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Warning – For Wonky Lawyers Only – A Lone Voice Rails Against The Indemnity Exception To The Indirect Damages Cap

July 5, 2016 Tuvyah (Terry) D. Aronoff in:  no comments

Don’t say I didn’t warn you.

Until now my posts have been attempts to provide erudite elucidation of some of the finer points of the law for general consumption and enjoyment.

Today, I get on my soapbox.

There is a particular point of negotiation in standard commercial contracts where the accepted wisdom does not seem to make sense.

I am posting this with the hope that maybe it will get forwarded to someone who would like to do a better job of defending the accepted wisdom in a manner other than the following lame arguments that I usually hear:

  • This is our “corporate policy” and we can’t change it (translation – we have more negotiating leverage than you and we know it, so kindly bend over)
  • This is the way it has always been done
  • “Everyone does it this way” (i.e. the lemming excuse)

Here is the issue:

I am wondering if there is anyone out there who would like to take a shot at defending the practice of including language that allows for an exception to a limit on consequential damages when it comes to a claim for indemnification.

That’s it in a nutshell.

Pretty wonky, no?

And now, for the background…

Most commercial contracts contain a clause limiting the potential liability of one or both parties if something goes wrong.

The most typical of these clauses limits what are called indirect or consequential damages.

Over the years, many courts have allowed lawyers for plaintiffs to argue for and win damages on using theories that are increasingly speculative in nature. They have nothing to do with the actual damage that was done. They have more to do with theoretical losses that could be claimed to have occurred as a result of the actual damage. Courts have also ordered the losing side in a commercial lawsuit to pay “punitive damages” which is exactly what it sounds like. It has nothing to do with the actual damage caused. It is meant to be a punishment to deter future wrongdoing.

Companies don’t want to be exposed to this kind of risk when they enter into standard commercial contracts. So they insert language whereby both sides agree that whatever goes wrong, the wrongdoer won’t be liable for any indirect damages — only actual damages.

So far, so good.

There are a couple of exceptions to this limit on damages – bad behavior that is so egregious that the party who did it does not deserve to be protected from unlimited liability.

The two most common exceptions are as follows:

  • A breach of the confidentiality clause — a party goes and deliberately discloses the other party’s secret information or uses it in a damaging way.
  • A breach of the intellectual property protection clause – a party steals or misappropriates the other party’s intellectual property in a damaging way.

When that happens, the party that misbehaved does not deserve the protection from indirect or consequential damages that applies to other breaches such as failure to pay or failure to achieve deliverables on time. Throw the book at them. They should pay for every conceivable harm done as a result of this behavior. Not only actual damages, but also lost profits, pain and suffering, loss of consortium, punitive damages, you name it.

But then we come to a third exception that does not make as much sense.

First, some background.

Most commercial contracts contain an indemnification clause. This requires a party that does something wrong to “defend, indemnify and hold harmless” the other party for its wrongdoing.

This means not only paying for actual damages suffered by the other party for what you did wrong, but also, for example, hiring lawyers to defend the other party if they get sued by someone else as a result of the wrong that was done.

So now we are in a world where the exposure for something that goes wrong is extended to not only the other party to the contract but third parties who claim to have been damaged by the other party because of what you did wrong.

The question that comes up when negotiating limits on damages is whether, just like we have an exception that allows unlimited damages when there is a breach of confidentiality or intellectual property protection clauses, so too there should be an exception that allows unlimited damages in connection with a claim for indemnification.

Almost every contract template generated by very large companies that have very large in house attorney staff contains an exception to the limit on consequential damages when it comes to a claim of indemnification.

I have yet to hear a satisfactory justification for it.

Let’s review.

Generally, parties want their exposure for damages to be limited to real, actual financial harm suffered by the other party when they do something wrong. If a party does not pay on time, the other party can sue for the actual amount owed, and perhaps interest and the cost to collect the overdue payment. The party owed the money cannot sue for lost profits, punitive damages and other speculative damages. That is the point of the limitation.

And generally, we allow an exception to the limit on damages when the damaging party acted egregiously such as disclosing confidential information or stealing intellectual property.

So how did a claim for indemnification manage to slip into the list of exceptions for which a party is exposed to unlimited liability? On what basis?

Think about it. It is the exception that completely swallows the rule!

If you agree that I should not be exposed to unlimited damages when I harm you directly, why should my exposure be unlimited simply because someone else’s lawyer is suing you claiming the same ridiculous indirect damages that you yourself agreed I should not have to pay to you in the first place?

In fact, logic justifies the opposite conclusion. If I am not liable to you directly for damages other than actual damages when I behave in a certain way, then surely I should not be liable indirectly for those same type of speculative damages when they are claimed by someone else against you based on the same behavior.

When I make the argument that allowing unlimited liability in the context of an indemnification claim is the exception that swallows the rule, otherwise rational and cogent lawyers required to defend this language don’t seem to have a good counterargument.

So, to get back to my original question…..

I am wondering if there is anyone out there who would like to take a shot at defending the practice of including language that allows for an exception to a limit on consequential damages when it comes to a claim for indemnification.

And if you are still following me, let’s take it a step further.

The language is even harder to justify when the indemnification clause is not limited to third party claims against the indemnified party — because in that case you can’t even claim to be at the mercy of someone else’s lawsuit!

And if you are still following me….

If you are going to insist on jamming this exception down my throat, then at least be smart enough not to make the language mutual and accept the same illogical exception for your own side as well!

End of rant.

We now return to our regularly scheduled programming.

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