Overview and how to drafting best practices to protect parties and ensure agreement clarity
Contract law · contract elements · contract clause
Black’s Law Dictionary defines a clause as “a distinct section or provision of a legal document or instrument.”
Behind every commercial transaction lies a network of interlinked clauses that anticipate and allocate risks, preserve value, and govern the transaction’s functioning. Whether a party is entering into a subscription agreement, a merger agreement, or a stock purchase agreement, well-drafted clauses that accurately translate the parties’ intent are of utmost importance.
A clause forms an essential part of any contract, and typically provides the terms, conditions, rights, and obligations of the transaction and the parties involved. It may be identified by a specific numerical order, letter, or heading.
Jump to ↓
CoCounsel
Bringing together generative AI, trusted content and expert insights for contract law
Meet your AI assistant ↗Clause contract categories
Operative clauses
These clauses set out the parties’ substantive rights and obligations, typically including payment terms, performance commitments, and delivery frameworks in their ambit.
Boilerplate clauses
These standard clauses are part of every contract, safeguarding the parties against procedural ambiguities. Boilerplate clauses include clauses related to jurisdiction and dispute resolution, notices, enforcement, and assignment rights.
Restrictive clauses
Restrictive clauses and covenants impose limitations on party rights and tend to create obligations such as confidentiality, non-compete, and non-solicitation, to prevent post-closing disputes.
Drafting best practices
“U.S. supplier Howmet Aerospace had declared a “force majeure event,” effectively claiming the right to halt shipments if they were affected by U.S. President Donald Trump’s tariffs.”
Clauses form the backbone of every contract, dealing with eventualities which can and cannot be foreseen when executing the contract.
Address knowledge and MAE within representations and warranties
In transactional contracts, the stakes are very high in terms of capital and control. Hence, it’s important to address and allocate the legal risks based on what the parties know and agree to.
Sandbagging clauses
Anti or pro-sandbagging clauses determine the treatment of breaches that occur after signing but before closing the deal. Pro-sandbagging clauses let the buyer enforce warranties, even if they knew about the breach beforehand, prioritizing contractual terms over the buyer’s knowledge. Conversely, anti-sandbagging clauses restrict the buyer from claiming indemnity if the buyer was aware of the breach before closing.
To include sandbagging clauses, define actual and constructive knowledge, buyer’s awareness, and clarify if the buyer is relying on information and warranties provided by the seller, irrespective of any due diligence carried out by the buyer.
Material adverse effect (MAE ) is typically mentioned within representations, warranties, and closing conditions to qualify obligations. It makes a breach enforceable only if it results in a materially adverse outcome, thereby limiting the seller’s liability for immaterial deviations.
Additionally, MAE may allow the buyer to rescind the agreement before closing if an event occurs that has, or could reasonably be expected to have, a materially adverse effect on the target’s business or the seller’s ability to perform their obligations.
To be effective, the agreement should clearly define what constitutes an MAE, include exceptions, such as general economic changes, and address disproportionate effects on the target.
In Akorn, Inc. v. Fresenius Kabi AG, 2018 Del. LEXIS 548, 198 A.3d 724, the Delaware Supreme Court gave way to a significant development, holding that the buyer had valid grounds to terminate a purchase agreement due to a sudden reduction in the seller’s business performance, thus constituting an MAE. The exceptional decline of Akron’s share price and its operating income post-signing were considered relevant factors.
Define conditions precedent and triggering events
Conditions precedent
Certain conditions must be satisfied before closing a transaction and performing contractual obligations, normally referred to as conditions precedent.
This clause is often used in mergers, construction contracts, and loan agreements to address property inspections and collateral security. A well-drafted condition precedent clause should address performance metrics, deadlines, consequences of non-fulfillment, and steps for determining condition fulfillment.
Triggering events
Instruments like convertible notes and SAFEs include triggering events such as equity financing, change of control, liquidity events, and IPOs. These events dictate when the instrument converts to equity or pays out.
Clauses should clearly state when and how conversion happens, with options like valuation caps or discounts. They must also state investor notice requirements and liquidation priorities.
Price protection and post-signing safeguards
After signing the agreement to purchase the entire issued share capital, the consideration is typically locked and remains the same. During this time, the buyer conducts due diligence on the target and finalizes other conditions before closing. During this time, the seller is expected to run the business as usual in a commercially viable manner.
Leakage Protection
While the agreed-upon purchase consideration is locked, the business should not lose its value, and there should not be any leakage to the seller or any related affiliates. For price protection, a non-exhaustive list of permitted leakages and a pre-determined definition of leakage must be determined.
