Limits of Liability Don’t Work for Indemnities

This post has been superseded by a more recent (and more nuanced) article. See, “Your limit of liability might not work on your indemnity.”

Contracting parties often debate whether the limit of liability should apply to indemnities. But few notice the problem. Even if the contract specifically says the limit applies to an indemnity … it doesn’t. The indemnity obligation remains unlimited. I’m serious.

heart attack from surprise application of an indemnity
The indemnitor could be in for an unpleasant surprise.

An Indemnity Is Just Another Obligation to Perform (in IT Contracts)

Contrary to common belief, the typical IT contract indemnity is not a punishment or a remedy for wrongdoing. The indemnitor promises to defend certain types of lawsuits against the other party (indemnified claims) and to pay settlements and/or judgments. That’s an obligation to perform under the contract. And limit of liability terms restrict liability for breach — for damages — not obligations to perform.

Imagine a third party sues a software customer for IP infringement related to the provider/indemnitor’s software. Fortunately for the customer, the contract has a typical IP indemnity: “Provider shall indemnify Customer against any third party claim arising out of or alleging IP infringement resulting from Customer’s authorized use of the Software.” Imagine also that the third party’s claim is no good: the software does not infringe. So the provider/indemnitor did nothing “wrong.” But the indemnity applies whether the claim is good or not. The provider/indemnitor defends the case and pays any settlements or judgments, despite its “innocence.”

Since the indemnitor performs whether or not it’s “guilty,” the indemnity obviously is not a form of damages or liability for wrongdoing. And limits of liability address damages: liability. (This gets more complicated with data indemnities and some others, and this post can’t go into the subtleties. But even in those cases, the indemnitor defends the case whether it did anything wrong or not.)

Limits of Liability Restrict Damages, Not Performance

indemnity warningThe typical limit of liability says something like, “Provider will not be liable for: (a) any amount in excess of $X; or (b) consequential, special, incidental, or punitive damages.” That limits the damages a court might award against that party, not its obligation to perform.

Imagine the provider agrees to develop software — in a contract with a $50K limit of liability. Does the $50K figure limit the money the provider has to spend on staff and other software development resources? Of course not. It limits the provider’s liability if it breaches its software development obligations (or other contract terms).

Just as a limit of liability would not restrict an obligation to develop software — or any other obligation to perform — it does not restrict obligations to perform an indemnity. The indemnitor must spend whatever is necessary to defend the indemnified claim, to settle the case, and/or to cover judgments.

To Benefit from a Limit of Liability, You Have to Breach

That doesn’t mean the limit of liability does the indemnitor no good. It can take advantage of the limit, but only if it breaches the contract. If it refuses its indemnity obligations, the limit of liability restricts the other party’s damages for that breach.

That fact has a troubling implication for the indemnitor: money spent on the indemnified claim does not count toward the limit of liability. Imagine the indemnitor spends $50K defending an indemnified claim and then breaches, refusing further defense. In a contract with a $50K limit of liability, the indemnitor could owe another $50K in damages — for a total of $100K. If the indemnitor really wants to spend no more than the limit of liability amount, it has to breach before it starts spending on the indemnity.

Limit on Indemnity Performance Obligations (Instead of on Liability)

Indemnitors can fix this with a different clause: a limit on indemnity performance obligations. “Indemnitor is not required to spend more than $X pursuant to Section __ (Indemnity), including without limitation on attorneys’ fees, court costs, settlements, judgements, and reimbursement of costs.” That clause restricts the indemnitor’s obligation to perform, not its liability for breach. It does the trick.

In most cases, you’d use the clause above in a contract that also has a typical limit of liability, probably with terms saying the latter does not apply to the indemnity. (With indemnity performance obligations limited, you have less reason to limit liability for breaching the indemnity.)

A couple caveats …

This all assumes a typical IT contract indemnity. IT indemnities usually just protect against third party claims (indemnified claims). Other types of contracts make broader use of the indemnity clause, protecting the indemnified party against all sorts of other losses. That sort of indemnity arguably does address liability, so a limit of liability is more likely to apply.

Also, this post addresses the clear implications of IT contract indemnity and limit of liability terms, as they’re usually written. But thanks to the confusion surrounding indemnities, it’s hard to predict what a given court will do with a limit on indemnity liability. If you’re the indemnitor, though, why risk it? Use the limit on indemnity performance obligations suggested above, in red.

© 2020 by Tech Contracts Academy, LLC. All rights reserved.

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