will not guarantee that the term sheet will not be seen as a binding contract or prevent all forms of legal obligations from occurring.

3.4 You may want some terms to be binding

You should also bear in mind, when you are thinking about whether you want your term sheet to be legally binding, that it is not an “all or nothing” decision. You may want some parts of



31

the term sheet to be binding. If this is the case, then you must state this clearly. The benefit of making an obligation binding is that you are able to claim for breach.

Some of the terms that you might want to be binding include a confidentiality obligation (although it’s also possible to have a separate agreement covering confidentiality). You might want to have a period of exclusive dealing or to actually commit to negotiate in good faith for, say, 2 weeks or another specified period. One party might be committing to do some feasibility studies or second some staff as part of a preliminary arrangement. As a supplier you may want the customer to commit to procuring goods/services at a certain price or a commitment to purchase a certain volume.

If these sorts of things appear in your terms sheet, you need to think carefully about whether you might actually want to enforce these terms.

3.5 Usefulness and limitations of term sheets

Term sheets can serve a useful purpose but one also needs to carefully consider limitations in using term sheets (see table below):

Usefulness of term sheets Limitation of term sheets

Good way of capturing commercial principles and instructing the person preparing long form agreements.

Term sheets are useful in complex transactions. They can help focus negotiations by highlighting major issues at a very early stage.

Allow parties to crystallise their thoughts without getting bogged down in legal detail or terminology.

Can be fast – if speed is important (but parties must remember to spend the time to convert to long form agreements).

Parties often do not prepare long form agreements. The risk is that the term sheets often don’t have enough detail to regulate the relationship (particularly in a dispute).

Term sheets may not be prepared with the same precision as the final agreement – same point as above.

Sometimes lack of clarity around binding / non binding.

If you believe a term sheet is going to take a protracted time to negotiate it may be better focussing your efforts on the final agreement.



32

Where a deal has to be explained and “sold” prior to the final agreement being signed to persons not directly involved in the negotiations (such as board of directors). Term sheets can provide a useful statement of the key terms of the proposed deal.

Even if term sheets are expressed to be non-binding they are usually considered to confirm a moral commitment on both sides to observe the terms agreed. It is psychologically harder for one party to renege on earlier commitments if they are recorded in a term sheet.

Otherwise there is the potential to have duplication of negotiations.

The other side could get two bites at the cherry (equally, you too also get another chance)

Even if the term sheet is expressed to be non-binding, it can carry strong moral force, they can limit room for manoeuvre in subsequent negotiations.

3.6 Practical tips

As a general rule, always have a clear strategy up-front for your negotiation process (including whether it is appropriate to use a term sheet).

The view of some commentators is that term sheets should cover commercial points rather than getting bogged down in drafting ones. Unfortunately, the distinctions blur but it is in the interests of both sides not to turn the negotiation of the term sheet into a full dress rehearsal for the final agreement. Time spent negotiating the term sheet should be limited to discussing the commercial deal in principle. Arguments over the fine print should be reserved for negotiating the final agreements.

However, term sheets need to be comprehensive enough to clearly set out what has been agreed, but not so detailed as to duplicate the final agreement. This is a difficult task but needs to done.

Here are a few suggestions:

(a) Decision regarding binding / non-binding As mentioned previously, if the intention is that the terms

outlined in the term sheet are not intended to be legally binding (which is recommended) then expressly say so. The parties may, however, want to make some provisions binding at the outset.



33

(b) Do not ignore important areas

Do not ignore important areas where agreement has not been reached. Related to this point is that you should not be too premature in trying to prepare and sign a term sheet when major issues remain unresolved.

(c) Include key provisions

If there are any particularl key provisions which you want to see incorporated into the final agreement, it is best to get these incorporated expressly into the term sheet. Don’t rely on subsequent negotiations rectifying a major omission from the term sheet as signed since, once the relationship has commenced, one is always facing an uphill battle to get provisions incorporated.

(d) Include “out of the ordinary” provisions

If the final agreement is going to include provisions which are “out of the ordinary” this should be set out in the term sheet. For example, unlimited liability for one party.

(e) Price versus risk

Parties often agree a pricing regime in a term sheet but fail to include the risk and performance criteria on which the price was calculated. If price is tied to a particular risk profile (for example, excluding liability) or particular performance characteristics (for example, meeting service level agreements), these risks and criterias should be included in the term sheet.

(f) Identify the key conditions to the completion of the contract

These conditions will obviously depend on the nature of the proposed arrangement. The conditions specified should be those which one party feels are absolutely necessary to be satisfied before it can sign the final agreement.

(g) Allocate procedural responsibilities

Which side will draft the main agreement? What about the schedules? Who, on each side, will be responsible for co-ordinating due diligence? What is the target timetable for the period to signature?



34

(h)Termsheetspecifictodeal

As you know every transaction is different and the term sheet for a particular deal will need to reflect that.

(i) Realistic timeframes

Do put in realistic timeframes for completion.

(j) Negotiationsonfinalagreement

It is essential to ensure that negotiations on the intended final agreement are pursued vigorously and not allowed to drag on.

(k) Seek legal input

Advise clients to seek legal input at the term sheet stage.

3.7 Importance of advising clients to seek legal input at the term sheet stage

One of the reasons parties like using term sheets is that they perceive them to have the characteristic of being “commercial” rather than “legal”. Clients often tell us that when they negotiate term sheets, they like to exclude lawyers as far as possible. The reasons given include saving costs and to ensure that the negotiations are commercially focussed and not subject to legal distractions.

Your response to this should be that even if the parties do intend the term sheet to be non-binding, as mentioned previously, the term sheet may well inadvertently become binding. This means for example, each parties’ respective rights and obligations may well be specified in the term sheet. If this is not what one or both of the parties intended – we then have a problem.

Further, the perceived cost savings of not getting legal input at the term sheet stage, may be negated if something goes wrong with the relationship before a final agreement has been signed. In this scenario a party may need to rely on the term sheet to enforce their legal rights. Having a properly documented term sheet may well save legal costs further down the line.

Getting a term sheet wrong may lead to delays in finalising the final agreement (as the term sheet may not necessarily reflect the deal). Also, if a party has made any commitments in respect of price in the term sheet, that party may find itself locked into that price when it had not intended to be.



35

This is the reason why clients should be advised to seek legal input early on when preparing and negotiating term sheets.

Task 6Assume you a head teacher procuring the supply of IT equipment for your school. It is very important that the IT equipment is delivered before the start of the school year. Unfortunately, you do not have the time to sign a full agreement if you want to meet your time-frames. The only way that the IT supplier will supply the IT equipment is if your school enters into a term sheet with the IT supplier. In order to protect the school’s interests what key provisions should the term sheet include?

4. Pre-Contract Liability

There is often a misconception that prior to contracting, a party is unable to incur any legal liability. It might be the case that if a party has not created a written or oral contract, that it does not have any liability under contract law, but the law of misrepresentation can often catch a party out and impose liability on that party during this period.

4.1 Misrepresentation

A representation is a statement of fact. It is not an opinion nor is it a statement of an intention. A misrepresentation is a representation which is false for whatever reason. A representation will be actionable only if it has been made by one party to another with a view to inducing that other party to enter into a contract. By its nature a representation is made before a contract is made. If a party to a contract has altered its position in reliance on a misrepresentation, then contract law will provide a remedy. The nature of the remedy will depend upon the reason for the misrepresentation but will typically be the right to rescind the contract and/or receive damages.

As a general rule, silence will not constitute a representation. However, a person’s actions, such as a smile, nod or a wink, may convey a representation. There is no general obligation to provide information prior to a contract being entered into, even if such information may affect the decision to enter into the contract. There are exceptions to this general rule. If a person remaining silent owes a fiduciary duty to the person entering into a contract, then he may not remain silent about salient facts. Equally it is not permissible to remain silent if by doing so a representation which has been made is distorted. This may be the case where a person provides only some of the facts about a situation, but leaves a material fact untold without which the information conveyed is misleading. Similarly,



36

if there is a change in circumstances before the contract is made which renders the representation misleading or false, then failure to disclose the new information may amount to a misrepresentation. Some contracts, such as contracts of insurance, require the parties to act in utmost good faith. Failure to disclose pertinent information will amount to a misrepresentation in such circumstances.

