Until now my posts have been attempts to provide erudite elucidation of some of the finer points of the law for general consumption and enjoyment.

Today, I get on my soapbox.

There is a particular point of negotiation in standard commercial contracts where the accepted wisdom does not seem to make sense.

I am posting this with the hope that maybe it will get forwarded to someone who would like to do a better job of defending the accepted wisdom in a manner other than the following lame arguments that I usually hear:

• This is our “corporate policy” and we can’t change it (translation – we have more negotiating leverage than you and we know it, so kindly bend over)
• This is the way it has always been done
• “Everyone does it this way” (i.e. the lemming excuse)

Here is the issue:

I am wondering if there is anyone out there who would like to take a shot at defending the practice of including language that allows for an exception to a limit on consequential damages when it comes to a claim for indemnification.

That’s it in a nutshell.

Pretty wonky, no?

And now, for the background…

Most commercial contracts contain a clause limiting the potential liability of one or both parties if something goes wrong.

The most typical of these clauses limits what are called indirect or consequential damages.

Over the years, many courts have allowed lawyers for plaintiffs to argue for and win damages on using theories that are increasingly speculative in nature. They have nothing to do with the actual damage that was done. They have more to do with theoretical losses that could be claimed to have occurred as a result of the actual damage. Courts have also ordered the losing side in a commercial lawsuit to pay “punitive damages” which is exactly what it sounds like. It has nothing to do with the actual damage caused. It is meant to be a punishment to deter future wrongdoing.

Companies don’t want to be exposed to this kind of risk when they enter into standard commercial contracts. So they insert language whereby both sides agree that whatever goes wrong, the wrongdoer won’t be liable for any indirect damages — only actual damages.

So far, so good.

There are a couple of exceptions to this limit on damages – bad behavior that is so egregious that the party who did it does not deserve to be protected from unlimited liability.

The two most common exceptions are as follows:

• A breach of the confidentiality clause — a party goes and deliberately discloses the other party’s secret information or uses it in a damaging way.
• A breach of the intellectual property protection clause – a party steals or misappropriates the other party’s intellectual property in a damaging way.

When that happens, the party that misbehaved does not deserve the protection from indirect or consequential damages that applies to other breaches such as failure to pay or failure to achieve deliverables on time. Throw the book at them. They should pay for every conceivable harm done as a result of this behavior. Not only actual damages, but also lost profits, pain and suffering, loss of consortium, punitive damages, you name it.

But then we come to a third exception that does not make as much sense.

First, some background.

Most commercial contracts contain an indemnification clause. This requires a party that does something wrong to “defend, indemnify and hold harmless” the other party for its wrongdoing.

This means not only paying for actual damages suffered by the other party for what you did wrong, but also, for example, hiring lawyers to defend the other party if they get sued by someone else as a result of the wrong that was done.

So now we are in a world where the exposure for something that goes wrong is extended to not only the other party to the contract but third parties who claim to have been damaged by the other party because of what you did wrong.

The question that comes up when negotiating limits on damages is whether, just like we have an exception that allows unlimited damages when there is a breach of confidentiality or intellectual property protection clauses, so too there should be an exception that allows unlimited damages in connection with a claim for indemnification.

Almost every contract template generated by very large companies that have very large in house attorney staff contains an exception to the limit on consequential damages when it comes to a claim of indemnification.

I have yet to hear a satisfactory justification for it.

Let’s review.

Generally, parties want their exposure for damages to be limited to real, actual financial harm suffered by the other party when they do something wrong. If a party does not pay on time, the other party can sue for the actual amount owed, and perhaps interest and the cost to collect the overdue payment. The party owed the money cannot sue for lost profits, punitive damages and other speculative damages. That is the point of the limitation.

And generally, we allow an exception to the limit on damages when the damaging party acted egregiously such as disclosing confidential information or stealing intellectual property.

So how did a claim for indemnification manage to slip into the list of exceptions for which a party is exposed to unlimited liability? On what basis?

Think about it. It is the exception that completely swallows the rule!

If you agree that I should not be exposed to unlimited damages when I harm you directly, why should my exposure be unlimited simply because someone else’s lawyer is suing you claiming the same ridiculous indirect damages that you yourself agreed I should not have to pay to you in the first place?

In fact, logic justifies the opposite conclusion. If I am not liable to you directly for damages other than actual damages when I behave in a certain way, then surely I should not be liable indirectly for those same type of speculative damages when they are claimed by someone else against you based on the same behavior.

When I make the argument that allowing unlimited liability in the context of an indemnification claim is the exception that swallows the rule, otherwise rational and cogent lawyers required to defend this language don’t seem to have a good counterargument.

So, to get back to my original question…..

I am wondering if there is anyone out there who would like to take a shot at defending the practice of including language that allows for an exception to a limit on consequential damages when it comes to a claim for indemnification.

And if you are still following me, let’s take it a step further.

The language is even harder to justify when the indemnification clause is not limited to third party claims against the indemnified party — because in that case you can’t even claim to be at the mercy of someone else’s lawsuit!

And if you are still following me….

