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November 19, 2014

Mechanics' Liens: Part 6. No-lien agreements


This one of a series of six posts regarding mechanics' liens:

Part 1. The basics of credit risk and subcontracting.

Part 2. Reallocating risk in construction projects.

Part 3. Acquiring a lien.

Part 4. Enforcing a lien.

Part 5. Personal liability notices.

Part 6. No-lien agreements.

The last post in our series on mechanics' liens addresses a situation in which mechanics' liens are not available. For certain types of projects, the Indiana Mechanic's Lien Statute permits the owner and principal contactor to enter into an agreement or stipulation that prohibits liens that arise from a particular contract.

There are essentially two categories of projects that are eligible for no-lien agreements. The first category includes "class 2 structures" (as defined at Indiana Code section 22-12-1-5), which encompasses single- and double-unit residential structures and some related projects. The second encompasses construction owned by certain types of utilities, including public utilities, municipal utilities, and rural membership utilities. The details of the projects that are eligible for no-lien agreements can be found at Indiana Code 32-28-3-1(3).

A no-lien agreement that meets the statutory requirements prohibits liens against the owner's property. However, in order to be valid against subcontractors, mechanics, journeymen, laborers, or other persons furnishing labor,materials, or machinery (i.e., those who are not parties to the no-lien agreement itself), the no-lien agreement must be in writing, must contain a legal description of the property where the construction is to take place, must meet the same requirements for acknowledgement (i.e., notarization) that deeds must meet, and must be recorded in the office of the recorder in the county where the property is located. Moreover, it must be recorded within five days after it is signed.

As a practical matter, there is no need to record the entire construction contract, which may be dozens of pages long with attachments and schedules that include drawings and lengthy, detailed specifications. Instead, the owner and the principal can sign and record an ancillary no-lien agreement, memorandum, or stipulation, separate from (and usually referenced by) the main construction agreement, that meets the statutory requirements for no-lien contracts.

One last note: Although a no-lien agreement prohibits liens, it does not affect the rights of subcontractors and others to hold the owner personally liable by sending a personal liability notice, discussed in part 5 of this series.

[Rev. 11/25/2014. A second last note. My thanks to my friend and colleague, Ted Waggoner of Peterson, Waggoner, & Perkins, LLP, for reminding me that mechanics' liens are unavailable for public property without the need for a no-lien agreement.]

Continue reading "Mechanics' Liens: Part 6. No-lien agreements" »

October 23, 2014

Mechanics' Liens: Part 5. Personal Liability Notices


[Note: This one of a series of six posts regarding mechanics' liens:

Part 1. The basics of credit risk and subcontracting.

Part 2. Reallocating risk in construction projects.

Part 3. Acquiring a lien.

Part 4. Enforcing a lien.

Part 5. Personal liability notices.

Part 6. No-lien agreements.]

We've been examining the role of mechanics' liens in construction contacts, including the way they reallocate credit risk among contractors and the owner of a construction project. The Indiana Mechanics' Lien Statute includes another remedy for subcontractors who do not get paid, entirely apart from a mechanic's lien against the real property where the construction takes place. The statute does not give a name to the remedy, but it's often called a personal liability notice or PLN.

To see how it works, let's go back to the hypothetical example of our last article. Assume you are a subcontractor with a $15,000 claim against the general contractor, a claim the GC disputes. Now let's assume that the deadline for filing a sworn statement and notice of intention to hold a mechanic's lien has already slipped by. Are you out of luck?

Not necessarily. First, remember from our earlier articles that the failure to acquire a mechanic's lien does not affect your breach of contract claim against the GC. All it does is provide collateral to secure that claim, so you still have the right to sue the GC for breach of contract. But that's not all. The PLN gives you a second way to transfer the GC's credit risk to the owner

Who may send a Personal Liability Notice?

The remedy of a PLN is available to subcontractors, lessors leasing construction or other equipment or tools, journeymen, and laborers. That's most, but not all, of the people who would also be entitled to a lien. (Note: Are suppliers of materials entitled to a PLN? That's an interesting question but one that we're not going to answer now. We might take it up someday in another article, but not this time.)

What should the notice say?

To assert a claim of personal liability against the owner, you must send a written notice to the owner that includes:

  • The name and mailing address of the owner of the property as shown on the records of the county auditor or assessor

  • The location of the property, preferably a legal description but at least the street address.

  • The amount of the claim

  • The name of the person who owes you money (in our hypothetical example, the general contractor)

  • A statement that the named person is indebted to you or owes you money

  • A statement that you are holding the owner of the property liable to you for payment of that amount

  • A description of the services that you provided for which you are owed payment

(Technically, not all of these items may be strictly required, but a good notice should include them.)

Then what?

Once the owner receives the notice, the owner is directly liable to you, but only to the extent that the owner owes money to the general contractor, including money that may be currently owed and money that may be owed in the future. In other words, if, at the time the owner receives your notice the owner owes the general contractor $2,000 on an invoice that the owner has already received and the contractor later submits invoices to the owner for another $10,000, the owner will be liable to you for $12,000 of the $15,000 you are owed. If the owner has already paid the general contractor in full for the entire project, the owner has no liability to you.

What if the general contractor has been fully paid for the project that I worked on but holds another contract with the same owner for another project on the same property?

In that case, the owner still has no liability to you. In essence, the PLN gives you a claim to money that the owner has yet to pay to the general contractor under the contract that covered the work you performed, but not to money that the owner may owe the general contractor for other reasons.

How long do I have to send the PLN?

There is no strict deadline equivalent to the one that applies to mechanics' liens. You can send a PLN at any time; however, your claim against the owner is only for the amount that the owner still owes the general contractor. Once the owner has fully paid the general contractor, the owner has no liability to you.

Interestingly, the statute also allows you to send a PLN to the owner even before you do the work. In that case, of course, your notice must include the total amount that you will be owed for all the work you're contracted to perform and a description of that work. Doing so may not make you very popular with either the general contractor or the owner because it creates additional concerns for both of them, but you have the right to do so and, once you do, the owner is liable to you even after the general contractor is fully paid.

Okay, I sent the PLN. Now what?

Most likely, you will enter into discussions with the owner. If you, the GC, and the owner reach an agreement on the amount you are actually owed, a common practice is for the owner to issue a two-party check, payable to you and the GC, in the amount that you are owed, then the GC will endorse the check over to you. If you can't reach an agreement, you can sue both the GC and the owner, making sure you file the lawsuit before the statute of limitations for breach of contract expires.

Continue reading "Mechanics' Liens: Part 5. Personal Liability Notices" »

October 18, 2014

Mechanics' Liens: Part 4. Enforcing a Lien


[Note: This one of a series of six posts regarding mechanics' liens:

Part 1. The basics of credit risk and subcontracting.

Part 2. Reallocating risk in construction projects.

Part 3. Acquiring a lien.

Part 4. Enforcing a lien.

Part 5. Personal liability notices.

Part 6. No-lien agreements.]

