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PART 1: CONSEQUENTIAL DAMAGES – HOW TO NEGOTIATE LIABILITY LIMITS (Read “Part 2: Hard Cap Limitation of Liability Clauses“)
A limitation of liability clause is one of the most commonly negotiated clauses in the world of contracts. Basically, people fear the possibility of a future dispute, so they spend most of their time negotiating potential liability for that dispute. If a customer worries about the possibility of a dispute with a third, unrelated party, and the vendor caused that claim, then the customer negotiates strongly to include an elaborate indemnification clause in the contract (watch our indemnification video, or read more about the indemnify definition and see a sample hold harmless clause).
Vendors generally don’t worry about third party disputes caused by customers, because customers usually perform few obligations under a contract so there are less opportunities to violate someone else’s rights.
RULE No. 1: So customers want indemnification, while vendors do not.
The major exception to this rule of thumb is the transaction where the customer designs a new product and asks the vendor to create it. In that case, if the customer violated a third party’s proprietary rights in the design, then the vendor faces potential liability for infringing those rights during the build phase of the deal. As a result, vendors within this context often ask for indemnification. Otherwise, vendors mainly fear that the customer will sue them because the vendor’s performance was disappointing. Chiefly, a customer often expects a newly purchased product to increase business, such as new software designed to manage sales issues. If sales decrease, or if the software suffers an outage and the customer loses sales during that time frame, the customer might want to sue the vendor for those lost profits. Vendors are not in this position, as the customer doesn’t normally provide the vendor with anything that could impact the vendor’s sales.
RULE No. 2: So vendors want limitation of liability, while customers do not.
If you are a vendor, though, be aware that most savvy negotiating customers push back and insist that if contract includes a limit of liability, then that provision must protect the customer as well when the vendor sues the customer for any reason. This is called “Mutuality” or a “Mutual Limitation of Liability” clause. By the way, the same concept applies to indemnification negotiations. Savvy vendors often insist on mutuality when a customer introduces an indemnification clause into a contract.
Bullet Point Issues. Today we are going to cover how to draft the first part of a contract clause known as the limitation of liability clause, which a vendor might want to include in a contract to provide liability limits if the customer sues that vendor. In a future video, we’ll explain the “hard cap” provision (the second half of the limitation of liability clause).
This video explains these common issues for a limit of liability:
- Aggregate vs. Per Claim Limits
- Claims in Tort, Negligence, Contract or Other Theory of Liability
- Customer Advised of the Possibility of or Foresaw the Damages
- Failure of Essential Purpose of a Limited Remedy
- Exclusions: Gross Negligence, Confidentiality Breaches, Indemnification Obligations and Intentional Misconduct
- List of Limited Consequential Damages: Indirect, Special, Incidental, Punitive, Exemplary, Consequential Damages
Click play below to learn these key points now.
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As noted in the video, you really want to be sure that you consider the following key issues:
- List of Consequential Damages: Indirect, Special, Incidental, Punitive, Exemplary, Consequential Damages. As a vendor, this is the list of damages that scare you because they are often enormous. If a customer pays you only $10,000, but then sues you for two million dollars for punitive damages, you might be quite afraid to ever transact business again. Punitive, or exemplary, damages concern outrageously bad conduct on the part of the vendor, such as when a vendor knowingly dumps toxic chemicals into a residential area, or knowingly rejects valid insurance claims causing ongoing suffering. However, any customer can sue you for punitive damages regardless of whether or not you think that your conduct is wholly appropriate. As a result, a limitation of liability clause that excludes these kinds of damages (as well as lost profits) at the start can head off a customer claim via a summary judgment motion before you face actual liability at a trial.
- Exclusions: Gross Negligence, Confidentiality Breaches, Indemnification Obligations and Intentional Misconduct. Customers experienced at negotiating might allow a vendor to include a limitation of liability clause in the contract, but usually ask for certain exclusions to the limitation. If any damages fall under these exclusions, then the customer can sue the vendor for compensation without any limitation. Typically, these exclusions concern particularly bad conduct by the vendor, such as:
- Gross Negligence. Engaging in gross negligence by not supervising rogue employees properly.
- Confidentiality Breach. Violating the customer’s confidentiality by sharing their trade secrets with a competitor.
- Not Indemnifying a Valid Claim. Failing to live up to indemnification duties in the contract, such as paying off a copyright infringement claim stemming from the vendor wrongfully using a third party’s software code.
- Intentional Misconduct. Intentionally destroying customer property. Amazingly, vendors often fight this exclusion, even though a court will not apply a limitation of liability clause in this context. If a vendor, for instance, decides to delete a customer’s key marketing database to help win business from the customer’s competitor, a judge won’t allow the vendor to shield itself from full liability with a contract provision. During negotiations over this issue, vendor attorneys might say something like, “Well, I’d like a court to decide that issue.” Don’t be persuaded by this statement. If you absolutely insist on this exclusion, a vendor almost always concedes the issue and includes this exclusion to the limitation of liability clause.
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