Today’s business lawyers face a toxic paradox of increasing demand for their services with fewer resources to do the job. To combat this problem, a nascent movement is advocating rigorous data gathering and analysis with practical application to business law, using tactics popularized by LEAN and Sabermetrics that have revolutionized manufacturing and baseball, respectively. The first two articles in this series practically demonstrate how LEAN-inspired thinking can tactically deliver better performance, savings and efficiency. The third article in the series shows that, while combining data with continuous improvement approaches are valuable, the key to unlocking the potential of business lawyers lies not in empiricism and numbers, but in determining what motivates us as people.
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A long time ago, I was a Peace Corps volunteer in Morocco. In rural Morocco, the most popular place to buy things is at the “souk,” a weekly combination farmers/flea market where you can buy such things as spices, souvenirs, and used books. One fundamental rule of the souk is that there are no set prices – everything is negotiable. After the Peace Corps, I went to law school, then worked for business law firms and big companies where I learned that negotiating the key pressure points in commercial contracts – limitations of liability, insurance, and indemnity provisions – is as arbitrary, time consuming, and maddening as negotiating for trinkets in the souk. Although you cannot avoid unnecessary negotiations in the souk, there is a practical way to avoid the waste and frustration inherent in contract negotiations regarding these provisions: eliminate the provisions entirely. Despite what you might have heard, doing so is often the best option for your client.
Some Data and Personal Experience
Business lawyers and other professionals who negotiate commercial contracts say that they routinely waste their time negotiating terms that have little impact. For the last 13 years, the International Association for Contract & Commercial Management (IACCM) has been tracking the Top Terms in Negotiation, an annual report based on data gathered from professionals from all over the world who work with commercial contracts, which includes the following side-by-side comparison of the “most negotiated term” versus the “most important term”:
This chart perfectly illustrates what commercial contract professionals are spending their time negotiating versus what they believe they should be spending their time negotiating. Year after year, limitations of liability and indemnification both rank at the top of the “most negotiated term” list, while consistently ranking below that on the “most important term” list. The conclusion from this data is clear – negotiating limitations of liability and indemnities destroys value relative to other, more important terms.
The same conclusion is evident for many of the other commercial contract provisions, but we will include insurance in this discussion because insurance often becomes entangled with limitations of liability and indemnification in a negotiation (insurance appears as number 16 on the most negotiated list and below number 20 on the most important list for 2013–14). For example, typical concerns might include whether the insurance policy covers consequential damages, whether the insurance policy covers indemnification of the other party for damages arising from our negligence, and whether we should limit our exposure to our insurance limits.
Look at the following sample contract provision – a practical example of how limitations of liability, indemnification, and insurance are often mixed into a single, toxic stew of contract confusion:
“Each Party shall be liable for and shall indemnify the other Party against any and all claims, expenses, losses, damages, and costs sustained and/or incurred by the other party as a result of any: (a) breach of the other Party’s obligations, covenants, commitments, warranties, and/or representations set forth in this Agreement; (b) Negligent, wrongful act or omission by the Party or any of its employees, agents, and representatives in the course of or related to its obligations as set forth in this Agreement; (c) Fraud, dishonesty, misrepresentation, and/or default by the Party; and/or (d) Loss of or damage to any property or injury to or death of any person arising as a result of any of the sub-articles (a) to (c) mentioned above. In order to cover its liability under this agreement, the Seller shall take out and maintain at its expense, during the term of this agreement, Employers Liability insurance with limits of not less than $2,000,000 per accident, $1,000,000 per employee, and Commercial General Liability insurance, with limits of not less than $5,000,000 per occurrence and $5,000,000 general and products completed aggregate. Neither Party shall be liable to the other Party for any consequential, incidental, or punitive damages, or for loss of profit and, in any event, each party is liable to the other party for no more than $100,000.”
YELLOW – INDEMNIFICATION
PURPLE – INSURANCE
GREEN – LIMITATION OF LIABILITY
This is a mess! This kind of provision often has a real, negative, and costly impact on business negotiations. I have seen multimillion-dollar deals delayed because the parties could not agree on a provision like this, resulting in millions of dollars in loss to both the buyer and the seller. I have also seen many instances in which the parties go ahead with the deal even though the contract remains unsigned because there is no agreement on this provision, creating ambiguity around the terms of the deal if something goes wrong before the parties can reach a solution. Still, if a compromise is eventually reached on the provision and the contract is signed, the compromised provision often has little real, practical benefit to either party.