So far we've looked at the basics of subcontracting and allocation of credit risk, how a mechanic's lien changes things by reallocating credit risk, and how a contractor, subcontractor, supplier, or worker goes about acquiring a mechanic's lien. Now we'll discuss how to enforce a lien once you have it. Assume you are a subcontractor with a claim against the general contractor, or GC, for $15,000. The GC has withheld that amount from your fees, accusing you of not finishing your work on schedule. The general contractor says it incurred $15,000 in additional labor charges because its workers had to wait around with nothing else to do until your work was completed. You blame the general contractor for the delay and additional expense, and you have recorded a sworn statement and notice of intention to hold a mechanic's lien in the amount of $15,000. A copy of it has been sent to the owner.

Now what happens?

At this point, there are several possibilities.

  • What you hope will happen is that either the owner or the GC will pay you - you hope it will be the entire amount but more likely it will be a negotiated compromise amount - in exchange for your signed release, which will then be filed with the county recorder. If the owner pays you, it will probably turn into a dispute between the GC and the owner, but you will not be involved (except as a witness).

  • If the owner believes there is a flaw in the lien, for example that it was recorded too late, the owner can challenge the lien in court, asking the court to remove it. If the owner is successful, it does not mean that you lose your claim. You will still have a breach of contract claim against the GC, but, if you win that case, your ability to collect will turn on the ability of the GC to pay. (Remember that earlier discussion of credit risk? The lien reallocates the GC's credit risk to the owner because the owner's property serves as collateral to secure your claim. Without the lien, the GC's credit risk falls back on you.) By the way, recording a lien that is invalid can make you liable to the owner for a tort known as slander of title.

  • The owner can post a bond to serve as substitute collateral and ask the court to order that the lien be released. That removes the owner from the middle of your dispute with the GC. If you sue the GC for breach of contract and win, and if the GC does not pay you the amount of the judgment, you can collect from the surety who underwrote the bond. (In essence, the GC's credit risk is again reallocated to the surety who charges a fee to assume that risk.) This process is often called "bonding off" a lien.

  • The owner and GC can wait to see if you sue to enforce the lien. If you do not sue within one year, the lien expires. If that happens, you will still have your claim against the GC because the statute of limitations on your breach of contract claim is either six or ten years. (See our earlier blog for a discussion of the uncertainty in the exact amount of time you have to sue the GC.)

  • The owner can send you a letter demanding that you sue to enforce the lien within 30 days. If you do not, you lose the lien. It's sort of a put-up-or-shut-up provision in the mechanic's lien statute that gives the owner a way to speed things along.

  • You can sue to foreclose on the lien. However, to do that successfully, you will have to prove that the GC actually owes you the $15,000, which means you will have to litigate your breach of contract claim against the GC. Although there are a few different procedural paths to get there, the lawsuit will involve you, the GC, and the owner. If you lose on the breach of contract claim against the GC, the court will order the lien to be removed. If you win on the breach of contract claim against the GC, and the GC pays you the amount of the judgment, the lien will be removed. If the GC does not pay you the amount of the judgment, the owner can pay you, and the lien will be removed. If you win against the GC and neither the GC nor the owner pays you, you can force a sale of the owner's property, with the amount of the judgment being paid to you out of the proceeds of the sale and the balance paid to the owner.

As we've discussed, all the lien really does is to reallocate to the owner the risk that the GC will not pay you the amount you are properly owed. In most cases, if you win your breach of contract case against the GC, the GC will pay the judgment and the lien will be removed without the need for you to foreclose.

So what good does a mechanic's lien do? Really?

In the case of a mechanic's lien filed by a general contractor, the lien provides the GC with collateral to secure its claim against the owner. That can be very important if the owner goes into bankruptcy because the GC will be a secured creditor rather than an unsecured creditor. Of course, in most cases, if the GC wins its claim against the owner, the owner will pay and the lien will be removed. In addtion, sometimes it gives the owner an additional incentive to settle a claim by the GC because selling the property will be more difficult while the lien is in place. (Of course, if the owner really wants to sell the property, the owner can bond off the lien, albeit at the expense of having to pay for the bond.)

From a legal perspective, things aren't much different for a lien recorded by a subcontractor, but as a practical matter, the ability to record a lien gives the subcontractor more leverage in negotiating a resolution to a dispute. The lien will bring the owner into the discussion, and that may provide the GC (or higher tier subcontractor, as applicable) with additional incentive to settle your claim.

Continue reading "Mechanics' Liens: Part 4. Enforcing a Lien" »

October 17, 2014

Mechanics' Liens: Part 3. Acquiring a Lien


[Note: This one of a series of six posts regarding mechanics' liens:

Part 1. The basics of credit risk and subcontracting.

Part 2. Reallocating risk in construction projects.

Part 3. Acquiring a lien.

Part 4. Enforcing a lien.

Part 5. Personal liability notices.

Part 6. No-lien agreements.]

In the first article in this series, we discussed the basics of credit risks associated with subcontracting in an area other than construction. In the second, we examined how a mechanic's lien reallocates those credit risks for construction contracts. In this one, we explain how a contractor or subcontactor goes about acquiring a mechanic's lien. For a change of pace, we'll do it in a question-and-answer format.

Some caveats: First, mechanic's lien requirement vary significantly from state to state. Given that this is the Indiana Business Law Blog, we'll answer the questions based on Indiana law. Also note that the Indiana Mechanic's Lien Statute is filled with complicated, cumbersome, even archaic language that can be difficult for even lawyers to parse, so we'll try to give answers that are more easily understood. However, that also means we may leave out some details, making the answers a bit imprecise in some circumstances. As always, this blog is not legal advice and you should not rely on it as a substitute for legal advice.

Who can acquire a mechanic's lien?

Generally, anyone who furnishes labor, materials, or equipment (including leased equipment or tools) to the construction, repair, or removal of a building or structure, or to any other earth moving operation, is entitled to a mechanic's lien on the building or structure and the land where the construction, repair, or removal was performed. In addition, registered architects, registered engineers, and registered land surveyors are entitled to hold a mechanic's lien. The person who provides the labor, material, or equipment may do so in a contract directly with the owner of the land or under a subcontract.

How does someone go about acquiring a lien?

First things first. On some types of projects -- specifically on the original construction a single or double family dwelling, intended to be the residence of the owner of the land on which it is built, or on the repair or alteration of an owner-occupied single or double family dwelling -- there is a requirement for a "pre-lien notice." Anyone providing labor, material or equipment to such a project must notify the owner in writing that the person is providing the labor, material, or equipment and that the person has rights to a mechanic's lien, unless the person provides the labor, material, or equipment in a contract directly with the owner. (The idea is that the owner already knows about the people who hold contracts directly with the owner.) If the project is the new construction of the dwelling, the notice must be given within 60 days after the person first provides labor, material, or equipment to the project. If it is the repair of a dwelling rather than new construction, the notice is due within 30 days. If the notice isn't given, there's no right to a lien later.

Does the pre-lien notice have to be recorded in the office of the county recorder?

No. It has to be in writing and furnished to the occupying owner or the owner of record of the property, but it does not have to be recorded.

Okay, assume the person provided a pre-lien notice or that no pre-lien notice was required. Now what?

