This is the first post in a 3-part series.
When business negotiations are in full swing, clients are typically focused on bottom line business objectives, content to leave the lawyers to hash out standard legal provisions. However, certain legal provisions can also impact business risk, enough so that clients should understand how they work and what can be done to avoid unnecessary risk. One such provision that often receives little attention from clients is contract damages. However, the reality is that negotiating the scope of allowable damages requires a strategic examination of the risks inherent in the transaction and their possible impact on your position in the event of a breach of contract.Damages or “remedies” are covered in two basic contract provisions: indemnification and limitation on liability. In most commercial transactions, indemnity clauses are designed to cover only third party claims, while limitation on liability clauses address direct claims between the contract parties. Your position on each of these provisions will depend on your role in the transaction and your company’s overall risk tolerance.
To better understand how each provision works, let’s first clarify the difference between direct damages and third party claims.
Direct damages are losses and remedies directly between the two parties to a contract. For example, if you buy or license software from a vendor, and there is a problem with the software, you might want your money back. The extent of your loss is typically limited to the amounts paid, because the most you might need to be made whole is to get your money back for inadequate product/service. In most contracts, this limit comes in the form of a “cap” on damages – as expressly provided for in the limitation on liability clause – and is tied to the value of the performance promised in the contract.
In contrast, third party claims are losses incurred by a party outside of the contract. For instance, if you buy or license software from a vendor, and that software infringes on a third party’s patent, you will owe money to the third party as a result of something the vendor did wrong. In this situation, the potential harm is wholly unrelated to the original deal; and in fact, you can have a very small (even a cashless) deal with large potential third party exposure. Third party claims are handled in the indemnification provision of a contract, where the non-breaching party receives protection from the risk in the form of an indemnity from the breaching party.
In the next post, we will take a closer look at how indemnification clauses work, and the strategy behind their negotiation. Read Post 2 now.