Risk Considerations in Commercial Contracts with Customers
A company will want to have terms that are consistent with market norms for the relevant industry and are “sellable” to customers, but are protective of the company’s interests and go-to-market strategy. Having balanced terms can reduce negotiation time and energy, allowing the company to get customers and close sales more quickly.
This article focuses on three key areas of risk that need to be considered in offering services and products—warranties, indemnities, and liabilities.
Customers will want to know what happens if the service or product does not function as intended. This relatively simple expectation raises a number of questions, most importantly what actually is being promised. This promise often takes the form of a warranty, which is a statement as to the quality, characteristics, and performance of the product or service being sold.
Warranties are often limited in a number of ways, for example, limited to a defined set of specifications or a particular duration. A company will want to be precise in defining what it is committing and for how long, and by implication or by exclusion, what it is not committing.
Some warranties, however, are given by operation of law. Warranties of merchantability and fitness may be implied. Accordingly, to the extent permissible under applicable law, sellers of products and services will generally try to disclaim all warranties other than those expressly stated in the contract.
A company also needs to consider what obligations it will have and what remedies the customer will have if the warranty is not met. Is the obligation to provide a replacement product or re-perform the service? Can the customer terminate the contract (and what impact will that have on the commercial terms)? The obligations and remedies also typically get defined in the contract.
Depending on the nature of the product or service, customers may be concerned about certain types of losses or liabilities. Customers will often expect various indemnities, which are undertakings to protect against potential liabilities. For example, if the customer is subject to a claim that its use of the product or service provided infringes the intellectual property rights of a third party, the customer will want to be protected against such a claim. The customer may also expect that the seller have the obligation and cost of defending such a claim, even if the infringement is only alleged.A company should carefully consider the types of losses and liabilities it is willing to indemnify its customers against. Broad indemnities can impose untold obligations and risks, which are difficult to predict, let alone manage. However, well-constructed indemnities for certain manageable risks can give customers assurance against potential liabilities.
Limitation of Liability
In entering into any one contract with a customer, it is rarely, if ever the case, that a seller is willing to “bet the company.” Put differently, a company will look to balance the risk of a contract with its reward. This risk-reward analysis takes the form of a limitation of liability. It is common practice to cap liability to a level commensurate with the fees to be earned under the contract, and for a long-term contract, the fees earned over a certain period.
Of course, for every rule, there are exceptions. And limitations of liability will sometimes have some exceptions or enhanced limitations for areas of higher risk. For example, certain indemnification obligations may be not be limited. Given the sensitivities regarding personal data privacy, a company may be expected to accept higher risk for breaches of the relevant data privacy and security obligations, if there is significant or sensitive personal data involved.There are, of course, many other issues that a company will need to consider in assessing the risk profile of its commercial contracts with customers. Warranties, indemnities, and liabilities are key areas of risk, and the contract language used to set boundaries on each is a critical part of risk mitigation and go-to- market strategy.
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