Common Elements of Business Contracts, Part 6: Representations, Warranties, and Risk Allocation

This is the sixth in a series of articles [1] presenting an overview of various provisions commonly found in business contracts, primarily from the point of view of the drafting attorney. [2]

Representations and Warranties

The distinction between covenants, representations, and warranties has already been discussed. The substance of representations and warranties is entirely dependent on the type of transaction and on the deal negotiated by the parties. One of the most important things for the business lawyer to remember is to explain the provisions to the client thoroughly, including the value of representations and warranties made by the other party to the contract and the risks involved with inaccuracies in the client’s representations and with breach of the client’s warranties.

Risk Allocation Provisions

Arguably, almost every provision of a contract is the allocation of risk of one sort or another between the parties. However, several common provisions of business contracts are more directly related to the allocation of risk. Several of them are discussed below.

Remedies for Breach

In the absence of contract provisions addressing remedies for breach, the non-breaching party has whatever provisions are provided by law. However, the parties have a great deal of freedom to expand or contract those remedies. In addition, contracts often recite the same remedy that would be available to the non-breaching party if the provision did not exist. While that may be criticized as being unnecessarily wordy, it addresses the issue that not all of the intended readers of an agreement will know what remedies are provided by law.

Termination

If one party materially breaches its obligations under a contract, the other party is excused from performing its remaining obligations. [3] Even so, most business agreements contain provisions that address the right to terminate for cause. In drafting a termination for cause provision, the lawyer should consider at least the following factors: (i) What events give rise to a right to terminate? (ii) What action must the non-breaching party take (typically, what sort of notice must it give) in order to terminate the agreement? (iii) Will the breaching party have an opportunity to cure the breach before termination is effective? )

Liquidated Damages

A liquidated damages clause “provides for the forfeiture of a stated sum of money without proof of damages.” [4] The purpose is to “compensate for damages that would be uncertain and difficult to ascertain.” [5] If certain requirements are satisfied, liquidated damages clauses are generally enforceable.

Under the fundamental principle of freedom of contract, the parties to a contract have a broad right to stipulate in their agreement the amount of damages recoverable in the event of a breach, and the courts will generally enforce such an agreement, so long as the amount agreed upon is not unconscionable, is not determined to be an illegal penalty, and does not otherwise violate public policy.

It is generally agreed that a liquidated damages provision does not violate public policy when, at the time the parties enter into the contract containing the clause, the circumstances are such that the actual damages likely to flow from a subsequent breach would be difficult for the parties to estimate or for the non‑breaching party to prove, and the sum agreed upon is designed merely to compensate the non‑breaching party for the other party's failure to perform. On the other hand, a liquidated damages provision will be held to violate public policy, and hence will not be enforced, when it is intended to punish, or has the effect of punishing, a party for breaching the contract or when there is a large disparity between the amount payable under the provision and the actual damages likely to be caused by a breach, so that it in effect seeks to coerce performance of the underlying agreement by penalizing non-performance and making a breach prohibitively and unreasonably costly. In such cases the clause, rather than establishing damages that approximate or are proportional to the harm likely to flow from a particular breach, actually constitutes a penalty, and, since penal clauses are generally unenforceable, provisions having this effect are declared invalid; and this is generally true even where the provision is negotiated in good faith, at arms' length and between parties of equal bargaining power. [6]

Typical liquidated damages clauses state that the parties acknowledge that damages are difficult to ascertain, that the amount to be paid is reasonably calculated to compensate the non-breaching party, and that the amount is not a penalty. Do such statements ensure that a court will view the provision as liquidated damages and not as a penalty? Although such statements are not controlling, they are nonetheless useful to show the intent of the parties. [7] In any event, they can’t hurt.

DRAFTING TIPS:

Use a heading such as “Liquidated Damages,” and avoid using words such as “penalty” or “forfeit.”

Describe the particular breach that will trigger the limited liability clause (e.g., breach of a covenant not to compete).

Describe the particular harm (e.g., lost sales) for which the liquidated damages are intended to compensate the non-breaching party and state that the actual damages for that particular harm will be difficult to ascertain or quantify.

