Common Elements of Business Contracts, Part 4: Essential Covenants

This is the fourth in a series of articles [1] presenting an overview of various provisions commonly found in business contracts, primarily from the point of view of the drafting attorney. [2]

Essential Covenants

The essence of most business contracts, even the most complicated ones, can usually be boiled down to a few essential promises that the parties make to each other. In an office lease, the landlord leases the premises to the tenant, and the tenant agrees to pay rent to the landlord. In an asset purchase agreement, the seller promises to convey the assets to the buyer, and the buyer promises to pay the seller the purchase price. In a patent license agreement, the licensor grants a license [3] to the licensee, and the licensee agrees to pay a license fee or royalty to the licensor.

The drafter does well to isolate those essential promises and place them very early in the contract document. In a well drafted contract, the essential covenants flow very naturally from the recitals. The remaining substantive provisions that, even though important, are ancillary to the essential covenants go later in the document. [4]

Although the following points apply to covenants in general, not just to essential covenants, this is a good point in the discussion to take them up.

Covenants versus warranties versus representations<

Covenants, representations, and warranties are easily and often confused, but they have distinct definitions and, to some degree, distinct legal consequences.

A covenant is often described as a promise or an agreement, but the same is true of a warranty. To distinguish between the two, we need to be more specific. A covenant is a promise made by a party to the contract to do something or to refrain from doing something. It is a synonym to “obligation.” [5]

In contrast, a warranty is a promise that a particular statement of a fact is or will be true. The party making a warranty does not promise to do or not to do anything, and in fact the party making a warranty may be powerless to make the warranted statement true. It is simply a promise that the statement is or will be true.

So much for the primary distinction between a warranty and a covenant. [6] There are more similarities than distinctions: Both contractual promises, and an action for breach of a warranty and breach of a covenant are both actions for breach of contract. Both covenants and warranties are subject to strict liability, and they have essentially the same set of remedies for breach.

A representation, on the other hand, is not a promise. Instead it is a statement of current fact (not future fact) that one party makes for the purpose of inducing the other party to take some action, generally to enter into the contract. However, because a representation is not a promise, the legal action for a false representation is essentially a tort claim, not a contract claim. It is not subject to strict liability, but rather to the standards or negligent or intentional torts, and the remedies are those available for torts, not those available for breach of contract.

Note, however, the precise word used to describe a contract provision does not necessarily control the outcome. For example, it is possible to make a warranty without using the words “warrant” or “warranty.” [7] Nonetheless, a careful drafter should consider whether a certain provision should be a representation, a warranty, or a covenant, and to draft the language accordingly.

Drafting Covenants using “Shall”

One of the most misused words in American contracts is “shall.” Drafters understand the concept that “shall” is a mandatory verb, but it has a more nuanced meaning, at least in contracts. In contracts, “shall” should be used to create an obligation , and, given that the only people that can be obligated by a contract are its parties, it should be used only when a party is a subject of a sentence. In other words, “shall” signals a covenant.

Covenants That Are Not Really Covenants

One type of contractual provision that frequently appears in the set of essential covenants that does not really fit the definition of covenants, and that is the self-executing provision, such as the following:

Licensor hereby grants to Licensee a perpetual, nonexclusive, nontransferable License to use the Licensed Technology anywhere within the Territory.

Self-executing provisions are not truly covenants because they are not promises to do something; instead, they accomplish something as soon as the contract is signed. Even so, they serve a purpose similar to that of covenants, and they often appear in the same places in a contract that covenants appear.



[1] These articles are adapted from materials prepared by the author for a continuing legal education seminar, “Business Contracts from A to Z,” sponsored by National Business Institute, and presented by Michael Ray Smith of Smith Rayl Law Office, LLC; and by Trevor J. Belden and Robert K. Stanley of Faegre Baker Daniels, LLP. Used by permission of National Business Institute.

[2] There is no universally accepted structure, format, or style for writing business contracts. In contract drafting, as in computers, “The nice thing about standards is that you have so many to choose from.” Andrew S. Tannenbaum, Computer Networks, 4th ed., quoted at http://en.wikiquote.org/wiki/Andrew_S._Tanenbaum. Two references sometimes used by the author are Kenneth Adams, A Manual of Style for Contract Drafting (2008). Another reference for specific provisions is Tina L. Stark (ed.), Negotiating and Drafting Contract Boilerplate (2003). These two sources are subsequently referred to as “Adams” and “Stark.”

[3] Note that the essence of the license is a promise – a promise not to sue the licensee for acts that would otherwise constitute infringement.

[4] A particular type of term that is an essential covenant in one agreement may be ancillary in another. For example, the essential covenants in a confidentiality agreement are the covenants of nondisclosure and nonuse of the other party’s confidential information. In other agreements, the confidentiality provisions are ancillary to the essential covenants.

[5] In fact, Adams, pp. 272-274, recommends using “obligation” to replace “covenant,” and his advice is sound. Nonetheless, because the term “covenant” is still widely used among lawyers, particularly when distinguishing them from representations and warranties, this paper sticks with that word.

[6] There can be other distinctions that are beyond this discussion, including the beneficiaries of a warranty versus the beneficiaries of a covenant. For example, while a covenant benefits only the other party to an agreement (leaving aside the possibility of third-party beneficiaries), a warranty on goods may benefit not just the immediate purchaser but also subsequent purchasers.

[7] See Adams, p. 287, discussing provisions of the Uniform Commercial Code and a court decision construing “represents” to include “warrants.”