In the first of a series examining common contractual issues Conor Folan of McDowell Purcell’s Commercial team looks at why it is important for businesses (and individuals) to limit their potential liability in commercial contracts and provides practical tips for the best ways to do so.
Why limit liability?
Every commercial transaction carries a risk of liability. Performance of the contract can give rise to a range of legal liabilities, including for example breach of contract, negligence, misrepresentation, infringement of intellectual property rights, breach of statutory duty, regulatory offences and defamation. In the absence of an effective limitation of liability clause, there is no financial limit on the damages a counter party can recover from your client. At the very least this could lead to financial pain and in a worst case scenario it could put your client out of business entirely. For these reasons, it is very important to ensure that commercial contracts include some form of limitation, and that these limitations are both effective and enforceable.
Issues to consider
These steps should be followed when considering how to protect a party from unlimited liability - generally the supplier of goods or services:
- Identify the risks.
- Consider other ways to minimise the risks.
- Consider what insurance is available.
- Decide which liabilities to exclude, cap or accept.
- Draft an enforceable limitation clause.
Identifying the risks
In order to limit liability effectively a commercial lawyer needs to be aware of all of the possible risks in a transaction. It is essential to discuss these in detail with the client in respect of each particular contract. Questions to ask the client include:
- What could realistically go wrong?
- How much might it cost?
- How likely is it to happen?
- How will the client deal with the risk if it arises?
- Is the risk acceptable for this deal?
Common risks to consider include:
- Insolvency. How financially robust is the counterparty?
- Breach of contract. How likely is a failure of performance by the counterparty?
- Non-contractual liability. eg Are there concurrent duties in tort and contract, as in most professional services contracts?
- Misrepresentation. How reliable is the information exchanged in the negotiation? Can claims made by representatives be substantiated or verified?
- Claims by non-parties. Will this transaction expose a party to claims by third parties such as end users, visitors, contractors, sub-contractors, the public? Is there a risk of liability for defective products, negligence, nuisance, occupiers' liability or infringement of intellectual property rights?
- Contribution claims. In a multi-party transaction, each party should consider its position in relation to the others. eg A contractor may limit its own liability to the customer, but that will not help if the other contracted parties (jointly responsible for the project) have unlimited liability to the customer and can claim a contribution from you if it all goes wrong.
- Vicarious liability. What actions or omissions of other people (staff, agents, sub-contractors) might a party be liable for?
- Economic risk. What changes in prices, exchange rates, wages or other factors might affect the profitability of the contract?
- Regulatory risk. Is there a risk that a default might put either party in breach of regulations, leading to regulatory action and penalties?
- Tax. Is there a risk that the arrangement may create unforeseen tax consequences?
Exclude, cap or accept?
Ideally limitation clauses should set out:
- The risks a party wholly excludes. eg A supplier will often seek to exclude loss of profits, loss of sales or business, loss of contracts, loss of anticipated savings, loss of data and loss of goodwill.
- The limits the parties place on other risks. eg A party might propose an overall cap on liability, or different caps for different types of loss. In addition, either party might want to list expressly liabilities which the supplier accepts subject to the caps.
- The risks each party accepts without limit. Examples are liabilities a party cannot limit, such as fraud or death and injury caused by negligence, or failing to give good title to goods. A party may also accept unlimited liability for other losses within its exclusive control, or by giving an indemnity against those losses.
For risks that are not wholly excluded it is sensible to introduce a financial cap on liability, or different caps for different types of loss. The supplier will want to ensure that the cap is appropriate for the value it will get from the transaction.
A useful starting-point for negotiations is the contract price, if there is one, or an estimate of the total contract value, or a percentage of the contract value (we have seen from 25% to 150%). However, the cap need not be a fixed sum or a formula, as long as it will be clear how to calculate it. A cap could also limit losses to the proceeds of an insurance policy.
Caps can be structured in a variety of ways:
- A single figure which applies for the duration of the contract.
- An annual cap which renews each year.
- An amount linked to the sums paid under the contract.
- The higher of a fixed sum and a percentage of the sums paid under the contract.
Combinations of the above can be used. eg An annual cap could be a percentage (which could exceed 100%) of the sums paid in a year.