If you are going to insist on jamming this exception down my throat, then at least be smart enough not to make the language mutual and accept the same illogical exception for your own side as well!

End of rant.

We now return to our regularly scheduled programming.

The post Warning – For Wonky Lawyers Only – A Lone Voice Rails Against The Indemnity Exception To The Indirect Damages Cap first appeared on Schwell Wimpfheimer & Associates LLP.

In a world where lawyers are often touted and rated and ranked and liked for the size of the verdict or the dollar value of the contract, what often gets overlooked is the flip side. Namely, avoiding unnecessary risk. Here is a recent example.

I was contacted by an author that had successfully self-published a book and had been approached by a publisher in connection with the sequel.

Here was a potential break-through. The chance to have someone else take over the headache of printing, publishing, marketing, distributing, and selling this author’s next great work just in time for the holiday season.

Naturally the client was excited. Unfortunately, the contracts offered by the publisher were poorly written and one-sided.It wasn’t just that the financial deal points were below expectations.

Even if the money had been right, the most important non-monetary clauses did not allocate commercial risk fairly between the parties the publisher was trying to get all of the financial reward and leave the author with all of the risk.

I felt bad having to burst my client’s bubble, but I did not want her signing a bad deal.
Together, we made suggested changes that would have been acceptable if the publisher had agreed.
The publisher did not, and the deal did not proceed.

I was gratified a few weeks later when the client asked a common acquaintance to let me know that “you saved me from something really bad.”

She found another alternative to get the book published, by the way, and is in the process of arranging a tour to back it up.
Achieving the upside will always be sexier.
But avoiding the downside is no less important.

The post You Saved Me from a Really Bad Deal first appeared on Schwell Wimpfheimer & Associates LLP.

It all started innocently enough.

Our client, the seller, manufactures certain products abroad and sells them in the U.S. and elsewhere.

His customer, a large U.S. distributor of the product, had already successfully placed six orders without incident. A typical high-tech transaction — order placed by email, invoice generated by email, payment wired, and products shipped. So far, so good.

Then came the fateful seventh order.

When payment did not show up on time after our client shipped the products, the upset seller called the customer and the call went something like this:

SELLER: Where’s our money?
CUSTOMER: We paid!
SELLER: No you didn’t!
CUSTOMER: Yes we did! I have proof of funds wired.
SELLER: And my bank says we have nothing from you.
CUSTOMER: Well the money is gone from my bank, that’s for sure. And I sent it directly to your account in Singapore exactly as specified on your invoice.
SELLER: Singapore?! We don’t have any bank accounts in Singapore!

Long, uncomfortable silence.

Turns out that an impostor managed to hack into the seller’s account and obtain enough information about the customer to be able to send an email to the seller pretending to be the customer.

In the email exchange between the impostor and the seller, the impostor was able to coax enough deal specific information out of the seller to be able to then turn around and contact the customer pretending to be the seller.

Whereupon the impostor, posing as the seller, asked the customer to wire the payment for the seventh order to an account in Singapore.

The impostor’s account, of course. Not the seller’s.

And the customer, thinking that no one but the seller could have sent such a detailed invoice, paid it.

At which point the lawyers were brought into the picture.

In retrospect, a little more diligence on the part of both parties could have prevented the fraud.

1. The sales person for the customer was named Brian. But when the impostor first emailed the seller, his return email address misspelled the name as Brain rather than Brian.
2. The customer always communicated using the url of the company which contained the customer’s name, like this: brian@customername.com; whereas, the first email from the impostor was sent from Yahoo, like this: brain@yahoo.com
3. Every email from the seller to the customer had a unique signature block at the bottom including pictures of the seller’s line of products. There was no such signature block at the bottom of any of the emails from the impostor to the customer. Just the name of the CEO of the seller without anything else.
4. And, of course, each of the prior six invoices sent by the seller to the customer requested payment to a single bank account in a country nowhere near Singapore either geographically or culturally. After six straight invoices to only one account, a seventh invoice suddenly asking for payment to a completely different account in a completely different country should have set off an alarm.

Fortunately, we were able to negotiate a mutually satisfactory settlement that set the relationship back on course and involved mutual cooperation with the appropriate investigative authorities to try and catch the impostor, settlement of the disputed sum, and even two new orders.

Both our client and the customer learned some valuable lessons about doing business via email and how to avoid fraud in the future.

This case study highlights the need for due diligence even with existing business relationships.

The post Case Study: The Seventh Order – A True Story Of Fraud And What Could Have Been Done To Prevent It first appeared on Schwell Wimpfheimer & Associates LLP.

Congratulations! You are married.

But what if you woke up one morning and found someone other than your spouse at the breakfast table?

“Who are you?”

“Hi. I am your new spouse. I hope you don’t mind. Your old one decided to move on and appointed me to take over. But don’t worry. I will fulfill all of your former spouse’s marital responsibilities faithfully. And, of course, I am entitled to all of your former spouse’s benefits. We have an appointment with the bank later today to formalize our new joint account. But enough small talk. What’s for breakfast?”

