December 31, 2012

TRAINING FOR TOMORROW: Ethical Issues in Negotiating Contracts

Scott J. Burnham

An employer discharged an employee, offering the employee $38,000 if he agreed, in the words of the release he was tendered, to release the employer "from all claims." The employee thought it over and later agreed to sign the release, which he returned to the employer. After the release was signed, the employee sued the employer for age discrimination and breach of contract. When the employer raised the release as a defense, the employee said, "Ha ha," and pointed to the language of the release, which stated that the employee released the employer "from all claims except as to claims of age discrimination and breach of contract." When the employer protested that it had been tricked, the employee acknowledged that he had changed the language of the document, but claimed that because a party is bound by the agreement it signs, it fails to read the agreement at its peril.

This article looks at this situation and a number of other situations arising during the process of negotiating a draft agreement that raise ethical issues. While the Rules of Professional Conduct are an initial resource in attempting to resolve the questions, it can be a challenge to apply the Rules to the tasks of the transactional lawyer. The principal Rules relevant to drafting are 1.2 and 4.1, which state in relevant part:

1.2 A lawyer shall not counsel or assist a client in conduct that the lawyer knows or reasonably should know is criminal or fraudulent . . . .

and

4.1 In the course of representing a client a lawyer shall not knowingly:

(a) make a false statement of material fact or law to a third person; or
(b) fail to disclose a material fact to a third person when disclosure is necessary to avoid assisting a criminal or fraudulent act by a client, unless disclosure is prohibited by Rule 1.6.

In determining whether conduct is ethical, it may be helpful to examine:

  • Whether there is a duty to read a draft.
  • Whether an affirmative misrepresentation is made.
  • Whether there is a duty to disclose.
  • What the reasonable expectations of the parties are.

Four Hypothetical Situations

1. The attorney receiving the draft alters it after receipt.

The first attorney tenders a draft contract. The second attorney returns it, saying that it is acceptable, and both parties sign it. However, the second attorney has made changes in the draft and did not call the first attorney's attention to those changes.

The facts in the introductory paragraph of this article are from the case of Hand v. Dayton-Hudson, 775 F.2d 757 (6th Cir. 1985). Did Hand act unethically in failing to inform Dayton-Hudson that he had made the changes? On Dayton-Hudson's motion for summary judgment, the trial court found that because Dayton-Hudson's signature had been induced by fraud, the agreement would be reformed to conform to its understanding. The appellate court affirmed. It probably did not help his case that Hand, the perpetrator of the fraud, had been employed by Dayton-Hudson as an attorney, even if he was not acting as an attorney in the matter in issue.

The decision is undoubtedly correct. By returning the document while saying it was acceptable, Hand was effectively saying that the document as prepared by Dayton-Hudson was acceptable. Although Rule 4.1 prohibits only "mak[ing] a false statement of material fact," and Hand's lapse was his non-disclosure, here non-disclosure seems the equivalent of an affirmative misrepresentation. In these circumstances, Dayton-Hudson's duty to read should be excused since the employer would reasonably expect that Hand was returning the document it had tendered to him.

As a general rule, when one attorney makes changes to the other's draft, the ethical practice is to inform the other attorney of those changes. But what if the changes are made before the draft is presented to the other attorney; that is, they are made to a form contract?

2. The party preparing the draft alters a standard form contract.

Assume that the attorneys are negotiating a contract for the sale of real property, and in the jurisdiction, it is customary for the seller to pay certain closing costs. The seller's attorney tenders to the buyer's attorney a draft contract in which the seller's attorney has altered the customary language to provide that these costs are borne by the buyer rather than by the seller. The buyer's attorney reads the variable terms, but not the boilerplate terms, and does not notice this change before her client signs the agreement. At closing, the change becomes apparent.

Did the seller's attorney act unethically in altering the customary terms without informing the buyer's attorney?

Even though this is a sharp practice on the part of the seller's attorney, I don't think an attorney has a duty to disclose the fact that changes were made to the customary terms. No affirmative misrepresentation was made, and the buyer's attorney may not be justified in assuming the draft contract contains the customary terms. The situation might be different if the form was presented as a model form prepared, for example, by the ABA or a state bar. In that case, there may be a reasonable expectation that the boilerplate terms are those set forth in the model form. But in other cases, I think the attorney to whom the contract was tendered takes the risk that it does not contain the expected terms. That attorney should either read it, put it through the "compare" feature of a word processor or stand-alone program that will compare it to standardized terms, or ask the other lawyer to make an affirmative statement about whether any changes were made to the customary terms.