A person entitled to a lien must file, in duplicate, in the office of the county recorder a sworn statement and notice of intention to hold a lien. The sworn statement and notice of intention to hold a lien must include all of the following information:

  • the name and address of the person making the claim

  • the amount of the claim

  • the owner's name and last address as shown on the county's property tax records

  • both the street address and legal description of the property where the project is located.

The statement must be notarized and satisfy all other requirements for recording documents.

The statement and notice must be filed within either 60 days or 90 days of the last day the person making the claim furnished labor, materials, or equipment to the project. The deadline is 60 days for "Class 2" structures -- essentially single or double family dwelling units and related structures--and 90 days for all others. The lien attaches immediately when the notice is filed with the county recorder. The county recorder will then send a copy of the statement and notice to the owner.

Continue reading "Mechanics' Liens: Part 3. Acquiring a Lien" »

October 5, 2014

Mechanics' Liens: Part 2. Reallocating credit risk in construction projects


[Note: This one of a series of six posts regarding mechanics' liens:

Part 1. The basics of credit risk and subcontracting.

Part 2. Reallocating risk in construction projects.

Part 3. Acquiring a lien.

Part 4. Enforcing a lien.

Part 5. Personal liability notices.

Part 6. No-lien agreements.]

In part 1 of this series, we discussed a hypothetical situation with a company that hired an ad agency, with the ad agency subcontracting some work to a production company and purchasing advertising time on a television station. The production company bore the ad agency's credit risk because its contract was with the ad agency, and when the ad agency went out of business the production company faced the possibility of not being paid. In contrast, the television station did not bear the ad agency's credit risk because its contract with directly with the ad agency's client. The ad agency's client faced the possibility of having to pay for the television air time twice - once to the ad agency and a second time directly to the television station when the ad agency failed to pay for the air time on the client's behalf.

Now let's look at the credit risks associated with a construction project in which the owner of a construction project hires a general contractor to complete the entire project on a time-and-materials basis, which means that the price paid by the owner is equal to the amount the general contractor pays for the labor (i.e., the "time") and materials required to do the construction, plus a markup to cover overhead and profit. The general contractor does some of the work with its own employees and subcontracts some of the work, including the installation of the electrical wiring, to another contractor.

The electrical subcontractor completes its work and submits its invoice to the general contractor. The general contractor adds its markup to the amount of the subcontractor's invoice and submits its own invoice to the owner. The owner pays the general contractor, but before the general contractor pays the subcontractor, the general contractor goes into bankruptcy. As we saw before, the subcontractor faces the possibility of not being paid for its work; in other words, the subcontractor bears the credit risk of the general contractor. The subcontractor has no claim against the owner because there's no contractual relationship directly between the owner and the subcontractor.

Or at least that would be the case if it were not for the subcontractor's right to a mechanic's lien. The Indiana Mechanic's Lien Statute (Ind. Code 32-28-3) allows a person who provides labor or materials to the improvement of real property (in this case, the electrical subcontractor) to hold a lien on the property. Ultimately, the electrical subcontractor can foreclose on the lien, forcing the property to be sold at auction, with the proceeds of the sale being used to pay the subcontractor and any remaining proceeds going to the owner. As a practical matter, what usually happens is that the owner of the property pays the subcontractor directly, and the subcontractor releases the lien. Instead of the subcontractor not getting paid, the owner has to pay twice.

In other words, the mechanic's lien statute reallocates the credit risk of the general contractor so that it is borne by the owner of the property, not by the subcontractor. Technically, that's an oversimplification because if the property does not bring enough at auction to pay the subcontractor in full, the owner has no obligation to make up the difference, but the point remains that the mechanic's lien statute rearranges the allocation of the general contractor's credit risk, reducing the risk to subcontractors and assigning it to the owner.

In the next blog entry, we'll start an in-depth look at mechanics' liens, starting with the perspective of a subcontractor.

Continue reading "Mechanics' Liens: Part 2. Reallocating credit risk in construction projects" »

October 2, 2014

Mechanics' Liens: Part 1. The basics of credit risk and subcontracting


[Note: This one of a series of six posts regarding mechanics' liens:

Part 1. The basics of credit risk and subcontracting.

Part 2. Reallocating risk in construction projects.

Part 3. Acquiring a lien.

Part 4. Enforcing a lien.

Part 5. Personal liability notices.

Part 6. No-lien agreements.]

This starts a short series of blog articles discussing mechanics' liens and their cousins, notices of personal liability, concepts that arise in the context of construction contracts and similar agreements. To understand what's special about construction contracts, you need to understand a bit about how contract law, subcontracting, and credit risk work in other settings. So let's review the basics.

Imagine your company signs an advertising agency agreement, hiring the ad agency to create a television advertising campaign for your business. The ad agency comes up with the ideas for the commercials, hires a production company to produce them, and purchases advertising time on your behalf from local television stations. The contract to produce the commercial is between the ad agency and the production company, but the contract with the television station is between the television station and your company, signed by the ad agency as your company's agent, as it is authorized to do by the ad agency agreement.

All seems to go well, and you pay the advertising agency the full amount your company owes under the agency agreement, including money that the ad agency is supposed to pay to the television stations on your behalf. Then the advertising agency goes belly-up. It closes its doors, fires all its employees, and files for bankruptcy. Among its unpaid creditors are the production company that produced your commercial and a television station that aired it. Can the production company and the television station force your company to pay them what they should have been received from the ad agency?

Under these facts, there are two different answers. The production company is a subcontractor to the ad agency. It has no claim against your company simply because it does not have a contract with your company. The only thing the production company can do is file a proof of claim in the ad agency's bankruptcy and hope to recover something.

In contrast, the television station's contract was with your company, not with the ad agency, and your company is directly responsible for the amount owed to the television station. You'll have to pay the television station (even though you've already paid the ad agency money that was supposed to go to the television station) and hope you can recover something on your company's own proof of claim in the bankruptcy based on the ad agency's breach of contract (or some other possible legal theories that we won't go into).

In producing the commercials without getting paid first, the production company took on the ad agency's credit risk, and your company does not bear it. However, by paying the ad agency the money the ad agency was supposed to go to the television station, your company took on the ad agency's credit risk, and that risk does not fall on the television station. In the next blog entry, we'll examine how mechanics' liens change that allocation of risk for construction contracts.

Continue reading "Mechanics' Liens: Part 1. The basics of credit risk and subcontracting" »

August 27, 2014

Account Stated

iStock_000007946595Small.jpgOn December 12, 2008, Layne and Anita Dellamuth bought flooring materials and installation services from Carpets Unlimited. The Dellamuths made a downpayment that left a balance of a little more than $23,000. Carpets Unlimited subcontracted the installation services to Jared Keeton, who performed that work later the same month, but apparently not to the liking of the Dellamuths because a dispute arose between them and Keeton about the quality of the installation. In addition, the Dellamuths objected to additional charges that Keeton added to the amount owed. In February 2009 Carpets Unlimited corrected the work at no additional cost to the Dellamuths.

