A Contract is Reality, Not Formality

By now, most if not all businesses know about the need for a contract to govern a business relationship or to capture the essence of a transaction. However there are still some which see the contract as a mere formality, something to signal that they operate in the same cultural ecosystem as the other parties or a necessary step to fulfill before they can get on with the operational procedures. This mentality of a contract as a formality carries a risk of a significant magnitude as a client recently learned.

I received a referral for a shareholders’ agreement and the initial stages seemed quite normal. I was even assured that the parties involved had a come to an in-principle agreement on certain basic issues, so we proceeded to the drafting. However after the first draft was sent over, cracks started appearing – somehow the shareholders began holding divergent views and it looked like the deal might be aborted. I thought it was a rare unfortunate occurrence since we had already established some common denominators.

I was caught by surprise when the client called to say that she and other investors wanted to back out and withdraw their investment. It turned out that they had already proceeded with the capital contributions, and only upon the suggestion of the founder to sign a shareholders agreement had the client (who was apparently given a key management role) then set out to fulfill this “formality”. Basically, they had put themselves in a position of a minority with bare minimum shareholder rights and very little leverage to craft the agreement to protect other key interest. And, their capital contributions had probably been sunk into the business with little prospect of returning to them via a buyout.

Of course, there was the possibility of commencing an action in minority oppression, but for those in the know, it’s essentially a historical reconstruction of the parties’ relationship and relying on memory of verbal discussions or stitching together piecemeal correspondence increases the risk of the judge disagreeing with the client, not to mention the substantial time and cost involved. All of which could have been avoided if a contract had been used to define the reality of the relationship before it began, rather than seeing it as normative packaging and corporate virtue signalling.

This mentality is not limited to small companies – even businesses which many would readily label as a multinational corporation also operate within this risky paradigm. I was recently involved in the renewal of a distributor relationship, which the operational personnel merely noted the many red flags that we raised as diverging from what was happening on the ground. The reason for not asking to amend the agreement to better reflect the real situation was lack of bargaining power against the principal, but somehow the magnitude of a foreign court making them liable for breaching the agreement, if and when the principal found it commercially convenient to, did not seem to impress them. Hopefully they won’t have to learn the hard way.

At least in Singapore, the contract has the power to define the reality of the relationship, and it takes considerable effort to get the court to ignore or go behind what is written and conclude that the parties had some other intention. Seeing the contract as a formal step or superficial wrapping not only misses the opportunity to harness this defining power, but also risks depleting limited resources if a dispute escalates. Leverage on your contract to create the commercial reality that you want, instead of trying to give the court a history lesson later.