Contracts are not only the foundation of business relationships, they also are a key tool for managing risk. Whether you are an owner, manager, or representative of a company, understanding how to use contracts to allocate and control risk is essential. This article explains important contract clauses that help manage risk and offers practical tips for reviewing and negotiating contracts.
YOUR CONTRACT VS. THEIR CONTRACT: WHOSE TERMS APPLY?
When starting a business relationship, you may be presented with the other party’s contract, or you may have your own standard contract. It is important to remember that each party’s contract usually is written to favor their own interests. Before signing, review the business terms carefully to ensure they are accurate and include all negotiated items.
Under contract law, anything you and the other party agree on during negotiations, whether in person, by phone, or in writing, must be included in the written contract. If it is not in the contract, usually it will not be binding legally or enforceable later.
Also, look for clauses that assign risk. These are provisions where one party agrees to take responsibility for certain risks, losses, or obligations. Such clauses clarify which party will bear the financial or legal consequences if specific events occur, such as damage to products or failure to provide a service.
KEY CONTRACT CLAUSES FOR MANAGING RISK INDEMNIFICATION
What is it? Indemnification provisions mean that one party agrees to cover certain losses, damages, or costs that the other party might face because of specific events or actions. In simple terms, it is a promise to protect the other party from certain risks or liabilities. Indemnification clauses often are called “hold harmless” clauses, ensuring that a party is not harmed by the acts of the other party financially.
Why is it important? Indemnification shifts risk from one party to another, often covering third-party claims, breaches of contract, or negligence.
Example: Suppose John hires Matt to cut down a tree in his front yard. Matt agrees to indemnify John if Matt acts negligently. While working, Matt fails to notice a fence next to the tree. The tree falls, damaging the fence. The fence’s owner sues John for the repair costs. John notifies Matt and relies on the indemnification clause. Matt then pays all costs John incurs in defending the lawsuit, as well as any damages John must pay to the fence’s owner.
Key questions to ask:
- Who is responsible for indemnifying whom?
- Who is protected by the indemnification (just your company, or also affiliates, employees, etc.)?
- What is the “triggering event” (negligence, breach of contract, violation of law)
- What types of losses are covered (damages, legal fees, settlements, fines, property damage, personal injury)?
- Are there exceptions (such as if the claim was caused by the party seeking indemnification)?
- Is the indemnification mutual or only one-sided?
INSURANCE
What is it? Insurance is a way to protect against financial loss. It is a contract in which one party (the insurer) agrees to pay for certain losses, damages, or liabilities that another party (the insured) might incur, usually in exchange for regular payments called premiums. In contracts, insurance provisions require one or both parties to maintain certain types and amounts of insurance coverage.
Why is it important? Insurance provides coverage for financial losses if something goes wrong.
Example: If Matt has insurance for his tree removal business, and the fence is damaged, Matt’s insurance can help cover the costs of defending the lawsuit and paying for the damage. This means John is less likely to face out-of-pocket expenses, since Matt’s insurance provides financial protection for accidents like this.
Key considerations:
• Who (one or both parties) must carry insurance?
• What types of insurance are required (general liability, professional liability, etc.)?
• What amount of coverage is required? Is it reasonable for the risks involved?
• Does the contract require one party to be named as an additional insured? If so, your company gets some of the same protection as the policyholder for claims related to the work.
• Will you receive proof of insurance coverage? Always require a certificate of insurance.
REPRESENTATIONS AND WARRANTIES
What are they? Representations are statements of fact about the present or future state of goods or services. Warranties are promises that certain facts about the goods or services are true or will be true.
Why are they important? If a representation or warranty turns out to be untrue, the other party may have the right to seek damages or terminate the contract. These clauses help set expectations and allocate risk.
Example: If the contract says Matt is not making any warranties about the condition of the yard after the tree is removed, and some minor damage occurs that is not due to negligence, John would have a harder time claiming that Matt is responsible for fixing it.
Key considerations:
• What promises are being made? Make sure all important promises about goods or services
are included.
• What is the scope and duration of the promise? Is it limited to a certain time period?
• What are your rights if the promise is untrue? Can you recover damages or terminate the contract?
• Are there limitations or disclaimers? For example, a seller might state they do not guarantee future performance or make promises beyond what is written in the contract.
LIMITATION OF LIABILITY
What is it? A limitation of liability clause sets a maximum amount or specific types of damages that one party can be held responsible for if something goes wrong. It limits how much one party has to pay the other in case of a breach, mistake, or loss.
Why is it important? These clauses help manage risk by preventing large or unexpected financial losses. If your company is selling goods or services, this clause can help limit your financial exposure. If your company is the buyer, however, it restricts the amount of damages you can recover.
Example: If the contract states that Matt’s liability is limited to the amount John paid for the tree-cutting service, then even if the damage to the neighbor’s fence is much greater than that amount, Matt would only be responsible for paying up to that limit. This helps Matt avoid large, unexpected financial losses. However, for John, this type of clause means that John could end up paying his own money for damages that exceed the stated amount.
Key considerations:
• Are certain types of damages excluded from the limitation (such as consequential or punitive damages)?
• Is there a dollar limit on liability (often tied to the contract value)?
• Are there exceptions (such as for indemnified claims, breaches of confidentiality, or intentional misconduct)?
PRACTICAL TIPS FOR MANAGING CONTRACTUAL RISK
• Develop or update your company’s contract templates to reflect your business needs and risk tolerance.
• Pay special attention to key clauses when reviewing another party’s contract.
• Negotiate until you are comfortable with the level of risk your company is accepting.
• Be prepared to walk away if the risks are too great and the other party is unwilling to compromise.
Effectively managing risk and liability in contracts is essential for protecting your company and ensuring long-term success. By understanding and negotiating key contract clauses, you can better control your company’s exposure and enter into agreements with confidence. If you have questions about specific contract terms or need help drafting or reviewing agreements, consider consulting with a qualified attorney to ensure your interests are protected fully.
Barbara Dunn is the attorney and owner of Barbara Dunn Law PLLC and
serves as legal counsel to the National Wood Flooring Association (NWFA).
She can be reached at barbara@barbaradunn.com or 312.825.3880.
