Limiting Liability Under a Contract

Limiting liability under a contract is a common thing for suppliers or sellers to want to do but limitation of liability clauses are often drafted without much thought. A strong commercial awareness of the position of each party is essential when deciding how best to deal with liability issues.

Limiting liability – why bother?

Every commercial transaction carries a risk of liability. Performance can bring the parties into contact with each other, their staff, sub-contractors, suppliers, customers, associates, visitors and the public, in ways that could give rise to all sorts of legal liability: for breach of contract, negligence, misrepresentation, infringement of rights to physical or intellectual property, breach of statutory duty, regulatory offences, defamation and more. Liability may be incurred without fault, and through the acts of others.

In the absence of a limitation clause, there is no financial limit on the damages a counter-party can recover. There are practical limits, and legal limits under the general law of damages. Beyond these, no limits are normally implied. A party wishing to reduce its exposure therefore needs to be limiting its liability through express limitation of liability wording.

Should a customer ever propose a limitation clause?

Suppliers are normally the ones that are keen to be limiting liability; customers less so. Reasons why the customer may propose a draft limitation clause are:

• The supplier is likely to insist on a limitation clause. By including one in its first draft the customer can set the parameters for negotiation, rather than allowing the supplier to insert its standard clause.
• The customer can propose losses that are recoverable. For reasons why the supplier should consider accepting identified, capped losses.
• A customer may want to limit its own liability for breach, if it has contractual duties other than payment. For example, a contract may require the customer to co-operate with the supplier to enable the supplier to perform.

Identify the risks

Limiting liability effectively requires a lawyer to review the risks in the transaction with his or her commercial colleagues or client. Even if the commercial client has already negotiated limits on liability, the lawyer should understand the thinking behind it. The lawyer can then give better advice and draft the clause against the same background of commercial purpose the courts will use to interpret it.

Common risks to consider

• Insolvency of a party. How financially robust is the counterparty?
• Change of control. A party’s reorganisation or change of control could affect performance, at worst leaving the other party with a claim against a defunct or penniless entity.
• Breach of this contract. How likely is a default by your client or the counterparty?
• Third party rights. Does the contract create enforceable third party rights, exposing one party to claims by the other party’s affiliates?
• Breach of other contracts. Are there contracts with others, that might be affected by breach of the contract under negotiation?
• Misrepresentation. Each party needs to consider how reliable is the information exchanged in the negotiation.
• Non-contractual liability to the other party. What other liability might one party incur to the other?
• Other liabilities. Will this transaction expose a party to non-contractual claims by end users, visitors or the public?
• Contribution claims. In a multi-party transaction, each party should consider its position in relation to the others.
• Vicarious liability. What acts 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 be viewed in a way that creates unwelcome tax consequences for a party?

Consider other ways to minimise the risks

Here are some practical commercial actions that may help reduce some identified risks:

• Backup. Identify alternative sources and consider backup arrangements to deal with them if the preferred contractor fails.
• Research. Take up references, do credit checks and other research.
• Third-party guarantees. Require a third party (such as a parent company) to guarantee payment or performance. Consider requesting a letter of credit to ensure payment.
• Quality control. Review customer feedback and update the product, procedures or customer service to improve customer satisfaction and reduce complaints and disputes.
• Notices and disclaimers. Use notices and disclaimers on products and in marketing material to reduce the risk of liability to non-parties (for example, for negligence or for breach of onward sale conditions).
• Product documentation. Review product descriptions and instructions for use.
• Marketing and advertising. Review any marketing and advertising material to ensure that it does not make any unsupported claims about the products.
• Compliance. If you have identified a risk that performance of the contract may run into regulatory or tax problems, consider dealing directly with the regulatory and tax authorities to reduce those risks.
• A separate entity. Use a separate legal entity, with limited liability, to enter the contract.

Limiting liability without a limitation clause

There are other possible drafting techniques to consider, in addition to inserting the usual limitation clause. Some of them are listed here. Because these terms can, in practice, reduce the risk of liability to a counterparty, they are often subject to the same common law and statutory controls as limitation clauses

• Limit liability for misrepresentation. Limits on liability and remedies for misrepresentation often appear in a clause headed “entire agreement”, rather than “limits on liability”.
• Redefine your obligations. Limit the content of duties. Keep them specific and identifiable. Make them conditional on performance by the counterparty.
• Limit rights and duties in time. Limit a buyer’s time to inspect or accept goods or services. Set an expiry date on continuing duties which may survive termination, such as duties of confidentiality and indemnities.
• Restrict implied terms. Some duties implied into contracts by statute may be limited by express wording.
• Use risk allocation clauses. These clauses allocate risk between the parties, regardless of fault. For example, a clause may allocate a risk to the party who is best able to insure against it.
• Use a net contribution clause. This is the usual solution to the risk of contribution claims by other participants in a multi-party project.
• Change the payment terms. Introduce a deposit, a retention, instalments, interest, set-off and retention of title provisions, to reduce the risk of non-payment.
• Add a force majeure clause. This could suspend or, eventually, allow you to end your obligations if performance is prevented by a cause beyond your control.
• Add termination rights. Add a right to terminate for cause (including change of control and threats to solvency) or for convenience.
• Take indemnities. Ask the counterparty to indemnify you against potential regulatory liabilities, tax, or third party claims.
• 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.
• Agree defined remedies. Defined remedies could include repair, replacement, credit against a future purchase or liquidated damages. A defined remedy may be cheaper than damages and can reduce the scope for debate if a claim arises.
• Agree the contract provides an adequate remedy for breach. This is an indirect and uncertain way to limit recourse to uncapped remedies such as an order to perform the contract.
• Fix contractual interest. Statutory interest at 8% or more is often payable on the price of goods and services under the Late Payment of Commercial Debts (Interest) Act 1998. A contract term can replace this with contractual interest at a lower (but still substantial) rate.
• 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 inspector’s certificate of quality may be conclusive evidence of the quality of goods delivered. Or a lender may certify (conclusively) the amount of interest due. This can eliminate some points of dispute.
• Call for insurance. The counterparty can be contractually required to obtain appropriate insurance.
• Exclude third party rights. A contract cannot bind a non-party. It is therefore pointless in most cases to try limiting third party rights or claims. The exception is third party rights created by the contract.

Limiting liability with a limitation clause cap

When considering a limitation clause 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 reflects the value it will get from the transaction.

A common 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%), or the limit of the supplier’s insurance.

The cap should not be so low as to risk unenforceability, at least if the UCTA reasonableness test applies. UCTA reasonableness depends on the effect of the clause as a whole, considering all the circumstances of the transaction. In some cases, a refund of sums paid was found acceptable, but this may not always be so. A cap that allows the customer to recover sums paid plus a sum to reflect its other losses is more likely to be enforceable.

The cap will be influenced by market practice: customers do review the limits on liability when comparing suppliers. The figure chosen may sometimes appear arbitrary. One way to justify an apparently arbitrary figure may be to offer alternative prices, with and without the cap. The business client’s policies and commercial aims will be as important as the lawyers’ advice in fixing the cap. Suppliers often agree to a limit which is not their ideal, to win the business and get onto the customer’s supplier list.

Negotiation

Having a strong understanding of the commercial aspects of a contract and how best to translate this into the legal position (by gaining advice) should help when negotiating limiting liability. It is also important to consider ways of limiting liability without simply adding a limitation clause.

If you have any questions about limiting liability or about contract law more generally please contact Neil Williamson.