This article is an illustrated rapid resolution example for lawyers drafting contracts where the parties must perform their obligations in a specific order.
The article discusses drafting solutions that lawyers can incorporate into contracts to ensure the rapid resolution of disputes arising from the order of performance by the parties.
Keywords: Breach of Contract, Order of Performance, Investment Agreements, Share Transfer Agreements
Reference: Section 52, Indian Contract Act, illustration (b)
Section 52, Indian Contract Act:
Section 52 of the Indian Contract Act deals with the order in which reciprocal promises by parties to a contract are to be performed. The section specifies that when the contract provides for the order in which the reciprocal promises are to be performed, then obviously, that order is to be followed. However, when the contract does not provide for the order in which the promises are to be performed, the same is to be determined based on the contract’s nature.
Section 52, illustration (b)
A and B contract that A shall make over his stock-in-trade to B at a fixed price and B promises to give security for the payment of the money. A’s promise need not be performed until the security is given, for the transaction’s nature requires that A should have security before he delivers up his stock.
In contracts, like the one mentioned in the illustration, where the nature of the contract requires parties to fulfill their obligations in a certain order, a dispute may arise if the contract does not specify the order in which the obligations are to be performed.
Company X and Y, an investor, entered into an agreement where Y would invest in the company. However, as the founders wanted to dilute as little as possible, the investment was structured to be done partly as a loan and partly as a standard equity investment. Per the agreement, the loan part of the investment would become payable ‘on or after’ the company hit a pre-agreed revenue milestone, and after that, upon a second revenue milestone being hit, the balance would be paid to the company as an investment in return for a 5% equity stake. However, when the company hit the first revenue milestone, Y did not loan the company the money, stating that the agreement did not mandate him to disburse the loan immediately upon X hitting the revenue milestone.
As Y failed to loan the X the money, X refused to accept the investment and transfer the equity to Y when the second revenue milestone was hit.
Interpretation and Scenarios:
In the above illustration, the dispute arose because the contract did not specify the process to be followed by the parties. Therefore, a Judge or Arbitrator would need to interpret the contract based on the agreement’s nature. However, the parties’ intention at the time of signing the agreement would also need to be considered.
The company would argue that since the parties’ intention was for Y to be obligated to disburse the loan once the revenue milestone was hit, there was no obligation for it to grant the equity upon hitting the second revenue milestone.
Y would argue that since the agreement stated that the loan was to be disbursed ‘on or after’ the first revenue milestone was hit, it meant that he could do so at his discretion once the milestone was reached, and not necessarily as soon as the milestone was reached.
The dispute could have been resolved quickly and inexpensively using a rapid resolution platform if the contract had specified the order in which the parties were to perform their obligations. This could be done by employing the drafting solutions discussed herein.
Solution 1 – Makes It Easy To Determine The Order In Which Promises Are To Be Performed
In a contract with reciprocal promises, the agreement must specify the process by which the contract is to be performed. This is especially true when the contract’s nature demands that the parties perform their respective obligations in a specific order.
It is also important that the contract provides strict timelines for the parties to perform their obligations and the consequences for any breach or failure by a party.
If the contract is clear about the parties promises to each other, the method by which the promises are to be performed, and the timelines in which the promises are to be performed, it becomes easy for a Judge or Arbitrator to arrive at a finding on which party is in breach of the agreement.
In our example, the contract ought to have specified that once Company X hit the first revenue milestone, Y was obligated to disburse the loan and, unless he did so, X would not be obligated to give him equity even if it did hit the second revenue milestone.
Solution 2 – Makes It Easy To Determine Compensation
Just as agreements must be drafted to enable a Judge or Arbitrator to be able to quickly determine which party has breached a contract, it must also be drafted to enable the Judge or Arbitrator to quickly compute compensation and damages.
Contracts can be drafted to enable easy computation of compensation by incorporating clauses that either pre-decide the compensation one party would be liable to pay the other if it breaches the contract, or provides an easy-to-apply formula to compute the compensation.
In our example, the agreement could have had a clause specifying a daily or weekly penalty that Y would have to pay Company X if he did not disburse the loan once X had communicated to him that the revenue milestone had been reached.
Solution 3 — Accelerates the Dispute Resolution Process
The agreement should have a dispute resolution clause giving the claimant the right to ask for the arbitrator’s appointment by a named institution or ODR platform, and for such appointment to be made within 35 days of receipt of the defendant receiving notice.
In these cases, it will better serve the parties if either the dispute resolution clause itself or the institution or ODR platform promises a process that binds the arbitrator to rapid resolution. ODR Platforms often do this by minimizing oral hearings, not accepting documentation delays, and not allowing adjournments unless in emergencies.
Simple Explainer For The Layman
SafetyFirst Private Limited, a cybersecurity technology company, and Mukesh, an investor, entered into an agreement where Mukesh would invest in the company. However, as SafetyFirst’s promoters wanted to keep shareholding dilution to a minimum, the agreement was structured to make Mukesh’s investment in tranches.
One tranche would be in the form of a loan to be disbursed ‘on or after’ SafetyFirst hit a pre-agreed revenue milestone. The other tranche would be a standard equity investment, where Mukesh would get a 5 percent stake in the company.
However, when the SafetyFirst hit the first revenue milestone, Mukesh did not immediately loan the company the money, stating that the agreement did not mandate him to disburse the loan immediately upon SafetyFirst hitting the revenue milestone.
As Mukesh had failed to disburse the loan, when the second revenue milestone was hit, SafetyFirst refused to accept the investment and transfer the equity to him, even though he offered to pay both tranches at the same time.
Both parties invoked arbitration.
SafetyFirst argued that the parties’ intention was for Mukesh to be obligated to disburse the loan once the revenue milestone was hit. Hence, since he failed to do so, there was no obligation for it to accept the investment and grant the equity upon hitting the second revenue milestone.
Mukesh argued that since the agreement stated that the loan was to be disbursed ‘on or after’ the first revenue milestone was hit, it meant that he could do so at his discretion once the milestone was reached, and not necessarily immediately upon the milestone being reached.
The dispute could have been quickly and inexpensively resolved using a rapid resolution platform if the agreement had been clear that Mukesh was obligated to disburse the loan immediately upon the first milestone being reached and, unless he did so, SafetyFirst was not liable to grant him an equity stake once the second milestone had been reached.
About the Article
Rapid Contract Enforcement is an essential requirement for the growth and prosperity of India. It will enable more investment, entrepreneurship, and trust for all stakeholders in business and commerce. The community of lawyers in India does not have access to a practical and scholarly manual that gives them a path to deliver rapid contract enforcement to their clients. Such a manual will also help lawyers to draft contracts that enable timely enforcement. Quick enforcement requires the effective use of the Arbitration Act, the institutional framework, and technology-enabled dispute resolution infrastructure. This article belongs to a series where the author analyses each of the Illustrations available in the Contract Act and recommends practical approaches to rapid enforcement.
About the Author:
Dushyant Krishnan is a Mumbai based lawyer and the co-founder of House Court, an online dispute resolution platform.