To the extent possible, use a formula for calculating the amount of liquidated damages rather than specifying a lump sum. For example, if a landlord is late in making retail premises available to the tenant, it will difficult to calculate the actual damages the tenant will suffer, but it is a reasonable assumption that the amount of damages will be proportional to the amount of delay. In that case, rather than specifying a lump sum, specify a certain number of dollars for each day or week of delay.

Indemnification

Perhaps the most direct way of allocating risk between the parties is through an indemnity. An indemnification allows a party (or third party beneficiary) who suffers a loss to demand that another party pay for that loss. “Indemnify” is synonymous with “hold harmless,” the common phrase “indemnify and hold harmless” is redundant. The occasionally encountered “save harmless” is also synonymous with “indemnify.” On the other hand, the obligation to defend another person against a loss is distinct from the obligation to indemnify that person. [8] In most business contracts, indemnification provisions include both obligations, to defend and to indemnify.

From a drafting perspective, the first step is to write a sentence that answers the following questions: Who shall indemnify and defend whom from what?

The “who” must be a party to the contract. That may seem obvious, but sometimes drafters forget that basic principle and write indemnification provisions that purport to obligate people who are not parties to the contracts – for example, the parent company to a party to the contract –to defend and indemnify someone.

In contrast, the “whom” can be essentially anyone, including a party’s officers, directors, employees, agents, parents, subsidiaries, other affiliates. . . the only limit is the willingness of the indemnitor to take on the obligation.

The “what” is also very broad, but there are some limits. For example, it is generally permissible for one party to indemnify the other for losses arising from the indemnitee’s own negligence, but the indemnitor must take on that obligation knowingly and willingly, and the contract must state that intent in clear an unequivocal terms. [9]

In addition to specifying who defends and indemnifies whom for what, most indemnification provisions also contain procedures that deal with notification of an indemnity obligation and sorts out the control of the defense against a claims. Examples of indemnification clauses, from simple to complex, are available in numerous references, including Stark at pp. 309-317.

>Limitations of Liability

A complement to indemnification is the concept of limiting the liability of the parties to each other. There are at least two common structures of limitations of liability. The first structure is a provision that places a monetary limit, or a cap, on the damages that one party is obligated to pay the other. The second is to eliminate completely one or more particular types of damages, most often, consequential damages. Again, examples of both types of clauses are readily available.



[1] These articles are adapted from materials prepared by the author for a continuing legal education seminar, “Business Contracts from A to Z,” sponsored by National Business Institute, and presented by Michael Ray Smith of Smith Rayl Law Office, LLC; and by Trevor J. Belden and Robert K. Stanley of Faegre Baker Daniels, LLP. Used by permission of National Business Institute.

[2] There is no universally accepted structure, format, or style for writing business contracts. In contract drafting, as in computers, “The nice thing about standards is that you have so many to choose from.” Andrew S. Tannenbaum, Computer Networks, 4th ed., quoted at http://en.wikiquote.org/wiki/Andrew_S._Tanenbaum. Two references sometimes used by the author are Kenneth Adams, A Manual of Style for Contract Drafting (2008). Another reference for specific provisions is Tina L. Stark (ed.), Negotiating and Drafting Contract Boilerplate (2003). These two sources are subsequently referred to as “Adams” and “Stark.”

[3] See Restatement (2nd) Contracts, § 237.

[4] Corvee, Inc. v. French , 943 N.E.2d 844, 846 (Ind.Ct.App.2011).

[5] Harbours Condominium Ass’n, Inc. v. Hudson, 852 N.E.2d 985, 993 (Ind.Ct.App.2006) available at http://www.ai.org/judiciary/opinions/pdf/08220602ewn.pdf.

[6] 24 Williston on Contracts § 65:1 (4th ed.). See also Harbours Condominium Ass’n, Inc. v. Hudson, 852 N.E.2d at 993 (“. . . the distinction between a penalty provision and one for liquidated damages is that a penalty is imposed to secure performance of the contract and liquidated damages are to be paid in lieu of performance”).

[7] Beck v. Mason , 580 N.E.2d 290, 293 (Ind.Ct.App.1991).

[8] Henthorn v. Legacy Healthcare, Inc. , 764 N.E.2d 751, 756 (Ind.Ct.App.2002).

[9] Id.