Pre-contractual negotiations – warranties and exclusion clauses
by Brett McGuire and Tony Grasso, Coudert Bothers
Brett McGuire and Tony Grasso of Coudert Brothers, assert that any good business relationship is usually the product of successful pre-contractual negotiations, particularly when negotiating IT contracts. They emphasis that getting matters right at the start of negotiations will enhance the relationship between the parties and will avoid future problems. The authors identify what they believe to be the crucial elements required for successful pre-contractual negotiations of IT contracts and proceed to outline the general principles of contract law relating to warranties, exclusion clauses and indemnity clauses. They also consider the provisions and implications of the Trade Practices Act (Cth) 1974 upon the negotiation and terms of IT contracts.
Brett is a senior member of Coudert Brothers' IT, E-commerce and Telco groups. He has extensive IT and cyber-law experience having acted for a wide variety of Internet based companies and software developers. He also heads Coudert Brothers' privacy practice group and is a member of a number of working parties, including the Internet Industry Association Working Party on Privacy. Tony is an associate in Coudert Brothers' IT group. Tony's practice involves all aspects of e-commerce, information technology and intellectual property.
The basis of any good business relationship is usually laid down at the pre-contractual negotiation stage, particularly when negotiating Information Technology (IT) contracts. Accordingly, for an IT contract to be truly successful it is important that the parties get it right at this early stage. This will enhance the relationship between the parties and will avoid problems further down the track.
In this paper we propose to identify the crucial elements required for successful pre-contractual negotiations of IT contracts. This will be followed by a discussion of the general principles of contract law relating to warranties, exclusion clauses and indemnity clauses as well a consideration of the provisions and implications of the Trade Practices Act (Cth) 1974 (TPA) upon the negotiation and terms of IT contracts.
1. Elements required to achieve successful pre-contractual negotiations
There are three simple but important elements that should be present in order to achieve success in pre-contractual negotiations. They are:
(a) Understanding what exactly you want the contractual arrangement to achieve If you are a purchaser, this means understanding your business needs and ascertaining the requirements that the goods and/or services supplied must satisfy as well as ascertaining what the appropriate market price for such goods and/or services will be. If you are the vendor this means understanding your business capabilities and what exactly you can and cannot offer potential purchasers;
(b) Have an insight into what the other party will be looking to get out of the contract. A good understanding of the other side's business needs and requirements will put you in a better bargaining position, allowing you to determine which aspects the other side may be willing to concede and therefore allowing you to achieve better results;
(c) Be prepared. There is no substitute for good preparation at the pre-contractual stage. Attempting to negotiate a contract on a "blind" basis is more than likely going to lead to undesirable results. In addition, when both parties are thoroughly prepared significant cost savings can be achieved as the parties can reach a satisfactory agreement much more quickly then what might otherwise be the case.
But what is the purpose of negotiating a contract in the first place? One of the primary functions of any contract is to govern the allocation of risk between the parties. This means that the negotiator needs to also have a good understanding of the general principles of contract law in respect of the following:
· Warranties clauses;
· Exclusion clause;
· Indemnity clauses; and
· relevant statutory provisions including those of the TPA.
2. Warranties Clauses
One way of holding parties to the representations made by them during pre-contractual negotiations is to incorporate the content of the representations made by that party into warranties contained within the terms of the contract. A warranty is essentially an assurance that a proposition of fact is true.
When negotiating IT contracts, purchasers will generally seek broad warranties from the vendor that the product being bargained for will satisfy the purchaser's needs, will comply with the purchaser's current IT systems and that any services supplied by the vendor will be supplied with due care, skill and diligence. In addition, purchasers should generally try to incorporate as a warranty to the contract, any representations made by the vendor in respect of the "performance" of the product.
Vendors, on the other hand, will generally seek to limit such warranties and make them conditional upon such criteria as the purchaser ensuring that it uses the product according to the vendor's instructions.
Warranties are an excellent tool through which the parties can seek to allocate risk, and they should be seen as such. The parties should ensure that they are happy to live with any risks imposed upon them by the warranties, and as far as possible, should be comfortable taking on such risks. Accordingly, any warranties incorporated in a contract should not contain representations which the maker of those representations (be they the purchaser or the vendor) knows are not true or knows they can not satisfy. Conversely, a party should not seek warranties from the other side which they know will be difficult or impossible to satisfy, particularly where such warranties are superfluous.
In addition, the parties should seek to agree on what is to happen if a warranty is breached. Most purchasers or vendors will normally agree that the contract will contain warranty clauses under which any default purporting to be a breach of a warranty, must be remedied by the breaching party within a specified period. In the absence of the defaulting party remedying the default within that period, the non-breaching party will be entitled to sue for damages as a result of the breach but usually cannot terminate the contract on the basis of the breach of warranty alone.
3. Exclusion and Indemnity clauses
Two other mechanisms through which the parties may allocate risk are exclusion and indemnity clauses.
