Leveraging Risk Mitigation Terms in Contracts: Using Limitation on Liability, Indemnity and Dispute Resolution to Your Benefitby Michelle Bomberger | August 31, 2017
An essential part of the work we do at Equinox is helping clients to understand the risks inherent in their business and proactively plan to protect against those risks. I have written before on how to think about the tools available to business owners to insulate risk including the use of contracts, insurance, and the entity itself, which you can read about here. Each of these provides a tool to protect the company and its owners against the risks of the business. With contracts, a few key terms address the rights and responsibilities of parties in a dispute: limitation of liability, indemnification, arbitration, and choice of law and venue. These can often be confusing as they work together and are intertwined. Here’s a summary of how to view these when looking at a contract:
- Limitation on liability. The limitation on liability provision puts boundaries on the amount of damages available to a party in the case of a dispute. You often see these provisions limit liability to the amount paid by one party to another under the contract in dispute. This provides a cap on the risk exposure to a party. These provisions often also limit the amounts due to actual damages that can be proven and not consequential, special, or other damages that are speculative. These provisions are also typically written to protect the party most at risk – the one providing the goods or services. You should consider what your risk is in the relationship and whether and how the terms of any limitation on liability should apply to you.
- Indemnification is the reimbursement of one party to another for costs incurred by the first party. People often look at these terms as “boilerplate” and don’t review the details but the details in these provisions are really, really important. They describe the terms of 1) what amounts will be reimbursed and 2) under what circumstances. It’s essential that you look at this provision practically asking the question, “What are the possible scenarios where I might incur liability or be sued for something the other party did?” An example might be that your company is sued because of an action by a subcontractor. The subcontractor might be a designer that infringed someone else’s copyright or negligently installed a fixture or technology. You may have had nothing to do with the choices or actions but because you’re related by contract, you may be named in a lawsuit and forced to defend yourself. This defense may cost you a significant sum of money that you’ll want reimbursed. Similarly, if the other party breaches the contract, causing you to also breach or causing you additional damages, you’ll have some recourse for costs you incur. Therefore, you want to be sure the damages covered include not only a judgement but also attorneys’ costs and fees. Many times, contracts contain these provisions for one party but not the other. If there’s no indemnity provision for your side of the contract, you should consider whether there really is no potential for risk on your part. Usually, there’s some risk and it makes sense for you to add some protections with respect to that risk.
- Dispute Resolution. The dispute resolution procedures are typically laid out in an agreement. They can take the simple form of defining the “choice of law” and “venue” or they can describe a process for resolving disputes. In the simple “Choice of Law and Venue” provision, the contract is stating where any disputes must be brought. If there are no other terms, then the contract assumes litigation in that venue. Ideally, you want this provision to require disputes be resolved in your home jurisdiction so you can stay at home with local counsel and courts. It is often more cost effective. However, often you don’t get your home jurisdiction which means that you’d need to hire counsel in the stated location and travel there, as necessary, to make your case. Many agreements include procedures for dispute resolution in the hopes of avoiding litigation. These include a period of negotiating in “good faith” to resolve the matter and submitting it to mediation. These seem like very good tools to keep the dialogue open between parties. Arbitration is often also provided as the final, binding decision making body. Arbitration can be quicker than the court system, but not always less expensive. When determining what is the right approach, you need to put it in the context of what a potential dispute of the contract or relationship will entail. A 30 day negotiating or mediating period can feel like forever when you have significant money at risk. Also, in some instances such as obtaining an injunction, you want to be able to file with a court to get a quick decision.
Risk mitigation in contracts is not a one-size-fits-all approach but rather a case-by-case review of the potential risks of a particular relationship. The time taken to look at what could go wrong in the relationship, what the risks are to each party, and what recourse you’ll need to keep your business moving forward will be well spent if you ever need to invoke those terms to protect your interests.