Tuesday, May 25, 2010

Contract Building Blocks—the low hanging fruit of standardization

One of the challenges to creating contract templates as a reference standard is that a yardstick must be built for every document type; just as we need spell checkers for each language. Nevertheless, there are shared characteristics that can be exploited across all document types.

Virtually all contracts follow the same basic structure. While we may give these elements different labels, the basic organization of bi-lateral and multi-lateral contracts can be described as follows:

  • Statement of agreement and identification of the parties
  • Form and mechanics of the transaction
  • Representations and Warranties
  • Conditions Precedent
  • Covenants (ongoing promises)
  • Term and Termination (Events of Default)
  • Limitation on Liability
  • Indemnification
  • General Provisions (Miscellaneous)

With the exception of the form and mechanics of the transaction, legal agreements share many of the same terms and provisions. Furthermore, we can predict the likely degree of similarity of each building block. For example, the General Provisions will likely be more consistent across a wide range of agreements compared to Termination provisions. I would predict that the next most consistent terms can be found in the Representations and Warranties.

Consistency across all documents offers an opportunity to standardize terms "horizontally" or at least across blocks of related agreements. Then applying the wisdom of the 80/20 rule, a relatively simple 3-step approach can realize significant productivity and quality gains.

First, create a list of all clauses in each common contract section (e.g. Miscellaneous, Covenants, or Representations and Warranties).

Second, mark each clause as either standard or deal-specific.

Third, build a library containing the standard and alternative language for each clause.

Simple. However, I should disclose that I've received significant push-back on standard document building blocks. In one case, I was told that is would be impossible to create a standard Miscellaneous section of boiler-plate terms because, for example, the assignment clause requires customization to each deal. Of course, terms must be tailored to the transaction. However, the variations are predictable and can be supplied. Others have warned that clauses are dependent on the terms of other provisions and therefore cannot be read in isolation. It is true that some deal terms are conditional on other provisions, but again such conditionality can be predicted and, where it exists, it should be clearly identified to prevent mistakes in the use of precedent.

As an example, we can apply the approach to the Miscellaneous section of the set of 106 intellectual property security agreements analyzed in a prior post. The complete list contains 32 clauses shown in the chart below where the blue bar shows the commonality (frequency) of each clause and the yellow bar display the language consistency (variance), based on calculation of standard deviation.

If we focus on the 8 most common clauses appearing in at least 1/3 or more the documents, we can see that the language is universally more consistent. For the less common clauses there appears to be more divergence: some highly consistent; others very inconsistent.

In non-mathematical terms, the analysis provides additional support for the 80/20 rule, namely: in the case of frequently appearing clauses there is already broad consensus on the standard language. And, such consensus can hopefully reduce some of the political hurdles associated with contract standardization.

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