By August 2011 the Dellamuths still had not paid Carpets Unlimited the remaining $23,000. Carpets Unlimited sent the Dellamuths a letter and invoice, demanding payment, by certified mail, which the Dellamuths signed for on August 27. Another letter and invoice, sent on June 26, 2012, was returned unclaimed. In August the same year, Carpets Unlimited sued the Dellamuths, and the trial court granted Carpets Unlimited's motion for summary judgment. The Dellamuths appealed, and today the Indiana Court of Appeals affirmed the trial court's decision.

An interesting aspect of this case is that Carpets Unlimited did not sue on the basis of breach of contract. Instead, Carpets Unlimited sued solely on the basis of a legal theory known as account stated, a theory that is more often used as an alternative basis for a lawsuit, included in a complaint primarily as a back-up theory in case the plaintiff's breach of contract fails for one reason or another, perhaps because the contract is held to be unenforceable.

An account stated is an agreement between two parties that a statement of an amount owed by one of the parties to the other is correct and an agreement, either express or implied, that the person owing the amount will pay it. Once an account stated is established, it becomes an independent, enforceable agreement; the creditor no longer has to prove the elements of the contract or other basis of the original obligation. Instead, the burden shifts to the debtor to show that the amount is not owed.

Perhaps the most important aspect of account stated - the most powerful for the creditor and the most dangerous for the debtor - is that an agreement need not be expressed but can be implied. If the creditor sends an invoice or account statement to the debtor, and the debtor fails to object within a reasonable time after receiving the invoice or statement, the debtor is deemed to have agreed that the amount set forth in the invoice or statement is correct and to have agreed to pay that amount.

In this case, the Dellamuths failed to object to the August 2011 letter and invoice and were deemed to have accepted the amount of the invoice as a correct statement of the amount they owed and to have agreed to pay that amount. Carpets Unlimited did not have to prove that a contract with the Dellamuths existed or that the materials had been delivered and the services properly performed. Instead, the burden shifted to the Dellamuths to prove that they did not owe the amount of the invoice, and they did not (and presumably could not) do so.

However, the Dellamuths argued two other points that, in other circumstances, might have worked. First, they pointed to case law holding that once a dispute has arisen about debtor's obligation, the debtor need not continue to object to future statements from the creditor. In this case, the Dellamuths argued that by complaining to Keeton about the quality of the installation and they no longer needed to object to statements from Carpets Unlimited in order to avoid an implied acceptance of those statements. The Court of Appeals rejected that argument, pointing out that Carpets Unlimited had corrected the installation and that, although the Dellamuths objected to additional amounts that Keeton added to the total obligation, Carpets Unlimited's invoice was for the $23,000 balance to which the Dellamuths had never objected.

Second, the Dellamuths claimed that the relationship between them and Carpets Unlimited could not give rise to an account stated, pointing to case law holding that prior dealings between the parties is a prerequisite to account stated, apparently arguing that there could be no account stated because they had not previously done business with Carpets Unlimited. The Court of Appeals disagreed, looking to case law from other states to clarify that the requirement for prior dealings between the parties means that there must have been prior dealings that gave rise to the debt described in the account statement. Accordingly, the Court held that the contract between the Dellamuths and Carpets Unlimited for materials and services, as well as the delivery of the materials and performance of the services, satisfied the requirement for prior dealings.

There are two sides to the moral of this story. On the debtors's side, never ignore an invoice or an account statement because you think you do not owe it. Instead of ignoring it, object - and do it in writing to make a record of the objection. On the creditor's side, account stated can be a powerful way to shore up your ability to recover amounts that are owed to you. If in doubt, send a statement or invoice - preferably by a method that includes confirmation of receipt -- and see if the debtor objects.

Continue reading "Account Stated " »

July 21, 2014

Covenant or Condition? Why does it matter?

iStock_000025338621Small.jpgI remember a story told by a business owner who had been involved in the negotiation of a very complicated contract, with both sides represented by high-priced lawyers. In one particularly brutal negotiating session, the lawyers argued at length about a particular provision, with one side saying it should be a warranty and the other side saying it should be a covenant. At long last, they reached some sort of agreement, and everyone took a break for dinner. The business owner related that, as he rode down the elevator with his lawyer, he asked, "What's the difference between a covenant and a warranty?" The answer: "Not much." And that is not too far from the truth. But it would be a very different story if the question had been, "What is the difference between a covenant and a condition?"

The importance of the distinction between a covenant and a condition was driven home by a 2010 decision from the Ninth Circuit Court of Appeals. The decision received a great deal of attention at the time, and I used it as an assignment in the law school class I was teaching on contract drafting. Even though the decision has been thoroughly discussed from every angle, it still serves as a useful reminder to lawyers not to be careless with license agreements and to pay particularly close attention when drafting conditions.

The case was MDY Industries v. Blizzard Entertainment, and it dealt with a license agreement for the popular online role-playing game, World of Warcraft, or WoW. The license agreement prohibited the licensee from using bots to simulate people playing WoW. There was no question that the licensee had violated that term of the agreement. The question was whether the provision was a covenant or a condition.

A covenant is a promise by a party to a contract to do something or not to do something. If the promise is broken, the breaching party is liable to the other party for monetary damages -- usually the amount of money required to put the non-breaching party in the same situation it would have occupied if the covenant had not been broken.

In contrast, a condition is a fact that must exist (or not exist) before another substantive provision of a contract takes effect. In the context of a license agreement, the other substantive provision is the license itself. If the conditions to a license are not satisfied, the license is void. And if the license is void, the breaching party will probably be liable for infringement of the underlying intellectual property -- in this case, the copyright to the software.

So the question before the Ninth Circuit was whether the crucial contract provision was a promise by the licensee not to use bots or a condition on the grant of the license itself. If the former, the licensee would be liable for monetary damages, which would amount to relatively little. However, if the prohibition on using bots was a condition to the license, the licensee would be liable for copyright infringement, including statutory damages that could greatly exceed the damages owed for breach of contract.

In analyzing the provision, the Ninth Circuit noted that the folowing language was under a heading, "Limitations on Your Use of the Service."

You agree that you will not . . . create or use cheats, bots, "mods," and/or hacks, or any other third-party software designed to modify the World of Warcraft experience . . .

First the court disregarded the heading, using the common rule of contract interpretation that headings are for convenience only and are not part of the actual language of the contract. Once that was done, the court noted that there was nothing else about the language to connect the prohibition on bots to the scope of the license or the effectiveness of the grant of the license. Instead, the provision was written merely as an ordinary agreement, or a promise. If the copyright owner's real intent when the license agreement was drafted was to restrict the scope of the license, it could easily have done so by designating the prohibition as a condition to the license. The resolution of the case, or at least part of the case, turned on that subtle, technical drafting issue.

So if you are ever in a contract negotiation and your lawyer is arguing with the other side that a provision should be a covenant instead of a warranty, or vice versa, you might want to take a break and, outside the negotiating room, ask your lawyer if it is really worth the time to argue about it. However, if your lawyer is arguing with the other lawyer about a covenant versus a condition, you can be fairly certain it really is worth the time.