******

While that scenario is a bit unusual for domestic partners, when it comes to commercial partners — especially commercial partners who are just entering into a business relationship together — there is often a legitimate concern by one — or both — that they avoid waking up one morning to find out that they are in business with someone else.

So how do commercial partners make sure that the party they thought they were going to be doing business with when they signed their contract remains their partner throughout the life of the agreement?

They include in the contract a non-assignment clause.

The basic idea is simple — we entered into this contract because of who you are and what you bring to the table. We don’t want to wake up one morning and find ourselves in business with anyone else but you. Therefore, you are not allowed to transfer your rights or obligations under this contract to anyone else without our consent. If you do, this contract is over and you may have to pay damages as well.

This is simple in concept but watch what happens when the lawyers try to say it. It comes out like this:

“This Agreement and all rights and duties hereunder are personal to Party B and shall not, without the written consent of Party A, be assigned, mortgaged, or otherwise encumbered by Party B or by operation of law.  For purposes of this Agreement, the term “assignment” shall, in addition to the transfer of this Agreement or the rights or obligations thereunder, whether voluntarily, involuntarily, by operation of law, or otherwise, be deemed to include (i) a sale or other transfer by Party B of all or substantially all of its assets; (ii) the merger, amalgamation, consolidation, or reorganization of Party B into or with another corporation or other entity as a result of which Party B is not the surviving corporation; or (iii) any transaction (including any of the foregoing transactions, as well as any in which Party B is the surviving corporation) which, whether by way of sale, gift, or other transfer, whether involving Party B or the record or beneficial owners of equity interests in Party B, results in the transfer of more than twenty percent (20%)  of the voting control of Party B to a party or parties not a principal of Party B at the time of execution of this Agreement.”

Whew!

Here are some things to look for when you finally get to the end of the contract where the non-assignment clause is usually hiding.

1. Is it mutual or one-way only? Very often a contract that calls itself a “mutual” agreement and starts out talking about both parties doing this or that will suddenly change tone in the assignment clause and become one-sided, as follows: Party A can assign to anyone it wants. Party B cannot assign to anyone without Party A’s permission. Watch out for this.

2. Corporate reorganization. Businesses are often organized into parent and subsidiary companies or separate companies with a common owner. Sometimes for business or tax reasons it is a good idea to reorganize the internal corporate structure of a business. Before that happens, you need to check the assignment clause of each contract between any of the companies that is being “reorganized” to make sure that what you are doing is not a breach of that contract. Better yet, when you are negotiating the contract in the first place, try to make sure that you are free to internally organize your business without having to ask permission of any other commercial partner. As long as the reorganization does not result in a different owner or management team, then, in theory, the other side should not care. They are still effectively doing business with the same partner. But some companies can get awfully nitpicky about it.

3. Change of control. One step removed from corporate reorganization is a change of control. Whereas it might be true that the outward looking interface between the company and its customers, vendors and commercial partners has not changed, on the inside there is suddenly a new owner of the business. Many companies are understandably nervous about a change in ownership of their commercial partners and so they make sure to include language that will not allow it to happen without their consent. If you are a company that is getting into business with another party specifically because of who owns or controls the business, make sure you include this language to protect you.

4. You mean I can’t even sub-contract or sub-license? Well, that depends on what your contract language says. While in theory the job of a non-assignment clause is to prevent you from turning the entire contract over to someone else and moving on, in practice the language will sometimes prevent you from even contracting out part of the job. If you rely heavily on sub-contractors or if your business involves sub-licenses, make sure that the non-assignment clause does not technically trip you up.

5. Can I get rid of it altogether? One of the most aggravating experiences for a start-up company that has succeeded and is now on the verge of selling out (or going public) is not being able to close the deal until they get permission from every commercial party with whom they signed a contract containing a restrictive non-assignment clause. This can be a frustrating and time consuming process. If only we had thought of this when we were drafting all of those contracts! Well, you can. You can try for something as simple as this in all of your commercial contracts:

Party B may assign this Agreement and its rights and obligations hereunder in connection with a corporate reorganization, merger or combination, or a sale of all or substantially all of the equity or assets of Party B.

But be careful when the other side says yes, and then the contract comes back looking like this:

Party B may assign this Agreement and its rights and obligations hereunder in connection with a corporate reorganization, merger or combination, or a sale of all or substantially all of the equity or assets of Party B; provided, however, that Party B agrees to remain secondarily liable for the performance of its assignee.

Now you are still on the hook! And, worse, you no longer are in control of what happens. This is not where you want to end up when you are looking to make your big exit.

6. Don’t be too nice. Even the most accommodating partners need to set certain limits when it comes to letting the other party assign the contract. For example, under no circumstances should the other party be allowed to assign to a competitor of yours. Or, let’s say you are doing business with the government — the other party should not be allowed to assign to anyone that would cause you to be in breach of specific government regulations such as origin of product or exporting of technology restrictions.

As always, an experienced commercial attorney will be able to recognize the advantages and disadvantages for both parties of an agreement limiting assignability.

The post “Change your partner?” Beware of Non-Assignment Clauses in Commercial Contracts first appeared on Schwell Wimpfheimer & Associates LLP.