I have also seen colleagues spend hours performing an academic dissection of these clauses or, incredibly, hiring outside law firms to draft memos analyzing the meanings of these provisions, case law governing their interpretations, and their purported benefits. For what purpose? No one, not even this author, disputes that each of these provisions are theoretically beneficial, but the drawbacks of including these provisions in commercial agreements outweigh the benefits in the vast majority of business deals.
So what solution is there for the waste, expense, and delay caused by these contract provisions? Many of the so-called solutions that I have heard for resolving these issues amount to gimmicks, horse trading, and attempts to outsmart the other party. Instead of playing games, we can mitigate the problems caused by these provisions by drastically reducing our use of them and, in many cases, eliminating them altogether. Before we can reduce our reliance on these clauses, however, we must look back into the history and origins of common law governing contract breach and damages and examine the implications for our clients of reducing our reliance on these clauses.
The fundamental principles of recovering damages for common law breach of contract were famously articulated in the English case of Hadley v. Baxendale, (1854) 156 Eng. Rep. 145 (Court of Exchequer). In that case, the plaintiffs owned a mill that was shut down because of a broken crankshaft. The plaintiffs went to a carrier company (the defendant) to have the broken crankshaft delivered to the crankshaft manufacturer for repair. The defendant delivered the broken crankshaft to the manufacturer later than promised, causing the plaintiff’s mill to be shut down longer than anticipated. The plaintiff sued the defendant for the losses caused by the mill’s shutdown due to the defendant’s late delivery of the crankshaft to the manufacturer, including loss of profits. The English court found that the plaintiff could recover all the losses arising from the breach that were foreseeable when the parties entered into the contract. This basic rule – that the nonbreaching party can recover foreseeable damages arising from the breach – survives today. This case and its basic precepts should inform how we treat both limitations of liability and indemnification.
Limitations of Liability
A limitation of liability is simply an attempt by one party to reduce its financial exposure to the other party if something goes wrong in a business transaction. In the sample contract provision quoted above, the limitation of liability is “neither Party shall be liable to the other Party for any consequential, incidental, or punitive damages, or for loss of profit and, in any event, each party is liable to the other party for no more than $100,000.”
Before we analyze the legal meaning of this provision, let us review a couple of fundamental business principles, based in fairness, that should put the in-house lawyer’s legal analysis into context:
- The seller should stand behind its goods and services. If the seller promises to deliver, and cannot, the seller should be responsible for the proven consequences of that failure.
- The seller is in the best position to manage the risk arising from its goods and services. The seller knows its industry and clients and has the greatest incentive to manage the risks arising from its business. Inserting a limitation of liability into the contract shifts the risk of loss to the buyer, who is almost always in an inferior position to manage it.
Even those who agree with these principles often defend limitations of liability on a few different grounds. One familiar refrain of sellers’ lawyers is that the goods or services to be provided are either low in value or not very profitable. The seller is, in essence, correlating price or profit with risk. As we all know, however, those two concepts are not necessarily correlated. Cheap or low-profit goods or services can create enormous financial risks to the buyer, and expensive or high-profit goods and services can create limited or no financial risk to the buyer.
Another frequently invoked defense of limitations of liability is that the seller does not know what the buyer is going to do with the goods or services. If the seller really does not know what the buyer is going to do with the goods or services (which most often is not the case), a simple solution to this problem is to ask. Practically speaking, for the vast majority of goods and services that a buyer buys, the buyer will modify, adapt, improve, inspect, and engage in any number of activities that would either eliminate or dramatically reduce the risk that the seller is the proximate cause of the loss.
These traditional arguments in support of a limitation of liability are further weakened by the realities of the laws of evidence. As anyone who has ever pursued a breach of contract claim knows, damages are notoriously difficult to prove. A buyer may assert that the seller’s breach resulted in lost sales, lost profits, diminution of brand equity, etc., but is there evidence to prove those losses? A seller has a broad array of counterarguments to any assertion of damages caused by breach, and getting past accusations and allegations often subjects the buyer to complex, time-consuming, and expensive endeavors like hiring economists and forensic accountants and analyzing years of sales data.