Continue reading "Covenant or Condition? Why does it matter?" »

July 17, 2014

Anticipatory Breach and Mitigation of Damages revisited: The Indiana Supreme Court Clears the Minefield

iStock_000030882778Small.jpgLast year we wrote about a decision of the Indiana Court of Appeals, Fisher v. Heyman, that addressed the amount of damages owed to the seller of a condominium after the buyers refused to go through with the sale unless the seller corrected a minor electrical problem. See "Anticipatory Breach and Damage Mitigation: A Minefield for Real Estate Sellers?" Today the Indiana Supreme Court overruled the decision of the Court of Appeals.

The case began with a purchase agreement for a condo between Gayle Fisher, the seller, and Michael and Noel Heyman, the buyers. The purchase agreement permitted the buyers to have the condo inspected and to terminate the agreement if the inspection revealed major defects. The inspection report showed that some electical outlets and lights did not work. The Heymans informed Fisher that they would terminate the contract unless Fisher corrected the problem by a specified date. Fisher did not meet the deadline, and the Heymans refused to go through with the purchase. However, shortly after the deadline passed, Fisher had an electrician repair the problems, for which the electrician charged her $117. By then, however, the Heymans had found another property and refused to purchase Fisher's condo. Fisher put the condo back on the market, but the best offer she received was $75,000 less than the price that the Heymans had agreed to pay. In the meantime, she incurred additional expenses that raised her damages to over $90,000.

The buyers argued that they believed the electrical problem was a major defect that allowed them to back out of the deal. However, the trial court and the Court of Appeals disagreed with the buyers, holding that the demand for repairs was an anticipatory breach, a concept we discussed in our previous blog post. The Supreme Court decision changes nothing about that aspect of the Court of Appeals decision. Both the Court of Appeals and the Supreme Court held that trial court did not err by finding that the electrical problems were not a "major defect" and that the buyers breached the purchase agreement by making a demand that they were not entitled to make. The difference between the two opinions is how to analyze the seller's duty to mitigate damages.

When one party breaches a contract, the other party is entitled to damages sufficient to put the non-breaching party in the same position it would have occupied had the contract been performed. However, the non-breaching party must use reasonable efforts to mitigate the damages. This case illustrates the concept nicely. The original purchase price was $315,000. Sometime later, Fisher received, but rejected, an offer of $240,000. Ultimately, she sold the condo for $180,000. The trial court found (and the Supreme Court affirmed) that Fisher acted unreasonably when she rejected the offer of $240,000. Accordingly, the most she could recover was the difference between $315,000 and $240,000, not the difference between $315,000 and $180,000. The question, however, is whether the doctrine of mitigation of damages required Fisher to comply with the Heymans' demand to have the electrical problem fixed. If so, she would be able to recover only $117, the amount it cost her to fix the electrical problems. Last year, the Court of Appeals said yes.

Today, the Supreme Court said no, agreeing with Judge Cale Bradford of the Court of Appeals. In his dissenting opinion, Judge Bradford reasoned that the doctrine of mitigation of damages does not require the non-breaching party to accede to a demand that creates a breach. The Supreme Court agreed with that reasoning and elaborated that, just as a non-breaching party may not put itself in a better position than it would have been had the contract been performed as agreed, neither can the breaching party. Here, the buyers agreed to pay $315,000 for a condo that had minor electrical problems (if tripped ground fault interrupters and burnt out light bulbs can be considered "problems"), and the seller was not obligated to sell them a condo with no electrical problems for the same price. Result: The Heymans owed Fisher not $117, but more than $90,000.

Setting aside the legal arguments, the Supreme Court decision avoids some very practical, real-world issues that would have been posed by the Court of Appeals decision. Had that decision stood, the law in Indiana would have allowed a party to a contract to continue to make additional demands on the other side, confident that the worst thing that could happen is that it would be required to pay the incremental cost of the demand. Conversely, the party on the receiving end of those demands would be forced to choose between acceding to them or being satisfied with the incremental cost of the demand, regardless of the magnitude of its actual damages.

A simple example: Imagine a musician who agrees to perform at a concert for $20,000. The organizer of the concert has already incurred another $30,000 in expenses and sold $100,000 worth of tickets. At the last minute, the musician refuses to go on stage unless he is paid an additional $10,000. The organizer would be forced to choose between paying the additional $10,000 or suffering a loss of $80,000, while being able to recover no more than $10,000. Surely that is not how mitigation of damages is supposed to work.

[Note: In discussing the example of the last paragraph, this post originally mentioned a loss of $130,000 rather than $80,000, but that's not the way damages are calculated. The organizer's damages would be the cost of refunding the price of the tickets ($100,000) less the $20,000 that the organizer originally promised the musician. The $30,000 in expenses would have been incurred even if the concert proceeded, giving the organizer a profit of $50,000. If the musician breached, the organizer would have to refund the price of the tickets, leaving the organizer with a $30,000 loss. To put the organizer in the same position it would have occupied had the contract not been breached -- i.e., with a $50,000 profit -- the musician would owe the organizer $80,000.]

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July 9, 2014

Office Lease: No signature, no personal guaranty

iStock_000014240498_Small (1).jpgBJ Thompson Associates, Inc. leased an office from Jubilee Investment Corp. The lease included the following language:

Guaranty of Performance In consideration of the making of the above Lease by LANDLORD with TENANT at the request of the undersigned Guarantor, and in reliance by LANDLORD on this guaranty the Guarantor hereby guarantees as its own debt, the payment of the rent and all other sums of money to be paid by TENANT, and the performance by TENANT of all the terms, conditions, covenants, and agreements of the Lease, and the undersigned promises to pay all LANDLORD'S costs, expenses, and reasonable attorney's fees (whether for negotiations, trial, appellate or other legal services), incurred by LANDLORD in enforcing this guaranty, and LANDLORD shall not be required to first proceed against TENANT before enforcing this guaranty. In addition, the Guarantor further agrees to pay cash the present cash value of the rent and other payments stipulated in this Lease upon demand by LANDLORD following TENANT being adjudged bankrupt or insolvent, or if a receiver or trustee in bankruptcy shall be appointed, or if TENANT makes an assignment for the benefit of creditors.

Even though the above language referred to "the undersigned Guarantor," the lease had no signature block for a guarantor. It had signature blocks for only the landlord and tenant. The signature block looked like this

BJ Thompson Associates, Inc.

By: ____________________

Date: __________________

followed by the address for BJ Thompson Associates, Inc. and the word "TENANT." It was signed by BJ Thompson, the sole shareholder and president of BJ Thompson Associates, Inc.

The original term of the lease was for one year, but the tenant held over for a number of years. (In essence, the lease was automatically renewed for successive one-year terms.) Eventually, however, the tenant moved out three months into the year and stopped paying rent. The landlord sued both BJ Thompson Associates, Inc. for rent for the remaining nine months, and it also sued BJ Thompson personally on the theory that he had personally guaranteed his company's obligations under the lease. The trial court dismissed the complaint against BJ Thompson personally because he had signed the lease only on behalf of his company as tenant and not on his own behalf as guarantor. In an unpublished opinion, the Court of Appeals agreed.

