By: Gregory Prekupec and Rahul Gupta 

Introduction

When drafting commercial agreements, it’s crucial to consider how risk is allocated between the parties to ensure your client’s interests are protected and that they don’t fall victim to outdated or unexamined precedents. A strong understanding of risk allocation allows lawyers to clearly articulate their clients’ post-closing obligations and potential liabilities.

Key Methods of Risk Allocation

Risk allocation in commercial contracts can take many forms. Below is a non-exhaustive list of common mechanisms:

• Indemnification
• Limitations on Liability
• Termination Rights
• Force Majeure
• Contractual Remedies
• Product Conditions & Warranties
• Insurance Coverage
• Payment Terms
• Guarantees

Now, let’s break down these risk allocation tools in more detail.

Indemnification

Definition: An indemnity clause requires one party to compensate the other for specific costs or liabilities, such as lawsuits, damages, or legal fees. This is often paired with a duty to defend and a hold-harmless obligation.

Purpose: A well-drafted indemnity clause can:

• Shift financial burdens onto the indemnifying party.
• Cover expenses not protected under common law (e.g., legal fees).
• Minimize uncertainty regarding future liabilities.
• Reduce litigation risks.
• Handle third-party claims effectively.

Enforcement: Courts generally enforce indemnity clauses unless they are deemed unreasonable or unconscionable (e.g., due to vague language, significant bargaining power disparities, or absurd results).

However, practical issues such as jurisdictional enforcement (i.e., enforcing a judgment in a foreign jurisdiction) and prolonged litigation can affect their utility.

Best Practices:

• Scope: Who is indemnified? (e.g., shareholders, employees, affiliates, capital providers)
• Nexus Language: What events trigger indemnification? (e.g., are the events “related to,” “caused by,” or “solely resulting from”?)
• Recoverable Damages: Define whether indemnification includes only incurred costs or also future/unpaid expenses.
• Exceptions: Consider excluding indemnification for gross negligence, willful misconduct, or failure to mitigate damages.
• Limitations: Use minimal thresholds, upward caps, and time limits to control exposure.
• Procedures: Specify the notice period, control the indemnifying party has over the litigation, and required cooperation of the indemnified party.

Limitations on Liability (“LL”) Clauses

Definition: LL clauses define and limit a party’s exposure under a contract.

Purpose:

• Capping damages (e.g., a multiple of fees paid under the contract).
• Excluding liability for indirect, consequential, or punitive damages.
• Avoiding application of tort-based remedies.

Enforcement: Courts generally uphold LL clauses if they are:

• Clear and specific (ambiguous language can be interpreted against the obligor).
• Explicit about covered and excluded liabilities (e.g., negligence).

Best Practices:

• Ensure the LL clause aligns with the indemnification provisions.
• Consider carve-outs for fraud, gross negligence, or intentional misconduct.
• Avoid conflicts with any “cumulative remedies” provisions.

Termination Rights

Definition and Categories: Termination Rights allow a party to end a commercial agreement. There are two types of termination rights:

1. Termination for Cause: Allows a party to end the contract due to specific breaches (e.g., non-payment, insolvency).
2. Termination for Convenience: Enables a party to exit the contract without cause (often requires notice, transition cooperation, or termination fees).

Considerations:

• Negotiation Power: Unilateral termination rights create leverage for a party and increases pressure on the counterparty.
• Consequences of Termination: Define penalties, required transition periods, and other obligations upon exit.

Force Majeure (“FM”)

Definition: “Superior force” in French.

Purpose: Allows a party to be excused from their contractual obligations if certain events occur which are negotiated to be beyond that party’s control (e.g., COVID-19, health emergencies, natural disasters, wars, civil unrest).

Best Practices:

• Events not covered by the FM clause will not be deemed as such. Specificity and intentionally are key to drafting effective FM clauses.
• A party should be able to terminate the agreement of disruptions over an FM event continue over a certain period of time.
• Prescribe which obligations remain despite any such termination (e.g., confidentiality)

Contractual Remedies

Definition and Categories: A list of contractually available reliefs to a party in a commercial agreement. There are four types:

• Equitable Remedies: Courts may order specific performance, injunctions, or rectification.
• Cumulative Remedies: Allows parties to pursue all available remedies beyond the contract.
• Exclusive Remedies: Limits remedies to those explicitly listed in the contract.
• Liquidated Damages: Pre-determined penalties for breaches. They are useful when damages are difficult to quantify.

Purpose: To create greater certainty by either expanding or minimizing the level of liability as a result of a breach of the agreement.

Best Practices:

• Ensure cumulative and exclusive remedies provisions don’t conflict.
• Confirm liquidated damages are compensatory and not punitive.
• Consider prohibiting or permitting equitable relief based on the circumstances of all parties.

Product Conditions & Warranties

Definition: Provincial laws provide for implied warranties on the sale of goods within the actual agreement. Parties to such agreements can manage risk by subscribing to or contracting out of these implied warranties.

Best Practices:

• Clearly state whether implied warranties apply or are excluded.
• Define the scope of express warranties to avoid unintended liabilities.

Insurance

Definition and Purpose: Parties can manage risk by negotiating for certain insurance requirements to ensure either party has the monetary capability to comply with its commercial obligations under an agreement.

Best Practices:

• Assess the need for additional insurance before mandating coverage. Do internal resources provide enough protection for ensuring contractual compliance?
• Ensure insurance aligns with indemnification obligations.

Payment Terms

Definition and Categories: The timing of when payment is required for the goods or services being contracted for can help to manage risk. There are two types:

• Deferred Payments: Favourable to buyers but risky for sellers.
• Advance Payments: Reduce seller risk but may require concessions to the buyer.

Best Practices:

• Define triggers for payment acceleration or deferral.
• Include late-payment penalties or early-payment discounts.

Guarantee

Definition: Guarantees are used to ensure payment or performance will be made on time by requiring a separate entity (e.g., the directors of a party, the parent corporation, etc.) guarantee or ensure the same.

Purpose: The inclusion of a third-party increases the chances that the counterparty will receive payment on time or performance.

Best Practices:

• Scope of Guarantee: Define if it is full or limited.
• Enforceability: Ensure the guarantor has the means to fulfill obligations.
• Exclusions & Expiry: Define conditions for termination of the guarantee.