An action may be brought for misrepresentation if and to the extent that the misrepresentation in question induced the party bringing the action to enter into the contract. Whilst there is no requirement for the misrepresentation to be the sole reason for entering into the contract, it must have played a material part in the decision to do so. This means that where a person relies on his own judgement or investigations or knows the statement to be incorrect before entering into a contract, no action for misrepresentation will arise. It follows that unless the misrepresentation has been communicated to the contracting party before the contract is entered into, no case for misrepresentation will arise.

Originally the law recognised only two types of misrepresentation: innocent and fraudulent. A fraudulent misrepresentation is a false statement which is “made (i) knowingly, or (ii) without belief in its truth, or (iii) recklessly, careless as to whether it be true or false” (see Derry v Peek (1889) 14 App. Cas. 337). In essence, a fraudulent misrepresentation will be made if the person making the representation does not honestly believe the facts stated to be true. Only fraudulent misrepresentations give rise to a right to claim damages.

In 1967 the Misrepresentation Act was passed. As a consequence, there are now 3 types of misrepresentation under English law:

(a) fraudulent misrepresentation;

(b) negligent misrepresentation; and

(c) innocent misrepresentation.

The concept of negligent misrepresentation was introduced by section 2(1) of the Misrepresentation Act 1967, which provides as follows:

“Where a person has entered into a contract after a misrepresentation has been made to him by another party thereto and as a result thereof he has suffered loss, then, if the person making the misrepresentation would be liable to damages in respect thereof had the misrepresentation been made fraudulently, that person shall be so liable notwithstanding that the misrepresentation was not made fraudulently, unless he proves



37

that he had a reasonable ground to believe and did believe up to the time the contract was made that the facts represented were true.”

This means that it is no longer just an absence of honest belief in the truth of a statement that is necessary to give rise to action for damages. If the person making the statement had no basis for believing the truth of the statement or did not check into the facts before making the statement then he will be liable in damages.

An innocent misrepresentation is exactly as it sounds. It is a statement of fact, which when made was honestly believed to be true by the person making it and which the person making the statement believed to be true up to the time the contract was entered into.

There are two remedies for misrepresentation namely rescission and damages. Rescission means setting aside the contract and putting the parties back into the position they would have been in if the contract had not been entered into. However, the right to rescind a contract may be lost if the party concerned has affirmed the contract once he is aware of the misrepresentation either by his actions or through the passage of time.

The right to rescind will not be available if it is impossible to put the parties back into the position in which they were before the contract was entered into or if a third party has acquired for value some rights which will be adversely affected if rescission occurred.

Damages will be payable for both fraudulent and negligent misrepresentations. Whilst damages cannot be claimed for an innocent misrepresentation, a right of rescission may arise. If the contract is rescinded an order may be made for a payment to be made to the party rescinding the contract if it is needed to put him or her back in the position in which he would have been in but for the contract. Such a payment will, for example, cover out of pocket expenses.

If the contract cannot be rescinded, then damages may be ordered in lieu of rescinding the contract. Section 2(2) of the Misrepresentation Act 1967 provides a specific right to receive damages in relation to negligent misrepresentations in lieu of the right to rescind the contract.



38

5. Frustration and Force Majeure

Before looking at failure to perform, let us look at some excuses for a failure to perform. Some terms that you may be familiar with are frustration and force majeure.

5.1 What is “frustration”?

Frustration of a contract occurs where, through no fault of either party, the obligations under the contract become impossible to perform, or the circumstances in which the contract is to be performed are fundamentally different from those contemplated by the parties. Some examples of frustrating events include the physical destruction of the goods to be provided or the government’s compulsory acquisition of premises connected with the performance of the contract.

5.2 The effect of frustration is that the contract is automatically terminated

If a contract is frustrated, it is terminated automatically although this termination is called “discharge” and is more like expiry than termination. In general terms, the parties are no longer required to comply with their future contractual obligations.

5.3 Avoiding frustration within a force majeure clause

Contracting parties may avoid frustration of their contract by including a force majeure clause.

Force majeure clauses generally operate to keep the contract in operation if there is a frustration-type event. Common events stipulated as being “force majeure” events are frustration type events mentioned above as well as strikes, natural disasters or similar kinds of events. The effect of listing these types of events as force majeure events is that they excuse a party from the obligation to perform by allowing an extension of time for performance or a suspension of the contract. These clauses protect parties against claims for damages for their failure to perform a contract due to the occurrence of events beyond their control. This is the reason why, from a supplier perspective, you want your force majeure events to be as wide as possible.

Task 7Access the “terms and conditions” from argos.co.uk. Identify the “force majeure” clause. Assume you are acting for the customer, how would you improve this clause for the customer’s benefit.



39

6. Breach of Contract

6.1 Overview

In this next section we discuss the place where, as contract negotiators, we all hope our contracts do not go. We will look at situations where there is a breach of contract which should help you to recognise some of those situations in your contracts and the administration of them.

We will look at what action you might be able to take if you think that there may have been a breach of contract by the other party.

Also, you need to be aware of and think about what action the other party may be able to take if your client has failed to meet its contractual obligations and if that happens whether there is any action which you should take if you find yourself in that situation.

You also need to be aware that not every breach of contract entitles the innocent party to terminate the contract; we will discuss this in more detail in Unit 2. One thing which you will need to think about in each contract is the circumstances in which a breach will give you, or the other party, the right to terminate the contract.

6.2 The two types of breach of contract

There are 2 forms of breach of contract: (1) failure to perform and (2) repudiation.

6.3 Failure to perform

Failure to perform occurs where the party who is supposed to perform the obligation fails to do so at the time stipulated for performance. There are three different types of “failure to perform”:(a) Non-performance: where the party who is supposed

to perform makes no attempt to perform, or their performance is entirely different from that required by the contract. For example, a customer has a contract for the supply of laptops with Dell and instead Dell delivers desktops.

(b) Defective performance: where the performance of the obligation is not to the standard required by the contract, or not fit for the purpose required, for example, a breach of warranty.

(c) Late performance: where the obligation is not performed by the required time.



40

6.4 Repudiation

The other type of breach of contract is called repudiation or anticipatory/prospective breach.

This occurs where, before the time for performance of an obligation has arrived, a party demonstrates that it is unwilling or unable to perform its obligations. A repudiation occurs before the obligation to perform has arisen. An example would be a software supplier announcing that they were no longer going to supply software to a customer and making this announcement before the date for delivering the software ordered by the customer.

A repudiation usually gives the non-repudiating party the right to terminate the agreement, BUT a party seeking to terminate an agreement based on a repudiation needs to be very careful. It may be difficult to decide whether the performing party’s perceived unwillingness or inability actually amounts to repudiation, and, if it does not, the terminating party could be found to have wrongfully terminated the agreement.

6.5 Election

So, what happens when a party breaches a contract?

Where there is a breach of contract or a repudiation, the contract does not usually automatically terminate (unless the contract has specific automatic termination clauses in it), and the contract will continue on foot if the party not in breach wants it to. If the breach gives rise to a right to terminate (which not all breaches do), the “innocent” party must elect to either terminate the performance of the contract, or to continue with performance of the contract.

The election, once made, is permanent, and the electing party usually gives up a right to terminate if it has elected to continue, regardless of whether or not the non-performing party has relied on the election. Election may be express or implied from the “innocent” party’s conduct, but the electing party must show an intention to continue with performance if that is its election.

Failing to elect to terminate within a reasonable time after the breach may mean that you give up that right to terminate for that particular breach, so take care. This presumption, however, can be overridden by specific waiver clauses which are commonly found in commercial contracts. Such a clause might say, for example, that the innocent party does not give up its right to terminate for a breach because it has taken some



41

action which might otherwise indicate that it wishes to proceed with the contract despite the breach.

