In the business world, risk is an omnipresent factor that can significantly impact the outcome of transactions and agreements. These risks can arise from various sources, including market volatility, regulatory changes, and the occurrence of unforeseen events. When entering into business transactions, effective risk management should involve identifying, and assessing these risks at the outset, and taking steps to minimize, control, or eliminate the potential adverse effects these risks may impose as part of the contract formation process.
In this guide, we will discuss seven critical contractual clauses that can be used as essential risk management tools. These clauses not only provide a blueprint for defining the obligations and rights of the parties involved, but also offer a mechanism for allocating unexpected costs and establishing clear processes for handling issues as they arise.
Indemnification clauses are contractual provisions in which one party (the indemnifier) agrees to compensate the other (the indemnitee) for any losses, damages, or liabilities incurred by the indemnitee due to the actions, (or sometimes the inactions), of the indemnifier. In terms of risk management, these clauses can protect businesses from financial losses and legal liabilities by shifting the financial burden of various risks including:
Indemnification clauses generally do not protect the indemnitee against losses or liabilities resulting from their own gross negligence, tortious conduct, recklessness, or violations of law.
Limitation of liability clauses are contractual provisions that cap the amount and types of damages one party can recover from the other under various circumstances. They can be excellent risk management tools by defining in advance the extent of liability for both parties, thus providing a predictable framework for the potential financial impact of breaches, negligence, or other liabilities. By limiting the scope of recoverable damages, such as indirect, consequential, or punitive damages, the parties can control their exposure to high-risk liabilities. Some examples of their uses include:
Similar to indemnification clauses, limitation of liability clauses are not always enforceable, and may not protect a party from liability arising from their gross negligence, intentional wrongdoing, or from damages arising from the personal injury or death of another. Furthermore, for reasons of public policy, limitation of liability clauses are a lot more likely to be upheld in B2B contracts as opposed to consumer contracts. This is especially true in the case of contracts of adhesion or standard form contracts which are presented to the consumer on a “take-it-or-leave-it” basis.
Force majeure clauses are contractual provisions that may release one or more parties from liability or excuse them from fulfilling contractual obligations when an extraordinary event or circumstance (commonly referred to as “force majeure events,”) beyond their control occurs, and which significantly hinders or prevents one or both parties from meeting their obligations. Common force majeure events include
It's important to note that these clauses cannot be invoked merely when unforeseen circumstances make performance more difficult, expensive, or inconvenient. Furthermore, the event must be both unavoidable and sufficiently severe to significantly disrupt the agreed-upon performance.
Confidentiality or non-disclosure agreements (NDAs) are legally binding contracts, or clauses contained within contracts, that are designed to protect sensitive and proprietary information shared between parties. NDAs establish a confidential relationship, clearly outlining what information is deemed confidential, the permitted uses of that information, and the restrictions and consequences surrounding its unauthorized disclosure.
Types of information commonly protected by NDAs in various business contexts:
NDAs should clearly outline the consequences for unauthorized disclosure of confidential information, such as financial penalties, the availability of injunctive relief (to prevent further disclosure), and/or the right to terminate the underlying contract and related agreements.
Termination clauses are contractual provisions that define the specific circumstances or events that allow for a contract to end prematurely. These clauses establish the conditions under which one or both parties can legally terminate the agreement before its originally intended completion date. Common grounds for termination include:
Note that a termination clause can work in conjunction with other clauses discussed here. For example, a termination clause might specify that if one party breaches a confidentiality provision, the other party has the right to terminate the agreement and seek specific damages. Similarly, a termination clause can be paired with a force majeure clause (discussed above). While the force majeure clause outlines the events that allow for termination, the termination clause provides the steps and procedures for an orderly and fair ending to the agreement if those events occur.
Dispute resolution clauses are sections within a contract that outline the agreed-upon steps the parties involved will take if a disagreement or conflict arises related to the contract. They are designed to provide a structured way to resolve issues outside of the courtroom, saving both time and money for all parties involved, and may require the following as alternatives to, or preconditions for, litigation:
Choice of Law: Often considered separate and distinct from dispute resolution clauses, choice of law clause provisions designate which jurisdiction's laws govern the contract and subsequent dispute resolution. While this primarily creates clarity and reduces uncertainty in interpretation, the ability to select applicable law adds additional strategic consideration and potential advantages in those laws affecting remedies, available defenses, contract validity, and other significant elements that can differ dramatically between jurisdictions.
Selection of Venue: Selection of venue clauses determine the geographic location (e.g., city, state, or country) where mediation, arbitration, or any required court proceedings will take place, which can affect convenience and costs in litigating or settling disputes.
While generally upheld, courts may disregard choice of law clauses in certain instances, particularly if the selected jurisdiction has no reasonable connection to the contract, its subject matter, or the parties themselves.
Severability clauses are essential provisions within contracts that ensure the overall agreement remains valid and enforceable, even if one or more of its parts are found to be void or unenforceable. In some cases, a severability clause may include a mechanism for modifying or adjusting the affected provision to make it valid and enforceable, while still reflecting the original intentions of the parties as closely as possible. For example, if a specific non-compete clause within an employment contract is deemed overly broad and thus unenforceable by a court, the severability clause might allow for the automatic adjustment of the clause's geographic scope or duration to levels considered reasonable and lawful.
Severability clauses often work in tandem with other contractual provisions, such as dispute resolution and choice of law clauses, to ensure the smooth functioning of the contract. For example, a dispute arising from the interpretation or application of a severability clause may be resolved through the agreed-upon dispute resolution mechanism, under the chosen law.
As this guide illustrates, implementing risk allocation and mitigation strategies by use of contractual clauses can be essential. Whether you're drafting a new contract or revisiting existing agreements, understanding these clauses can make a significant difference in your business's legal position. Through AAL's directory, you can find skilled attorneys with extensive experience in practicing business law who can provide expert guidance and representation during crucial contract negotiations.
