By Sandra B. Wick Mulvany, CWCC Member
Managing risk is something on the mind of essentially all business owners, whether small or large. In the world of commercial contracts, there is no “one size fits all” approach. When navigating through what may be viewed as challenging waters, there are risk allocation tools, two of which are discussed below, that may be used in negotiating contract terms that can help reduce liability and provide clear guidance in understanding the level of risk involved in a particular contract. Keep in mind that the ability to use the tools discussed below are dependent on the type of contract, where it was created, and where it is performed, all of which are factors in determining what law applies to a particular contract. It is also important to understand that whatever risk management tools are used in a contract, the language must not be in conflict, and the terms must be both enforceable and consistent with applicable law to be effective.
One tool is a limitation of liability provision, which is used to limit the amount or type of damages available to a party under a contract. Without a limitation of liability provision, a party may seek damages for any legal harm caused by a breach of a contract term or for any injury that may arise under a contract. To limit these risks, an exclusive remedy term, for example, outlines that only certain remedies are allowed by either party in the event of a breach. Likewise, a prohibition or ceiling of damages term, outlines damages that are either expressly not recoverable in the event of a breach, or states a specific cap on the limit of any damages from a breach. These types of terms allow contracting parties to clearly define how an injured party would be compensated in the event of a breach, which provides a level of certainty to both parties regarding the risk involved in the contract.
Another tool is an indemnification provision, which is used to shift risk or liability from one party to another. In essence, an indemnification provision allows for one party to assume liability for future loss arising from its actions or actions of a third party. Put another way, it is a term where one party agrees to pay for any loss or damages suffered by the other under certain circumstances. Because it shifts risk or liability, an indemnity provision may make sense when one party to a contract is not well suited to adequately manage a contract risk. For example, in a software licensing contract, a software seller (or licensor) may agree to indemnify the buyer (or licensee) from claims by third parties related to the improper use of the seller’s software (e.g., copyright or infringement issues), since the seller is in a better position than the buyer to manage these types of risks. In this example, without an indemnification term, the buyer could take on additional and unnecessary contractual and financial risk. Of course, indemnification provisions should be carefully drafted and considered together with limitation of liability provisions to ensure the contract as a whole is consistent and the risk allocation provisions work together as they should.
As Benjamin Franklin astutely observed hundreds of years ago, “an ounce of prevention is worth a pound of cure.” This famous saying certainly rings true for businesses entering into contracts. Ensuring that adequate consideration is given to risk allocation terms at the time of contract negotiations, and if necessary, legal advice is sought for difficult issues that may arise before the contract is signed, are important steps in managing risk in contracting. Indeed, if a company takes the time to negotiate a contract that adequately allocates risk, the chances of avoiding significant financial harm are greatly improved in the unfortunate event of either performance failures or other contractual disputes down the road.
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