Month: September 2016

Structuring a solid contract is all about minimizing risk and uncertainty at every step of the process.

In most cases, parties want to ensure that there is a shared understanding as to the provisions of the contract. When parties reach a clear and mutual understanding, this necessarily minimizes the risk of a lawsuit later on.

A well-drafted sale of goods contract will specifically address the expectations of each party with regard to the type and quality of the goods. A service contract will indicate the timeline for the provision of such services, as well as the cost expectations. Provisions relating to the choice of law and venue may be included to minimize the uncertainties of legal interpretation – for example, an employment contract might require the application of California law, which will render the interpretation of certain contract provisions quite differently than the laws of other states.

Though a lawsuit may seem unlikely when you first enter into a contract, conflict is sometimes unavoidable. As such, properly drafting a contract requires that the parties account for the real risk of litigation. One common way for minimizing this risk is the implementation of a limitation of liability clause.

What is a Limitation of Liability Clause?

A limitation of liability clause can be written in a multitude of ways, but generally speaking, it is a provision or set of provisions that work to limit or otherwise circumscribe the potential damages of a breach of contract.

Let’s sift through this legal terminology with a short example.

Imagine that you are a contractor, and you would like to enter into a contract to help renovate a client’s kitchen. The contract is well-defined and adequately describes the services to be rendered, the timeline, and the costs involved. As an extra precaution to protect yourself, however, you consider a limitation of liability clause, primarily because of the potential for damages in a breach of contract situation.

Suppose that you renovate the kitchen, but the client feels that the quality of the materials used is insufficient and therefore constitutes a breach of contract. If the client were to sue you for breach of contract, they might assert substantial damages based on an estimation of the costs of hiring you, plus the cost of re-renovating with a different contractor. Though you conducted the renovation for, say, $20,000, the various damages asserted by the client later on might add up to much more, perhaps $50,000 or higher.

With a clear, unambiguous, and uniquely tailored limitation of liability clause, you can prevent this risk of substantially higher damages than expected. A limitation of liability clause can be used to set a flat damage amount in the event of breach, or it can indicate some other agreed-upon value (perhaps the cost of the services in total – here, $20,000).

Limited liability clauses can be specifically tailored to suit the needs of the contracting parties: flat damage amounts (otherwise known as liquidated damages) can be imposed, damages in the event of delay or other issues of minor breach can be limited, and breaching parties can be forced to indemnify (to pay) the non-breaching party for the costs of litigation.

The Enforceability of Limitation of Liability Clauses

Whether a particular limitation of liability clause will be enforceable depends largely on state law governing the contract, the unique circumstances of the case, and the drafting of the limitation of liability clause itself. Though the intricacies of state enforcement of limitation of liability clauses are not within the scope of this article, you can better ensure that your clause is enforced by drafting your limitation of liability clause according to certain accepted standards.

Clear and unambiguous.
In states where limitation of liability clauses are acceptable, they are generally not enforceable unless the provisions are written clearly and unambiguously such that the contracting parties were truly aware how the clause would affect their right to recover damages.

The clause should clearly specify the circumstances under which it applies. Concise clauses tend to be more readable and more unambiguous, so do make an attempt to write cleanly and in a way that avoids excessive verbosity. The intent of the contracting parties should be expressed in an obvious manner.

Visual prominence.
The courts in some states have occasionally refused to enforce limitation of liability clauses in situations where the language of the clause was not visually prominent enough. It is recommended that you capitalize, bold, or otherwise “highlight” your limitation of liability section to ensure that even a casual scan of the contract would reveal its existence.

Maintain the balance of power between the parties.
As a matter of public policy, many states require that the balance of power between the contracting parties be relatively equal. If one party enjoys a significantly stronger position at the bargaining table, or is significantly more sophisticated, this may count against enforcement of the limitation of liability clause. As a rule, courts typically do not want to enforce provisions where one of the parties was not an equal or knowledgeable partner.

Discussion between the parties.
A limitation of liability clause is not likely to be enforced if a mutual understanding has not been reached. Though this should be resolved through clear and unambiguous drafting, it will certainly help if you discuss the details of the clause with the other contracting parties. Sufficient engagement not only helps to ensure that a mutual understanding has been reached, but may also minimize conflict by opening up communication between the parties.

The provisions of a contract must be interpreted and enforced in accordance with the laws of a particular country and/or state.  Application of different national and state laws can have significant effects on enforceability of the contract.

For example, in the state of California, employee non-compete agreements are generally void.  In the state of New York, on the other hand, employee non-compete agreements can be enforced – in limited circumstances – but are highly dependent on the facts.  Thus, whether a non-compete clause is enforceable may ultimately depend on what law is used to interpret the underlying contract.

