Thursday, November 10, 2011

Damages and Indemnity & How Terms Are Interconected

In a LinkedIN group an individual asked the question “What’s the difference between damages and indemnity? I thought that this would be a good topic to write about and at the same time discuss the inter-relationship between a number of contract terms. 

In contracts "damages" are what you sustain from a breach of the agreement. Damages are also what third parties could claim for damages to their property or for personal injuries. Indemnities provide you with protection against third party claims for injuries or damages they sustained as a result or actions by one of the parties to the agreement.

There are various types of indemnities. General indemnities provide protection against personal injury or property damage. Intellectual property indemnification provides protection against third party claims of infringement of their intellectual property rights. Most indemnities have the supplier indemnifying the buyer against claims caused by the supplier's actions, exceptions to that could be where the buyer is performing acts or providing designs or materials that could create the cause of the injury or damage. In the oil industry there is what’s called a knock-to-knock or mutual indemnity that’s unique and more of a risk sharing approach. In that approach each party is responsible for damage to their own property or injuries to their own employees irrespective of who was at fault.  

There is a link between the indemnification section, the limitation of liability, the warranties, and the insurance sections and all of them need to work together. The protection you get from a general indemnity will depend upon how the clause is written.

Most indemnities would not protect either a contractor or owner against a general breach of the contract they can be written to protect against the breach of a warranty that could also be the source of a third party claim. They usually will cover injuries or death to a third party or property damage caused by the negligence of the party.

The protection you get from an indemnity from the supplier may be limited by any limitation of liability provision unless you specifically carve the indemnity provision out of the limitation of liability. Most limitations of liability are written to exclude all types of damages other than direct damages. That exclusion does not apply to the types of damages a third party could sue for. So unless you carve the general indemnification out of the limitation of liability you would have the situation where you could be liable for all types of damages the third party could sue for, but you would only be able to collect the portion of that claim that was direct damages from the supplier. Most limitation of liability provisions also include a financial cap. Those financial caps do not apply to what a third party could sue for. If you didn’t carve the general indemnification out of the limitation of liability you could be liable for an unlimited amount and you could only recover up to the cap amount in the limitation from the supplier.

The reason why breach of the warranties may be included as part or the indemnification is because many warranties are there to drive a behavior so third party claims can be avoided. For example a warranty that the product is safe is to protect against product liability claims. A warranty that a product complies with all applicable environmental laws is to protect against claims from customers or governments in the event the product is found not to be complaint. When you include breach of warranties as part of the general indemnification it places the defense and cost of any damages that were cause by the breach directly on the supplier. You want that because those damages could be far more than the limitation of liability amount that you would be available to collect for a breach of the warranty. Without including the breach of warranties as part of the indemnification, if the supplier breached the warranty what you could claim against the supplier would first be limited by the types of damages that were allowed in the limitation of liability. Those damages would further be limited by any financial cap on liability.

Limitations of liability are to limit the liability of the parties to the agreement. They do not limit the liability of the insurance company as the insurance company is not a party to the agreement. Their limits on their liability are defined by what they agree in the insurance policy. This means that in claims under general indemnification that apply to insured risks covered by the policy that was required by the agreement, you would have both the supplier’s assets and the insurance company to collect against. For example, if there was a $7,000,000 loss and you had a $5,000,000 comprehensive and general liability policy required and the agreement has a limitation of liability of $1,000,000. The insurance company would pay the first $5,000,000 of the loss, less any deductible. The supplier would be liable for no more than the $1,000,000 and you would be responsible for the remainder.

I recommend that you always carve the general indemnity out of the limitation of liability because of one simple fact. An injured third party is not limited in terms of what they could sue for. If they sued the supplier directly there would be no limitation on the supplier’s liability. Since they would have unlimited liability on their own, why should they have limited liability simply because the injured party sued you rather than the supplier?

