Corporate Counsel Connect collection

February 2016 edition

10 steps to avoid key risk allocation pitfalls in commercial contracts

Practical Law, Commercial Transactions

paper on desk between people Transactional attorneys typically spend considerable time negotiating indemnification and limitation of liability provisions to allocate risk in commercial contracts. However, they can often overlook or misjudge the complexities and impacts of other risk allocation provisions, especially if they are commonly considered mere boilerplate. As a result, parties can find themselves facing more liability than they bargained for when they signed the agreement. The following are 10 steps transactional attorneys can take to avoid common pitfalls when drafting risk allocation provisions.

1. Draft clear and comprehensive termination provisions

Ensure that the conditions to termination are adequate, for example by:

including suitable termination conditions and cure periods; and
defining materiality (if termination is based on material breach), which is a more common practice in some industries (like construction) than others.

Clearly define the termination procedures (for example, by including notice requirements).
Set out the effects of termination, for example, those relating to:

tangible and intangible property disposition (for example, confidential information);
transition to a new supplier; or
any termination fees (for convenience-based termination).

Make all termination provisions in the agreement consistent.

2. Include meaningful indemnification procedures

To help establish predictability and certainty of recourse, parties should include indemnification procedures addressing:

Claim initiation.
Timing of the claim.
The defense and settlement of third-party claims.

3. Carefully consider applicable statutes of limitation

Ensure that the applicable statutes of limitation are appropriate considering the party's liabilities.
Ensure that each contractual statute of limitation unambiguously reflects the parties’ intent to shorten the statutory period, or else the limitation may not be enforceable.

4. Watch out for sole remedy provisions

The party likely to be aggrieved (in most cases, the buyer or customer) should try to exclude sole remedy provisions so that it can adequately protect itself against liability from the other party's wrongdoing or breach by seeking damages beyond those stated under the contract.
The party likely to be wrongdoer or breaching party (in most cases, the seller or supplier) should include a sole remedy provision to make the damages available to the nonbreaching party exclusive and, therefore, limited.
Ensure that any sole remedy provision is enforceable by carving out the sole remedy clause from any cumulative remedies provision.

5. Do not ignore the cumulative remedies provision

The party likely to be aggrieved (in most cases, the buyer or customer) should try to include a cumulative remedies provision so that it can adequately protect itself against liability from the other party's wrongdoing or breach.
The party likely to be the wrongdoer or breaching party (in most cases, the seller or supplier) should try to exclude a cumulative remedies provision to avoid liability for damages in excess of what it thought it originally bargained for.
Ensure the cumulative remedies provision is enforceable by carving out each sole remedy clause.

6. Carefully draft the consequential damages waiver

Ensure that the waiver covers only damages that the waiving party expects by considering whether these damages are included:

damages caused by the wrongdoer's bad acts; or
direct damages if the waiver includes lost profits, lost revenues and diminution in value, which can be direct damages.

Consider whether the waiver should be reciprocal.
Consider whether specific damages should be excluded from the waiver, such as damages relating to:

indemnification;
a party's gross negligence, recklessness or intentional wrongdoing;
lost profits, lost revenues, and diminution in value;
intellectual property breaches, and violations; or
breaches of confidentiality obligations.

7. Set the right liability cap

Ensure that the cap is reasonable in relation to the contract price and, therefore, enforceable.
Ensure that the exceptions to the cap are not so expansive as to render the liability cap irrelevant.
Consider the cap in the context of the whole agreement. For example, the party against whom the cap is enforceable should try to exclude the consequential damages waiver and include a cumulative damages provision so that it can seek damages beyond those provided under the contract.
Consider making the cap mutual.
Set the cap at the right amount to provide each party with a sufficient incentive to avoid liability.
Consider carving out exceptions to the limitations, such as damages relating to:

indemnification;
the seller's gross negligence, recklessness, or intentional wrongdoing
intellectual property breaches and violations; or
breaches of confidentiality obligations.

8. Tailor the warranties to the transaction

Ensure that the scope of the warranties is appropriate, considering:

the nature, type, quality and condition of the goods, assets or services central to the agreement; and
the market's expectation.

Mirror or harmonize upstream and downstream warranties to avoid a gap in supply chain liability protection.
Consider including a warranty disclaimer (for example, excluding the implied warranties of merchantability and fitness for a particular purpose).
The warranty maker should:

consider including a warranty-related remedies provision that sets out the recipient's limited and exclusive remedies; and
carve out any sole and exclusive remedies from the cumulative remedies provision.

The warranty recipients should try to include warranty breaches under the indemnification and defense provision so that the recipients are likely to obtain attorneys' fees in the event of breach.

9. Address pricing and payment risk

The parties should consider:

Adjusting the price periodically during the term to reflect changes in the seller's costs, such as transportation or raw materials.
Varying the price based on different factors, such as quantity or frequency of purchase.
Fixing the price for the duration of the contract.
Including one or more clauses requiring the costs or price to be competitive, such as a most favored customer (MFC) clause. However, MFC clauses can implicate U.S. antitrust laws.
Including favorable payment terms (for example, 30 or 60 days after invoice).
Including credit-related covenants or termination rights (for example, giving the seller the right to terminate if the buyer's creditworthiness deteriorates).

10. Consider allocating risk using alternative provisions or agreements

If a party cannot negotiate a favorable position under any of the foregoing risk allocation provisions, that party can seek additional liability protection under:

Other contract provisions, for example:

force majeure clauses;
insurance covenants
liquidated damages clauses;
equitable remedies provisions;
choice of law provisions; and
choice of forum provisions.

Guaranties.

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