A cap may apply to each claim (or series of connected claims) or it may be an overall cap. Alternatively there can be a combination, such as a cap of € X per claim or series of connected claims, subject to an overall cap. Caps for property damage and other liabilities may be different to reflect the relevant insurance policies.
Alternative drafting methods
In addition to inserting the usual limitation of liability clauses discussed above, you could seek to reduce risk to your client by:
- Use non-reliance wording. These clauses confirm that a party has not relied on statements that are not contained in the contract and are designed to prevent a claim arising for misrepresentation.
- Limit the party’s obligations or duties. Keep them specific and identifiable. Make them conditional on performance by the counterparty. Reduce absolute obligations to best endeavours, and reduce best endeavours to reasonable endeavours, or a duty to use reasonable care and skill. Qualify warranties by reference to actual knowledge and enquiries made at a specific time. Your client should not promise more than they can deliver.
- Limit rights and duties in time. Limit a purchaser's time to inspect or accept goods or services. Set an ultimate expiry date on continuing duties which may survive termination, such as duties of confidentiality and indemnities.
- Exclude implied terms. In business to business contracts it is common to exclude implied terms to the fullest extent possible. However, not all implied terms can be excluded, particularly in consumer contracts.
- Use risk allocation clauses to allocate risk between the parties, regardless of fault. eg A clause may allocate a risk to the party who is best able to insure against it rr a party may offer to accept a certain risk for an amended price.
- Change the payment terms to reduce the risk of non-payment. eg Include a deposit, instalments, interest, set-off or retention of title provisions,
- A force majeure clause will allow suspension or termination of a party’s obligations if performance is prevented by a cause beyond their control.
- Add more termination rights. Add a right to terminate for causes such as change of control of the counter party and threats to solvency, or termination for convenience.
- Take indemnities. Ask the counterparty to indemnify you against potential regulatory liabilities, tax, or third party claims such as breach of intellectual property rights.
- Impose preconditions to claims. Spell out circumstances in which you will not accept liability, such as attempts at do-it-yourself repairs, use of the product contrary to a clear recommendation, and defects caused by compliance with the buyer's own specification.
- Set time limits on claims. Agree time limits for notifying claims, or to begin litigation (reducing statutory limitation periods). Short time limits are easiest to justify when driven by external demands such as an insurance policy.
- Clearly defined remedies reduce the scope for dispute if a claim arises. Such defined remedies could include repair, replacement, credit against a future purchase or liquidated damages. A defined remedy may replace a party's rights under contract law, making it the sole remedy. However the contract needs to be explicit if doing so or alternatively state that it supplements the remedies provided by law.
- Provide for conclusive evidence. The parties may agree that one of them, or an independent expert, can certify matters which neither can then dispute. For example, an expert or inspector's certificate of quality may be conclusive evidence of the quality of goods delivered or constructed.
- Insist upon insurance. The counterparty can be contractually required to obtain appropriate insurance.
Precedents are helpful but use caution
Using precedents ensures everything important has been addressed. However, documents drafted as precedents may offer extensive wording to deal with every possibility. They should be edited to reflect the commercial deal the parties have worked out. Only use the exclusions you need.
“Second hand” documents used in previous transactions will be specific to the risks identified and negotiations undertaken for that particular transaction. They may also include compromises in terms of drafting, in order to expedite closure of that deal.
Check interaction with indemnities
An indemnity is usually inserted to protect the receiving party from all possible loss resulting from a specified cause and is therefore usually exempt from any limits on recovery.
However, consider the following when a contract contains both an indemnity and a limit on liability:
- Does the limitation clause limit recovery under the indemnity?
- If there is any recovery under the indemnity, does it count towards the limit on liability?
Check for consistency with other parts of the contract
Often limits on liability can be found outside the main limitation clause, for example in an:
- Entire agreement clause. This often limits liability for pre-contract statements or verbal discussions.
- Insurance clause. This may seek to cap liability to the maximum level of claim(s) covered under the relevant policy.
- Net contribution clause. This seeks to prevent over-recovery from any contractor and remove the risk of contribution claims.
- Remedies clause. This may try to exclude the parties' remedies at common law.
Confining all exclusions and limitations to one clause entitled "limitation of liability" would reduce the risk of conflicting provisions and make the headings a more reliable guide to the agreement. However, if this cannot be done then at least ensure the provisions do not conflict or contradict each other and that there are no gaps or duplication.