My last article pointed out a situation where parties conflate contractual indemnity and damages clauses.  The standard language in Dunce’s Caps’ contract provided for an indemnification of “any and all losses arising from any breach of any representation or warranty in the agreement” and capped those losses at the price of the order. When Dunce’s failed to deliver the promised 100,000 hats, Flat Backs filed an arbitration action seeking recovery of an alleged $4 million in damages, even though the purchase order price was only $500,000. Ignoring Dunce’s damages cap argument, the arbitrator Terry B.L. Judge awarded Flat Backs the full $4 million. Arguing that Judge was not permitted to award Flat Backs more than $500,000, Dunce’s appealed to the state court seeking to overturn the arbitration award because Judge exceeded his jurisdictional limits. Did Dunce’s contractual indemnification provision operate as a cap on the damages that Flat Backs could recover for Dunce’s breach of contract?

No. In short, Dunce’s contractual provision was an indemnification clause. It only provides that Dunce’s will reimburse Flat Backs, up to the capped amount, for successful claims of third parties against Flat Backs. It does not limit Dunce’s contractual liability to Flat Backs. If Dunce’s wished to cap its contractual exposure to Flat Backs, then Dunce’s contractual limitation of liability language must be clear, unambiguous, unmistakable and conspicuous. Dunce’s was not.

What is an indemnification clause?

An indemnity clause benefits Party B from the possible claims of Party C. One of the parties to a contract (Party A) agrees to compensate the other party to the contract (Party B) for losses that Party B incurs due to claims successfully brought by third parties (Party C).  Because Party A and Party B are free to negotiate the scope of an indemnity, these clauses come in many different shapes and sizes.  One important distinction about indemnification clauses is that they may give rise to liability under a contract without the indemnitor (Party A) actually breaching the contract.

For example, some indemnification clauses limit the indemnitor’s liability (Party A) to the amount recovered by a third party (Party C) – whether by settlement or judgment.  Other common indemnification clauses limit the Party A indemnitor’s liability to reimbursement of the amount actually recovered by Party C from Party B, which can also include the expenses, attorney’s fees and other costs borne by Party C in its litigation.

What is a limitation on liability clause?

A limitation on liability clause is where both Party A and Party B enter into a contract agreeing that any recoverable damages are capped at a specified amount if the contract is breached. In this case, Dunce’s (Party A) argues that the indemnification language in his contract with Flat Backs (Party B) limits his liability even when Dunce’s breaches his performance of the contract. For the language upon which Dunce’s relies to be a limitation on his liability in this situation, the language must be clear, unambiguous, unmistakable and conspicuous – such as “losses, costs and damages arising from any common law or statutory theory of recovery, or reimbursement of expenses, shall not exceed $500,000.”

Because the law recognizes the parties’ freedom to contract as they wish, most limitation on liability clauses are valid.  There are a few exceptions, particularly where the parties have unequal bargaining power.

Tilting the Scales in Your Favor

It is important to understand the scope of an indemnification clause, particularly where one of the parties to a contract wants a cap on liability. In that instance, the party needs to include limitation on liability clauses in the indemnity provision, and also in a separate provision in the contract spelling out the limit on liability if that party breaches the contract. If both clauses are not in the contract, the party has not fully limited its potential exposure.