Contracts and Indebtedness 101
Contracts, in essence, are agreements between two or more parties which involve various aspects of law, including how the parties will conduct various types of transactions, how contracts will impact the parties’ legal rights and responsibilities, various business matters and, of course, who’s going to pay up financially if things don’t go quite as planned.
Indebtedness, meanwhile, can stem from any number of financial transactions that involve debt, which is created when parties involved promise, through a legally binding instrument, payment in the future for property these parties receive today.
So, for example, let’s say you’re purchasing a home. The home lender will provide you with the money to purchase the home. In turn, you’ll promise the lender your future mortgage payments, granting them a lien on the home itself . This means that the lender has an interest (or "lien") in the home, and if you don’t make your loan payments, the lender has the right to recover the money it’s missing by foreclosing on and taking possession of the home.
There are many different forms of indebtedness, but they typically are created by formal promises to pay – often secured by collateral – that parties utilize to obtain or pay for a wide range of goods and services. Indebtedness relates to contracts because these promises are codified through written agreements, or contracts, which often define how much the debtor must pay, how interest will be applied, when payments are due and what happens if the debtor misses a payment.
Further, contracts that call for payments are typically performed over a certain period of time, which can differ considerably based on the type of contract involved and the business and legal concerns at play. In some cases, the payments can stretch over the course of decades, as is common in home mortgages.
Contract Law
Contracts are an essential part of doing business and are generally defined as an agreement between two or more parties to do or to not do a given thing. To be legally binding, each party to the contract must have contractual capacity; this means that they are over 18 years of age and of sound mind when signing. The contents of the contract must not be illegal or against public policy. Every person who signs the contract should understand the contents, and only after the parties have executed the contract does it become legally binding. A contract generally requires "consideration" to be legally enforceable, which is a legal term for something of value (usually money) that is exchanged within the context of the contract.
Although contracts can be fairly informal, certain types of contracts must be executed in writing to be legally enforceable. These types of contracts typically include:
A contract based on the sale of real property must be in a writing that is signed by the person selling the property.
Promissory notes or bonds (which are legally considered negotiable instruments) must be in writing and signed by the person to whom the note or bond is payable. An example of a note would be an IOU, while a bond is a promise to pay a certain amount of interest on a sum of money.
A contract based on an agreement that cannot be performed within one year must be in writing. An example of this would be a contract between a car service and a business that requires the car service to provide services for one year. However, if the contract can be performed within one year, it does not need to be in writing to be legally enforceable.
A contract made in consideration of marriage must be in writing, such as a prenuptial agreement.
Some types of contracts where indebtedness is often incurred include sales contracts, leases (which may also be classified as a license), and loan agreements.
Indebtedness in Contracts
Contracts can create debts, and most of the money problems debtors face are caused by a breach of contract. A loan is a breach of contract situation where a creditor did not receive a payment. In situations where a party does not follow through on its obligations, the one left hanging with empty pockets from your perspective, will seek to collect on the breach of contract. Since creditors don’t get paid if the contract is broken, it’s in the debtors best interest to keep its obligations.
The focus of today’s discussion is not so much breached contracts, but debt that arises out of a contract. Both contracts and debts are governed by the Texas Business and Commerce Code, titled "Uniform Commercial Code", section "Sec. 3.101". The first four sections of that chapter are: "General Provisions", "General Definitions and Principles of Interpretation", "Notice, Signature, Agreement and Conspicuousness of Terms", and "Obtaining Payment or Collateral From Third Persons": together, a fairly comprehensive statement on the common laws of contracts and indebtedness. Some typical situations of debt arising from a contract are: A lender makes a loan and you borrow the money; You sign a personal guaranty of a debt; You sign a lease for an apartment, car, or equipment; or You give a check to someone else. Perhaps the most common way of the four presented here, is that last one: writing a bad check.
Writing a bad check creates a contractual obligation under the Texas Business and Commerce Code. Section 3.103 provides: (2) "Instrument" means a negotiable instrument. (6) "Negotiable instrument" means an unconditional promise or order to pay a fixed amount of money with or without interest that: (A) is payable to bearer or to an identified person; (B) is payable on demand or at a definite time; and (C) is payable in the medium and in the kind of money described. (7) "Order" means a written instruction to pay money made by the signer to the drawee. (12) "Promise" means a written undertaking to pay money signed by the person undertaking. (11) "Draft" means: (A) an unconditional order, addressed by the drawer to the drawee, to pay a sum certain in money, and which is not expressed to be only an authorization or assurance of payment; or (B) a check. (14) "Check" means a draft, other than a documentary draft, that is : (A) payable on demand; and (B) drawn on a banker. "Section 1.201 Changes. (54) checks, drafts, and orders for the payment of money payable to the order of a payee or other promise or order to pay money" [emphasis added.]