In discussing indemnification, the “Indemnitor” is the party that makes the indemnification commitment. The Indemnitee is the party that receives it. Most indemnities are given by suppliers to buyers. The reason for this is because liability follows the principle of agency. In a buyer / supplier relationship the buyer is considered the principal. The supplier is considered the agent. The principal can be liable for the acts of the agent. The agent is not liable for the acts of the principal. So if a Supplier is negligent and injures a third party, that third party could sue the supplier, the buyer or both. It’s those types of claims by third parties that are made against the Buyer for the acts of the supplier is what a general indemnity is designed to protect against, If the Buyer is the one that is negligent, since the indemnity is only for the supplier’s negligence. the buyer cannot ask the supplier to indemnify them on that claim. The supplier would also not be sued by the third party as an agent cannot be sued for the acts of the principal. 

If both parties are negligent you would need to look at what the general indemnification clause says. If it says the supplier is only responsible to indemnify in the event the injury or damage was caused by their sole negligence, and both parties were negligent, the indemnity would not apply. Both parties could be sued and the courts would determine the percentage of liability attributable to both. This is called comparative negligence. If the language did not say sole negligence, the indemnity would still apply even though the buyer was partially at fault. Suppliers may try to water down the general indemnity by adding the concepts of gross negligence or willful misconduct. What both of those attempt to do is add a higher standard for them to the responsibility to indemnify the buyer. Willful misconduct requires that the misconduct must be deliberate. Gross negligence would excuse them from indemnifying for injuries or damages that result from ordinary negligence. As a buyer I wouldn’t accept either gross negligence or willful misconduct. They were the ones that caused the injury or damage, they should be responsible for their acts.

Intellectual property indemnifications are also normally excluded from the limitation of liability. Just as with the general indemnification the buyer has no control over what the third party could sue for, If the supplier was sued directly their potential liability would be unlimited so why should their liability be limited simply because the claim of infringement was made against the buyer rather than the supplier. Another reason for excluding it from the limitation of liability is that many jurisdictions provide for penalties to be assessed in the event of a willful infringement. This is done to discourage infringements. For example in the U.S. under patent law, a party whose patent was willfully infringed upon could be awarded treble (3X) damages. If you didn't carve the intellectual property indemnification out of the limitation of liability clause, you could wind up in the situation where the party whose rights were infringed could collect 3X damages from you and you could only collect 1X from the supplier. Even worse you could not collect any portion of the 1X amount that exceeded the limitation of liability nor could you collect any portion of the claim that wasn’t direct damages. Most Intellectual property claims include claims for lost revenue and lost profits which are both traditionally types of damages that are excluded under a limitation of liability provision.

Contracts are interpreted where the terms are considered to be complimentary. When it comes to the limitation of liability provision, what that means is the limitation of liability will apply to all terms and obligations between the buyer and the supplier unless you specifically exclude those terms from the limitation of liability, Those exclusions can be full exclusions, You could exclude the limit on the types of damages that may be recovered under a specific clause. You could also establish different limits of liability for different sections. For example you could have the indemnities be unlimited, establish individual caps on liability for the breach of specific warranties. You could have a much higher limitation for things like epidemic defects and have the remaining terms be subject to the different liability amounts.

One last point on the topic. When the contract is written with a buyer that has multiple subsidiaries and the intend is that each subsidiary will create a “duplicate agreement” that duplicates the terms of the buyer / supplier agreement, a smart supplier will see that as a risk and will want to address that in the agreement. The reason is that when you create duplicate agreements, you are now creating a new independent agreement between different legal entities. If you had a $10,000,000 limit in the buyer / supplier agreement and six subsidiaries signed duplicate agreements. Instead of having a limit of liability of $10,000,000. the supplier now has a combined potential liability of $70,000,000 with $10,000,000 to the buyer and $10,000,000 to each subsidiary. To protect against that the supplier may require a statement in the buyer / supplier agreement to the effect that their combined liability to the buyer and all its subsidiaries shall not exceed that one stated amount.

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