Tuesday, January 19, 2010

"L" is for "Limitation" and "Liability"

It’s a provision found in almost every commercial contract:
Vendor shall be liable only for direct damages, in an amount not to exceed $X. In no event will vendor be liable for indirect, special, consequential, exemplary, or punitive damages or for lost profits.”

Although the actual words may vary, the meaning is the same:
  •  The most vendor will pay is $X;
  • For certain claims, vendor has NO liability.
Such provisions raise a number of issues: 
  •  They are unfair. Vendor’s liability is capped, but customer’s is not. In other words, vendor knows his or her own maximum liability under the contract, while customer’s liability is unlimited.
  • Vendor’s maximum liability - $X – may be inadequate. For example, “X” may be “no more than customer paid under this contract” or “no more than customer paid in the xyz months preceding the event giving rise to the claim for damages.” If we assume customer is paying 10 grand a month, and “xyz” is 12 months, then vendor’s liability is capped at $120,000. While that is not pocket change, is it adequate to cover damage that vendor could cause?
How much damage can a vendor cause?
  •  How much is the contract worth?
  • How much is the over-all project worth?
  • Will the vendor have access to sensitive/valuable information?
  • Will the vendor have access to sensitive systems or facilities?
Being good business persons, vendors will resist expanding their potential liability, and they will offer a variety of arguments in opposition. Some of these arguments carry more weight than others:
  •  We cannot accept unlimited liability.”
    Customer is not asking for unlimited liability, just responsibility. Customer should not bear a loss resulting from errors or omissions of vendor. Curiously, standard language routinely exposes customers to unlimited liability.
    • Our pricing tied to the amount of liability we can accept.”
    Again, customer is simply looking for responsibility. In addition, a great price combined with an unacceptable level of risk is not a good deal. A customer who is concerned only with price may be persuaded by this argument. Customers willing to assess the project as a whole may decide that the “great price” is not a good deal after all. There is nothing wrong with telling a vendor “No.”
    • We need a sum certain, so we can manage our risk and buy our insurance, etc.”
    Customer has the same concerns, so it is only fair to make the limitation mutual. Also, customer has no objection to a sum certain; customer merely wants an ADEQUATE sum. Which is one of the questions we began with.
    It may not be possible to determine with certainty how much protection is enough; in which case it is better to ask for too much rather than too little. A number of tools are worth consideration: 
    • X times the fees paid and payable under the contract. Three times is a good starting point. Vendor cannot object that they cannot quantify the risk. But, is it adequate to cover the exposure?
    • Vendor will be responsible for direct damages incurred. Vendor will object that “direct damages” cannot be quantified. But:
      • Direct damages”- damages that are foreseeable and which flow directly from the breach or action – are the traditional measure of damages under contract law. This is the amount vendor, and customer, would be liable for if the contract did not contain a limitation of liability;
      • Presumably vendor carries insurance. (If they do not, why are you doing business with them?)
      • Is it unfair to ask the vendor to make good any harm that it causes?
      • One caveat. As with any legal term, the meaning of “direct damages” is open to interpretation, and debate, and debate.

    • Vendor will be responsible for up to $X. We began with this approach, which is perfectly reasonable, provided X is sufficiently large. A $500,000 cap is terribly insufficient if the exposure is $2 or 3 million. In addition, with a specified cap, vendor cannot claim unknown and potentially unlimited exposure, AND Vendor can obtain the necessarily insurance more easily.
    • Vendor will be responsible for up to the limits of its insurance. This approach removes the objection that the risk cannot be quantified and that it cannot be insured against. BUT:

      • The insurance limits must be sufficient to cover the possible risk;
      • Customer must require certificates of insurance, evidencing the existence of insurance (not to mention that the insurance must be from reputable companies, licensed to do business in your state);
      • Customer must monitor Vendor’s compliance.

    All in all, focusing on the limits of vendor’s insurance may be the most productive approach. It overcomes most standard vendor objections AND it helps ensure that sufficient assets are available if things to wrong. Without insurance, vendor may not have sufficient liquid assets to cover the damages. A judgment against a vendor is of little value if it cannot be enforced.
    A word about the types of damages to be covered. Contract law traditional protects against direct, foreseeable damages, not those that are so remote that they cannot be reasonably foreseen. The test of “reasonably foreseeable damages” is perhaps misleading. If vendor knows that dropping the ball will interrupt customer’s core business processes, vendor should reasonably expect that customer suffer lost profits. But what would those profits have been had the vendor delivered as promised? Would customer have earned the millions it expected, or would mistakes by customer, or changes in the market, have produced substantially less revenue? Better to exclude special, exemplary and punitive damages – which are awarded by the court (or jury) and have little direct relation to the value of the contract or the harm done, and specify a comfortable limit on damages – all damages, however described or characterized.
    Too much protection costs vendor little or nothing. Too little could cost customer dearly.

