Managing Legal Risks Through Contracts

Success in business involves both taking risks and managing risks. The successful entrepreneur takes financial risks towards a greater return, but must also manage legal risks that go hand in hand with conducting business. Fortunately, there are legal mechanisms that help manage or limit some of the legal risks so you can ultimately focus on those financial risks that are necessary for success.

Two contractual terms that help manage some legal risks are limitation-of-liability clauses and liquidated damages clauses. Both show up in contracts, and their consequences and protections should be considered before signing.

Limitation-of-liability clauses are often utilized in service contracts to limit the exposure of the performing party should something go wrong. Ohio courts have enforced such clauses under freedom of contract policies. In other words, as long as the two sides understand and freely agree to the limitation of liability, then the clause is enforceable. The typical clause limits the recovery of damages to the cost of services being performed.

For example, if you charge $5,000 for your services under the contract, and the contracting party alleges it was damaged in an amount greater than $5,000, the contract would limit recovery to the $5,000 cost of services performed. These clauses clearly protect the service provider and should be strongly considered by the contracting party if there is a risk of damages that far exceed the cost of the services.

Liquidated damages clauses play a different role in contracts, as they attempt to fix the amount of damages that would be available should a breach of contract occur. Courts have looked closely at such clauses and consider:

  • whether the actual damages are uncertain and difficult to prove.
  • whether the amount of damages constitutes a penalty as opposed to compensation for a loss.
  • whether the parties freely agreed to the fixed amount of damages.

These clauses, when used correctly, can provide some semblance of certainty and allow both sides of the contract to better assess and manage the risks of proceeding with the business relationship.

Some of the pitfalls to be aware of regarding the enforceability of these clauses are the standard arguments against contracts in general. The courts will look at the bargaining power of the two sides, including age, education, intelligence, business acumen and experience.

The courts will also consider who drafted the contract, was there an opportunity to seek legal advice, or any undue pressure to sign the contract?

Finally, courts will look at how the clauses are portrayed in the contract. Are they buried in lengthy paragraphs with small font, as opposed to a separate paragraph clearly indicating their intent?

These contractual tools are particularly important in the event of a worst-case scenario. The liquidated damages clause allows for some certainty in a worst-case scenario by better defining what potential damages may be incurred. The limitation of liability clause provides certainty for the service provider in limiting their exposure for potential bad outcomes. In either case, they can help manage the legal risks of conducting business in the world today.

Barnes & Thornburg LLP is a large, full-service law firm that seeks to take a more entrepreneurial and cost-effective approach both to client service and its own business.