However, an election not to terminate does not preclude the electing party from terminating the contract for a subsequent or continuing breach, provided that the other relevant breach gives rise to a right to terminate.

6.6 Remedies

How is the innocent party compensated when it can be shown that there has been a breach of contract? Remedies are the legal term for types of compensation which may be available to the innocent party when there has been a breach of contract.

Let’s look at some remedies that are available for breach of contract.

(a) Damages – the usual remedy

(a) Damages – the usual remedy

If there is a breach of contract, there are a number of remedies available to the innocent party, and more than one remedy may be sought. The most common remedy for breach of contract is damages (which is compensation in the form of money).

The object of damages for breach of contract is to place the innocent party in the position in which they would have been had the breaching party performed the contract. Liability for damages is discussed in greater detail under the heading “What are damages and what are their purpose”..

(b) Other remedies – specific performance and injunctions

Where damages are not an adequate remedy for breach of contract because a payment of money can not provide adequate compensation for what the other party has done or failed to do, the innocent party might seek a remedy called specific performance or an injunction. Specific performance is an order from the Court that the breaching party must perform their contractual obligations. Specific performance will only be ordered where the Court is satisfied that the unperformed obligations will be carried out, and that the innocent party is willing to perform their remaining obligations.

An injunction is a Court order restraining a party from acting in breach of contract. It has a similar effect to an order of specific performance, but is a negative remedy i.e. an order saying “do not” rather than “you must….”. The



42

decision to grant an injunction is based on similar principles as those relating to specific performance.

7. Limitation of Liability

7.1 Overview

Contract law provides the rules which determine when one party is liable to another under, or in connection with, a contract. The rules define not only the elements of a successful claim of liability, but also the elements of a successful defence against a claim of liability. Parties to a contract have a right to agree a liability regime that is different to, or can agree a measure of damages which may be greater or less than what the law would offer in the absence of agreement.

7.2 Terminology

In this section when we refer to “customer” we mean a party which is procuring and/or using the goods or services. The term “service provider” is used to refer to the party which is actually supplying the good or services.

7.3 What does “liability” mean?

When we talk about liability or being liable, we are talking about being responsible, “on the hook”, vulnerable or suable.

A person ‘liable’ is one ‘who can be compelled to pay by using the due process of law’. In other words, as ‘vulnerable’ means ‘who can be wounded if attacked’, so ‘liable’ means ‘who can be bound if sued’ (Hall v Bennett [1956] SASR 10, Napier CJ and Abbott J).

7.4 When does contract liability arise?

Under a contract, a party will be liable to pay damages where there is:(a) breach of contract; and(b) some loss which:

(i) was caused by the breach of contract; and(ii) is not too remote (or too unconnected), as a matter of

law.

You need to also remember that liability can arise under statutes or regulatory regimes, but that is outside the scope of this course.

What is the consequence once you establish that the other party is liable to you? In other words, what is your remedy? As



43

mentioned previously, the usual remedy for breach of contract is damages.

7.5 What are damages and what are their purpose?

Damages are monetary compensation for breach of contract and are intended to put the innocent party in the position in which it would have been had the contract been performed according to its terms.

For example, let’s assume that a business has entered into a contract to procure a new IT system for billing. Let’s also assume that the IT system is installed and during the first month of live operation the IT system fails (and for these purposes, fails to meet the agreed specifications). As a consequence of this failure, all of the billing data of that business is lost or corrupted. One of the main losses is that it has to spend time and effort in manually re-entering the data. In order to complete this task, the business has to employ temporary staff. A Court could award damages to compensate the business for these extra staff costs, subject to the rules of causation and remoteness (discussed below). This is one reason why supplier’s attempt to exclude liability for loss of data.

The measure of damages is always a question of fact and degree in each case. The principles governing award of damages can only provide guidance, not necessarily a certain answer.

There are two concepts relevant to the award of damages. These are causation and remoteness.

7.6 Causation

The breach has to cause the loss for which the innocent party seeks damages. Whether or not a breach has occurred is often a question of fact. The breach does not have to be the sole cause or even the dominant cause, provided that there is no break in the chain of events between the breach and the loss or damage. If you can say that the non-breaching party would not have suffered the loss “but for” the breach, you will have established “causation”.

7.7 Remoteness - Hadley v Baxendale principles

There is a rule that prevents a breaching party being held liable for damages that are too remote or just too far removed from what they have done. The rules on what is “too remote” are provided by a case called Hadley v Baxendale (1854) 9 Ex 341.



44

Hadley v Baxendale distinguishes between two types of potentially recoverable damages:(a) damages which flow as the direct consequence of the

breach and are therefore not “too remote”. These are commonly known as general damages; and

(b) damages which are of an exceptional nature and are only recoverable and not “too remote” in special circumstances. These are commonly known as special damages.

General damages are damages for loss which arises naturally from the breach of contract itself. These losses are commonly known as “direct loss”.

Special damages are awarded for loss that the contracting parties, at the time they entered into the contract, could have reasonably contemplated as being the probable result of the breach. These losses are commonly known as “indirect loss”.

Task 8The case of Hadley v Baxendale is probably one of the most important cases when considering liability and the principle of “remoteness”. Although it almost 150 years old, it is still quoted to this day. Access a copy of this case from the British and Irish Legal Information Institute (www.bailii.org). Locate the extract which sets out the two types of damages described above.

7.8 Types of loss

In negotiating contracts, in particular, in liability and indemnity provisions, parties often talk about different types of loss. These include:(a) direct loss;(b) indirect loss; and(c) consequential loss.

7.9 Direct loss

What is direct loss? It is commonly regarded that direct loss is loss that naturally and logically flows from a breach of contract.

Types of losses that are direct losses are things that are “not unlikely” to occur or “a serious possibility” or a “real danger”. Types of losses that have been found to be recoverable as “direct losses” are:(a) selling defective seed which fails to produce a crop;(b) supplying defective components which results in a loss of

repeat orders from customers because of the poor quality of the end product;



45

(c) late arrival of a ship which causes the charterer to have to transport goods using another ship.

For example, a company, from time to time, may engage contractors to perform work. The work performed by contractors might need to be redone because the work was not performed in accordance with the terms of the relevant contract. The company might need to engage a new contractor to redo the work. The company would be entitled to an award of damages, payable by the original contractor, to compensate the company for the costs associated with engaging the new contractor.

7.10 Consequential loss or indirect loss

Consequential loss or indirect loss are terms often used in exclusion clauses. Service providers will often seek to exclude their liability for such losses. Unfortunately the meaning of “indirect” or “consequential” loss is not entirely clear under English law. Generally, English cases appear to equate “indirect” loss to “consequential” loss.

The scope of the phrase “consequential loss” is both legally and factually uncertain. It should therefore be avoided if possible. If there are particular types of loss that the parties agree to exclude either or both parties’ liability for, then these should be expressly stated instead of resorting to general terms like “consequential” or “indirect”. “Consequential loss” also has a specific meaning in United States law that is different from its meaning under English law.

What is covered by an exclusion of liability for consequential loss?

Although it will often be difficult to determine exactly what liability is being excluded under an exclusion for consequential loss, customers should be extremely cautious about agreeing to such an exclusion in favour of a service provider as it could severely limit the customer’s recourse in the event of a breach of contract by the service provider.

That said, while service provider’s will often want to use an exclusion of liability for indirect loss as a way of excluding their liability for lost profits, the Courts have indicated that loss of profits is not always a consequential loss as held in Hotel Services Ltd v Hilton International Hotels (UK) Ltd [2000] 1 ALL ER (Comm) 750).In addition, matters such as wasted expenditure or wasted management time may be direct losses and will not always be caught by an exclusion of consequential loss.