    Copyright 2010, Thomas J. Hall.  All rights reserved.

    "M" Is For Material

    The term “material breach” is a familiar one. It appears routinely in contracts, generally in the termination provisions:

    “Either party may terminate this agreement if the other commits a material breach of any term hereof, and fails to cure such breach within thirty days of receiving written notice of the existence thereof.”

    At first reading, this provision appears to be clear, fair and easily enforced. It is mutual – it protects either party. It provides notice and an opportunity to cure, in the event the breach was inadvertent. It permits termination only for serious - “material” - breaches. But what is a “material breach”?

    In the legal world, a breach is failure to fulfill an obligation set forth in a contract. A “material breach” is a failure so severe that it threatens the value of the entire contract. For example, if a customer orders one ton of steel, she will probably not want to terminate the contract if the vendor delivers only 1, 998 pounds, rather than the 2,000 expected. Vendor might issue a credit or refund or promise to deliver the missing material immediately. Or customer might overlook the missing two pounds as inconsequential. In contrast, if the vendor delivers one ton of brass rather than steel, customer may wish to cancel the order or terminate the supply contract. If we assume the customer needs the steel for an office tower, the brass simply will not suffice; it is simply not strong enough. Clearly a material breach.

    Or is it?

    Assume the contract says “metal,” rather than “steel.” Brass is a metal.
    Now assume customer wants to terminate the contract because she needs the steel immediately, and lacks the time to wait for vendor to deliver the correct product. Is timely and accurate delivery a condition of the contract? Is it a MATERIAL condition of the contract? Put another way, did vendor know that the contract required him to deliver the right product, at the right time?

    What if the contract simply calls for “steel”? Does it matter whether vendor delivers the latest space-age alloy or a truckload of rusting auto parts?

    Let's change industries. Customer orders a “computer.”
    • Does it matter that the new device processes 16 million instructions per section, when the industry standard is 25 MIPS?
    • Does it matter if customer paid a discount price?
    • Does it matter if customer paid a premium price?
    • Does it matter if the product is delivered “a little” late?
    • That is “slightly” over budget? What is “slightly”?
    • That it “doesn't quite” work? What is “doesn't quite”?
    • That it runs fine as a stand alone, but won't interface with customer's systems?
    • That it won't run customer's software?
    • Does it matter whether that software is incidental or critical to customer's operations?

    Lawyers have a method for finding answers to questions such as these. They call it “discovery.” It is one of the more expensive and time consuming parts of a lawsuit. If there is enough money at stake, vendor's lawyers will leave no file untouched, and no employee not-interviewed, in an effort to show that the alleged breach is not material – that the failure (assuming there was one) did not cause real and substantive harm to customer. Alternatively, vendor's lawyers will argue that the product or service complained about meets the standards set forth in the contract, or that customer never disclosed that requirement X would be central to the deal. Vendor's lawyers will suggest that, at best, customer is mistaken or confused; at worst they will suggest that customer is making a dishonest attempt to escape the contract, for whatever reason.

    Which delivers us to a quandary: What is a drafter to do if the officially sanctioned term “material breach” is simply an invitation to dispute and litigation?

    Change the definition.

    The problem is not the term itself, but the meaning given that term by the law. But, in commercial contracts, laws, regulations, and legal definitions are generally DEFAULT provisions – they apply only if the parties do not set their own rules or definitions. (Within limits. A contract to commit a crime is still a crime, and unenforceable.)

    Which of these provisions would you prefer to administer and enforce?
    “Either party may terminate this agreement if the other commits a material breach of any term hereof, and fails to cure such breach within thirty days of receiving written notice of the existence thereof.”


    “Either party may terminate this agreement if the other commits a material breach of any term hereof, and fails to cure such breach within thirty days of receiving written notice of the existence thereof.  For the purposes of this provision, 'material breach' shall mean....”

    Admittedly, the latter is more difficult to complete. Each party must ask itself “What would cause me to want to call off this deal?” Then they must persuade the other party to include those provisions in the agreement. Both steps run counter to the common understanding of the deal process - “Get it done” and “Be positive.” A more realistic rule is probably “Be thorough.” The more time spent up-front spelling out the details of a deal – and identifying the key parts of the deal – the less time will be spent arguing about perceived failings.

    Or, as our parents always taught us: “Get it right the first time.”

    Copyright 2010, Thomas J. Hall. All rights reserved.