Types of Contract Clauses

Discover some of the most common contract clauses, what they mean, and how they are used.

What is an exemption clause?

An exemption clause is a provision in a contract that limits the liability of one party. It applies in the case of breach of contract or contract default. Not all exemption clauses are the same. Three principal types exist: limitation clauses, exclusion clauses, and indemnity clauses.

What is an exclusion clause?

An exclusion clause is a type of exemption clause included in contracts to limit a party’s liability. It stipulates that one of the parties will not be liable to the other in certain specified situations or circumstances. For example, an exclusion clause in a life insurance contract may state that a death by suicide is excluded.

Generally, only the parties to the contract can rely on the exclusion clause, absent clear evidence that non-parties are intended to be protected too. If a court becomes involved in reviewing an exclusion clause, it may interpret any language that is unclear or ambiguous against the party looking to rely on an exclusion clause.

What is an indemnity clause?

An indemnity clause is a type of exemption clause in a contract in which one party agrees to indemnify, or answer for, liability or losses incurred by another party. When two parties enter into a contract with an indemnity clause, party A agrees to be held liable for all losses party B may incur. That is, party A agrees to compensate and/or defend party B if party B is sued for a certain, specified action. Party A’s liability is limited to party B’s liability.

What is an arbitration clause?

An arbitration clause is a provision in a contract that specifies how the parties intend to resolve disputes relating to the contract. Generally, by including an arbitration clause in a contract, the parties agree to first attempt to resolve any disputes through arbitration rather than litigation.

Arbitration is a process that allows a neutral third-party arbitrator to work with the parties to resolve their disputes. It is much less formal than a court proceeding. If the parties do not come to a mutual agreement during the arbitration, the arbitrator will issue a ruling on the dispute.

If the arbitration clause specifies that the arbitration will be binding, it means that both parties must abide by the ruling and it cannot be appealed in court. A party to a non-binding arbitration may take the matter to court if it is not satisfied with the arbitration ruling.

What is a force majeure clause?

A force majeure clause is a provision in a contract that exempts the parties from liability if they are prevented from performing their contractual obligations by unforeseeable circumstances beyond their control. The term force majeure is French for “superior force.”

Events such as “acts of God” that prevent contract performance are usually considered force majeure. Examples include a major earthquake or severe flooding. There are also cases of human-caused force majeure, such as an act of terrorism or war.

What is an escalation clause?

An escalation clause is a provision in a contract that allows for one party to increase the contracted-for prices or wages under certain specified conditions. This clause is often found in labor contracts, which may include escalation clauses that tie such increases to the rate of inflation. Many different types of contracts contain multiple escalation clauses addressing different subjects, allowing the parties to accommodate shifts and changes in the market.

In construction contracts, an escalation clause may provide for increases in the contracted price for labor or materials based on a change in market price or the increase of an index, such as the consumer price index. In leases, this clause may allow for lease costs to rise if maintenance and operation expenses rise. In real estate sales, an escalation clause may provide for an increase the purchase price if higher bona fide offers are made on the property by third parties. In lending, an escalation clause may allow for the interest rate to rise under certain conditions.

What is a cancellation clause?

A cancellation clause, also known as a termination clause, permits one or both parties to terminate the agreement before it is fulfilled. When a cancellation clause is included in a contract, it specifies the terms or conditions that must be met in order for a party to end the contract under the cancellation clause. Generally, a party seeking to terminate the contract based on the cancellation clause must provide the other party with written notice.

What is a penalty clause?

A penalty clause in a contract is a provision that requires a party that has not fulfilled its contractual obligations to pay specified compensation to the other party for the breach. Unlike a liquidated damages clause, a penalty clause is not tied to an estimate of possible actual damages. For example, a penalty clause may state that if either party breaches the contract, they must pay the other $10,000.

What is a sunset clause?

A sunset clause is a provision in a contract that sets an outer time limit on the contract’s viability. If the parties have not been able to consummate the contemplated transaction by the sunset date, either party has the right to walk away from the contract.

What is an exculpatory clause?

An exculpatory clause limits a party’s liability for damage incurred during the performance of the contract terms. For example, a dry-cleaning business may include an exculpatory clause that releases it from liability if an article of clothing is damaged during the dry-cleaning process.

What is a non-compete clause?

A non-compete clause is usually found in an employment contract. It prohibits the employee from competing with the employer during a set span of time by either working for a competitor. Usually the clause also describes the region or state in which the employee may not compete as well as the relevant scope of the services and skills. For example, usually the clause also describes the region or state in which the employee may not compete as well as the relevant scope of the services and skills.

What is a confidentiality clause?

When a business wants to keep trade secrets or business matters confidential, it may include a confidentiality clause in contracts with employees, independent contractors, suppliers or other individuals or firms it works with. These clauses bar the receiving party from disclosing the information specified except under certain specified circumstances. While any contract can have a confidentiality clause, this kind of language can be found in stand-alone contracts called confidentiality agreements or non-disclosure agreements.

**What is a severability clause?
**A severability clause is contract language that states what happens to the contract if a part of it is found to be unenforceable. For example, if an employment contract contains provisions that remove an employee’s protections under the applicable labor laws, those provisions are unenforceable. Would the remainder of the contract be valid and enforceable, or would the entire contract be void? The purpose of a severability clause is to provide the answer to that question. Generally, a severability clause states that if any clause of the contract is found invalid or unenforceable, the remainder of the contract shall remain valid and enforceable.