By Lisa Temple, Editor, Practical Law Commercial
If you're a transactional attorney, chances are you regularly negotiate risk allocation provisions. Contractual risk allocation tools are powerful, and therefore commonly subject to negotiation and litigation. However, counsel often overlooks or misjudges the provisions' complexities and impacts. Therefore, parties commonly find themselves facing more liability than they thought they bargained for when they signed the agreement. This article gives ten key tips to avoid common risk allocation drafting pitfalls and achieve legal and business objectives.
This list is not an exhaustive summary of issues but is a companion piece to our comprehensive suite of general contract clauses found in our General Contract Clauses Toolkit.
1. Prepare a termination clause that won't get you terminated When preparing a commercial agreement, counsel can mistakenly treat the termination clause as a boilerplate provision that can be copied from a prior agreement without much care or thought. In particular, attorneys often fail to adequately consider the effects of termination. In many cases, with better drafting and foresight, attorneys can help their clients avoid undesirable termination-related outcomes and cultivate happier, long-term client relationships. Consequently, counsel should clearly set out the effects of termination, particularly those relating to:
- tangible and intangible property disposition (for example, confidential information), and termination fees (for convenience-based termination).
2. Better control your indemnification process. Although most parties heavily negotiate the indemnification provisions, they often overlook the rules governing whether and how to exercise their indemnification rights and perform their indemnification obligations. Indemnification procedures help establish predictability and certainty of recourse regarding:
- claim initiation, timing of the claim, and the defense and settlement of third-party claims.
Since indemnification procedures help avoid confusion and conflict, each party should try to include indemnification procedures in the agreement, unless the negotiation costs are disproportionate to the risks the parties intend to mitigate.
Nearly every contractual provision is governed by a statute of limitation that is either set by state law or the contract (which typically shortens the statutory period). Favorable remedies provisions become useless if the statute of limitation bars the claimant from pursuing the stated remedies. Therefore, you should ensure that:
- The applicable statutes of limitation are appropriate considering your client's liabilities; and Each contractual statute of limitation unambiguously reflects the parties' intent to shorten the statutory period, or else the limitation may not be enforceable.
4. Beware of sole remedy provisions.
Sole remedy provisions prohibit a party from exercising remedies outside of the relevant remedies provision. The attorney who glosses over these potent provisions risks having a disgruntled client who is subject to disproportionate liability. With a sole remedy provision, the aggrieved party may not be able to adequately protect itself against liability from the other party's wrongdoing or breach. Without a sole remedy provision, the wrongdoer or breaching party may be liable for damages in excess of what it thought it originally bargained for. Typically, the balance of bargaining power between the parties heavily influences whether a party can successfully designate a remedy as the sole remedy. If the sole remedy provision is included, you should ensure it is enforceable by carving out the sole remedy clause from any cumulative remedies provision.
5. Don't ignore the cumulative remedies provision. Counsel often ignore or marginalize the cumulative remedies provision because it is typically located near the back of the agreement and considered mere boilerplate. However, attorneys who ignore this provision risk losing substantial liability protection for their clients. A cumulative remedies provision can significantly impact each party's liabilities by ensuring that the beneficiary can pursue all remedies provided by law and equity, beyond those provided in the agreement. Without it, the court may assume that the parties intended for only the agreement's terms to govern the relationship, especially if the agreement includes an entire agreement clause. If the cumulative remedies provision is included, you should ensure it is enforceable by carving out each sole remedy clause.
6. Ensure your consequential damages waiver meets expectations. Although this waiver is typically set out in conspicuous font in the agreement, counsel often fail to appreciate the waiver's impact. Parties generally use this waiver to protect themselves against excessive or unpredictable damages, including indirect, consequential, incidental, punitive and special damages. However, depending on the provision and the facts of the transaction, the waiver may cover damages that the waiving party may not have expected, including:
- damages caused by the wrongdoer's bad acts, and direct damages if the waiver includes lost profits, lost revenues and diminution in value, which can be direct damages.
7. Make sure the monetary cap is a good fit. Parties who bear the most risk in commercial transactions (typically, sellers or suppliers) nearly always insist on a monetary cap on damages. Without a cap, the seller could be subject to unlimited liability that is greatly disproportionate to the benefit of its bargain. However, exceptions to the cap can undermine the cap's strength. Even if the parties deem the cap acceptable:
- The seller's counsel must ensure that the exceptions to the cap are not so expansive as to render the cap irrelevant; and The customer's counsel must ensure that the cap is not so expansive that it is subject to disproportionate liability. Therefore, counsel should carve out exceptions to the cap, such as damages relating to:
- the seller's gross negligence, recklessness or intentional wrongdoing;
- intellectual property breaches and violations; or breaches of confidentiality obligations.
8. Ensure all provisions support your warranties. Although your agreement is likely to include warranties, it may include other contractual provisions that undercut the warranties' effectiveness. For example, even if a customer obtains a warranty against the seller's breach, the customer may not be able to recover attorneys' fees unless it includes warranty breaches under the indemnification and defense provisions. On the other hand, the seller may be liable for damages beyond those contemplated by the warranties' sole remedy provision because seller's counsel neglected to carve out the sole remedies from the cumulative remedies provision.
9. Consider potential market swings when setting pricing terms. Even if a party obtains a reasonable price, that party can still fail to get the full benefit of its bargain if the agreement's other pricing terms are unfavorable.Therefore, depending on the parties' roles and the nature of the transaction, you should consider pricing adjustments for changes in:
- costs, such as transportation or raw materials, quantity or frequency of purchase, and competitor's pricing, by requiring the costs or price to be competitive by including a most favored customer (MFC) clause. Note that MFC clauses can implicate US antitrust laws.
10. Choose your battles wisely. Dispute resolution provisions can provide a predictable path to recourse and limit the scope of potential disputes. However, if counsel improperly addresses forum and governing law when drafting their dispute resolution provision, the provision may instead encourage a dispute by denying timely or adequate relief. To obtain maximum and timely relief, you should ensure that the dispute resolution provision:
- Is broadly worded to encompass all possible disputes and claims (including tort and other non-contractual claims) so that all disputes are resolved in only one jurisdiction or by one tribunal; and Selects a forum or arbitration rules that recognize arbitration as a valid dispute resolution mechanism, such as jurisdictions that follow the UNCITRAL Model Law on International Commercial Arbitration (for arbitration provisions only).
About the Author Lisa Temple works as an Editor for Practical Law Commercial. Lisa joined Practical Law from IBM, where she was Counsel in the Systems and Technology Group. Previously she was a corporate finance associate at Seward & Kissel LLP.
The information in this Top Ten should not be construed as legal advice or legal opinion on specific facts and should not be considered representative of the views of its authors, its sponsors, and/or the ACC. This Top Ten is not intended as a definitive statement on the subject addressed. Rather, it is intended to serve as a tool providing practical advice and references for the busy in-house practitioner and other readers.