46

Considerations in drafting a clause excluding liability for consequential loss

The uncertain exercise of drawing a line between direct and consequential loss is only required if the contract treats the two types of loss differently (usually by excluding or limiting liability for consequential loss). If the contract does not treat consequential loss differently from direct loss, then both direct and consequential loss will be recoverable if they arise from the default or other relevant action of the service provider (subject to any applicable liability provisions).

If there are certain types of loss that the parties wish to exclude the other’s liability for, then these types of loss should be expressly stated. As an example: “the parties will not be liable to each other for any loss of profits or loss of revenue”.

However, if the other contracting party insists on using the term “consequential loss” (or one of its synonyms), a danger to be aware of is trying to cover all bases by elaborating on what the parties consider to be consequential loss. A clause that excludes a party’s liability for “consequential loss including loss of profits and wasted business expenditure” may consequently only exclude that party’s liability for loss of profits or wasted business expenditure that is considered consequential loss. It will not necessarily exclude liability for loss of profits or wasted expenditure that is direct loss.

7.11 Lossofprofit

If a service provider seeks to exclude liability for loss of profit, the customer needs to analyse the risk to it from accepting such an exclusion. Often, public sector customers do not view this exclusion as a major point. However, while a public sector customer may not be in business and may not seek to make a profit, the use of the services may result in a damages claim against the customer that involves a third party’s loss of profit. If the liability cap excludes the service provider’s liability for loss of profit and the customer is liable to a third party for damages including loss of profit, the customer will be exposed to the loss of profit itself.

7.12 Loss of use

The customer may suffer a loss of use, for example, when there is a delay in the delivery of the services or when the services are being rectified. The damages suffered by the customer due to a loss of use of the services is generally difficult to calculate. As a result, to provide for a level of certainty the damages for loss of use could be treated in a similar way to liquidated



47

damages for delay whereby the parties agree in advance the damages payable for each day of loss of use.

If this approach is taken, a limitation of liability for loss of use could effectively be achieved through the adoption of a liability cap for liquidated damages.

The customer should make its uses of the services known to the service provider to ensure that the service provider can understand the full risks. Not only does this improve the service provider’s awareness and ability to price and manage the risk, but it supports a customer’s damages claim should it be necessary to take this action.

7.13 Unlimited liability

The term “unlimited liability” is a slightly misleading term and sometimes prevents a constructive and informed debate on the issue of liability. In practice, not all loss that stems from a breach or infringement is recoverable. There are several limiting factors that are applied by the Courts in assessing damages. In relation to contract damages, these include that the damage is not too remote, that a causal connection exists between the breach or infringement and the loss alleged to have been suffered, and that the party bringing the action must have taken reasonable steps to mitigate its losses.

For example, where if a customer procures a system that is required to integrate with other systems and it is defective, the types of losses that may be recoverable in this situation include:

(a) the cost of acquiring a replacement system;(b) the cost of repairing other systems that have been

damaged as a consequence of the default in integration by the service provider; and

(c) aspects of costs incurred during the time that has been lost in acquiring the new capability.

Losses that may be too remote to recover in these circumstances may include loss of use of personnel in respect of personnel who were to have operated the new system but as a consequence of the delay have been redeployed elsewhere.

However, even though there will be natural limits on the liability that is claimable for a default by a service provider, service provider’s as part of their corporate governance frameworks need more certainty about their potential exposure under a contract. This is one of the reasons why service provider’s seek to cap their liability.



48

7.14 Issues to Consider in Relation to Liability Clauses

The following are typical issues which may arise when preparing or negotiating limitation of liability provisions.

7.15 Clarity

As a form of exclusion clause, a limitation of liability clause will generally be given its natural meaning, but in the event of any ambiguity will be interpreted, against the party seeking protection from the clause (Photo Production Limited v Securicor Transport Limited [1980] AC 827). However, it should be noted that legislation in some cases imposes controls on exclusion clauses. For example, English Courts may consider the application of “reasonableness’ under the Unfair Contract Terms Act 1977 (“UCTA”) when interpreting liability clauses. Further comment on UCTA can be found under the heading “Restrictions on limiting and excluding liability”.

As a result, it is essential that limitations of liability clauses are drafted clearly so as to reflect the intentions of the parties.

Therefore, the use of any terms for which there is not a generally accepted meaning should be avoided. If a customer, for example:(a) wants to limit its liability for loss of profits, or wasted

management time, or any other sort of specific loss; or (b) is prepared to agree to the service provider limiting its

liability for specific losses,

then those types of loss should be specifically excluded, or specifically not excluded, as the case may be. Leaving an important issue to be resolved in the Courts is not going to provide either party with much certainty.

In drafting a limitation of liability clause, it should be noted that a limitation of liability clause will be interpreted in light of the contract as a whole (Darlington Futures Ltd v Delco Australia Pty Ltd (1986) 161 CLR 500 at 510 per the Full High Court).Consequently, a clause which was interpreted in a specific way in one contract may be interpreted differently in another contract if the context in which the clause appears is significantly different. Persons negotiating the contract must therefore consider a proposed limitation of liability clause in the context of the specific contract which is being developed and must not rely on the fact that the same clause was successfully used in a different contract.



49

7.16 Liability caps

There is no simple answer or formula to the question of how does one calculate an appropriate liability cap? In some cases a service provider will seek that the liability cap is set by reference to the contract price (i.e. a percentage of the contract price, the contract price or a multiple of the contract price). While it may be valid to express the liability cap as a percentage of, or a multiple of the contract price, the liability cap should not be chosen simply because it is a particular proportion or multiple of the contract price. This is because the contract price by itself will not reflect the potential liability of the service provider, or the risk that the liability will be incurred.

The liability cap needs to be considered on a case by case basis. A number of factors should be taken into account, for example:

(a) the likely nature and extent of the risks of the contract, having regard to its size, complexity etc;

(b) an assessment of the damages that would be payable in the event of a claim in negligence (e.g. the cost of repeating the services/procuring a replacement system);

(c) the resources that the service provider could be expected to have available to meet any liability;

(d) any previous dealings between the parties; and(e) the amount and cover available to the service provider

(and the customer) under their respective insurance policies (and the ability of the parties to obtain insurance).

There are many different ways that liability caps can be expressed, for example: as a dollar amount; a percentage of the contract price; an increasing or decreasing cap over the term of the contract; or a specified amount per year. Prior to accepting any of these drafting forms, both parties need to understand the risk exposure and then choose the most appropriate drafting to suit the needs and, in particular, the agreed apportionment of risk between the parties.

7.17 Per event versus aggregate liability

“Per event”, “per occurrence” or “per claim” liability refers to liability that arises as a consequence of a single event, occurrence or claim or a series of related events, occurrences or claims resulting from a single cause or event. For the purposes of the general discussion in the following paragraphs these will be referenced using the term “per occurrence”.

To the extent that a liability cap is agreed on a per occurrence basis, the customer (or the party seeking to sue) would be able to recover up to the amount of the liability cap on each



50

occasion an event giving rise to loss or damage occurs. In the event of subsequent occurrences, the full amount of the agreed liability cap is available for the purpose of recovering damages on each occasion.

In the case of an aggregate liability cap, once the monetary limit has been reached, the service provider’s liability is effectively extinguished and the customer will have no further entitlement to damages from the service provider in respect of the liability. For example, if a service provider damages the customer’s property in the course of performing a contract, the customer would be able to recover its losses up to the amount of the relevant liability cap. If further damage is caused to the customer’s property as a result of a separate incident, the Customer can only recover damages to the extent that the first claim had not exhausted the amount available (if any) by virtue of the aggregate liability cap.

As a general concept, service providers prefer aggregate liability caps as such a cap gives them more certainty.

Per occurrence (or per event) cap is a more limited form of capping because it operates in relation to “each single occurrence (or event) or a series of related occurrences (or events) arising from a single cause”. A per occurrence (or per event) cap does not allow the service provider to form a view about its exposure under the contract as clearly as an aggregate cap does, and it is therefore likely to be more difficult for the service provider to make provision to support any possible liability and may cause the service provider’s insurance premiums to be higher to accommodate the uncertain risks. This may then be included in the price offered to the customer, and ultimately needs to be considered in the value for money assessment.

