ABA Section of Business Law
July/August 2001 (Volume 10, Number 6) Legal-ease
Wrinkles in the enforceability boilerplate
By Howard Darmstadter
While munching through a typical credit agreement, you may come upon this paradoxical plum: Borrower warrants that this agreement is the legal, valid and binding obligation of borrower, enforceable in accordance with its terms.
What can it mean? If the agreement is unenforceable, won't the warranty be unenforceable as well? In a legal opinion, the sentence (without the warranty language) makes sense, but placed in the agreement itself, it seems to verge on self-contradiction. It's like the liar paradox: You can say that someone else always lies, but you can't say it about yourself.
But there may be another way to read the warranty. There's been a debate about what the sentence means in legal opinions, with easy-going Californians feeling that it's enough if the agreement is enforceable by-and-large, while buttoned-down New Yorkers insist that the sentence means that every last little itty-bitty provision of the agreement is enforceable. The New York interpretation may not be the most natural reading of the sentence, but it at least makes the sentence's appearance in an agreement logically inoffensive: In New York, at least, the borrower is warranting that every (other) provision in the agreement is enforceable.
Hold that thought while we look at two other typical provisions:
If any provision in this agreement is held invalid, illegal or unenforceable in any respect, the legality, validity and enforceability of the remaining provisions in this agreement shall not in any way be affected or impaired thereby. If any warranty in this agreement is false in any material respect when made, the lender may (i) terminate its commitment to lend and (ii) declare the outstanding loans immediately due and payable. The first provision is usually referred to as a severability clause; the second is a radically simplified version of an acceleration clause.
It's beginning to make sense: If the entire agreement is unenforceable - for example, because it was not authorized, or was signed by a 6-year old - the enforceability warranty will also be unenforceable. But if the lack of enforceability only affects a particular provision, then the severability clause will preserve the rest of the agreement. Among the survivors will be the enforceability warranty, which our borrower, Judy, will now have breached. And that breach will enable Punch, the lender, to cut off Judy's line of credit and accelerate any outstanding loans under the surviving acceleration clause.
Wait a minute. The provisions that are likely to be unenforceable are those involving remedies - provisions for default interest, liquidated damages, foreclosure on collateral, and their ilk - and these were most likely drafted by Punch's lawyers. When it comes to remedies, lenders and their lawyers tend to take as much as they can - and then take more. Punch wants to get his toes as close to the line as possible, and he need not worry about stepping over because he can rely on the severability clause. So Punch will draft the documents aggressively.
Fine for Punch, and probably acceptable to Judy (most borrowers don't think a lot about life after default), except that it may allow Punch to pull the plug at any time, based on some dodgy provision that Punch himself inserted into the agreement.
Could this really happen? Maybe not. I find it hard to believe that a court would allow Punch to cancel a line of credit and call a loan because he suddenly realizes that a provision he drafted is not enforceable. But I can't think of a good legal argument that gets me to that conclusion. Waiver arguments, for example, probably won't work, since the agreement will no doubt have a provision that requires all waivers to be in writing. Nor am I confident that a court would find the quoted provisions to be unconscionable.
Will Punch's arguments fail because they are not made in "good faith"? Assuming that good faith only requires honesty in fact, Punch can argue that
Gee, your honor, I just took an old agreement off the shelf - it's really pretty much like everybody else's agreement - but when Judy started having problems, I read the agreement more carefully, and imagine my Surprise and Horror when I realized that one of the remedies was unenforceable! Of course, I had to call the loan.
I'm all choked up. But can any one say that Punch is being dishonest? Punch's story is all too plausible: The lawyers used several bits of venerable boilerplate without giving them a lot of thought. Only when matters escalated to DefCon3 did they sit down and read the agreements very carefully. (These considerations also indicate that Punch would not be subject to an estoppel defense.)
Punch may, of course, have known from the outset that the provision might be unenforceable, because Judy's counsel excepted it out of the legal opinion. But even if Punch hadn't a clue as to the possible unenforceability of a provision, you might argue that Punch should be charged with knowledge of what the document means. But then so should Judy. And this "charging with knowledge" business seems a little harsh when, in truth, almost no one knows what the document means. I only recently thought about the interrelations of the quoted provisions, and I may have misinterpreted them.
So how do you find out what the provisions mean? I don't know. There is little commentary on standard boilerplate, and few cases. Lawyers may insist that a provision has "stood the test of time." This only means, however, that the provision has been around so long that no one in the room is old enough to know how it got there originally.
What can Judy do? Not much. Let's face it, there's a lot of law that's purely formalistic, and you are unlikely to get far arguing against it. The whole point of standard clauses is that, with so much more important stuff to deal with in the typical transaction, you don't want to waste time arguing about provisions that earlier generations of lawyers have fought and died for. Lives the lawyer who hath not said, "Let's not reinventeth the wheel"?
Unfortunately, the standard provisions may not be appropriate for every agreement. Consider the severability provision: Sometimes you can't do without it. For example, in a security agreement, you'd much rather lose one of your remedies than find that your entire security interest has vanished. But even in a security agreement, you might regret having a severability clause if the unenforceable provision turned out to be the grant of the security interest itself.
The upshot is that sometimes you might prefer that the entire agreement become invalid rather than be stuck with an agreement without a clause that meant a lot to your side. It may therefore be better in many cases to leave out the severability clause, and rely on the common law to sort out which provisions are an essential part of the agreed exchange. After all, the Restatement (Second) of Contracts provides (§ 184) that:
(1) If [for public policy reasons] less than all of an agreement is enforceable , a court may nevertheless enforce the rest of the agreement in favor of a party who did not engage in serious misconduct if the performance as to which the agreement is unenforcable is not an essential part of the exchange.
(2) A court may treat only part of a term as unenforceable under the rule stated in subsection (1) if the party who seeks to enforce the term obtained it in good faith and in accordance with reasonable standards of fair dealing.
The Restatement illustrates subsection (2) by a provision for an interest rate that exceeds the legal maximum. According to the Restatement, if the parties simply made an error in calculating the rate, the provision is enforceable up to the maximum legal rate. But if the lender knew when the loan was made that the interest rate exceeded the legal maximum, the Restatement's view is that the entire provision for interest would be unenforceable.
So, unless you know exactly what you're doing - that is, you're dealing with a specific problem rather than just inserting the traditional boilerplate - it might be better to leave out the severability clause. (In fact, lots of lenders do without a severability clause, perhaps for this reason.) And don't posture by sticking in provisions that you know are unenforceable. Darmstadter is an assistant general counsel at Citigroup in New York City. His e-mail is darmstadte@citi.com.