Using Contracts to Deal with Unknowns: Part 2 “Unknown Unknowns”
In the previous issue of this newsletter, I discussed how to use contracts to protect against “known unknowns,” those events and circumstances for which you know the general category of uncertainty, but not the outcome.
This article covers “unknown unknowns,” those events and circumstances that you cannot foresee.
Here are several approaches to deal with unknown unknowns in a contract relationship:
1. Representations, warranties and indemnification approach. The previous issue of this newsletter defined and discussed how representations, warranties and indemnities can be used in a contract to protect you against known unknowns. By drafting representations, warranties and indemnification broadly, you often can cover many unknown unknowns as well.
For example, indemnification could cover very broadly “any act or omission of the other party in connection with the relationship or the contract.” That of course does not cover events or circumstances beyond the other party’s acts or omissions (such as a change in government regulations). It also does not cover all threats to the existence of a party (such as bankruptcy of a company or death of an individual), which may be covered by bankruptcy, trusts & estates and family law, as I discussed before.
2. Procedural approach. Some unknown unknowns can be dealt with by adding procedural provisions to your contracts: escalation, mediation or arbitration. (These provisions work for known unknowns too. I see them often in deals with high complexity or high uncertainty.)
In essence, the parties control their own mechanisms for resolving disputes, to avoid going to court over unexpected circumstances.
Escalation mechanisms provide a means for the parties to raise (or “escalate”) issues from the working group level to the senior executive level, with the assumption that senior business people can defuse potential lawsuits.
Mediation uses a third party to help the parties understand their differences and negotiate a resolution.
Arbitration uses a privately hired third party (often a retired judge) to resolve disputes outside of the public court system. Often, to provide greater certainty, the arbitration clause can limit the arbitrator’s power and authority, such as limiting the scope of document discovery or ability to impose non-monetary penalties (injunctions).
3. Substitution of parties approach. You can seek to substitute someone else in the relationship in place of the original (non-performing) party. For example, permitting a contract to be sold and assigned to someone else enables a third party to assume the performance obligations and step into the shoes of the non-performer.
A third party guarantee has a similar effect, but it generally covers only the payment of money ““ the third party’s money (the guarantor’s) effectively replaces the money of the non-per-former. Insurance can also serve this purpose to a limited extent. See my article, “Contract Provisions for Troubled Times: Part 3 How Third Parties Can Assure Performance” (Technology Law Letter #3). This can be a good strategy, unless the guarantor cannot fulfill its commitments or ceases to exist.
4. Hedging approach. You may choose to deal with more than one party.
In the field of procurement, this means finding a second source. If one of the parties ceases to exist, you have limited your downside and can obtain performance from others.
Of course, the 2008 economic meltdown demonstrates that there can be nowhere to hide if all the players in the industry sink at the same time.
A similar approach is to have a contract with a major vendor, but separately make a small investment in a new, unproven technology provider. Although the main contract should fully cover the parties’ relationship, the relationship with the small newcomer provides a hedge against unknown shifts in technology or unexpected problems with the major supplier. It also might deter the major supplier from demanding unreasonable prices.
5. Robust “we’ll-deal-with-it” approach. Instead of trying to predict future outcomes, focus on becoming a robust, resilient player. Examples of good defenses against the unexpected include:
- Developing contingency plans to address categories of risks.
- Creating a culture of resilience and resourcefulness that recognizes that tech-nology, the business and the market are constantly changing, and that any obstacle will be worked around and overcome.
- Emphasizing flexibility and speed of execution.
- Developing strategic relationships with industry organizations and market leaders.
For more examples of unknown unknowns, see the book The Black Swan: The Impact of the Highly Improbable by Nassim Nicholas Taleb.
It’s impossible to foresee every event that can affect a contract. The five approaches above will help you overcome circumstances that you cannot foresee.