Risk Allocation in Commercial Contracts: Indemnity, Reps and Warranties, Termination, Damages Provisions

Presenting a live 90-minute webinar with interactive Q&A

THURSDAY, FEBRUARY 28, 2019

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

Today’s faculty features:

Amir Azaran, Partner, Loeb & Loeb, Chicago Mark Cohen, J.D., LL.M., Attorney, Boulder, Colo.

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Strafford CLE Webinar February 28, 2019

Mark Cohen, J.D., LL.M. Amir Azaran – Loeb & Loeb LLP Risk Allocation – Types of Risk

•Risk of non-performance •Risk of flawed performance •Risk of foregone opportunities •Risk of change circumstances ------(And I would add risk of poor drafting)

6 Risk Allocation – Considering Risk

• What are the client’s expectations? • What damages will the client incur from non-performance or flawed performance? • What possible remedies are available? • What is the risk that circumstances will change? • What is the risk that the client could get a better deal elsewhere? • What are the opportunity costs?

7 Risk Allocation – Two Functions of a Contract

A typical contract serves two functions: 1. Clarify and Express Expectations. Who will do what, by when, in what manner, and how will the results and proceeds of their efforts (risks, losses, gains) be allocated; and 2. Dealing with Disruption. The contract should simplify and stream how the parties manage disruptive change and disagreement – how issues are identified, how parties are notified, and how the conflict is engaged and resolved.

Linda Alvarez, Discovering Agreement, American Bar Association, 2016.

8 Drafting and Litigation: The Three Main Causes of Contract Disputes

• Ambiguity When an ambiguity is found to exist and cannot be resolved by reference to other contractual provisions, extrinsic evidence must be considered by the trial court in order to determine the mutual intent of the parties at the time of contracting. Pepcol Mfg. Co. v. Denver Union Corp., 687 P.2d 1310 (Colo. 1984). • Inconsistency Where it is impossible to reconcile conflicting clauses of a contract, it is proper to receive extrinsic evidence for the purpose of determining the intent of the parties. Ryan v. Fitzpatrick Drilling Co., 342 P.2d 1040 (Colo. 1959). • Failure to address an issue altogether Silence on a matter in a contract creates an ambiguity when it involves a matter naturally within the scope of the contract. Cheyenne Mtn. Sch. Dist. #12 v. Thompson, 81 P.2d 711 (Colo. 1993). Extrinsic evidence is admissible to determine the intent of the parties.

9 Drafting and Litigation: Questions of Fact and Questions of Law

• Whether a contract is ambiguous is a question of law. Pepcol Mfg. Co. v. Denver Union Corp., 687 P.2d 1310 (Colo. 1984)

• However, once a court determines that a contract is ambiguous, the meaning of the ambiguous term is a question of fact. Dorman v. Petrol Aspen, Inc., 914 P.2d 909 (Colo. 1996)

• Once a court determines that a contract is ambiguous, the intent of the parties is question of fact. Metropolitan Paving Co. v. City of Aurora, 449 F.2d 177 (10th Cir. 1971)

10 Drafting and Litigation: Questions of Fact and Questions of Law

And If a Question of Fact Exists… NO SUMMARY JUDGMENT

11 Drafting and Litigation: The Parol Evidence Rule

• In the absence of allegations of fraud, accident, or mistake in the formation of the contract, parol evidence may not be admitted to add to, subtract from, vary, contradict, change, or modify an unambiguous integrated contract. Boyer v. Karahenian, 915 P.2d 1295 (Colo. 1996)

• Terms used in a contract are ambiguous when they are susceptible to more than one reasonable interpretation. B&B Livery, Inc. v. Riehl, 960 P.2d 134 (Colo. 1998)

• An integrated contract is one that contains all the terms the contracting parties agreed to. Harmon v. Waugh, 414 P.2d 110 (Colo. 1966)

12 The Main Risk Allocation Provisions

• Representations and Warranties • Indemnification • Limitation of liability • Termination • Exculpatory clauses