Some insurers may regard a per event cap as exposing the service provider to a higher level of risk, though they factor into the risk scenario the fact that if one occurrence results in a significant dispute or litigation between the parties, there are not likely to be many more occurrences as the contract will probably be terminated.

From the perspective of the customer, an aggregate cap also offers a larger liability cap to claim against in a damages claim. If an event occurs that triggers a claim by a customer against the service provider, the customer may also consider a termination option, in which case, obtaining claims for further occurrences may not be relevant.



51

7.18 Categories of liabilities which are capped

Customers should note that service providers may seek to reduce the categories and/or add new categories for the heads of liability for liability caps.

As a general rule, the customer should consider the obligations of the service provider under the contract and specifically the nature of the service being procured under the contract before agreeing to any amendments to the categories of liability caps. Customers should also consider the following:(a) Service providers may seek to limit their liability for an

insurable risk to the level of indemnity paid under the relevant insurance policy. The inclusion of a clause which has this effect would clearly be a positive outcome for a service provider. However, the insurance pay out will not necessarily reflect the loss or damage suffered by the customer and, therefore, inclusion of a clause of this nature should generally be resisted. If a customer is considering inclusion of such a clause, it should consider the terms of any relevant insurance policy, together with other issues relevant to determining a value for money outcome.

(b) English case law such as Canada Steamship Lines Ltd v The King [1952] AC 192 states that an exclusion clause will not be construed as applying to liability for negligence unless it expressly refers to negligence or it is clear that negligence was within the contemplation of the parties. As a result, for reasons of certainty, if the parties do intend to limit the liability of a party for its own negligence this should be stated expressly in the limitation of liability clause.

7.19 Terms for Limiting or Excluding Liability

As noted above, it is essential that exclusion clauses are drafted clearly. Sometimes clauses and terms put forward by service providers are developed by overseas lawyers or parent companies to suit foreign jurisdictions, and are not necessarily appropriate under English law. Service providers may propose to limit or exclude liability for things like “consequential loss”, “indirect loss”, “loss of profits” or “loss of use”.

Some of the terms proposed by service providers do not have a well defined meaning under English law and as such should not be included in the contract as the interpretation of these terms by a Court will depend on the circumstances and may not be favourable to the customer.

When negotiating the final form of a liability cap clause, the parties must ensure that the terms used have a meaning which



52

is clearly understood by the parties and which will be clearly understood and applied by the Courts. It should be noted that a number of the terms do not have a generally accepted meaning, or may have meanings in other jurisdictions (for example, the United States) which they do not have under English law. This emphasises the importance of the choice of law governing the contract. As a result, if the parties wish to use the term in a liability clause the term should be clearly defined.

Any exclusion proposed by a service provider must be the subject of a risk assessment and considered on a case by case basis. For example, a specifically defined loss in an exclusion clause could cut across what the customer would otherwise be entitled to be awarded as direct loss, and so may already be covered by one or other of the limitations provided for in the contract. If an exclusion is agreed, the clause must be carefully drafted so that it has a clear meaning in law as well as to ensure it is understood by the parties.

7.20 Restrictions on Limiting and Excluding Liability

Under English law if a term in a business to business contract purports to exclude or restrict the liability of one of the contracting parties, then that term may be subject to the Unfair Contract Terms Act 1977 (“UCTA”). Under UCTA, clauses that limit or exclude liability for negligence or for contractual liability (where, in the latter case, the limitation or exclusion is contained in the service provider’s standard terms of business) are only enforceable if they meet the “requirement of reasonableness”. This involves looking at all the circumstances that were or ought to have been known at the date of the contract, and at factors such as bargaining strength, inducements and alternatives available to the customer. Where a party seeks to restrict his liability to a specified amount, an English Court will consider “the resources which he could expect to be available to him for the purpose of meeting the liability and how far it was open to him to cover himself by insurance” (see Section 11(4) UCTA). This is not the same as what insurance either party actually had in place.

The application of the UCTA is such that an exclusion clause may be rendered completely ineffective if it does not satisfy the “requirement of reasonableness”. The English Courts will not re-write the clause by increasing the limitation to an amount they regard as being reasonable. Guidelines for the application of the reasonableness test are included in UCTA. These include:(a) the strength of the bargaining positions of the parties

relative to each other; and



53

(b) whether the customer knew or ought reasonably to have known of the existence and extent of the term.

The burden of proving that a term is reasonable falls upon the party seeking to rely on the clause (see Section 11(5) UCTA).

UCTA applies to all consumer contracts and to business contracts made on the service provider’ standard terms (and where contracts purport to exclude or limit liability for negligence). However, it has to be said that the Judges seem very relaxed about overcoming this hurdle and it is extremely hard to argue that UCTA (or some equivalent common law test) does not apply. Service providers should therefore consider the UCTA even in situations where the contract has been heavily negotiated. While standard terms are common in the IT industry, increasingly customers demand changes and the first step is to see when an amended contract is no longer “standard”. The English Courts have taken a wide view as to what is standard. Previous cases have established that:

(c) lengthy negotiation of a standard contract resulting in additional terms (St Albans v ICL [1996] 4 All ER 481); and

(d) adding exclusions from another agreement to a service provider’s standard form and using some of the customer’s own preferred terms (South West Water v ICL (unreported)), does not necessarily stop a contract being “standard.”

This trend was reinforced in the case of Pegler v Wang [2000] All ER (D) 260. In that case, the service provider was treated as having dealt on its standard terms, despite agreeing changes (including to its standard exclusions). The changes were still considered too minor to prevent the overall terms being standard. The judge suggested that to fall outside UCTA changes to standard exclusions needed to be “material”. Therefore, it is safer to assume that UCTA will apply in respect of most IT contracts.

Recommendations were published in February 2005 by the Law Commission for both England and Wales and Scotland respectively in relation to revising (amongst other things) UCTA. For the most part, the proposed new legislation will preserve the effect of UCTA in business to business contracts. The major change is in relation to “international supply contracts”. Currently UCTA does not apply to cross border contracts for the sale or supply of goods or services. It is proposed that the new legislation will apply to such contracts but only in so far as the goods are being delivered to the UK, regardless of whether the seller is based in the UK or overseas. Therefore, even if a contract is governed by law other than



54

English law, the UCTA would apply. The position in relation to cross border supply of services will not change.

Although the UK Government has announced its acceptance, in principle, of the recommendations tabled by the Law Commission, the timetable for change is unclear. An assessment of the cost impact of the proposals on UK businesses will have to be undertaken, as part of a wider public consultation.

Under English law it is also not possible to exclude or restrict liability for death or personal injury resulting from negligence (see Section 2(1) UCTA). With regard to other claims, a person cannot exclude or restrict their liability for negligence except insofar as the term or notice satisfies the requirement of reasonableness (see Section 2(2) UCTA).

Task 9Access a copy of Unfair Contract Terms Act 1977. You can, using the search function access a copy from the Office of Public Sector Information (http://www.opsi.gov.uk/acts.htm), Identify and print out the guidelines for the application of the reasonableness test.

7.21 Insurance Considerations

A significant factor for a customer to consider in determining whether to agree to limit a service provider’s liability is the nature and extent of insurance cover which the service provider may either have or be capable of obtaining in the marketplace. By its nature, insurance is the laying off of risk by an insured to an insurer, with the practical consequence that, in return for the payment of a premium, the insured has access to financial resources which may otherwise be unavailable to it.

It is in customer’s interests that, where it is exposed to risk under a contract by reason of the acts and omissions of a service provider, it has confidence knowing that the service provider has insurance cover available to it to indemnify it in respect of any liability it may have to the customer (or to anyone else) resulting from those acts or omissions.

The customer may take a view as to the appropriate liability cap dependent upon whether the service provider is, or is not, insured with respect to a particular liability and, if so, to what extent the service provider is insured.

