Liability – How does it arise and how can it be limited?
This fourth article in the Back to Basics series looks at a topic which is often considered to be the most crucial for any contracting party – liability. How it arises and how, in contractual terms, it can be limited.
The limitation of liability provisions in commercial contracts are frequently the subject of intense negotiation between the contracting parties, with many hours being spent trying to justify excluding liability for certain types of loss or placing financial caps on the parties’ overall liability. In addition, decades of judicial scrutiny have shaped the drafting of such clauses with the result that many contain common phrases and characteristics.
The purpose of this article is to identify the different types of potential loss, to review some of the more typical limitation of liability clauses and to provide some helpful tips for use when drafting, reviewing and negotiating liability provisions in commercial contracts. It is worth noting that this article focuses on ‘business to business’ contracts and that more stringent rules apply when dealing with consumers.
Limitation of liability clauses are a useful way of balancing the risk between parties to a commercial contract. The parties can seek to limit their liability under the contract in a number of ways, often by excluding liability for certain types of loss or by putting a financial cap on liability for such losses.
The traditional approach when drafting and negotiating commercial contracts is to define liability by exclusion, with the losses which have not been specifically carved out by the parties being recoverable under the contract (provided they are not too remote or otherwise excluded by law). However, there are some key considerations which should be borne in mind when drafting limitation of liability clauses:
Exclusion or limitation of liability clauses need to be approached with care. The parties should be aware that if they seek to impose exclusions that are too wide, or liability caps that are too low, they run the risk of the entire clause being deemed unenforceable, leaving the defaulting party at risk of potentially unlimited liability (subject to the common law rules on recovery).
The Unfair Contract Terms Act 1977 (UCTA)
It is a general principle of law that parties should be able to contract freely. However, UCTA imposes limits on the extent to which liability for breach of contract, negligence or other breaches of duty can be avoided using contractual provisions. UCTA makes certain terms wholly ineffective and states that others will only be enforceable to the extent that they are ‘reasonable’. The most important UCTA principles of note are as follows:
- It is not possible to exclude liability for death or personal injury resulting from negligence and any attempt to do so runs the risk of rendering the entire limitation of liability clause unenforceable
- As regards limiting or excluding liability for other losses arising from negligence, such limitations or exclusions have to be ‘reasonable’
- Liability for the implied terms relating to title and quiet possession cannot be excluded
- Liability for other implied terms relating to the quality or fitness for purpose of goods can only be excluded or limited if those exclusions or limitations are ‘reasonable’
- If one party is relying on its standard written terms of business (i.e. the contract has not been freely negotiated by the parties), any exclusions or limitations have to be ‘reasonable’
- Provisions which exclude or limit liability for any pre-contractual misrepresentations have to be ‘reasonable’
What is reasonable?
A detailed review of the UCTA ‘reasonableness test’ is outside the scope of this article. However, factors which a court then take into account when considering whether a clause is reasonable include the parties’ relative strength of bargaining position, the availability of insurance and the information available to both parties when the contract was drawn up.
Limit or exclude?
In some circumstances it may be appropriate for a party to exclude their liability for certain types of loss. However, these should be carefully drafted and narrowly defined because a complete exclusion of a particular liability is likely to face greater resistance from the other contracting party and far stricter judicial scrutiny than a limitation.
Is it relevant?
Although many limitation of liability clauses contain standard wording, a sensible approach for any business is to draft a tailor-made clause based solely on that business’ precise concerns, thereby limiting the remit of the exclusions and limitation to issues of relevance. There is little to be gained from spending time fiercely negotiating clauses limiting liability for loss of data if the contract is for the supply of catering services and the risk of data loss is small.
One issue which often arises when considering limitation of liability provisions is the use of indemnities. In basic terms, an indemnity clause is a promise by one party to compensate another for the consequences of a specific event. Generally, indemnity clauses are used to allow the parties to allocate risk, particularly where the actions of one party can create a risk which the other party would otherwise have to bear.