Now that we have explored these basic business principles, why limitations of liability contravene them, and why conventional arguments in support of limitations of liability are weak, let us explore the specifics of the limitation of liability clause quoted above. This limitation of liability includes two components: (1) a category exclusion (consequential, incidental, punitive, loss of profit); and (2) a financial cap on nonexcluded damages ($100,000).
For the sake of argument, assume that “punitive damages” and “loss of profit” are clear. Let us examine the two ambiguous category exclusions in this clause: “consequential” and “incidental.” Black’s Law Dictionary defines “consequential damages” as “losses that do not flow directly and immediately from an injurious act, but that result indirectly from the act.” Huh? “Flow directly and immediately” is no less ambiguous than “consequential.” Black’s Law Dictionary defines “incidental damages” as “losses reasonably associated with or related to actual damages” and defines “actual damages” as “damages that repay actual losses.” Again, these definitions are just as ambiguous and circular as the terms themselves.
The ambiguity of these terms reminds us that limitations of liability are not about fairness, but about one party to a transaction trying to assert leverage over the other party. If the party with superior leverage wants to exercise that leverage, there is a more business-friendly way to do so than the conventional limitation of liability clause (like the one quoted above): eliminate all damage category exclusions in the limitation of liability provision (like consequential and indirect) and establish a financial cap (see Ken Adams, Excluding Consequential Damages Is a Bad Idea (Feb. 15, 2010), http://www.adamsdrafting.com/excluding-consequential-damages-is-a-bad-idea/). For example, “Neither party is liable to the other party for breach of contract for the amount of damages in excess of $20 million.”
The benefit of this kind of limitation of liability is that it clearly limits the financial exposure of the breaching party without the ambiguity inherent in categories of damages. After all, a business does not really care if you call a loss “consequential,” “indirect,” or “a giraffe”; what matters is the actual loss it must pay. In addition, if the nonbreaching party has evidence and can prove that the breach caused the loss (a big if), then the nonbreaching party should be able to recover.
In summary, there is no principled defense for a limitation of liability clause. A limitation of liability clause is simply one party trying to exercise business leverage over the other party by shifting the risk of loss. As discussed above, the principles of causation and the laws of evidence and damages have been limiting the financial liability of the party who breached the contract for at least the last 161 years in common law jurisdictions.
Unlike some of the damages category exclusions discussed above (like “consequential” and “incidental”), “indemnification” has a relatively straightforward definition. According to Black’s Law Dictionary, the verb “to indemnify” means “to reimburse (another) for a loss suffered because of a third party’s act or default.” The problem with indemnification provisions is not that indemnification as a concept is unfair or ambiguous, but that indemnification provisions are often long, complicated, duplicative, and, in many cases, completely unnecessary.
The contract clause quoted above is a perfect case in point. Let us begin with what each party is indemnifying the other party against: all claims, expenses, losses, damages, and costs resulting from: (1) breach of contract; (2) negligence; (3) fraud, dishonesty, or misrepresentation; and (4) loss of property, injury, and death arising from breach, negligence, fraud, dishonesty, or misrepresentation. Before a party can seek indemnification from the other party, it must prove that one of the first three conditions has occurred. The problem for the party seeking indemnification is that each of these three conditions is a legal conclusion. One party can allege breach, negligence, or fraud, but that does not make it so. If the buyer sends a demand for indemnification from the seller for negligence, for example, the seller’s lawyer would logically counter that, once the buyer has established that the seller had a legal duty, did not exercise reasonable care, was the actual or proximate cause, and the act or omission resulted in damages, the buyer is entitled to damages. In other words, prove negligence, and the seller will indemnify the buyer. The seller in this case would have the same right through a negligence claim, irrespective of a contract, even without the indemnification clause.
The same logic applies to indemnification for both category 1 (breach of contract) and category 3 (fraud, dishonesty, or misrepresentation). Both of these are legal conclusions, so why would a party reimburse the other for losses until those conclusions are proven? For the party seeking indemnification here, the clause does not have any real benefit – that party still has breach of contract claim and a fraud or misrepresentation claim under tort law.
It is important to note that, although many indemnification clauses mimic the structure analyzed above, not all do. Depending on the phrasing of the clause, or the jurisdiction that governs the agreement, an indemnification clause could make sense. For example, a buyer who is indemnified for the “claims of third parties related to intellectual property ownership of any part of the goods and services” by the seller could make sense, depending on the context. Another often-cited reason for indemnities is that, in some jurisdictions, they allow the indemnitee to collect attorney fees. In some jurisdictions (like the United Kingdom), an explicit indemnification clause may extend the statute of limitations on claims.