The nature and extent of insurance cover which may be appropriate for a service provider to carry, in connection with a contract entered into with the customer, will vary depending



55

upon the nature of the contract and the risks which exist in its performance. Insurance, if available, may allow a service provider to accept a greater level of liability as compared to the customer relying on the service provider’s balance sheet.

In determining whether to agree to a request by a service provider for a liability cap with respect to the performance of the contract, the customer should not generally agree to any such limitation on lesser terms than are reasonably available in the marketplace to the service provider to effect and maintain insurance.

What is an appropriate level of cover or whether such insurance cover is available relative to any given contract is a matter for judgment on a case by case basis. If uncertain as to what the appropriate level of cover ought to be, in the context of a request by the service provider to limit or cap its liability, the customer should seek advice from its insurance advisers.

If insurance arranged by the service provider is relevant to the decision whether to agree to a liability limitation or cap, the customer may take the view that, where appropriate, it should also be insured under contracts of insurance affected or maintained by the service provider.

7.22 No recovery of loss by a third party

When thinking about how damages are measured and assessed, it is important to realise that you can only recover loss that you actually suffer. That is, you can’t recover for loss that your customers suffer or occupiers of a neighbouring building suffer (unless those customers or neighbours sue you and you have a “loss” in the sense that you need to pay them). There are some exceptions to this rule which are very technical and beyond the scope of this unit.

7.23 Other relevant concepts

There are some other concepts which are relevant to liability. This section is not intended to cover all the possible issues that impact on liability, but it outlines some of the common issues.

7.24 Mitigation – you must take steps to reduce your loss

Mitigation is the principle that “the law will only help you if you help yourself”. It means that if you are a party to a contract and the other party breaches the contract, you need to take reasonable steps to minimise the loss that you suffer as a result of the breach, not simply stand by and let the loss accumulate. You will not be able to recover that part of the loss attributable



56

to your failure to mitigate. The difficult question in each case will be what “reasonable” steps are. For a large company with substantial resources, what is “reasonable” would be very different to if we were talking about an individual person.

7.25 Liquidated damages – where the parties agree the amount of damages to be recovered if there is a breach

The amount that is agreed to be recovered in the event of a breach of contract is called “liquidated damages”. Liquidated damages are more like a debt than actual damages, once the trigger event has taken place, a party can sue to recover the liquidated damages amount as a debt due.

However, a Court will only enforce a liquidated damages clause if it is a genuine pre-estimate of loss. Courts will not enforce so-called liquidated damages clauses that are “penalties”.

If a Court decides that the liquidated damages in a contract are in fact penalties, you run the risk of them being unenforceable. So, the key when including liquidated damages clauses is not to call them penalties (it’s not fatal, but it certainly doesn’t help) and to make sure you can justify the amount that you have put in your contract (for example, if the liquidated damages are for delay, what the daily cost of a “workaround” will be; or what the interest forgone or paid would be etc).

If your liquidated damages clause is determined to be unenforceable, as the innocent party you can still have your loss assessed by a Court under the general legal principles governing assessment which we have been discussing. The liquidated damages/penalty clause will not be taken into account if that happens.

Liquidated damages clauses can be a double edged sword. They can speed up recovery (by short-cutting the need to prove loss) but can potentially limit the innocent party’s recovery. That is, if there is a liquidated damages clause as a genuine pre-estimate of loss and the innocent party actually suffers a greater loss, the extra loss is not recoverable.Liquidated damages are discussed in further detail in Unit 4.

7.26 Exclusion clauses – exclude particular kinds of liability

Exclusion clauses, as the name suggests, are clauses dealing with liability for losses that the parties want to exclude. They mean that a party will not be liable, even if the common law says they would be.



57

Categories of exclusions for liability caps which may be raised during contract negotiations include loss or damages caused by, or in connection with:(a) breach of confidentiality or data protection/privacy

requirements;

(b) breach of a statutory requirement (laws, regulations or by-laws relating to the performance of the contract, or the lawful requirements of any authority with respect to the performance of the contract);

(c) breach of indemnity, which may include any indemnity in addition to the intellectual property indemnity; and

(d) malicious or fraudulent acts.

Whether or not the above categories of loss should be excluded from the liability cap will of course depend on the nature of the contract and the damage or loss which could be suffered by the customer if the service provider breached each specific requirement.

It is likely to be a policy decision for the customer as to whether to exclude damages or loss resulting from malicious or fraudulent events from the liability caps. However, if there is a concern that the service provider may not have sufficient safeguards against malicious or fraudulent acts being perpetrated during the course of the contract, such an exclusion is important. This issue, for example, could arise where a service provider is performing outsourced services for a public sector customer and in doing so may have access to public money.

7.27 Mutual liability caps – liability cap for the customer

Service provider’s often take the view that some customers (particularly those large ones, by reason of their size and financial strength), are capable of discharging their liability to the service provider for its breach, without having a liability cap.

However as a matter of general principle, there is no reason why, when requested by a service provider to agree to a liability cap, the customer should not consider, as a term of agreeing to the service provider’s request, requiring a liability cap on the liability of the customer to the service provider in respect of any breach of contract or other action by the customer. In other words, there is no necessary reason why the process should be a “one way street”. If a service provider is asking the customer to forego valuable rights which may otherwise be available to it, it may not be unreasonable for the customer to make a similar request of the service provider.



58

Thus, whilst it will be a matter for judgment in the case of each and every contract, the customer should approach any request by a service provider for a liability cap provision from the view that the customer should be provided with a similar benefit by the service provider. It is possible for example, that a customer could, through its act or omission, cause damage to the service provider. A customer liability cap would protect the customer in such a case. In the event an agreement is reached upon mutual limitations of liability, the provisions of the contract in favour of the customer will usually be a mirror of the limitation of liability provisions in favour of the service provider (except to the extent that the clause is not relevant).

7.28 Review of caps

If the scope of the services is amended or amendments made to the contract have the effect of increasing the contract price above a specified level, the parties may consider such an event as a trigger for a review of the liability caps.

In particular, triggers which require the parties to review the liability caps in a contract should relate to stages at which the level of risk and/or potential liability faced by one or both parties will change. This may relate to matters such as:

(a) the stage of completion of the services;(b) any change in the delivery obligations on the service

provider; or(c) addition of out of scope work through the change control

procedure.

8. Indemnites

8.1 What is an indemnity?

When lawyers use the word “indemnity” they are talking about a concept that is similar to insurance.

For example, your home and contents insurer insures you against certain types of damage to your house such as fire or theft. The policy might actually be worded to say that the insurance company indemnifies you against certain types of losses like fire, theft etc. The concept is that you will not be “harmed” by these types of events, even if they do happen. Once the particular event occurs, the insurer must honour its promise by paying you the value of what has been burnt, stolen etc. This illustrates that anyone who provides an indemnity is accepting a responsibility like that of an insurer.

It is important to note that the responsibility under an indemnity can be greater than the responsibility at common



59

law. The reason for this is it can capture losses that the common law would see as too remote.

You often see language in contracts like: “Party A indemnifies party B from any loss, costs or damage suffered or incurred by Party B as a result of X”. In essence, a party giving an indemnity of this nature is promising to “make good” any loss, costs or damage suffered or incurred by Party B as a result of X.

8.2 Indemnity versus liability cap

Indemnities and liability caps are different concepts.

It is often important to have a liability cap if a party is giving a broad indemnity. Having an indemnity does not mean that there is a liability cap and vice versa. The two concepts are mutually exclusive.

If you have an indemnity without a liability cap, then the indemnifying party’s obligation to indemnify you is presumed to be uncapped.

8.3 Main kinds of indemnities

Contractual indemnities come in different forms and have different purposes. When you are thinking about indemnities and including one in a contract, it is important to understand that each kind of indemnity serves a different purpose.

(a) The first type of indemnity is really a reflection of the basic concept, that is, a person agrees to hold another harmless on the occurrence of a particular event, for example, the home insurer and an event like a fire. This type of indemnity is called a general indemnity.