In other words, by writing checks, you’ve undertaken to pay the recipient’s contract obligation to his/its creditor.
So, what happens when you don’t pay. Quite simply you are now liable for breach of contract. When you take out a loan, sign a personal guarantee of a loan, lease an apartment, take a lease on a truck, and else, you become contractually obligated to pay. If you don’t do so, the breach of contract claim will be able to collect on the debt. The breach allows the creditor to sue immediately for the outstanding amount that’s owed. It’s the same for all other forms of contract, the right to sue arises immediately upon breach of the promise.
Finally, what happens when you write a bad check. Well, there’s criminal and civil liability for a bad check, and criminal penalties include imprisonment. So, more on this identifiable debt tomorrow.
Contractual Indebtedness
Managers of contracting entities which are generating a net deficit have a number of options to manage and reduce their indebtedness resulting from contracts. Some of these options need to be considered at an early stage in the contract management process. Others will arise at a later point in the management of the contract.
Pursuant to a management resource consent, a company will often need to raise funds to pay the balance owing on a contract. Funding may be from equity, loans, or a bank facility. Contracting entities often turn the same investors to fund each contract (or to a small pool of investors) which makes it difficult for those investors to refuse to provide that funding.
On some occasions, it may be desirable for a company to negotiate with its investors for a deferral of payments, a reduced return, an extension of the repayment period or a reduction in the principal amount outstanding. Whether this is achievable will depend on individual circumstances.
It is often the case that there are unplanned changes in the delivery of a contract which result in increased costs. These may include an increase in wages, fuel prices or in construction costs which make the contract deficit worse.
There are a number of mechanisms that can be used to deal with a contract deficit. An early warning that a contract will have a deficit allows creditors to mitigate their risk of non-payment, whether by insisting on security, funds being held on trust or the early repayment of facility advances. In addition, management can consider whether a deferred payment arrangement can be reached with investors or financiers.
Sometimes, the underlying issue is that a business is in financial distress. There are a number of frameworks that a contracting entity can consider employing:
In most circumstances, the latter options are unlikely to be relevant given that a contracting entity will receive substantial revenue under any new contract to which they can apply the interim measures.
Seeking potential buy in from senior lenders and equity holders is an important step in seeking to implement the above restructure measures. In practice, this will usually be done by obtaining their active support in a formal arrangement or deed.
Government contracting entities must also consider their obligations to comply with the Crown Entity Guidelines when restructuring. Without the specific approval of the relevant Minister responsible for the contracting state agency, a contracting entity may not enter into any form of moratorium, voluntary administration, deed of company arrangement, corporate reconstruction or buy back of shares.
In circumstances where a contracting entity is in financial distress, there are a number of key factors to consider in determining what type of measure may be appropriate. These include:
that need to be met if the measure is to be successful in the long term.
If the options above are insufficient, it may be necessary for management to consider a more orderly formal process, such as administration or liquidation. These steps do not preclude the restructuring alternatives discussed above.
Whether a contracting entity is in a distressed situation or contracted to provide defence services, the steps taken to reduce or manage contractual indebtedness will have a significant impact on its future viability.
For these reasons, early warning signs should be taken seriously. Identifying problems early can present the best opportunity to address them and create a workable solution.
Breach and Remedies in Contracts
Legal remedies for breach of contract can be divided into equitable and legal forms. In a suit on a promissory note, the court may properly issue an order for specific performance and/or render a money judgment for the liquidation of damages caused by breach of contract.
If the contract is breached, the non-breaching party may elect to seek an award of either consequential damages or expectation damages. Consequential damages are defined as extraordinary damages that do not ordinarily follow from a breach or default. Generally, damages for lost profits or expenses that would have been incurred in the future under a contract are considered consequential damages. Expectation damages arise when the non-breaching party seeks to be placed in the same position it would have occupied had the contract been performed . In a contract dispute for sale of goods, the measure of damages is the difference between the market price at the time and place of delivery and the contract price. Other contractual remedies could include liquidated damages and specific performance. Liquidated damages are used to compensate a party for future damages or injury. The principal tea for liquidated damages is that they should do more than compensate the non-breaching party. Generally, the amount of liquidated damages should be in a reasonable proportion to the probable loss. Specific performance of a contract is an equitable remedy compelling the parties to fulfill their contract. Specific performance is an appropriate remedy for breach of a promissory note if recovery of the money due on the note is an inadequate remedy because of the absence of a market for loans of money of the same character as that created by the note.