What if changes are disclosed, but not the consequences of those changes?

3. The attorney requesting a change fails to disclose ripple effects.

The first attorney asks for a change in a term, which the second attorney agrees to, but the first attorney does not inform the second attorney that the change in that term affects a term in another part of the agreement that is not favorable to the party represented by the second attorney. An example might be a choice of law provision, where the law in the chosen jurisdiction affects another part of the agreement. Does the first attorney have a duty to inform the second attorney that the change in language may affect another part of the agreement?

I think there is no such duty. One attorney does not have to educate another as to the legal effect of a contract provision, as long as no affirmative misrepresentation is made. In fact, the lawyer's duty of competent representation in Rule 1.1 would require the recipient to recognize the ripple effects.

These problems are exacerbated when the contract is drafted not through an exchange of drafts over time, but in real time, using a program such as Google Docs. The first attorney can suggest a change by typing it in, and the other attorney can assent or not. The alteration itself is clearly disclosed, but not the effect that the change in paragraph 7.2 has on paragraph 14.4. This is a significant drawback to real-time drafting, for such repercussions can best be discovered by reviewing the document in its entirety. Alas, the pace of modern business may not grant us this luxury. An attorney must therefore know the transaction well, including knowledge of how all the parts fit together.

Finally, what if an agreed term is omitted altogether?

4. The final contract omits a term the parties agreed to.

The parties agree to the terms of an agreement. One attorney reduces the agreement to writing and both parties review and sign it. Later, the first attorney realizes that an important term has been omitted. The second attorney acknowledges this "scrivener's error," but refuses to modify the writing, which purports to contain the final and complete agreement of the parties. Should the second attorney agree to reform the contract to include the missing provision?

The Restatement (Second) of Contracts says the answer is "yes." Section 155 provides:

Where a writing that evidences or embodies an agreement in whole or in part fails to express the agreement because of a mistake of both parties as to the contents or effect of the writing, the court may at the request of a party reform the writing to express the agreement, …

Calamari and Perillo state the rule more succinctly in § 9.31 of their Contracts hornbook: "Contracts are not reformed for mistake; records are." Note that this situation must be distinguished from the situation in which the parol evidence rule applies. The parol evidence rule provides that once the parties have adopted a writing that they intend to contain their final and complete agreement, then evidence may not be offered of terms that supplement or contradict it. The distinction is in the intent of the parties. In the case governed by the parol evidence rule, the party opposing inclusion of the term claims that while the parties may have discussed the term during negotiations, they did not intend it to be a part of their final agreement; in the mistake case, the party admits that they agreed to it and intended to include it in the writing, but inadvertently omitted it.

ABA Informal Opinion 86-1518 addressed this issue, concluding that under Rules 1.2 and 4.1, an attorney has a duty to disclose the omission of the term to the other attorney and to agree to reform the writing. An attorney might maintain that he informed his client of the omission, and while the attorney would of course be willing to disclose it, he had a duty to zealously represent his client, who insisted on taking advantage of the situation. The opinion concluded that because the client had already agreed to include the term in the contract, the attorney need not even consult the client before agreeing to reform the contract. Curiously, the Maryland State Bar Association Committee on Ethics addressed the same issue in Ethics Docket 89-44 and, without mentioning the ABA opinion, reached the contrary conclusion. However, the Maryland opinion did warn the attorney to explain to the client, pursuant to Rule 1.4(b), information necessary to permit the client to make an informed decision, including the fact that the other party may bring a reformation action, the likelihood of success of such an action, and the cost of defending it.

Conclusion

The attorney's duty to read the draft contract is excused when there is fraud or mistake. Nevertheless, as a matter of preventive law, the attorney should review the contract - perhaps with the help of a computer program - before it is signed. Also, the attorney should provide the client with an opportunity to review it. Not only can review by a second set of eyes be helpful in detecting problems, but if the attorney victimized by these situations faces a client's malpractice claim, it will be helpful if the attorney gave the client an adequate opportunity to review the contract, for most of the problems could be detected by the review of a layperson.

Additional Resources

"Commercial Law Forms: One Size Does Not Fit All; Tips on How to Use Forms Wisely," sponsored by the UCC Committee and the Commercial Finance Committee at the ABA Annual Meeting in August 2012.

Scott J. Burnham

Scott J. Burnham is the Curley Professor of Commercial Law at Gonzaga University School of Law. This article is adapted from material presented at the program.