Practice tip → reps/warranties, indemnification and limitation of liability provisions form the “core” risk allocation provisions of a contract, and are often “linked” in subtle ways

13 Representation and Warranties

• Representations and warranties are different than contract covenants • Covenant – a promise to perform an obligation • Representation – a statement of fact as of the time the contract is formed • Warranty – a guarantee that a certain fact will remain true for the term of the contract • Generally, a breach of a representation or warranty allows the aggrieved party more ways to recover • Fraudulent misrepresentation • Ziff-Davis Rule – a warranty is a promise of indemnity if a statement of fact is false • CBS Inc. v. Ziff-Davis Publishing Co., 75 N.Y.2d 496 (1990)

14 Representation and Warranties

• Common representations and warranties in contracts • Authority to enter contract • Properly organized and in good standing • Compliance with law / all required consents • No conflicts with other contracts • Ability to perform • More “specialized” representations and warranties • Ownership / original work • No viruses or other harmful code • Pass through of third party warranties

15 Representation and Warranties

• Implied warranties • UCC Article 2 – implied warranties of merchantability and fitness for a particular purpose • Many contracts will seek to disclaim implied warranties, and limit warranties only to those expressly stated in the contract • Practice tip → watch for warranty disclaimers that go too far • Party A’s performance hereunder is “as is” and “with all faults”

16 Indemnification

• Indemnity clauses essentially place the entire burden of a given circumstance on the indemnifying party • Practice tip → an indemnity is appropriate where one party is able to minimize or control for a risk, and it would be difficult or impossible for the other party to do so • Often coupled with a duty to defend the other party • “Party A shall indemnify, defend, and hold harmless Party B against all damages, losses, costs, and expenses (including reasonable attorneys’ fees) resulting from…” • Common indemnity clauses • Failure to comply with law • Gross negligence or willful misconduct • Breach of (certain) representations and warranties

17 Indemnification

• More specialized clauses • Third party claims of IP infringement • Costs related to a data security breach • Drafting considerations • Precisely define the breadth of indemnified parties • Affiliates, officers, directors, etc. • Usually drafted to protect against third party claims • What is a “first party” indemnity? • Define circumstances where the indemnity will not apply • Use of the other party’s materials • The other party’s alteration of improper use of the indemnifying party’s technology

18 Limitation of Liability

• Limitation of liability clauses generally have three components: • Exclusion of consequential damages • Cap on direct damages • Carve-outs to each of the above • Exclusion of consequential damages • Hadley v. Baxendale, 9 Exch. 341 (1854): damages awarded for breach only if it was foreseeable at the time of contracting that the type of damage being sought would result from the breach • In most contracts, the parties seek to remove the uncertainty of what is “foreseeable”, and exclude consequential, indirect, punitive, and other similar kinds of damages

19 Limitation of Liability

• Cap on direct damages • Goal is to rationally tie a party’s liability for breach to the economic value of the contract • Common formulation: • “Party A’s aggregate liability in connection with this Agreement will be limited to the greater of (i) the amounts paid by Party B hereunder during the [X] months preceding the event giving rise to such liability, and (ii) [$Y]” • Carve-outs • In certain circumstances it is appropriate to “carve out” certain types of damages from the exclusion of consequential damages and cap on direct damages • Common examples • Breaches of confidentiality • Indemnification obligations under the contract • Gross negligence or willful misconduct

20 Term and Termination

In general, if a transaction is high risk, clients prefer a short contract term so they are not stuck with a bad deal for a long time.

However, if a contract requires the client to make significant investment, the client may prefer a longer term to allow time for it to recoup its investment.