Contractual Prevention and Best Practices
There are numerous ways to protect oneself or one’s business from falling into excessive indebtedness. The most common, and least costly, is ensuring that contracts are drafted to minimize significant debt risks such as unfair retention of funds, non-standard payment terms, licensing agreements with poor termination clauses, and provisions allowing for unilateral amendment by the party wanting the money.
Another, more costly option, is to have the documents reviewed by a professional. Why? Because unqualified advice can be just as bad, if not worse, than no advice at all. For example, someone may receive a document with explicit language that strikes out any and all situations in which the document would be unilaterally amended and an attorney may advise that there is little risk of being taken to court because the wording is a blatant attempt at contractual overreach. This is generally true, but not always. If no one is monitoring the situation and a change does take place, then noncompliance may be assumed and the debt collector takes the money, leaving no recourse for the party wronged.
Look for arbitration clauses or those specifically barring arbitration. The former, apparently intended to limit the costs in litigating a claim, can prevent the claimant from actually receiving the money or making good on a breach of contract. This is in direct contrast to traditional agency relationships which have always involved some method of alternative dispute resolution and thus provide for their availability. Also check for waiver of jury trial provisions – another version of the aforementioned arbitration agreement.
Understand your rights. You should be familiar with the Uniform Security Act, Title 12, Chapter 30, D.C. Code Annotated, 2002 Edition, section 2101, et seq. While advertisements may not make the required disclosures, there are many protections in place. This is also true for contracts for credit within the District of Columbia. Consult with an attorney to determine what specific language may prove problematic or which contracts should be avoided.
Avoid consumers. Rather than use traditional loan sharks, this type of predatory lending behavior is now perpetrated by credit card companies offering deceptively low teaser rates only to increase the rates at a later date. Which brings up a good point.
Don’t use credit cards unless absolutely necessary and avoid them for as long as possible. While your business may be able to take advantage of the cash flow flexibility offered by a credit card company, be sure to read the fine print. For example, late fees do not necessarily apply to the statement due immediately prior to the missed payment. Therefore, if you were late on one payment and only made the minimum payment before arriving at the due date of the next statement, it is possible the late fee will attach to the payment due after the one you were late on rather than the one missed. If the document allows for such practice, then the company may be able to double dip and net a massive payout on your missed payment, pending the bill amount at the time.
Case Studies in Contracts
As much as parties may try to draft what they think will be the perfect contract, in reality, real-life examples have shown us that this is not always the case. These situations offer invaluable lessons and best practices that can help parties mitigate and/or reduce their risk and exposure. In January of 2013, two GP-owned private equity firms settled with the SEC regarding the firm’s failure to disclose fees and expenses involving their investors. Another deal where the management company was required to pay back $10,200,000.00 to investors for overcharging them in fees while their funds were performing poorly. In another example, we saw that one private equity fund’s general partner paid its counterpart back dated management fees to an investor group who had alerted the SEC about this overcharging.
One recent example, in November, illustrates yet again, the need to ensure that your deal documents are properly written and that parties pay close attention to its details. A recent vertical merger deal between two telecommunications companies, AT&T Inc. and DirecTV Inc., that will see AT&T acquire DirecTV has attracted the attention of regulators at the Department of Justice, the Federal Communications Commission, as well as many U.S. senators concerned about net neutrality. At the center of the net neutrality issue, is how AT&T would negotiate into deal documents what would happen should they lose the ability to manage the traffic flow of content over their network. In this case, the Department of Justice suggested that AT&T agreed in writing with the Federal Communication Commission to restrict certain practices which may adversely effect competition in the industry.
Conclusion and Future Trends
As we move forward, the landscape of contract law will likely continue to evolve in response to technological changes and shifting societal norms. The rise of digital contracts and electronic signing has made contract formation faster and more accessible, but has also raised new legal issues relating to authentication, modification, and enforcement. At the same time, trends such as alternative dispute resolution and arbitration may offer parties more streamlined and efficient means of resolving contract disputes outside of the court system. On the issue of indebtedness, the regulatory landscape may continue to shift in response to economic and social factors. As more people struggle with student loan debt and rising interest rates, lawmakers may explore new solutions to address these pressing concerns, both through legislation and courts . In the coming years, we can expect to see continued innovation in the ways that contracts are formed, enforced, and resolved, as well as new approaches to managing and addressing issues of indebtedness. Throughout this article, we have explored the various aspects of contract law, including the elements of a contract, the different types and classifications of contracts, the difference between express and implied contracts, and how contracts are enforced. We have also looked at injured parties as creditors and debtors and what recourse exists for a wronged party who is owed money under a contract. By understanding the ins and outs of contract law, you can better protect your rights and interests when entering into agreements of all kinds and be better prepared to deal with any problems that may arise.