There is an extensive body of law that describes the types and amounts of damages available if either party breaches a contract. Yet most contracts include terms that allocate more risks to one party, and less risk to the other party.
Generally, there are 5 primary risk allocation categories that appear in most business contracts:
- Representations and warranties
- Indemnification
- Limitations of liability
- Insurance
- Liquidated Damages
Below are very high-level explanations of these complex legal terms:
Representations and Warranties – Representations are statements of present or past facts, while warranties are promises that present or future facts will be true. Representations are used to obtain disclosures and warranties are used to obtain commitments. [See our blog, “What are Reps and Warranties?”]
Limitations of Liability – Limitation of liability clauses reduce the amount of exposure a company faces in the event of a lawsuit or other claim. These clauses may limit the types of damages available and/or they may limit (or cap) the total amount of damages.
Indemnification – Indemnification provisions commonly include three interrelated requirements: (1) to indemnify, (2) to hold harmless, and (3) to defend. To indemnify means to compensate a party for its liabilities or losses (or settlement). To hold harmless means one party will not assert a claim against the other party. To defend means to pay the fees of the attorneys who defend the claim. Some drafters treat indemnity and hold harmless as synonyms. [See our blog, “What is Indemnification?”]
Insurance – By requiring a party to carry certain types of insurance, with specific coverage limits and requirements to name the other party as an additional insured, the insured risks are shifted to a third party (the insurer). This can be especially helpful if the party required to carry the insurance is not financially strong.
Liquidated Damages – Liquidated damages are the amount the parties agree, at the time of signing the contract, will be paid by one party to the other if there is a breach of the contract. Liquidated damage clauses can be particularly useful when damages would be difficult to calculate, such as damages relating to lost opportunity.
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