21 Term and Termination

• Term of the Contract • Specified term versus a contract that continues until terminated. • Automatic renewal unless notice of intent not to renew provided by a specified date. • Contract ends on a specified date, but there is an option to renew if notice of intent to renew is provided by a specified date. • Rights to terminate allow a party to mitigate contract risk

22 Term and Termination

• Categories of Termination Rights • For cause • Material breach • Defined circumstances – e.g., “persistent” service level violations • Convenience • Often heavily negotiated • Amount of notice is frequently an issue • May require payment of a termination fee to compensate a party for upfront costs • Others • Material adverse change • Financial stability of counterparty • Change in control of counterparty

23 Term and Termination

• Consider the financial impact of termination • May not easy to exit a deal from an operational perspective • Significant transition-out costs • Consider whether a transition assistance provision is needed • Upon a party’s election to terminate, certain transition-related or “disentanglement” obligations are undertaken • Can allow a party to delay the termination date (extend the term) in order to “keep the lights on” • Survival – specify what provisions continue to apply after termination • Confidentiality • Indemnification and limitation of liability • Boilerplate provisions 24 Exculpatory Clauses

• An exculpatory clause is any provision that limits a party’s damages or the range of remedies that are available • Examples • Limitation of liability provisions • Liquidated damages • Identifying defined remedies as a party’s “sole and exclusive” remedies for breach • Force majeure clauses

25 Force Majeure Clauses

Is a Force Majeure Clause necessary?

The law offers two doctrines that will excuse a party’s obligations when an unanticipated, supervening event fundamentally alters the nature of the parties’ contract: (1) impossibility / impracticability, and (2) frustration of purpose. For a general discussion of these, see Seaboard Lumber Co. v. U.S., 308 F.3d 1283 (5th Cir. 2002).

26 Force Majeure Clauses

Defining what constitutes a Force Majeure event versus not defining it.

Not Defined:

• “To the extent caused by force majeure, no delay, failure, or default will constitute a breach of this Agreement.” See, David W. Tollen, The Tech Contracts Handbook, American Bar Association, 2010.

The danger of attempting to list every possible Force Majeure event lies in the doctrine of Expressio Unius Est Exclusio Alterius.

• If your clause says, “Acts of God, fire, or flood,” but doesn’t say “earthquake,” you may have an issue. An alternative might be:

Each party will be excused from performance under this Agreement while and to the extent it is unable to perform for unforeseen cause beyond its reasonable control. This does not include x, y, and z. This provision does not excuse any party from making timely payment of any amount due under this Agreement.

27 Force Majeure Clauses

Other Issues with Force Majeure clauses: • Is the non-performing party’s performance excused temporarily or permanently? If temporary, for how long is performance excused? • Must the event be unforeseen? Must the event be beyond the control of the non-performing party? • See, Perlman v. Pioneer Ltd. Partnership, 918 F.2d 1244 (5th Cir. 1990) (Where contract did not require the event be unforeseen or beyond control of a party, trial court erred in reading those terms into the contract). • Obligation of the non-performing party to give notice of Force Majeure event within a specified time. • Non-performing party’s duty, if any, to attempt to respond to Force Majeure event. • Right of a party to terminate contract if Force Majeure event continues for specified time.

28 Change as an Element of Risk

The more important the relationship is to the parties, the more willing they will be to be flexible in addressing their changing needs.

29 Change as an Element of Risk

Factors in Determining Importance of the Relationship

• Importance of the transaction to the parties • Alternatives available to the parties • Potential for future transactions with the other party • The other party’s ability to help develop new customers

30 Change as an Element of Risk

We tend to think there is tension between flexibility and predictability (stability) in contracts, but if the relationship is important, flexibility may promote long- term stability in the relationship.

See, Flexibility And Stability In Contracts, Thomas D. Barton, Helena Haapio, Tatiana Borisova, 2 Lapland Law Review 8 (2015).

31 Change as an Element of Risk

The less likely there is to be significant unforeseen change, the less risk there will be associated with a longer contract term

32 Change as an Element of Risk

Some Commons Types of Change:

1. Force Majeure Events. 2. Changes in business / market conditions. 3. Changes of law. 4. Changes in key personnel.

33 Change as an Element of Risk