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.
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
The 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.
Thank you to Pixabay.com for great, free stock images!
Thank you for these great points. I have two questions:
i) will the liability arising out of breaching indemnity obligation be subject to limits of liability?
ii) if the indemnity obligation is intentionally breached (hard to imagine a negligent case) , will limits of liability apply?
J.J., sorry for the slow reply! Answers below …
i) Yes, liability arising out of breaching the indemnity obligation should be subject to the limit of liability (LoL). That is the only role the LoL plays in indemnities, at least if interpreted according to plain language.
ii) Good question re intentional breach. I suspect the answer is “yes,” since intentional breach isn’t the same as intentional harm, but the answer may depend on the state.
Hi David, thanks for the interesting article. Is there any US case law supporting your conclusion here–i.e., instances where a US court has held that a cap on damages in a contract’s limitation of liability provision (where the contract does not carve out indemnity obligations from the cap) does not apply to indemnity obligations because such obligations are performance obligations rather than liabilities?
Also, if such indemnity obligations can’t be capped with the typical cap-on-damages language, why are indemnity obligations almost always explicitly carved out of such caps? General misunderstanding by the drafters?
Thanks again–your books have been a great resource!
Jordan
Jordan, those are excellent questions (and you’re not the first to ask about caselaw). No, we couldn’t find caselaw — and two experts I asked didn’t know of any. On-point caselaw may be out there, but further search could also reveal widely varying answers in 51 jurisdictions, including in cases addressing the question without direct analysis, in dictum, etc.
I don’t offer my views as guidance for what should happen in litigation. Rather, they’re offered to avoid litigation. So while a given court might limit indemnity obligations through a limit of liability clause (LoL), a contract-drafter shouldn’t take the risk. It’s easy enough to add a clear and specific limit on indemnity spending obligations, to avoid the risk altogether.
In answer to your other question, I think there are two reasons people carve indemnity obligations out of LoLs. First, I’m not arguing the LoL has NO impact on indemnity. It certainly should limit liability for BREACH of the indemnity obligation. So it makes sense to carve indemnity out if you want that liability to be unlimited. If the LoL applied, the indemnitor could escape — cheap — by breaching the obligation. Second, I suspect very few contract drafters have thought through this issue. So they’re carving the indemnity out of the LoL because they haven’t asked themselves if the latter applies to the former.
I suggest reading the language of your indemnity clause and thinking about what it says. Does it mention “damages” or “liability”: the issues addressed by LoLs? Does it mention damages or liability to the contract’s other party, as opposed those owed a third party plaintiff, not subject to the contract? I suspect the answer to both is “no.” Of course, you could argue that the word “indemnify” automatically addresses damages and liability, even if it doesn’t use those words. But is there any reason to risk an adverse judgment on that point, in advance, if you don’t have to? Also, if you adopt the IBM strategy — if you replace “indemnify” with “defend and pay judgments” — you don’t even have “indemnify” to fall back on. Once again, if you’re drafting a contract on behalf of the indemnitor, why take the risk?
I should make a final point. I think it would be far-fetched to say that a lawyer who fails to address this issue has committed malpractice. I can’t find anyone worried about this except a couple experts — and me. So I suspect that in most cases, failing to detect the issue would NOT fall below the standard of care common to the profession. And the fact that I didn’t find caselaw directly on point reinforces that conclusion.
Very interesting perspective David, thanks for sharing. Wondering how your opinion might be impacted by what I see very often when the customer provides the indemnity language, which universally brings in responsibility to indemnify for the customer’s damages in addition to the third-party’s damages (via settlement or judgement). I frequently see, “Supplier shall defend, indemnify, and hold harmless Customer of and from any losses, costs, expenses, damages, claims, etc. etc. etc.” I always correct this positioning to mirror your language above, which focuses on the third-party’s claim. But otherwise, would any damages (which Godforbid could include lost revenues and other consequentials), losses and costs incurred by the Customer be charged against the LOL cap? I would think so. It seems to me that more important than LOL being predicated on a “breach”, the more pertinent issue is whether there are monetary, compensatory funds going from the supplier to the customer.
Harry, that’s a great question — and it gets to the heart of the confusion about indemnities. Are they about performance or liability? I think you’re right; I think an indemnity against all losses, expenses, etc. is more likely to be considered damages and so subject to the LoL. I can imagine a court dividing the indemnity in two and saying (1) the indemnity against third party claims is a performance obligaiton and so not limited by the LoL. But (2) the LoL does govern the rest of the indemnity. However, this involves some speculatoin, and I don’t have any caselaw to offer offhand (absent some research). The answer may vary between jurisdictions. (It’s also possible — heaven forbid — that some jurisdiction’s court won’t know either, thanks to a lack of controlling caselaw. The last thing contract-drafters want is to blaze new trails litigating questions of first impression!)
In any case, when you represent the indmenitor, I think it’s fair to resist an indemnity that goes beyond 3rd party claims — on the grounds that none of your competitors does it. That could easily be true if you’re in IT.