A common example of an indemnity clause can be found in software licensing agreements. In these circumstances, if a software developer grants a company the right to use its software and that software was copied from a third party, then the licensee company’s use of the software will infringe the third party’s rights and the third party could sue the licensee company. As this risk will arise as a result of the software developer’s actions and is outside of the licensee company’s control, it is usual for the licensee company to seek to allocate this risk to the software developer by using an indemnity. An example clause is set out below:
‘The Software Developer will fully indemnify and hold harmless the Licensee from and against any losses, damages, costs (including all legal fees) and expenses incurred by or awarded against the Licensee as a result of, or in connection with any claim or action that the possession, use, development, modification or maintenance of the Software (or any part thereof) infringes the Intellectual Property Rights of a third party.’
Unlike indemnities for specific events (such as that set out above), it is common for US commercial agreements to contain general blanket indemnities for breach of contract. This is because, under the US legal system, a claimant would not normally be awarded his own costs in addition to a damages award. The indemnity wording is intended to extend the scope of the claimant’s right to recover to include its legal costs as well as common law damages. Whilst the same is not true under English law (where successful claimants will usually be able to recover their costs), it is becoming more common to see blanket indemnities for breach of contract appearing in English law contracts. However, these should be resisted where possible for the reasons set out below.
There have been cases which have suggested that an indemnity clause gives rise to a claim for a debt rather than for breach of contract and that the common law rules on remoteness and the duty to mitigate do not apply. If one party gives an indemnity against a certain event, then that party must bear all those costs regardless of how remote they are or if the other party could have taken steps to reduce the amount of such costs. The extent to which this is correct is uncertain and therefore, parties should be wary of agreeing to wide ranging indemnities covering any losses suffered as a result of a breach of the contract. This is because if the common law rules do apply to an indemnity for breach, then the clause would add nothing and if the rules do not apply, the clause could allow the other party to recover more than they would have otherwise been entitled to under common law.
Analysis of a typical clause
The following box contains a typical limitation of liability clause taken from a contract for the supply of services. This clause only applies to the supplier’s liability and does not include limits or exclusions which apply to the customer’s liability although it could be easily adapted to apply to both parties. The various elements which make up this clause are analysed in more detail below.
Limitation of liability
1. All warranties, conditions and other terms implied by statute or common law are, to the fullest extent permitted by law, excluded from this Agreement.
2. Nothing in this Agreement limits or excludes the liability of the Supplier for:
3. Subject to clause 1 and clause 2:
This clause seeks to exclude all implied terms in order to cut down the extent and scope of the supplier’s obligations. As set out above, where the contract relates to the supply of goods, UCTA prevents the implied terms relating to title and quiet possession from being excluded and states that liability for implied terms relating to the quality or fitness for purpose of the supplied goods can only be excluded or limited if those exclusions or limitations are reasonable.
This clause makes it clear what limits apply to the ambitions of the entire limitation of liability clause. This is important because, as noted above in relation to UCTA, a failure to do so could render the entire clause unenforceable.
The use of the words ‘Subject to clause 1 and clause 2’ at the start of clause 3 is to make it clear that clause 3 should be read subject to the first two clauses. This means that, for example, the exclusion of liability for loss of profits in clause 3 will not apply if the cause of the loss is fraud (as set out in clause 2).
Many people think that the expressions ‘indirect’ or ‘consequential’ loss include or even refer to loss of profits. This is incorrect. It is clear law that in order to exclude liability for loss of profits, it must be stated explicitly.
The reason why loss of profit is stated in a separate sub-clause rather than being included in clause 3.1.2 is twofold: first, to make it clear that the exclusion applies to all loss of profit (not just loss of profit which is indirect or consequential) and second to enable each sub-clause to be read independently so that if either provision were held to be unreasonable (and as such unenforceable) a court may be more willing to use their power to sever the unenforceable sub-clause only rather than excluding the entire clause.
The terms “indirect” or “consequential” loss are classic examples of legal words not bearing their usual dictionary meanings. The case law on this issue makes it clear that a person who breaches a contract is generally liable to the innocent party for any loss that falls within one of the following two categories:
- Loss that arises “naturally” or “according to the usual course of things” from the breach. This is what is referred to as direct loss.
- Such additional loss as the parties would, at the time when they made the contract, have reasonably expected to be the probable result of such a breach. This is what is referred to as indirect or consequential loss.
As noted above, it is clear from the case law that loss of profit can be a direct loss where it is a natural or usual result of the breach. There is no legal difference between “indirect”, “consequential” or “special” loss, and they are treated as one and the same although standard drafting convention is list all three as done in clause 3.1.2 above.
