Thursday, June 27, 2013

The Tech Contracts Handbook: What You Need to Know about Indemnification and Limitation of Liability in Software Agreements

I recently received my copy of The Tech Contracts Handbook by David W. Tollen and I have to tell you, - I am grateful to have it. The book immediately proved useful, - I was just in the process of revising a master services agreement and looked up the book’s sections on limitations of liability and indemnification exclusions. Below are some highlights.

It is helpful to understand the rationale behind the limitations of liability because at first glance they may appear to be unjustified. After all, why would you agree to limit liability for defective software if you lost millions of dollars as a result of its defects? As Mr. Tollen explains, it is all about scalability. According to him, a $5,000-dollar software may be used to design and operate a much more expensive product (like a multi-billion dollar asset portfolio), and if the software provider were to be held liable for all potential damages on every $5,000 sale, it would not be in business. A single malfunction would bankrupt the entire software company. In fact, there would be no software companies around since such exposure to liability would render this business unprofitable. So, limitations of liability are common in IT contracts. There are two typical limitations: dollar caps and exclusions of consequential damages. Mostly, you will find both. A dollar cap is an arbitrary number (it can be, for example, $5 or $5,000 or the amount of annual license fees the amount payable in the most recent three-month period). This is definitely up for negotiation (unless of course you are dealing with a clickwrap or a shrinkwrap agreement). Exclusion of consequential damages is very standard. Here, the focus is on limiting the type of liability, not the amount, but both clauses overlap. Consequential damages include all damages other than direct costs and can include special, incidental, punitive damages, damages to the reputation, loss of time and business opportunities, etc. Mr. Tollen also includes certain “magic” language that should be part of the liability limitation clause to ensure its enforceability.

However, the limitation of liability in an IT contract has its limits: the parties typically agree that it does not apply to certain sections of the contract, such as indemnification (discussed below). Negotiating these limits can get quite heated. For example, providers of IT services would want limitation of liability to apply to the indemnification clauses as well, whereas the company that is receiving the IT services from the provider would want to ensure that indemnification is excluded, especially when it comes to the obligation to indemnify for IP infringement claims that can cost millions of dollars. The bottom line is: it can get complicated, so there are clear advantages to being represented by an experienced attorney who can competently negotiate this for you.

Mr. Tollen breaks down the hard to follow and dense indemnification section so well that it starts making sense even for non-lawyers. It is actually quite simple: the provider of IT services and/or software promises to protect the client from lawsuits or claims by third parties. The negotiation then centers around what kind of claims should be covered. Claims related to IP infringement (claims saying that provider’s software infringes on someone else’s patent or copyright) most definitely will get covered since they present the biggest risk in IT contracts. Sometimes, the indemnified claims also include personal injury or injury to property (if the provider compromises someone’s data or sexually harasses someone). It is also possible for the provider to get indemnification from the client. Importantly, indemnification by the provider should contain restrictions that say that the provider is off the hook if the claim arose as a result of the client’s violation of the agreement, revisions to the software made without the provider’s consent, or client’s failure to install updates, among others.

The book goes on and on, deciphering for us the complicated IT contracts. The easy to understand language of the book makes it accessible to lawyers and non-lawyers alike. To use a legal term, the book is written in “plain English”. Mr. Tollen also provides access to multiple contract models found on his website, What else would you need?? Go, buy the book and get on with the drafting and negotiation of IT contracts.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.

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