The clause should also address remedies for claiming losses due to unpermitted leakages and obtaining a certificate from the seller stating that no leakage has occurred, termed as a “leakage certificate”.
Earnout
Earnout clauses provide additional consideration to the seller upon the target reaching certain financial thresholds after closing. The clause should address seller protections and steps for earn-out calculations, timelines, and payments. It should also mention the right to access books of accounts and audit practices.
While drafting this clause, state precise milestone definitions, standard of efforts expected from the buyer, such as commercially reasonable efforts, and whether the buyer retains discretion in determining how to meet those milestones.
In Neurvana Med., LLC v. Balt USA, LLC , the Delaware Chancery Court upheld the buyer’s sole discretion in deciding how to pursue regulatory milestones tied to an earnout. Although the seller argued that the buyer’s refusal to accept assistance led to failure in achieving the milestones, the court found no breach.
The agreement expressly granted Balt control over post-closing actions and defined the effort standard, leaving no room for the implied covenant of good faith to impose additional duties.
Indemnification and limitation of liability
An essential element of general risk allocation is providing indemnity clauses. However, other than adding general conditions and the process of indemnification, safeguarding exposure for all parties involved is important.
This can primarily be done in two ways:
Indemnity Cap
Indemnity clauses should address the overall ceiling limit to which a party may be indemnified for losses due to the breaching party’s conduct. These clauses should provide a special indemnity in fraud or intentional misconduct cases. The general and special indemnity cap can be expressed as a pre-determined value or a certain percentage of the contract.
Basket and Tipping Basket
Seeking indemnification for minor or immaterial events may deteriorate the party’s relationship and affect the commercial intent. A basket or tipping basket clause may be added to specify an aggregate loss that must be suffered before claiming indemnification.
The clause may be structured to include payment of all losses sustained once the aggregate amount is reached, or payment of all future losses, not including the loss already suffered. This clause should work in conjunction with the cap.
Jurisdiction and dispute resolution
Clauses that provide methods and timelines for resolving disputes between the parties and preventing escalation are part of every transactional agreement. However, they often omit some essential details that may create future enforcement issues.
Jurisdiction and governing law
Ensure the clause prevents parties from forum shopping. The clause should provide jurisdiction to a particular court, not to “all courts of competent jurisdiction,” thereby containing unnecessary exposure in a foreign court of law.
Dispute Resolution and Notices
Identify the dispute resolution method that best suits the parties’ interests. Ideally, a dispute resolution clause should involve a step-up or tiered approach to try mutually resolving the dispute by using negotiation, mediation, and arbitration before litigating.
A clause should also address notice requirements, timelines for notice issuance, authorized representatives, and permitted address details.
Exit and termination
Clauses should necessarily be forward-looking, reflecting changing market conditions and developing party priorities. However, there may be instances where a party is unable or unwilling to perform its obligations. In this scenario, firm exit and termination clauses become necessary.
Force majeure
Natural calamities and governmental policies may delay or render performance of the obligations impossible and trigger the force majeure clause. From the buyer’s perspective, the list of triggering events should be exhaustive to prevent any minor change in policy or market conditions from invoking the clause, and exclude vague catch-all terms like ‘unforeseen circumstances’ to avoid misuse.
From the seller’s perspective, the list is often kept non-exhaustive to allow for flexibility in the event of unforeseen circumstances. The clause should also specify notice requirements and the consequences, such as suspension or termination of obligations.
Termination
Default events, notice requirements, and timelines to remedy the default should be comprehensively addressed. It should also allow parties to terminate without cause or for convenience, so that changing commercial priorities do not bind unwilling parties to fulfill their obligations.
Also include a pre-determined break fee in the clause to compensate for losses incurred by the non-terminating party.
Transactional clause example
Once the main terms are agreed upon, the next step is to translate them into clear and accurate language. Even if both sides have good intentions, vague or messy wording can cause confusion, disputes, or make the contract hard to enforce.
For this, legal AI assistants such as CoCounsel become extremely useful.
Whether you’re working on an indemnity clause or something more specific such as a due diligence clause in a stock purchase agreement, CoCounsel helps shape the first draft.
Simply add details like your contract type, jurisdiction, and what you want to draft. The tool gives you a working version to review, tweak, and use as a base for your final clause.
CoCounsel Drafting
Professional-grade GenAI for drafting right from within Microsoft Word
Free drafting demo ↗