It is important to understand the legal meanings of “indirect”/“consequential” and “direct” losses as a failure to appreciate the distinction can lead to exclusion clauses that do not achieve their intended aims.
One final point in relation to clause 3.1.2, it is important that the wording does not state “any other indirect, consequential or special loss”. This is because the use of the word other could imply that clause 3.1.1 is only intended to exclude loss of profit which is indirect or consequential rather than excluding direct loss of profit as well.
This clause places a financial cap on the supplier’s liability which is not carved out by clause 2 or excluded by clauses 3.1.1 and 3.1.2. As currently drafted, the financial cap applies to the supplier’s total liability (sometimes called aggregate liability) in relation to the contract. However, financial caps can alternatively be stated to apply to the supplier’s liability per claim or to the supplier’s liability per contract year (or other period).
When considering what a suitable financial cap would be, the key is to find a limit which is reasonable in the context of the particular agreement in question. By simply providing a figure in its standard terms of business, a supplier runs the risk that the limit will be hopelessly low in the context of a particular transaction using those standard terms and therefore unenforceable. Conversely, there is a risk that the limit will be unnecessarily high and will therefore expose the supplier to a disproportionate risk when compared with the financial reward in the context of a particular deal.
The more successful approach is to provide for a limit which is mindful of the particular transaction in question. This can be achieved, for example, by setting the cap with reference to the cost of the goods or services (often limiting liability to a multiple of the anticipated cost) or by having regard to the supplier’s insurance cover. Another approach which has been accepted by the courts is for a supplier to provide the option of an increased liability cap in exchange for a higher price.
As noted above, the availability of insurance is one of the key factors which a court will consider when deciding whether a cap on liability is reasonable and businesses will often use the limit of their insurance cover to determine the overall financial cap on their liability under contracts. However, one point which can sometimes cause confusion is the difference between an obligation to maintain insurance and a clause which places a financial cap on liability. It is important to be aware that these are not the same thing. Just because a contract contains an obligation on a supplier to maintain insurance at a certain level, does not mean that its liability under the contract will be capped at that amount. Where a financial cap on liability is required, the contract should also contain a separate clause to cover this, such as the example in clause 3.2 above.
When a party has a right to claim for damages for breach of contract, the amount that party will be entitled to receive is often not fixed. It is an amount that has to be agreed between the parties or assessed in court. However, it is possible to use a liquidated damages clause to pre-set in the contract the amount of damages which could be recovered in respect of a specific breach should that breach occur. This liquidated damages figure must be a genuine pre-estimate of the loss that is likely to occur as a result of the specific breach, it cannot be disproportionately high otherwise it runs the risk of being an unenforceable penalty.
The benefit of including a liquidated damages clause is that it gives both parties certainty and it can discourage expensive litigation. The claim is dealt with as a debt claim and is, therefore, much more straight forward to enforce and no actual loss has to be proved. However, the difficultly arises in assessing a suitable figure for the liquidated damages clauses. In view of this, these clause are typically used for late or incomplete performance of contractual obligations as opposed to a complete failure to perform.
An alternative approach – Inclusive drafting
Although the traditional approach when drafting and negotiating commercial contracts is to define liability by exclusion, with the losses which have not been specifically carved being recoverable, an inclusive approach can sometimes be more useful where a contracting party can identify specific heads of loss that it will absolutely want to recover. By including provisions which are explicit about what can be recovered as opposed to what can’t, all parties can understand the deal on positive recoverability from the outset.
Limitation of liability clauses are important features of many commercial contracts. As noted above, a badly drawn clause can fail to achieve the desired ends (indeed it may achieve nothing at all). A well drafted clause allows the parties to balance their risk against the potential benefits of the contract, to procure appropriate insurance cover and to control and predict their potential financial exposure.
It is worth remembering that limitation of liability clauses are only part of a range of contractual steps which businesses can take to manage risk and operate in a commercially sensible way. Some of these steps, such as replacing some absolute obligations with ‘endeavours’ clauses and clearly defining the scope of the services, have been covered in previous articles in this series and can help businesses to avoid a breach of contract claim altogether.
Reviewed in 2015