In the event of a breach of contract, ambiguity over applicable law and jurisdiction can lead to an extensive preliminary legal dispute that requires additional time, effort, and expense to litigate.  To put it in simpler terms: parties generally want to litigate their contract disputes in accordance with the law that gives them the greatest advantage.  An employer attempting to enforce a non-compete agreement might prefer to apply New York law over California law.  A Florida-headquartered, U.S.-based company receiving shipments from a Chinese company might prefer to apply Florida law in interpreting the shipping contract.

The reality is that many contracting parties will fight tooth-and-nail to secure the legal framework and courts that are most advantageous to their arguments.  If it is in the best interest of a contracting party to invalidate the contract, then it should be assumed that they will make an attempt to apply the laws of a particular state or country that would invalidate the contract.

Fortunately, when drafting a contractual agreement, the preferred law can be chosen by the contracting parties through the insertion of a choice-of-law clause (otherwise known as a governing law clause), thus minimizing the uncertainty and costs associated with choice-of-law disputes.  Most reasonable parties seeking to draft effective contracts therefore negotiate the governing law before later disputes arise.

Choosing an Unambiguous Governing Law

If you are interested in selecting a U.S. state law to serve as the governing law of your contract, it pays to be aware of the limitations.  Primarily, U.S. courts cannot enforce a governing law clause unless there is some reasonable nexus (connection) between the subject matter of the contract and the state law selected to govern the contract.  Whether the court determining the enforceability of your governing law clause will find that there is a reasonable nexus is dependent on the circumstances, and as such is not completely predictable.  The presence of certain factors does improve the possibility that a court will find your governing law provision enforceable, however.

The following factors are likely to favor the enforceability of your governing law clause.  This is a non-exhaustive list.

• The physical residence or presence of one of the parties in the state.
• The manufacture, distribution, or sale of goods takes place in the state.
• Services are rendered, fully or partially, in the state.
• One of the parties does significant other business in the state.
• The state of incorporation of a corporate entity involved in the contract matches the governing state law.
• The contract was signed in the state.

Let’s run through a simplified example to highlight the issue without too much legalese.

Suppose that two parties enter into a contract for services.  One party is offering building renovation services – we’ll call them RenovateCorp – and the other party is a landlord purchasing those renovation services for one of their buildings.  We’ll call him Landlord.  The Landlord is located in California.  RenovateCorp has its physical headquarters in Texas.  The building to be renovated is located in Colorado.

If the contract is governed by either California, Texas, or Colorado law, it is likely to be enforceable.  Each of these states has an obvious and significant connection to one of the parties, or a significant connection to the content of the agreement itself (i.e. the renovation of the building).

What if the contract is governed by some other state law, however?  Finding a reasonable connection between the governing law and one of the parties (or the content of the agreement) becomes more difficult, but is not necessarily impossible.  If RenovateCorp has a regional office in New York, for example, that might serve as a reasonable connection to the application of New York governing law.  This connection might be strengthened if it could be shown that some of the design-work for the building’s renovation was conducted at the New York regional office.  If RenovateCorp was incorporated in New York, that would further strengthen the governing law claim.

We finally arrive at a general rule: you should choose a governing law that is directly related to the parties or the content of the agreement itself.  If you do not, make sure that there are substantial enough connections between the governing law and one of the parties (or the content of the agreement).  Otherwise, you may find that the governing law clause is unenforceable.

Selecting the Applicable Jurisdiction

When drafting a governing law clause into your contract, do not ignore the jurisdiction clause.

A governing law clause indicates what state and/or national law you would like to apply to your contract.

A jurisdiction clause indicates which courts you would like to apply the governing law.  It controls the venue in which your legal dispute will be heard.

This difference may seem confusing at first.  Many laypeople assume that a state or federal court can only apply its own law.  In reality, however, state courts can apply the laws of other states.  A California court can interpret and apply Texas law, for example.  A New York court can interpret and apply Florida law.  In certain circumstances, courts can even interpret and apply the laws of other countries.

Ambiguity over jurisdiction can lead to additional disputes and litigation, so – just like governing law – it is best negotiated while drafting the contract.  Jurisdictional choice might seem minor at first, but there are several reasons for negotiating jurisdiction: convenience, familiarity, bias (it is generally accepted that a party in its home state will enjoy a minor advantage against an out-of-state party), and cost.

Exclusive vs. Non-Exclusive Jurisdiction

When drafting your jurisdiction clause, you can make jurisdiction exclusive or non-exclusive.  Exclusive jurisdiction limits litigation to the specified venue.  Non-exclusive jurisdiction does not limit litigation, but simply allows for litigation at a particular venue.

Let’s compare.

Suppose that a contract is drafted to indicate New York governing law, and non-exclusive jurisdiction.  The parties are from California and New York.  As jurisdiction is non-exclusive, a lawsuit can be filed in both California and New York courts.  If jurisdiction were exclusive to New York, however, then a lawsuit could not be filed in California or any other state besides New York.

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Governing law and jurisdictional ambiguity in your contract can lead to extensive, costly litigation.  Knowledgeable parties draft governing law and jurisdiction clauses to avoid issues down the line.