Common Contract Clauses That Create Legal Risk

Every contract you sign contains provisions that allocate risk between the parties. While some of these provisions are straightforward, others can create significant legal exposure that many signers do not fully understand until problems arise. Understanding the most common contract clauses that create legal risk is essential for anyone entering into business agreements in the United States.

Understanding Risk Allocation in Contracts

At its core, every contract is an exercise in risk allocation. The parties are essentially deciding who will bear responsibility if things go wrong, who will pay for various contingencies, and what remedies are available when obligations are not met. The clauses that address these issues are often the most consequential in any agreement, yet they are frequently the ones that receive the least attention during review.

Understanding liability in contract negotiations requires recognizing that the drafting party typically allocates risk in their favor. This means the contract you receive is often designed to protect the other side while leaving you exposed to various risks.

Liquidated Damages Clauses

A liquidated damages clause specifies a predetermined amount that one party must pay if they breach the contract. While these provisions can provide certainty and simplify dispute resolution, they can also create significant financial exposure.

How Liquidated Damages Work

When parties enter into an agreement, they may recognize that certain breaches would cause harm that is difficult to calculate. Rather than leaving this calculation for later dispute, they agree in advance on a fixed amount. For example, a construction contract might specify that the contractor owes a certain amount for each day a project is delayed.

The Risks of Liquidated Damages

The danger of a poorly drafted or one-sided liquidated damages clause is that it can result in payments far exceeding actual damages. Courts will generally enforce these provisions unless they constitute an unenforceable penalty, but the line between a valid liquidated damages clause and an invalid penalty is often unclear.

Before signing any contract with liquidated damages provisions, consider whether the amounts specified bear a reasonable relationship to anticipated harm. If the numbers seem arbitrary or excessive, negotiation is advisable.

Indemnification Provisions

Indemnification clauses require one party to compensate the other for certain losses, damages, or liabilities. These provisions are among the most significant risk-shifting mechanisms in any contract, and they deserve careful attention.

The Scope of Indemnification

A broad indemnification provision might require you to defend and hold harmless the other party from any claims arising out of the agreement, including claims resulting from the other party's own negligence. This type of provision effectively makes you the insurer for the entire relationship.

Negotiating Indemnification Cap Provisions

One critical protection to negotiate is an indemnification cap that limits your maximum exposure under these provisions. Without such a cap, your liability could be unlimited, potentially exceeding the value of the entire contract many times over.

Consider negotiating for indemnification limited to claims caused by your own actions or breaches, exclusion of consequential or indirect damages, caps tied to the contract value or your insurance coverage, and mutual indemnification obligations.

Limitation of Liability Clauses

These provisions limit what one party can recover from the other in the event of a breach or other problem. While limitation of liability clauses can provide important protection, they can also leave you without adequate recourse if things go wrong.

Common Limitations

A typical liabilities clause might limit recovery to direct damages only, exclude consequential, incidental, or special damages, cap total liability at the fees paid under the contract, or exclude liability for certain types of claims entirely.

Evaluating Liability Limitations

When reviewing these provisions, consider the potential harm that could result from the other party's breach or negligence. If a software vendor's system failure could cause you millions in lost business, a liability cap of one year's fees may be grossly inadequate protection.

Also examine whether the limitations are mutual. Often, contracts limit the vendor's liability while leaving the customer's liability uncapped or subject to broader exposure through indemnification provisions.

Warranty Disclaimers

Most commercial contracts include provisions disclaiming implied warranties such as merchantability and fitness for a particular purpose. These disclaimers can significantly limit your rights if the goods or services you receive do not meet your expectations.

Understanding What You Are Giving Up

When you accept a warranty disclaimer, you are generally agreeing that the other party makes no promises about the quality, functionality, or suitability of what they are providing. If their product fails or does not meet your needs, your recourse may be limited to whatever express warranties remain in the contract.

Protecting Your Interests

Before accepting warranty disclaimers, ensure that the contract includes adequate express warranties that address your specific needs. Consider negotiating for performance standards, service level agreements, or specific functionality commitments that survive the general warranty disclaimer.

Dispute Resolution Provisions

How and where disputes are resolved can significantly impact your ability to enforce your rights or defend against claims. Dispute resolution provisions deserve careful attention.

Mandatory Arbitration

Many contracts require disputes to be resolved through binding arbitration rather than in court. While arbitration can be faster and less formal, it often limits discovery, may not allow for appeals, and can be more expensive than court for certain types of disputes.

Forum Selection

Contracts often specify that disputes must be brought in a particular location, typically one convenient for the drafting party. Being forced to litigate in a distant jurisdiction can significantly increase your costs and may discourage you from pursuing valid claims.

Class Action Waivers

Many consumer and commercial contracts now include provisions waiving the right to participate in class action lawsuits. This can be particularly problematic when individual claims are too small to pursue independently but would be significant in aggregate.

Intellectual Property Provisions

Clauses addressing intellectual property rights can have far-reaching consequences, particularly in technology and creative services agreements.

Work Product Ownership

Contracts with service providers often include provisions assigning all work product to the customer. While this seems beneficial, overly broad language can inadvertently capture pre-existing intellectual property or tools that the provider needs for other engagements.

License Grants

Be cautious of provisions granting broad licenses to your intellectual property. What seems like a reasonable license for the immediate purpose might give the other party rights far beyond what you intended.

Confidentiality Obligations

While protecting confidential information is important, overly broad confidentiality provisions can create ongoing obligations that are difficult to manage and potentially impossible to satisfy.

Scope and Duration

Review carefully what information is covered by confidentiality obligations and how long those obligations last. Perpetual confidentiality obligations for broad categories of information can create long-term compliance burdens.

Permitted Disclosures

Ensure the contract includes reasonable exceptions for information that becomes publicly available, was already known to you, or must be disclosed pursuant to legal process.

Termination Provisions

The ability to exit a contractual relationship is often as important as the terms of the relationship itself. Termination provisions can significantly impact your flexibility.

Termination for Convenience

Look for whether either party can terminate the agreement without cause. If only the other party has this right, you may find yourself locked into an arrangement you cannot exit while remaining subject to termination at the other party's discretion.

Post-Termination Obligations

Many contracts include provisions that survive termination, such as confidentiality obligations, indemnification duties, and intellectual property assignments. Understand what obligations continue after the relationship ends.

How to Protect Yourself

Given the significant risks embedded in common contract provisions, taking steps to protect yourself is essential:

First, read every provision carefully, particularly those addressing liability, indemnification, and dispute resolution. Second, do not assume that terms are non-negotiable simply because the other party presents them as standard. Third, consider the worst-case scenarios and evaluate whether the contract adequately protects you. Fourth, seek professional review for significant contracts, whether from an attorney or through AI-powered contract analysis tools. Fifth, document any verbal representations or understandings that are not reflected in the written agreement.

Conclusion

The clauses discussed in this article appear in countless contracts across every industry. While they are common, they are far from harmless. Each creates potential legal risk that signers often do not fully appreciate until disputes arise.

By understanding these provisions and their implications, you can approach contract negotiations with the knowledge necessary to protect your interests. Whether you negotiate changes, seek alternative arrangements, or simply make informed decisions about the risks you are accepting, awareness is the first step toward better outcomes.

Remember that every provision in a contract was drafted by someone, and it can be changed by negotiation. Do not let familiarity breed complacency when it comes to these common but consequential clauses.