A guaranty is a promise by one person to pay the obligations of another person. When landlords sign leases with small businesses, it is common for them to require the lease to be personally guaranteed by the business owners, and the same thing occurs with other types of contracts as well. A guaranty is simply a particular type of contract, and it is governed by the same rules that apply to the interpretation and enforcement of other contracts. However, a guaranty is also one of several types of contracts subject to the statute of frauds, which says that, in order for a contract to be enforced, the contract must be in writing and must be signed by the party against whom it is being enforced.

In this case, the lease included language obligating "the undersigned Guarantor," but it did not identify BJ Thompson as the guarantor, and, although BJ Thompson signed on behalf of his company, the tenant, nothing in the lease identified his as the guarantor and nothing in the signature blocks indicated that he was signing in any capacity other than as the agent of his company.

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March 21, 2014

The Confusing Status of the Indiana Statute of Limitations for Breach of Written Contracts

iStock_000005882706Small.jpgSuppose that eight years ago, you hired a construction contractor to build an addition to your house in Indiana. Shortly after the construction was finished, you noticed that the roof shingles on the addition weren't quite the same color as those on the rest of the house. You checked the bundle of extra shingles that the contractor left behind and compared the information on the label with the specification in the contract. Sure enough, the contractor used the wrong shingles. Not only were they the wrong color, but they were also a lower quality than the contract specifications required. Even so, you were busy at the time and never got around to calling the contractor to get him to correct the mistake. Now you have a potential buyer for the house who is threatening to back out of the deal unless you replace the shingles. You call the contractor and demand that he correct his mistake. He refuses, saying it is too late for you to complain about the problem, that you should have called him as soon as you noticed it. Are you out of luck or not?

Statutes of Limitations

The key to answering the question is to determine the applicable statute of limitations. A person who has the right to sue someone for breach of contract (or, for that matter, the right to sue for other reasons) cannot wait forever to do it. How long the person can wait is determined by the statute of limitations that applies to the particular type of claim. In Indiana, there are two different statutes that might apply to the situation described above:

Which one applies?

It has been more than six years, but less than ten, since the addition to your house was finished and you noticed the problem with the shingles. Which statute applies?

Certainly your construction contract called for the payment of money, but don't most contracts do that? Is every contract that requires payment of money subject to the six-year statute of limitations, regardless of the rest of the contract? If so, that leaves the ten-year statute of limitations to cover only those contracts that do not involve the payment of money at all. On the other hand, maybe the idea is that the six-year statute of limitation covers contracts that do not involve anything other than the payment of money.

Surprisingly, there are very few published Indiana court decisions that address the question of which written contracts are covered by the six-year statute of limitations and which are covered by the ten-year statute, even though those statutes originated in 1881. However, the Indiana Supreme Court addressed the question with respect to an earlier version of the statutes in 1923.

The Ten-Year Limitation

The case was Yarlott v. Brown (192 Ind. 648, 138 N.E. 17, for those who would like to look it up), and the question was the statute of limitations on a mortgage. (At the time, the two statutes of limitation on written contracts were 10 years and 20 years, rather than 6 years and 10 years. A lawsuit was brought more than ten years, but less than 20 years, after the loan was supposed to be repaid.) Even though people commonly refer to the loans they take out to buy their homes as "mortgages," in reality the mortgage is actually a document that reflects the lender's right to foreclose on the property if the loan is not repaid; the obligation to pay the loan itself is set out in another document, called a note. However, in Yarlott, even though the mortgage was accompanied by a note, the mortgage contained not only the right of the lender to foreclose; it also repeated the obligation to repay the loan. It was clear that the statute of limitations on the note itself -- a written contract for the payment of money -- expired after ten years. But what about the mortgage? If it had not mentioned the repayment of th loan, it would have been subject to the longer statute of limitations. Did the fact that it repeated the obligation to repay the loan move it to the shorter limitation, the one that applied to "promissory notes, bills of exchange, and other contracts for the payment of money"?

The Indiana Supreme Court said no, the 20-year statute of limitations applied to the mortgage, despite the fact that it also provided for the payment of money. The Court reasoned that

. . . a mortgage differs in essential particulars from a promissory note, bill of exchange, or other written contract for the payment of money of the same kind as notes and bills. On the other hand, many actions which may be brought on such a mortgage bear a close resemblance to actions for the collection of judgments of courts of record, which are liens on real estate, or to actions for the recovery of possession of real estate. A familiar rule of statutory construction is that, where words of specific and limited signification in a statute are followed by general words of more comprehensive import, the general words shall be construed to embrace only such things as are of like kind or class with those designated by the specific words, unless a contrary intention is clearly expressed in the statute.

The underlining in the above quotation is ours, not the court's, but those words are the key to understanding the decision. The shorter statute of limitations applies to written contracts that are similar to promissory notes and bills of exchange.

Now what about your construction contract? Even though it involves the payment of money, a construction contract is very different from a promissory note or bill of exchange. Doesn't that mean that the applicable statute of limitations is ten years and that you still have the right to expect the contractor to pay for the cost of replacing your shingles? Well, maybe not.

Or is it the six-year limitation?

In 1991, the Indiana Court of Appeals stated that a teacher's contract -- which is also very different from a promissory note or bill of exchange -- was a contract for the payment of money and therefore subject to the statute of limitations of six years, not ten. Aigner v. Cass School Tp. of Porter County, 577 N.E.2d 983. The decision did not even mention Yarlotte v. Brown or the possibility that the period of limitations might be ten years instead of six. However, the lawsuit regarding the teacher's contract was brought within two years, so it was not barred regardless of which statute of limitations applied.

So where does that leave your claim against your former contractor? If a teacher's contract is subject to a six-year statute of limitations, isn't your construction contract also subject to a six-year limitation? It certainly seems so. But if you sue the contractor, you may be able to persuade the court that the Court of Appeals decision regarding the teacher's contract was simply wrong because it failed to follow the precedent set by the Indiana Supreme Court in Yarlott v. Brown. Alternatively, perhaps you can pesuade the court that the statement in Aigner about the six-year statute of limitations is not binding precedent because that result in that case would have been the same even if the ten-year limitation applied. Unfortunately, you might have to go all the way to the Indiana Supreme Court to get a favorable decision on either rationale.

On the other hand, the decision in Aigner has been around more than 20 years, and it has not been overturned yet. Indiana courts may continue to follow Aigner for most written contracts, narrowly applying Yarlott to those that, even though they involve the payment of money, "bear a close resemblance to actions for the collection of judgments of courts of record, which are liens on real estate, or to actions for the recovery of possession of real estate." All we can say is that anyone with a claim for breach of a written contract that involves any payment of money is far better off to file the lawsuit within six years; to wait longer is, at best, risky.

We invite others who may be able to shed light on this question to send us a message using the contact form on this page.

