Severability

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Profound ontological uncertainty writ large. If one aspect of my contract becomes, through the machinations of the steampunk state, illegal, what does that mean for the rest of it?

This is really a way of looking at the question of illegality, the general proposition for which is that “a contract which obliges its participants to do illegal things is void and unenforceable as a matter of pubic policy.”

So, should you hire an assassin to kill your spouse and the assassin takes your money but fails to carry out the job, don’t expect her majesty’s courts to award you any damages, much less the courts of equity to direct specific performance.

Straightforward enough. But still, hypotheticals fester, at least in the minds of our learned friends the world over. The brethren and sistren of commercial solicitude fixate, as we know, upon divining our possible futures and preparing for all contingencies they might shower upon us, however remote. So, what if only a teeny little bit of the contract becomes illegal? Or not very illegal? Not punishable by imprisonment, nor a fine, but just sort of gauche?

If it is just a bish, can the parties still get on with the rest of it?

And if, otherwise, not, might it help if we say, “in this contract that any bit which later becomes illegal — or even turns out to have been illegal the whole time — just doesn’t count any more, so we can carry on with all the remaining good bits?

On crystal balls and unexpected inequities

The JC’s general concerns about boilerplate are here writ large.

So, firstly, that a severability clause is even on the table speaks to some apprehension on the parties’ part as the business they are proposing to do. Doesn’t it? Either that, or a misapprehension: that what they have in mind is, and will stay, legal for the period of time they are proposing to do it.

Second, even if their enterprise was fully kosher when they resolved upon it, we must presume that, if that changed, they wouldn’t seriously expect the country’s commercial courts to continue to uphold an enterprise that its criminal courts would put them jail for. So we must be talking about technical infringements and not fundamental ones.

Fundamental illegality — like our assassination hypothetical — would be enough to undermine a meeting of minds in the first place — in which case, what value a severability provision? — but even if it did not, it would be quite the stroke of luck if the lost benefit from amputating the newly outlawed part of the contract fell equally between the parties.

Odds are, that is to say, that the severing a contract will favour one party over the other, in a way that, logically, they cannot predict before it happens.

Say I have agreed, for a monthly fee of ten pounds, to provide you with five services, one of which later transpires to be illegal. The other four services remain valid, as does your obligation to pay me an amount of money once a month. So is the contract simply severed to cut out the illegal service? Must you now pay me ten pounds for four services?

Equity says there should be some adjustment of the commercials; as we didn’t have a crystal ball, resolving this at the outset of a contract, with a severability clause seems cavalier. It would be much better for the parties to get together and restrike the deal in light of the changed services.

Yet a severability clause seems to head this approach off.

I know I keep banging on about complexity, but if there were ever a better example of forlornly trying to cater for a complex world with simple rules, this is it. Face facts: you are going to have to figure it out at the time. That such a prospect might give the heebie-jeebies to internal audit, and the poor sap in compliance whose job it is to police the organisation’s risk taxonomy, is an added frisson that some of you might find strangely satisfying. I know I do.

Lady Macbeth

There is an element, too, of the lady protesting too much here: why would you enter a contract if you thought part of it might be illegal? What kind of operation are you running?

If the choice is between blindly allocating unforeseeable losses at the start of the relationship with a severability clause, and hoping the parties can be adult enough to come together in good faith to sort out a compromise as and when the unforeseeable becomes a reality later — trusting each other, in other words, to be good eggs and not dicks — then the JC knows where he’d rather be, and who he would rather be trading with.

Finance contract boilerplate

While a severability clause seems counterproductive in most arms’ length, symmetrical commercial settings, there is one where it is not: an asymmetrical commercial setting. A loan. Here, day one the lender ponies up a lot of money, and has his posterior in the proverbial sling until the last day, when the borrower gives the money back. If the contract becomes tangentially illegal in the meantime, then cancelling it would be a really bad outcome for the bank.

Let’s say the bank lends you a hundred million dollars for a year. The terms of the loan are that you must repay in a year, together with fixed interest in the meantime and, on the scheduled repayment date the bank must deliver you a single bowl of M&Ms with the brown ones removed. As a gesture of fun and goodwill, and to reflect what a hip outfit the bank is. You could imagine Northern Rock doing this sort of thing.

Everyone happy, right?

Now: what should happen if, unexpectedly, a new government is enacted on a platform of irrational hostility to eighties metal bands, and they legislate for it to be illegal — punishable by imprisonment — to doctor M&Ms? Without a functioning severability clause, the contract might be void.

Absurd, you might say: this is obviously a meaningless formality. The parties would at once get together and agree to waive the need for the M&Ms. Plainly, no-one is materially affected.

But here is the thing. Imagine the borrower is a hedge fund. One of the especially venal, rapacious, locusty ones. It has just had a free option drop into its lap in the shape of a compelling legal reason it might not have to give back a hundred million dollars. God forbid it might opportunistically claim ~ to its horreur, naturally ~ that this contract cannot now be honoured, on pain of imprisonment. It will wheel out its compliance officer, who will mutter about formal compliance with rules and the firm’s duty to its shareholders. Or its investors. It will not be hard for it to contrive reasons that, even though it would love to give the money back, it just can’t.

Those who don’t believe this are cordially invited to consider the stupid banker cases: that is exactly what the hedgefunds did to Citi on the Revlon loan debacle.

See also

Finance contracts

• Illegality
• Bonum ovum esse