Indemnity architecture: reading a liability cap as a system

Commercial negotiation tends to treat the liability provisions of a contract as three separate arguments: how large the cap should be, which heads of loss are excluded, and what the indemnities cover. The counterparty who reads the three together generally has the better of the bargain.

The interaction problem

A cap of one year's fees is meaningful only if the carve-outs from the cap are narrow. Where confidentiality breach, data protection liability, IP infringement and indemnity claims are each carved out, the cap governs almost nothing that is likely to happen.

Conversely, an uncapped indemnity for third-party IP claims may be entirely acceptable where the supplier controls the IP chain and unacceptable where it integrates third-party components it has not diligenced.

A workable sequence

• Identify the two or three loss events that are genuinely plausible for this contract.

• Trace each event through the indemnity, the exclusions, and the cap, in that order.

• Ask what the aggregate recoverable amount is for each event. That number, not the headline cap, is the commercial position.

Exclusion of consequential loss

The exclusion of indirect and consequential loss is near-universal and frequently misunderstood. Loss of profit may be direct loss depending on the nature of the bargain. Where profit is the point of the contract, excluding it as consequential loss can hollow out the remedy entirely - a result that is usually unintended by both parties and discovered only in dispute.

The remedy is specificity. Name the heads of loss that are recoverable and the heads that are not, rather than relying on a taxonomy that courts have applied inconsistently for a century.