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December 15, 2013

Social Media and Two Remarkably Unremarkable Contract Cases

bored woman.jpgConsider these two relatively recent cases, one from Massachusetts and one from Indiana, both involving allegations of breach of contract through the use of social media:

  • A vice president of a recruiting firm leaves her job and goes to work for another recruiting firm. She has a covenant not to compete with her first employer that prohibits her from providing recruiting services within a specified list of "fields of placement" and within a specified geographic area. She updates her LinkedIn profile to reflect the new job. A message goes out to her list of over 500 contacts, including a number of her former employer's customers. Her former employer sues, alleging (among other things) that her LinkedIn update violated the covenant not to compete.
  • The agreement between an IT contractor and one of its subcontractors prohibits the subcontractor from soliciting or inducing the contractor's employees to leave their jobs. The subcontractor posts a job opening on LinkedIn where it could be viewed by anyone who had joined a particular public group. One of the contractor's employees sees the job posting, contacts the president of the subcontractor, and expresses an interest in the job. At a later meeting, the employee tells the subcontractor his compensation requirements and what he is looking for in a job. The subcontractor makes an offer of employment, and it is accepted. The contractor sues the subcontractor for breach of the covenant not to solicit its employees.

Although the law sometimes struggles to keep up with technology, in each of these cases the court decided the issue very readily, relying on standard contract law.

The first case is KNF&T, Inc. v. Muller, a case filed earlier this year in Massachusetts Superior Court. In filing the lawsuit, the plaintiff asked for a preliminary injunction. After reviewing the law on covenants not to compete and explaining that they are to be construed narrowly, the court denied the plaintiff's request, noting that, although Ms. Muller's LinkedIn profile mentioned things such as "staffing services" and "recruiting," it made no mention at all of any of the fields of placement that were listed in her covenant not to compete and, therefore, did not breach her agreement with KNF&T.

The second case is Enhanced Network Solutions Group, Inc. v. Hypersonic, decided by the Indiana Court of Appeals in 2011. In doing so, the court had to determine the meaning of "solicit" and "induce," as those words were used in the covenant not to solicit the contractor's (ENS's) employees. Because neither the contract nor Indiana case law defined them, the court looked to the ordinary dictionary definitions. Citing Black's Law Dictionary, the court explained that "soliciting" involves requesting or seeking to obtain something, and "inducing" means enticing or persuading someone to do something. The court held that Hypersonic did not solicit or induce the employee to leave ENS, but rather the employee solicited Hypersonic. In fact, it appears that the court did not even consider the LinkedIn job posting as a close call, mentioning only that the employee "made the initial contact with Hypersonic after reading the job posting on a publicly available portal of LinkedIn."

Do these cases mean that one cannot violate a noncompete agreement or a nonsolicitation agreement by posting something on a social media site? Not at all. In fact, it seems entirely possible that the Massachusetts case would have gone the other way if Ms. Muller's LinkedIn profile had mentioned one fields of placement from which she was barred by her agreement with her former employer. Similarly, the Indiana case might have gone the other way if someone from Hypersonic had sent an email message specifically addressed to the ENS employee with a link to the LinkedIn job posting, particularly if the message encouraged him to apply.

Indeed, what is noteworthy about these cases is that the social media aspect of them had no bearing on the courts' analyses. The Massachusetts case would likely have turned out the same way had Ms. Muller sent out paper announcements saying the same thing her LinkedIn profile said, and the Indiana case would likely have turned out the same way had the job posting been a classified ad in a newspaper. The courts had to plow no new ground to deal with them.

In that sense, these cases are unremarkable. Remarkably so.

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September 11, 2013

Home Improvement Contracts

House painter.jpgIndiana has a relatively little known statute, the Home Improvement Contracts statute located in Title 24, Article 25, Chapter 11 of the Indiana Code, that protects the customers of home improvement contractors by establishing certain minimum contract requirements. Home improvement contractors are well advised to ensure that their contracts comply with the statute because those who violate it may find themselves on the receiving end of a lawsuit under companion Chapter 0.5 (Deceptive Consumer Sales) filed either by their customers or by the Indiana Attorney General. This article describes only some of the statutory requirements, and home improvement contractors who want to make sure they comply should seek legal advice.


The Home Improvement Contacts statute applies to contracts between a consumer and a "home improvement supplier" for any alteration, repair, replacement, reconstruction, or other modification to residential property, whether the consumer owns, leases, or rents the residence, but only if the contract is for more than $150. The statute defines "home improvement supplier" as someone who engages in or solicits home improvement contracts, even if that person does not actually do the work. For example, if a homeowner buys installed carpet from a carpet store, the contract to install the carpet is covered by the Home Improvement Contracts statute even if the store owner doesn't actually perform the installation but instead subcontracts the work to someone else.

Contract Requirements

Not surprisingly, home improvement contracts must be in writing. Although the Home Improvement Contracts statute does not include an express requirement for a written contract, and although the definition of "home improvement contract" includes oral agreements, as a practical matter it is impossible for an oral contract to comply with the statute.

Section 10(a) of the Home Improvement Contracts statute includes a laundry list of requirements. For example, the contract must include the name of the consumer and address of the home; the name, address, and telephone number of the contractor; the date the contract was presented to the consumer; a reasonably detailed description of the work; if specifications are not included in the description, then a statement that specifications will be provided separately and are subject to consumer approval; approximate start and end dates for the work; a statement of contingencies that may seriously alter the completion date; and the contract price.

The requirement that the contract contain specifications (or a statement that specifications will be supplied later for approval by the consumer) deserves a little more attention. The statute defines specifications as "the plans, detailed drawings, lists of materials, or other methods customarily used in the home improvement industry as a whole to describe with particularity the work, workmanship, materials, and quality of materials for each home improvement." Note that a specification must describe the work, workmanship, materials, and quality of materials with particularity.

Consider, for example, a contract to paint the exterior of a home. Does it comply with the requirement for a contract to contain specifications if the only description of the work is, "Paint all exterior siding and window frames with gray exterior latex paint"? Does that describe the work "with particularity"? Probably not. For example, it does not specify the number of coats of paint, obviously a significant consideration. Moreover, the specification of "exterior latex paint" is probably inadequate in light of the range of quality and prices of exterior latex paint available on the market, and "gray" is probably not specific enough either, given that paint stores carry a wide spectrum of colors that can reasonably be called gray.

Specific Requirements and Accommodations for Work Covered by Insurance

Section 10(b) of the statute deals with special issues presented by contracts to repair damage that is to be covered by an insurance policy. Several of the provisions provide alternative ways for the contract to comply with the general requirements listed in Section 10(a). For example, the requirement to include the start date can be satisfied by specifying that the repairs will begin within a specified amount of time after it is approved by the insurance company. Similarly, the contract price can be expressed by stating the amount owed by the consumer in addition to the amount of the insurance proceeds, and that includes a contract provision that the contractor will not charge the consumer any amount above the amount of the insurance proceeds. Note, however, that because of the prohibitions in Section 10.5 (discussed below), the consumer is responsible for any insurance deductible.

More importantly, Section 10(b) requires home improvement contracts for repairing exterior damage that covered by insurance to give the consumer a right to cancel the contract within three days of receiving notice from the insurance company denying coverage for some or all of the repairs. The contract must include some very specific language dealing with the right to cancel, and it also must include a form, attached to but easily removable from the contract, that the consumer can use to cancel the contract.


Section 10.5 of the statute also contains some prohibitions that home improvement contractors need to know about. One has already been mentioned -- contractors are prohibited from paying or rebating to the consumer any part of an insurance deductible or giving any sort of gift, allowance, or anything else of monetary value to the consumer to cover the insurance deductible, including things like referral fees and payments in exchange for the consumer allowing the contractor to place a sign in the yard.

