Drafting commercial contracts: warranties, indemnities and exemption clauses

These contractual protections are important concepts, and can be technical to implement. As a result, businesses should pay extra attention to these terms during negotiation and when drafting an agreement.

Warranties

Simply put, warranties are contractual statements and promises. A breach of the warranty does not give the non-defaulting party the right to treat the contract as repudiated. It only entitles the non-defaulting party to claim damages for any loss suffered.

It is common to see statements or assurances about factual matters designated as "warranties" in a contract. The purpose of warranties is twofold. Firstly, they encourage both parties to disclose any known issues to each other upfront. Secondly, they offer a remedy, such as a claim for breach of warranty, if any statements made later turn out to be incorrect. In this way, warranties also serve as a form of retrospective price adjustment, which encourages fairness and transparency in contracts.

For example, in a software licensing agreement, it is common to include a warranty that ensures the software conforms to a specific technical description or specification and the licensors will often set a time limit within which they will commit to improving the software if it does not meet the agreed-upon standards. Therefore, to ensure that the software meets the parties’ expectations and requirements, it is crucial for parties, especially the licensees, to thoroughly review the specification both before entering into the agreement and during the specified period.

Another common warranty clause is an intellectual property (IP) warranty in the context of a licensing or due diligence exercise. The type and extent of IP warranties required in each transaction vary based on several factors, including the nature of the target business and the composition of its IP portfolio. Typically, warranties will require the owner to have good title to the IP rights and a detailed disclosure of the status of those IP rights, such as trademarks and patents.

Indemnities

By contrast, an indemnity is a promise to reimburse the other party with respect to a certain type of liability, should it arise. An indemnity clause is often used where there is a specific risk.

The primary purpose of an indemnity is to transfer the risk of a specified event or matter to the indemnifying party. Indemnities are often used to streamline the compensation process by identifying a few matters or circumstances that will allow the indemnified party, or the non-defaulting party, to claim against. This allows the indemnified party to recover on a dollar-for-dollar basis for any losses or damage related to that event or matter.

For example, if during negotiation for a licensing agreement, a party finds out that the supplier is involved in unresolved litigation related to the transaction, the party may require the supplier to bear the risk of the outcome of that litigation in the form of an indemnity.  IP litigation can often become extremely costly. An IP indemnification clause can shield the licensee, or the buyer in an acquisition, from these potentially crippling litigation expenses. This financial protection allows businesses to operate with greater confidence, knowing they have a safeguard against unexpected disputes.

In real life, parties negotiate heavily on indemnity clauses. Businesses should attempt to negotiate appropriate qualifications for indemnity. This ensures the scope of the indemnity is confined to circumstances where both parties can have some certainty. In practice, parties sometimes use fraud or reckless or negligent behavior as triggering events in the indemnity clause, however, these terms could be open to interpretation, and parties should consider whether they serve as useful triggers in their particular circumstances.

Exemption clauses

The effect of an exemption clause is to exclude or limit liability, usually in a claim for damages. When drafting exclusion clauses, parties should carefully consider the potential losses they might incur in relation to the contract.

An exemption clause is one of the most technical clauses in a contract. Exemption clauses must be sufficiently wide to cover the liability in question. Crucially, excluding heads of loss that are fundamental to the agreement should be avoided. Poor drafting can sometimes lead to the unintentional exclusion of certain types of direct losses or failure to exclude losses as intended.

There are statutory controls that regulate exemption clauses. Each legal jurisdiction has its own statutes and case laws in this regard, and that will affect how the exemption clauses are to be interpreted.

Apart from the payment terms, the above clauses are some of the most intensely negotiated items in a software licensing contract.  Businesses should consider carefully when preparing and drafting these terms to ensure protection of their interests.