(b) The second type of indemnity is a variation on that theme. It involves a person agreeing to hold another harmless in relation to the conduct of a third party, for example, where a customer enters into a contract with a supplier and then a third company, perhaps the parent company of the supplier, indemnifies the customer in respect of the supplier’s obligations. A customer might want this type of arrangement where the party it is contracting with is not the party with all the assets. This type of indemnity is called a guarantee and indemnity.

(c) The third type of indemnity that you may see is where one party agrees to hold the other party harmless against any loss or damage arising from a claim by a unknown third party, for example, where a licensor of intellectual property such as a software supplier indemnifies the licensee or the



60

purchaser of the software against any infringement claims by third parties (a third-party indemnity).

A customer or end-user will naturally be concerned that its use of the software may involve the breach of a third party’s intellectual property rights and in order to assist the customer controlling its liability, might require an indemnity from the licensor. The effect of this would be that even if the customer’s use of the software infringes the IP rights of a third party, the licensor would make good any loss that the customer suffers as a result of the third party making an IP infringement claim against the customer.

(d) The fourth type of indemnity is a provision that says a party to a contract who is in breach will hold the other party (the innocent party) harmless against any loss or damage arising from the breach. This type of indemnity is called a party-party indemnity. This sort of indemnity can build upon a liability framework and usually entitles the innocent party to claim more compensation than they could claim under the principles of common law damages.

8.4 Operation of indemnities

An indemnity is a powerful device which should not be taken lightly.

In particular, a party party indemnity usually means greater protection for the indemnified party than is provided by the general contract law rules on the recovery of damages. That is, you should assume that a party party indemnity means “extra” liability.

This is one of the reasons why you should advise your clients to think very carefully before giving indemnities in all but the most exceptional circumstances. Yet, party-party indemnities are surprisingly common.

8.5 Issues for consideration in relation to indemnities

Here are some of the additional things that you should keep in mind in relation to indemnities.

(a) An indemnity is “triggered” on the happening of an event – no extra breach is required

If there is a party party indemnity in the contract (and breach of the contract is not a condition precedent to liability on the indemnity), then a breach is not required to trigger the indemnity.



61

(b) Indemnities can displace the common law rules on assessing liability and damages

Where an indemnity is given in respect of a breach by the indemnifier of some particular provision of the contract – the indemnity is likely to be interpreted as having displaced the common law rules on damages such as the rule on remoteness of damage.

8.6 Issues in drafting indemnities

Indemnities are a very complex area of law. As with liability clauses, words used in indemnities have quite specific meanings and some minor changes in language can change the effect substantially. It is also very important to consider how they sit with other liability regimes (for example, damages) in any contract.

Task 10

For each of the following identify the type of indemnity:

Indemnity example 1:

The Supplier is solely liable for and indemnifies the Principal from and against any Loss or Claim suffered by or made against the Principal or any of its Officers as a direct or indirect result of the Supplier’s failure to provide the Services in accordance with this Agreement.


The Contractor shall be solely liable for, and shall be deemed to indemnify and hold harmless the company against any and all liabilities, losses, damages of every name or nature whatsoever arising whether under any statute or at common law in respect of personal injury or death of any and all persons employed by it in the execution of the Work/Services resulting either directly or as a consequence of the performance of the Work/Services under the Contract.


The Contractor shall at all times, during and after the Term, on written demand indemnify the Authority and keep the Authority indemnified against all losses, damages, costs or expenses and other liabilities (including legal fees) incurred by, awarded against or agreed to be paid by the Authority arising from an IPR Claim.



62

9. Confidentiality9.1 Introduction

The value of confidential information to a business is well documented. From the formula for Coca-Cola to the Colonel’s secret 11 herbs and spices chicken recipe (for Kentucky Fried Chicken), the protection and controlled use of confidential information allows businesses to retain a competitive edge in the marketplace.

Given the value of confidential information, businesses seek to protect confidential information. How can confidential information be protected? The most common way is by entering into a confidentiality agreement with the recipient. It should also be noted that an obligation to keep information confidential may also be implied by law because of the special relationship between the parties involved. For example, that of employer and employee, doctor and patient.

9.2 Confidentialinformationversusintellectualproperty

Confidential information is not necessarily the same as intellectual property. Entering into a confidentiality agreement or non-disclosure agreement is not the same as entering into an arrangement for the ownership or licensing of intellectual property. Intellectual property and confidentiality are two different concepts.

9.3 Whatisconfidentialinformation?

There is no precise legal definition of “confidential information”.

However, the common law has given us some rules for determining if there has been a breach of confidentiality.

There are three basic elements to establishing a breach of confidence. These are:(a) the information must not be publicly known (i.e. it “must

have the necessary quality of confidence”);(b) information must have been communicated in

circumstances importing an “obligation of confidence”; and(c) there must have been unauthorised use or disclosure of

the information.Let’s look at each of these elements in turn.



63

9.3.2 Necessaryqualityofconfidence/notpublicly known

In many cases, the necessary “quality of confidence”, such as a secret formula, is easily recognised. Often, however, disputes arise about allegedly confidential information which is little different to that already in the public domain or which can, with effort be pieced together from what is in the public domain.

Checklist of things to consider when thinking about whether information might be “confidential”1. Is it known outside the particular business?2. To what extent is it known by people within the

business?3. What measures are taken to protect its secrecy?4. What value is it to the business, its competitors

and potential competitors?5. How much money or effort has been spent

developing it?6. How difficult would it be for others to duplicate?7. Would there be damage to the business if it were

revealed?

9.3.3 Communication in circumstances of confidence

The second element is that the recipient must know (or be taken to know) that the information is being given in confidence. They might know because they are told – or they might be taken to have known because of the relationship between the two parties (for example, tax adviser and client).

Third parties can also be placed under obligations of confidentiality – for example, if one of you came to know that two other parties were in confidential negotiations and what they were negotiating (because you overheard a conversation). The key issue is that you would have to know that the information was confidential or have agreed that it was confidential.

9.3.4 Unauthorised use or disclosure

The third element is that there must be unauthorised use or disclosure. This is the heart of the issue. The most obvious way to be in breach of a confidentiality



64

obligation to person A is to tell or provide the information to person B.

9.4 Benefitsofconfidentialityagreements

A formal written confidentiality agreement can provide a disclosing party with a greater level of protection of its sensitive technical or commercial information than that offered at common law. It also provides certainty around the extent of protection by setting out in detail the conduct which the disclosing party expects from the recipient.

A confidentiality agreement does not need to be limited to trade secrets (secrets which give the disclosing party a commercial advantage). It only matters that the information is not in the public domain, and is important to the disclosing party’s interest.

A confidentiality agreement establishes a simple contractual obligation which, as well as being easier to enforce, will assist a claim for breach of confidence because it confirms that the relationship is one of confidence (which can otherwise be difficult to establish). As such, in the event of unauthorised disclosure of confidential information, an action may be brought for breach of confidence at common law and for breach of contract.

A further benefit of a confidentiality agreement is that it enables the parties to tailor the rights and responsibilities of both parties to the particular circumstances, and to include other contractual provisions such as mechanisms for dispute resolution. If a collaboration or joint venture is involved, the confidentiality agreement can also lay ground rules regarding intellectual property ownership and licensing.

Also, much of the information that companies will look to protect is in the form of ideas or concepts, for example, a new business idea or a way of obtaining a competitive advantage. Unless these ideas or concepts are patentable, the only way they can be safeguarded is to keep them secret. Confidentiality agreements are often the best form of protecting these ideas and concepts from unauthorised exploitation when you need to share them with others.

9.5 Checklist of practical points

A checklist of some of the practical points to note are:(a) not every mention of an idea by one person to another

will be protected;



65

(b) the information itself needs to be given in circumstances where the recipient knows, or ought reasonably to know, that the information is confidential;

(c) confidential information can be oral information , it doesn’t need to be written down;

(d) unauthorised use of the information is a breach of confidence and whether or not it is disclosed or revealed to another person;

(e) there will be no breach if the information is derived independently.

