Contract Time Bomb #1: The Severability Clause

This is the first article in the new series entitled “Contract Time Bombs,” where I will address common contract terms that could leave your company financially and legally exposed.  I will address where they are, what they mean, and ways to help fix them.

Pull out any of your standard contracts and you will see this clause.  Large businesses and small businesses alike have this clause in, I dare say, all of their contracts.  I, myself, have seen this clause in every single non-government contract.  Lawyers include it to protect their clients’ interest, but its effect can be quite the opposite if it is not worded just right.

The severability clause.

Yes, that boring little slip of a clause has the potential to turn a contract on its head, and yield results that are the complete antithesis of either party’s intention.

If you are reading this and are not familiar with contracts lingo, you may have no idea of what a severability clause is, so let me explain.  A severability clause is usually a sentence or two that states that if a provision in the contract is found to be unenforceable or void, that provision should be removed, but the rest of the contract should remain intact.  It retains a majority of the contract to keep from throwing out the baby with the bathwater, so to speak.

Seems simple right?  Everything is simple … until it’s litigated.

In reality, what this clause does is allow the removal of a provision, but doesn’t balance out the remainder of the agreement to reflect the overall purpose and original intent of the parties involved.

Here’s an example.  Party A agrees to sell to Party B a clothing store valued at $2.5 million in exchange for $20,000 cash and 200 shares of Party B’s stock worth $2 million.  In their contract was the clause that stated “In the event that any part or provision of this Agreement is held illegal or unenforceable in a judicial proceeding, such part or provision shall be severed and shall be inoperative, and the remainder of the Agreement shall remain operative, binding, and enforceable.”

A performance dispute arose, and Parties A and B went to court.  The court found that the transfer of stock was illegal, so in accordance with the clear language of the severability clause, the court removed that provision from the contract, and nothing else.

The results are that Party B gets to keep the clothing store worth $2.5 million in exchange for only $20,000.

Was that either party’s intent?  Certainly not, but if the clause’s wording is very clear and unambiguous, the court may apply its meaning in the most literal sense (see Circle Appliance Leasing, Inc. v. Appliance Warehouse, Inc.).

So, how do you draft around that pesky little severability clause so that your company doesn’t lose its metaphorical shirt from a deal gone bad?  Here are a few tips:

Tip #1: Make the Clause Amendable

Include language that allows the parties to the agreement to change the wording so that it is enforceable, versus doing away with it altogether.  You can also make the clause amendable by a judge or arbitrator should it be found void or unenforceable by a judicial proceeding.

Here’s an example of a clause that allows it to be amended by negotiations of the parties:

If any term or other provision of this Agreement is determined to be fully or partially invalid, illegal, void, or unenforceable, all other conditions and provisions of this Agreement shall nevertheless remain in full force and effect so long as the economic or legal substance of the transactions contemplated hereby is not affected in any manner materially adverse to any party. Upon such determination that any term or other provision is invalid, illegal or incapable of being enforced, the parties hereto shall negotiate in good faith to modify this Agreement so as to effect the original intent of the parties as closely as possible in an acceptable manner to the end that transactions contemplated hereby are fulfilled to the greatest extent possible.

Tip #2: Outline Essential Terms

Insert language in the severability clause that clearly outlines the absolute essential terms of the agreement.  State that if any of those essentials are removed, the entire agreement is invalidated.

Here is an example severability clause that incorporates this tip:

In the event that any term, provision, paragraph, article, or section of this Agreement is declared fully or partially illegal, void, invalid, or unenforceable by a judicial proceeding, the remainder of that part or provision and the Agreement will remain in full force and effect, provided that the essential terms and conditions of this Agreement for each party as outlined in Section […] remain valid, binding, and enforceable.  If any essential terms or conditions in Section […] are declared fully or partially illegal, void, invalid, or unenforceable by a judicial proceeding, either party may elect to terminate the agreement in accordance with the termination clauses contained herein.

Now go fix those contract templates!

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