However, for each of these justifications, there is a simpler and more direct way to achieve these benefits. Want to collect attorney fees? Include an attorney fee provision. Want protection against a third-party claim? Include an obligation of the other party to ensure that your client is not subjected to such a claim. If your client is subjected to a claim, that is a breach of contract, and all losses arising from the breach are recoverable. Want to extend the statute of limitations on claims? Agree to a period within which the claim must be made in the contract.
The point here is that, like all contract provisions, indemnification provisions should only be used when its utility is clearly understood. In the majority of commercial contracts, it is unnecessary and, given the general contentiousness of these clauses in negotiations, wasteful.
The utility of insurance provisions seems unquestioned. The logic is that having an insurance clause in a contract gives the party seeking the clause additional protection in case something goes wrong. More careful review of the logic and common commercial practice, however, reveals that this conventional wisdom is a myth.
Let us begin with what insurance really is. Insurance is a financial backstop that may be able to pay in case the responsible party cannot. Therefore, unless the insurer is more creditworthy than the counterparty, there is not much logic to requiring the counterparty to carry insurance. In fact, many companies are more creditworthy than the insurers who are supposed to stand behind them. The 2008 financial crisis and the travails of large insurers like AIG are a perfect case in point.
Rather than focusing on what types of insurance the counterparty should have, and the amounts covered, the parties should focus on drafting clear rights and obligations. If one party breaches the contract, the other party is liable, per the general rule of contract damages articulated in Hadley v. Baxendale. How those damages are paid is not the nonbreaching party’s issue and, unless the counterparty is not creditworthy, should not be a real concern.
For argument’s sake, however, let us assume that the counterparty has a poor credit rating and your client is concerned that, if there is a breach of contract (or the other party commits a tort), it will not be able to pay. Then insurance might be good protection, right? Well, maybe. If the loss is covered by the counterparty’s insurance and if the counterparty is paying their insurance premiums on time, then, yes, insurance may be a good risk-management tool. However, the insurance clause quoted above (and every insurance clause that I have ever seen) does not help drive this outcome.
What would help drive this positive outcome with insurance is if the party seeking protection could both review the counterparty’s insurance contract and confirm that each premium is paid. In the first place, very few parties are willing to let another party review their insurance policies. Secondly, very few parties who would ultimately benefit from the other party’s insurance have the time or expertise to analyze those policies. Additionally, the risks covered by insurance related to categories do not neatly align with the contractual rights and obligations. Although a contractual obligation may be very clear, the facts surrounding the damages may trigger a policy exclusion clause not contemplated by the parties when they entered into the agreement. Most damning is that the insurance clause only serves one practical purpose – it establishes a breach of contract claim if the counterparty does not take out the required insurance. As a practical matter, this does not happen. By the time a party is examining the insurance clause, it is either because the other party has already breached the contract or committed a tort.
Despite this logic, however, contract professionals spend countless hours arguing about types of insurance and appropriate limits, determining what price increases to the goods or services are necessary so that the other party can get the required insurance, and trying to forecast worst-case scenarios. There are many justifications for this behavior, but none are persuasive. One common justification is that, by including the provision in the contract, it will remind the counterparty to procure the right insurance. Unless the behavior is confirmed (by verifying the policy content and that premiums are paid), however, the reminder has little value. As we all know, a certificate of insurance does not affirm the actual content of the insurance or give assurance that future premiums will be paid.
When I remember the Moroccan souk and why negotiation and haggling are so commonplace there, it strikes me that the primary reason for the behavior is cultural. In Moroccan culture, bargaining is a way of life. When I think about why so much waste is generated by limitations of liability, indemnification, and insurance, I come to a similar conclusion – it must be cultural. It may be that these clauses are so ingrained into lawyer nomenclature and templates that contract professionals assume they must add value. Alternatively, it may be that, even if one cannot articulate the exact benefit of the clauses, the lawyer would rather err on the safe side by leaving them in than risk taking them out. However, the point of this article is that these clauses often unnecessarily complicate and slow down business negotiations and should be used only when a lawyer can clearly articulate why they are necessary. Using this standard, in the vast majority of cases, the best option is to eliminate limitations of liability, indemnification, and insurance provisions from your commercial contract.