As another example, Section 10.5(d) contains a blanket prohibition on home improvement contractors acting as public adjusters.

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August 19, 2013

Is Your Business's Confidentiality Agreement Enforceable? Part 2

In a previous post we discussed a few basic principles of confidentiality agreements (also known as non-disclosure agreements or NDAs). That post discussed the basic of these agreements and the important principles of restrictive covenants and trade secrets. Left unanswered was the critical question: How long can, or should, a confidentiality obligation last?

Reasonable Periods of Confidentiality
Now let's get back to the question of a reasonable amount of time for confidentiality obligations to last with respect to CBI that does not meet the definition of a trade secret. As discussed above, a factor is the nature of the CBI owners legitimate business interests that are protected by the agreement. An example of a legitimate business interest of the owner is to protect the confidentiality its cost of goods sold or COGS. Disclosure of that information to competitors may give them an unfair advantage when bidding for the business of new customers. But how long does that legitimate business interest last? That depends on the nature of the goods and the nature of the industry. In some industries, costs are sufficiently stable that knowledge of a company's COGS from five years ago enables a competitor to make an accurate estimate of the company's COGS today, and a court might consider a confidentiality period of five years to be very reasonable. In other industries, costs change much more quickly, and a court might find that a confidentiality period of five years is unreasonable and rule that the agreement is unenforceable -- unless the COGS also meets the definition of a trade secret. Confidentiality man whispering to woman.jpg

Here's where things get more complicated because the definitions of CBI in most confidentiality agreements are not identical to the definition of a trade secret. In most cases, all trade secrets are also CBI, but not all CBI qualifies as a trade secret. So what to do?

One one might consider writing a confidentiality agreement that, for CBI that qualifies as a trade secret, lasts for as long as that is true and, for all other CBI, lasts for only, say, three years. And one can certainly write a contract with precisely that provision, but it will pose a dilemma for the recipient: The recipient will probably not be able to tell the difference between CBI that qualifies as a trade secret and CBI that does not. Here are some possible ways to resolve that dilemma.

  • The recipient may decide to simply live with the dilemma and assume that all CBI must be protected essentially forever. Some recipients find that acceptable.
  • The owner of the CBI may accept a time limitation for all CBI, including CBI that qualifies as a trade secret. However, that may create other problems for the CBI owner. Note the second part of the definition of a trade secret -- it must be subject to reasonable precautions to protect its secrecy. Is it a reasonable precaution to disclose information under a confidentiality agreement that permits the disclosure or use of the information after a certain period of time? Some courts say no, with the result that the information loses its status as a trade secret.
  • The confidentiality agreement may impose a limit that applies to ALL CBI, but only if, and for as long as, the CBI qualifies as a trade secret. In that case, the owner accepts the possibility that some CBI may have no protection at all because it never qualifies as a trade secret. For some owners in some situations, that is a more acceptable risk than the possibility of having its CBI lose status as a trade secret.

In short, there is no single solution that works in every case. Each situation must be negotiated individually, with the interests of both sides of the agreement taken into account.

Continue reading "Is Your Business's Confidentiality Agreement Enforceable? Part 2" »

August 19, 2013

Is Your Business's Confidentiality Agreement Enforceable? Part 1

Confidentiality man whispering to woman.jpgConfidentiality agreements (also known as non-disclosure agreements or NDAs) are common in today's business world. They are sometimes in the form of stand-alone agreements, often used when two businesses are discussing a potential deal and at least one of them needs to disclose to the other information that is not available to the public (sometimes called confidential business information or CBI). Other times, they are embedded in agreements with a broader scope, such as employment contracts, service contracts, and contracts for the sale and purchase of a business.

The fundamental concept of a confidentiality agreement is simple. The person receiving or possessing the other person's CBI promises not to disclose it to others and (usually) not to use the information for any purpose other than the discussions of a potential transaction or the purpose of the larger contract in which the confidential provision is embedded.

The details, however, can be tricky, and one of the thornier details is the question of how long the obligations of nondisclosure and nonuse last. Naturally, the person disclosing the CBI wants the commitments to last forever, but the person making the commitments wants them to expire at some point in time, not necessarily because he or she wants to use or disclose the information, but because he or she wants the possibility of being sued for breach to come to an end, and the sooner the better.

So how long can, or should, a confidentiality obligation last? Before answering that question, a little review of some legal principles is in order. Note that these issues are very fact-sensitive and that the law varies a fair amount from state to state. For that reason, this discussion is based on general concepts; the results may be very different in any particular case.

Restrictive Covenants
Confidentiality agreements are sometimes considered to be within a larger category of contracts known as restrictive covenants, i.e., agreements that in one way or another restrict commercial trade. With freedom of trade and commerce being so important to American society, restrictive covenants are not favored by public policy or the law. That doesn't mean restrictive covenants are necessarily void or illegal, but they may be unless the restrictions are sufficiently narrow. At least some courts have held that confidentiality obligations can last for only a reasonable period of time (with an exception discussed below), and a confidentiality obligation that lasts too long may result in a court refusing to enforce the agreement.

Unfortunately, there are no clear rules to tell us what amount of time is reasonable for the duration of a confidentiality obligation. Instead, there are factors that must be weighed and balanced. Those factors include the nature of the legitimate business interests of the owner of the CBI; the effect of the restrictions on the person making the non-disclosure and non-use commitments; and the public interest.

So far we know that it may be necessary for a confidentiality obligation to expire after a reasonable period of time, and, if it doesn't, the agreement may be unenforceable. HOWEVER, there is a major exception, and that exception is for CBI that also meets the definition of a "trade secret."

Trade Secrets
Although "confidential business information" does not have a universal meaning,the definitions contained in most confidentiality agreements are broad enough to encompass "trade secrets," a term defined by state statute. In Indiana, section 24-2-3-2 of the Indiana Code defines a trade secret as information that

  1. has independent economic value because others who could obtain economic value from the information do not have the information and cannot reasonable acquire it; and

  2. is the subject of reasonable efforts to maintain its secrecy.

Trade secrets are a form of intellectual property, and the trade secret statute provides protection against improper use or disclosure, in addition to the protection provided by a confidentiality agreement. Unlike most forms of intellectual property, such as patents, trade secrets never expire; they remain protected by statute for as long as the information continues to meet the definition. For that reason, some courts have ruled that the requirement for confidentiality agreements to be limited to a reasonable period of time is subject to an exception for trade secrets. To the extent a confidentiality agreement covers a trade secret, the confidentiality obligation is permitted to last forever, or at least for as long as the information continues to qualify as a trade secret under the statutory definition.

Here's where that leaves us: With respect to trade secrets, confidentiality obligations do not need to expire. (In fact, as we'll see later, they should not expire.) With respect to other CBI, confidentiality obligations may need to expire after a reasonable period of time to ensure enforceability. In the next article, we will consider how to deal with that bifurcation.

Continue reading "Is Your Business's Confidentiality Agreement Enforceable? Part 1" »