The first article in this series emphasized the need for thoughtful, strategic consideration when using boilerplate in contracts in order to minimize the likelihood of a problem down the road. This segment addresses three widely used contractual terms to illustrate the point: limitations on liability, merger (also known as integration), and indemnification. Too often, these concepts and provisions are given only casual consideration since they relate to that unpleasant scenario where a controversy might develop between the parties in the future. However, given the considerable cost and uncertainty of corporate and commercial litigation, it is wise at the point of contract formation to press the fast-forward button, to engage in prospective risk management and to minimize the chances of encountering unforeseen pitfalls.
Limitations on liability clauses are used to limit a party’s potential exposure to claims made by counterparties. These preemptive, contractual provisions preclude a litigant from recovering consequential and special damages, which include lost revenue and profits and other indirect damages that do not flow directly from the breach of the parties’ agreement but are otherwise available if they were reasonably foreseeable at the time of contract execution. The liability limitations are common and generally enforced by courts to the extent they are negotiated at arm’s length. But the impact of these contractual clauses may be extreme because garden-variety compensatory damages arising from the contract (which are often limited) may be all that is available under the circumstances. As a result, the practical consequences of a possible breach of contract (lost business, for example) should be evaluated in advance to determine whether the waiver or inclusion of these potential damages, in connection with a limitation of liability clause, is an acceptable business risk and, if so, to what extent.
The decision to include or exclude contractual limitations on liability can be multifaceted and difficult to make. If you have bargained for and are relying on your counterparty’s performance to achieve a certain commercial objective, it would be wise to avoid any limitations on liability. In the event of a breach, you will want to maximize your recovery to include a full range of consequential damages (loss of business opportunities, profits and the like), instead of being limited to a monetary judgment in the amount paid pursuant to the contract. Conversely, if you are the party obligated to perform services or deliver goods, you likely will want to limit liability to direct compensatory damages by excluding special and other indirect damages. Accordingly, it is critical to understand the nuances of limitation on liability clauses in order to reduce your risk profile in the event of a dispute.
The inclusion of a “standard” merger clause may also have a significant impact leading to hidden pitfalls. Ordinarily, this provision unequivocally signals the parties’ intent that the contract is fully integrated and supersedes all prior and contemporaneous agreements or understandings between the parties. The decision whether to include a merger clause, or what it should say, is often made reflexively with little or no attention paid to the actual language and its import.
However, not every commercial transaction is, or should be, best documented in a single writing. In instances where there exist prior or ancillary agreements or a well-established course of conduct between the parties, a blanket merger clause may inadvertently invalidate other rights and obligations by superseding the parties’ prior agreements and understandings. In addition to unintended results, a merger clause can provide a party with a false sense of security. Although a merger clause may appear to preclude all extrinsic legal claims — for example, fraud, misrepresentation and inducement claims — it will not preclude these claims if the parties do not expressly disclaim reliance on representations not contained within the agreement. As this explicit disclaimer is not typical in merger provisions, the language utilized in merger clauses must be carefully scrutinized.
Viewed from a different perspective, the failure to include a merger clause might be just as dangerous. If it is in the party’s best interests to insulate the contract terms from potential parol evidence — based on a course of dealing, oral representations or other extrinsic matter unrelated to claims of fraud — a merger clause is needed. As with all boilerplate-related decisions, it is important for the draftsperson to consider how the parties’ relationship is likely to unfold. While courts generally respect the terms of a merger clause, that deference is beneficial only if the language used achieves the desired result. The inclusion or purposeful omission of a merger clause should have a targeted objective based upon the calculated likelihood that extrinsic matter, such as course of conduct and other considerations, will favor your side in the event of a dispute.
Finally, be thoughtful about contractual indemnification. You may not be receiving what you think you bargained for in the agreement. Many believe that an indemnification holding a counterparty harmless against “all claims and damages, including attorneys’ fees relating to the indemnifying party’s breach of contract” entitles the indemnified party to recover its legal fees in actions for breach of contract directly against its counterparty. Looks may be deceiving. This indemnity provision, in actuality, does not permit a direct claim by the indemnified party for breach of contract and attorneys’ fees. Under New York law, attorneys’ fees are not recoverable unless expressly agreed upon by the parties. The parties’ indemnification agreement must be “unmistakably clear” that it was intended to apply to disputes against counterparties, rather than third-party claims against the indemnified party. While it has become common practice in many commercial circles for injured parties to rely on general indemnity clauses to recover legal fees, the indemnified party must prove that the indemnity was intended to apply to disputes between the parties. The better, safer practice is to include a separate provision awarding attorneys’ fees to the prevailing party in the event of a dispute. These issues should be addressed directly during contract negotiations, not after your counterparty has breached the contract and you find yourself without a meaningful legal fees provision.
Limitations on liability, merger clauses and indemnifications are perfect examples of contract boilerplate that parties mistakenly believe are perfunctory, risk-free terms, but in fact are rife with risk for the unwary. Consultation with litigation counsel will enable you more readily to identify and to minimize potential risks associated with the transaction. We encourage you to view this as an opportunity to protect against unexpected, but common, pitfalls in the negotiation and formation of business contracts by addressing these issues head-on before a dispute arises.
The next and final article in this series will focus on dispute-related mechanisms, including arbitration and mediation, and jurisdiction, venue and choice of law provisions.