If you work with a lot of contracts, you may already know that most contracts include an “indemnification” clause. This is essentially an “I’ll protect your back” clause, making the party giving the indemnity responsible to pay back the other party for things they might do wrong, bringing harm to the first party.
You may also know that most contracts also include a separate “limitation on liability” clause. This typically puts a maximum or cap on the amount each party might owe to other, for "direct damages," often based the size of the deal. For example, it might say that the maximum liability of either party to the other is the “amount paid or payable by the other party during the last 12 months”. This makes perfect sense when you think about it -- after all, why would you want to do a $100 deal where you risk losing $1mm. Therefore, it is common to limit each party's risk to the size of the deal (or some reasonable multiple thereof).
But there is also typically a provision saying that, despite these caps on liability for “direct” damages, that liability will be uncapped (i.e., unlimited) for indemnifications and/or breaches of confidentiality. Why is that?
All too often, when one party tries to change this provision, the business people tune out and let the lawyers discuss it, without fully understanding why they should care. The goal of this article is to explain these provisions in layperson’s terms so you can understand them and know what’s fair, and why you should care.
Direct Damages vs. Indemnification - What's the Difference?:
Direct Damages:
As mentioned above, typically, direct damages are capped at the value of the deal. What are “direct damages?” Direct damages are how much one party can get from another because of the direct harm, to the party making the claim. These are damages directly between the two parties to the agreement. As mentioned above, this makes sense to be capped. As between the two parties themselves directly, the value of the deal should be in line with the amount of risk.
EXAMPLE of Direct Damages:
Think of a simple example: I bought a widget from you for $5; the widget was broken; I want my $5 back directly. I don’t need $1mm of coverage, I just need my $5 back. Or if I bought or licensed software from you, and it doesn't work, all I need back is how much I paid you for the software. So for “direct damages” (between the two parties directly involved in the deal), this cap makes sense.
Indemnification:
By contrast, indemnification, for third party claims, are typically uncapped. What is an indemnification and how is it different than direct damages? Indemnification typically comes into play when a 3rd party is somehow involved. This is no longer an issue solely between the two parties directly involved with the agreement. For example, assume some third party sues one of the parties or tries to collect damages from them, as a result of something in the contract. These are now out-of-pocket expenses paid to a third party rather than direct damages to the counterparty. Here, the potential harm might not necessarily be related to the size of the deal. Some specific examples are shown below, which will help illustrate.
Examples of Indemnification:
Here are some simple examples:
(1) I bought a widget from you for $5 and resold it (as permitted) to an end user; it blew up in their face; the end user sued me and I have to pay them $100 million, so I want you (not me) to pay the $100 million.
(2) I bought some software or technology from you for $5, and it turns out that this technology infringed a third party’s patent; the third party sued me for $10 million and I want you to pay this $10 million.
(3) You bought an ad on my website for $5; The content in your ad violated the law, defamed someone, or used someone else’s logo; As a result, I got sued by that third party (and/or fined by the government) for $5 million; I want you to pay the $5 million.
(4) I gave you data about my customers (to store or process), and you breached their privacy and violated privacy laws; my customers sue me (and/or the government fines me) for $20 million for that breach of privacy; I need you to protect me from all these fines and the lawsuits from my customers, plus pay the costs of notifying users and providing credit monitoring (which costs me an additional $5-10 million).
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As you can see, in each of these examples, the extent of the liability is not necessarily correlated to the size of the deal, but rather, to the size of the harm caused.
In this case, each party should bear full responsibility for the harm it causes to the other party, to the extent the other party has exposure to any third parties. If your product or services or activities are what caused the liability, then you should be fully responsible for that, not me. Why should I help you pay a third party for any harm you cause to them, no matter how much?
In other words, if the other party puts a cap on their indemnity, they are effectively asking you to have uncapped liability for their mistakes.
Let’s walk through an example in more detail. Let’s assume you are a publisher or website and you accept a blog post written by someone else. You have a contract with the blogger saying that they will write content for you and you will publish it and promote it. They are responsible for the content, and you are responsible for making sure it appears on your website and gets promoted. This may even be a cashless deal (they give you content for free in exchange for the publicity). Now assume there is something wrong with the content in their posting (perhaps it was copied from another writer verbatim), and you publish it. Assume further that you get sued for $1mm by the true content owner for publishing and distributing their content. It was the blogger's fault, not yours. You were not responsible for any of the content or infringement. Yet, if the blogger's liability is capped at $100k, and you are sued for $1mm for the infringement, the blogger would owe $100k and you would owe $900k, all because they stole the content and you were an innocent victim. You are paying their liability for them.
In a case like this, the blogger would likely owe these amounts to these third parties for infringement whether or not they did this deal with you. If they published this content on their own website or blog, instead of on your website, they would likely owe the full $1m amount for the infringement. So why should you participate in the blogger's liability just because the content was published on your website instead of the blogger's website?
How to Make the Case to Them:
Armed with this information and logic, you can answer their request by using their own logic against them.
They will say that the reason they added the cap is because of risk management and the fact that they do not want to risk more than the value of the deal.
Argument #1: You do not want uncapped liability either - especially not for their mistakes. You can explain that you agree 100% that neither party's liability should exceed a reasonable multiple of the deal - and you do not want to have more liability than the value of the deal either. That is precisely why you need the cap, so that you are not bearing unlimited liability for their mistakes. You do not want to be their unintended insurance provider. Therefore, you must each have uncapped liability for indemnification.
Argument #2: It is within their control, not yours. The other argument you can use on the other party is that they can and should be able to manage this risk simply by not breaching the agreement and not infringing. It’s entirely within their control. As between the two of you, they have more control over whether or not they breach the agreement, violate confidentiality, or do something wrong that leads to an indemnity. To be clear, you are only asking them to pay if and to the extent they have “done something wrong” that caused harm to a third party. They are better equipped to control whether or not they “do something wrong” than you are.
Argument #3: Fairness. As between the parties, it is more “fair” to have them pay to the extent they have done something wrong, that costs you money out of your pocket due to their mistake.
That’s why I rarely agree to such caps. In extremely rare cases, where the counterpart can give a bona fide reason for a cap, the only way I'd even consider it is if it is in the order of magnitude of tens of millions of dollars, regardless whether the deal is much smaller.
FYI, this applies in both directions, because these clauses are typically mutual. So if you expect their indemnities to you to be uncapped, be prepared to also have your indemnities to them uncapped as well. That is “fair” and typical. But understand that. Before you decide how hard to fight, you may want to begin by trying to determine which party is more likely to be infringing or to cause third party harm or liability.
So if the counterparty to an agreement negotiation asks to cap their liability for indemnity or breach of confidentiality, you can explain to them why that is inequitable, why it essentially requires you to insure them, and how it gives you uncapped liability for their own mistakes.
About the Author:
Brian is a tech lawyer and "deal guy". http://www.outsidegc.com/brian-heller/ Outside GC is reinventing the business model for lawyers. Outside GC is 100% virtual, so they charge 1/3 what a larger more traditional firm might charge. All their lawyers have business experience or in-house legal experience (no career-law-firm-lawyers allowed), so they understand the business realities and can work efficiently. If you need a transactional deal lawyer with great real world experience, at a fair and reasonable price, check out Brian's bio at http://www.outsidegc.com/brian-heller/