What a company disclosing confidential information obviously does not want to do, though, is go to Court and spend days trying to prove that information disclosed was given in circumstances of confidence. Agreeing contractually what information is confidential and what uses can be made of it can short-circuit this.

9.6 Remedies and risks

Having looked at the three elements we need to think about what the sanctions or remedies for breach of confidence are. Generally available remedies are:(a) injunction (Court order to restrain use or disclosure of the

information);(b) damages (to compensate for loss caused by a breach of

confidence);(c) account of profits. Unlike damages, this focuses on stripping

the person in breach of the “gain” they have made rather than compensating the defendant. It should be noted that account of profits are rarely awarded in breach of confidence cases.

From a practical perspective, there is much more to be gained by acting before a breach of confidence occurs. This is because damages are often not sufficient to compensate a party for this breach.

9.7 Confidentialityagreements/clauses

We have mentioned confidentiality agreements/clauses a few times now and now that we have an understanding of what obligations of confidence are, we need to look at the purpose of confidentiality agreements and some common questions regarding them.

Although this section focussed on confidentiality agreements, the concepts are also similar to confidentiality clauses which appear in many IT contracts.



66

9.8 Purposeofconfidentialityagreements

A confidentiality agreement has basically three purposes:(a) it defines what information is “confidential”;(b) it limits the disclosure of that information; and(c) it imposes restrictions upon the recipient’s use of that

information.

9.9 Somecommonquestionsregardingconfidentialityagreements

9.9.1 WhatifIdon’thaveaconfidentialityagreement?

If an entity to whom you have disclosed confidential information (without entering into a confidentiality agreement) then uses or discloses that information without your permission, you may still be able to take action through the courts.

The position at common law is that any person who receives confidential information has an equitable duty not to disclose or use it without permission. Unauthorised disclosure or use of confidential information can be prevented through a common law action for breach of confidence.

To establish breach of confidence (absent an enforceable confidentiality agreement), as mentioned above, you must show that:(a) the information in question was of a confidential

nature (ie not public property or knowledge);(b) the information was communicated in

circumstances importing an obligation of confidence; and

(c) there was an actual or anticipated unauthorised use or disclosure of the information to the detriment of the disclosing party.

Without supporting evidence, it can be difficult to establish that the information was imparted in circumstances where it ought to have been apparent that the information was given confidentially. This requires that the party to whom you disclose the information must have been asked to treat the information as confidential or it must have been obvious to him or her that the information was given in confidence. Establishing that the unauthorised



67

use or disclosure was to your detriment can also be problematic.

9.9.2 Is it useful to limit the recipients use of confidentialinformation?

Definitely yes. Evaluation is certainly the most common use of confidential information, but it is by no means the only use.

Whatever the allowable uses, specify them in the confidentiality agreement. Limit the recipient to only the uses specified. If you do not do this, the recipient may use the information for purposes that you never intended.

Limit the recipient’s discretion. Make them come to you for permission to use the confidential information in a manner not authorised in the confidentiality agreement.

9.9.3 How can we bind individuals when a corporateentitysignstheconfidentialityagreement?

Because corporations are made up of people, a confidentiality agreement will often specify the individuals that will receive confidential information and the circumstances under which such individuals will receive confidential information. There are several ways to do this.

One way is to attach a schedule of individuals who may receive confidential information. The agreement would then restrict access only to those persons identified in such schedule.

Some confidentiality agreements require the individuals who actually receive the information to sign a statement agreeing to be bound by the terms that apply to the corporate recipient.

The key benefit of such a statement is that it gives the discloser of the confidential information a direct right of action against an individual who breaches the confidentiality agreement.



68

9.9.4 How can we deal with the situation if the discloserisnottheowneroftheconfidentialinformation

Sometimes, the discloser of confidential information is not the owner of the information. An affiliate, subsidiary or parent of the discloser may own the information, or it may even be owned by an individual shareholder of the discloser.

It is not necessary to include each and every owner of confidential information as a separate contracting party.

In cases where the confidential information is owned by person(s) other than the discloser, the agreement should define confidential information to include information supplied by such other person(s), so name them too.

9.9.5 Do we have to mark information confidential?

Clients often ask whether they have to mark information that they disclose as “confidential”. Although marking information “confidential” is certainly desirable, it is generally impractical.

The same is true with the requirement that confidential information be identified as such at the time of disclosure. In the rush of business, even reasonably diligent people will forget to identify information as confidential.

To deal with this include a clause to the effect that information shall be deemed confidential whether or not it is identified as such at the time of disclosure. Information is therefore presumed confidential unless otherwise noted.

9.9.6 Are there any special issues I need to be awareofiftheconfidentialinformationisnot written on paper?

Documentary information is the most common form of confidential information.

However, confidential information comes in a variety of formats. It may be electronic, such as a floppy disk, videotape, audiotape, CD-Rom or a secure website.



69

It may come from a visual examination, such as viewing a prototype or taking a plant tour. Plant tours frequently involve the disclosure of far more confidential information than documentary information.

Whereas documentary information can be stamped confidential and thereafter easily identified, this is not so with information received during a visual examination.

Unfortunately, a confidentiality agreement is a very imperfect means of protecting information received during a visual examination.

The best way to approach this problem is that if visual examination is the most likely means of disclosing confidential information, you should prepare a simple addendum to the confidentiality agreement describing the visual presentation and what elements thereof the discloser considers confidential.

9.9.7 The agreement I have signed has some “carve-outs”relatingtoconfidentialagreement. Is this OK?

There are some standard exceptions that appear in most confidentiality agreements. For example, exceptions relating to information that the recipient can demonstrate that they already knew at the time of disclosure (i.e. prior knowledge) or to information independently developed.

What you need to be aware of is that there is no such thing as unadulterated, 100% pure confidential information. Confidential information is always likely to be combined with material falling within one of the exceptions. The material may be in a public domain or be subject to the “prior knowledge” exception.

It is most likely that every single page of confidential information will contain at least some extraneous bits of non-confidential information. Thus, all confidential information, by its nature, is hybrid. Make sure that the confidentiality agreement does not treat confidential information as an all or nothing proposition. If it does, the discloser will always lose out.



70

9.9.8 Should I get protection for the recipient’s work product?

You give the recipient confidential information. There is no issue about its confidentiality. From your information, the recipient prepares internal memoranda, reports and other documents. This is to be expected and you can’t reasonably ask a recipient not to do this.

The issue then arises as to whether these are confidential. They are not your memoranda, reports or documents, while they may include your confidential information, the recipient prepared them from scratch.

The value of a piece of paper containing information is determined by the information on the paper. Therefore, your aim is not to protect specific pieces of paper; your aim is to protect specific pieces of information.

Therefore, your claim of confidentiality should extend to any memoranda, reports or documents that the recipient compiles or generates from information that you disclosed to the recipient.

9.9.9 Do I need to be aware of any issues post-termination?

Upon termination of a confidentiality agreement, the recipient should stop using the confidential information.

The confidentiality agreement should establish a procedure whereby, upon termination, confidential information is either returned to the disclosure or destroyed. Also, the confidentiality of the information should continue post-termination.

Incidentally, you don’t have to wait until the confidentiality agreement terminates to get back your confidential information. You should have the right to recall your confidential information at any time during the term of the agreement.



71

Task 11

What is the purpose of the following clause in a confidentiality agreement?

The Recipient shall only disclose the Confidential Information to those of its trusted employees and agents who require it for the purposes described in the agreement. The Recipient shall fully inform its employees and agents of the Recipient’s obligations to the Discloser concerning the Confidential Information. The Recipient shall obtain written confidentiality undertakings from its employees before disclosing any Confidential Information to them. The Recipient shall be responsible for making sure that its employees and agents understand and comply with such obligations.

N.B. The area of contract law is vast and for a detailed understanding of this topic, the learner should consult one of the many text books available for contract law.

unit 1: overview of general contract principles - software... · overview of general contract...

Documents