(a) Exclusion clauses
Not all parties are prepared to accept full contractual responsibility in the event of a breach on their part. Exclusion clauses usually try to avoid liability for particular actions/non actions by a party. They are subject to statute law and public policy. Thus, an exclusion clause purporting to avoid liability for breach of a warranty implied by the TPA will not be enforced by a court, particularly as a result of section 68 of the TPA which seeks to protect consumers from such exclusion clauses (see discussion below under the heading "Trade Practices Act Considerations"). There are three main types of exclusion clauses namely:
(i) complete exclusion of liability subject to public policy (ie a party may try to exclude certain types of liability eg liability for consequential loss). Parties should be careful that they don't allow the other party to exclude a liability for which they ought to be responsible;
(ii) capped liability (ie a party's liability is capped to a certain monetary amount). Where the vendor insists on such a clause, the purchaser will better be able to negotiate the price;
(iii) conditional exclusions of liability (eg claim must be brought within 12 months of breach). The exclusion will not be valid unless the condition is satisfied.
When drafting exclusion clauses there are several rules of construction that apply. The primary rules are as follows:
(i) Generally, the more serious the breach, the less likely it is for the parties to have intended an exclusion for liability arsing from the breach.
(ii) The reasonableness of the exclusion clause is also relevant to its enforceability. Courts will be reluctant to enforce an exclusion clause which on the face of it, appears to operate unreasonably, notwithstanding that, the courts will not reject an exclusion clause as invalid if the words used in the clause are clear and capable of only one meaning.
(iii) In the construction of exclusion clauses, the courts will generally apply the "contra proferentem" rule, such that where there is an ambiguity in the exclusion clause, the clause will be construed in the non-breaching party's favour.
(iv) A party cannot hide behind an exclusion clause where the product supplied under a contract is different to that bargained for. This rule is premised on the fact that the parties are assumed not to have contemplated such misperformance.
(iv) The courts will consider the "main purpose" of the contract, and will declare an exclusion clause which defeats the main purpose as invalid. Thus an exclusion clause completely excluding liability for non-performance will generally be seen as invalid as such a clause would defeat the main purpose of the contract.
(vi) If the parties wish to exclude liability for negligence this must be clearly expressed in the terms of the contract. Normally, an express reference to the exclusion for liability for negligence will be sufficient. However where there is no such reference the question for the court will be whether an intention to exclude liability for negligence should be imputed to the parties.
(vii) By virtue of the privity of contract rule, exclusion clauses only protect the parties to the contract.
(b) Indemnity Clauses
The third type of risk allocation mechanism are Indemnity clauses. Indemnity clauses can be thought of as "insurance" or "guarantee" type clauses. There are two main types of indemnity clauses:
(i) Third-party - includes clauses in a contract stating that one party will hold the other harmless against any loss or damage arising from a claim by a third party, whether connected with the contract or not; and
(ii) Party-party - includes indemnity clauses whereby one party agrees to take on the legal liability for any actions taken by the other party as a result of the indemnified party's breach.
In construing indemnity clauses the courts will usually adopt similar rules of construction used to interpret exclusion clause (see point (i) to (vii) under the heading "exclusion clauses").
4. Trade Practices Act ("TPA") Considerations
A further consideration at the pre-contractual negotiation stage is whether or not the Trade Practices Act Cth 1974 applies. In order to decide whether the TPA will apply the parties will need to determine:
(a) if the purchaser can be classified as a "consumer" under the TPA; and
(b) whether the products to be supplied under the contract constitute "goods" or "services" for the purposes of the TPA.
Clause 4B of the TPA provides that for the purposes of the TPA a person shall be taken to have acquired particular goods as a "consumer" if, and only if, the price of the goods did not exceed $40,000 and the person did not acquire the goods, or hold himself or herself out as acquiring the goods, for the purpose of re-supply or for the purpose of using them up or transforming them, in trade or commerce, in the course of a process of production or manufacture or of repairing or treating other goods or fixtures on land.
The definition of "goods" under the TPA is not exhaustive. Whether or not the provision of software pursuant to a contract constitutes the supply of "goods" or "services" is unclear, but it is likely that it would be a mixture of both, depending upon the terms of the contract.
If it is determined that the TPA does apply, then Division 2 Part 5 of the TPA will imply certain non excludable conditions and warranties in to the terms of the contract.
The main warranties that are implied by the TPA are:
(a) good title and right to quiet enjoyment (s. 69);
(b) goods are fit for their specified purpose (s. 71);
(c) services will be provided with due care and diligence (s. 74(1));
(d) services will be provided for an appropriate purpose. (s. 74(2)).
A clause purporting to exclude, restrict or modify any of the above warranties is void pursuant to section 68 of the TPA.
Where the TPA does not apply the parties (in particular the purchaser) should at least seek to protect themselves to a similar level as provided for in the TPA. That is the contract should contain, at the very least, the warranties mentioned in (a) to (d) above.
5. Conclusion
The key to successful pre-contractual negotiations is knowing yourself, knowing the other side and preparation. A good understanding of basic contract law is also useful in making a contract a success. However, a contract's ultimate success will depend upon the parties' ability to satisfactorily allocate risk between themselves and to bargain for a product they want (if they are a purchaser) and know what they can offer (if they are the vendor).
June 2001 contents
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