What is a limitation of liability clause?
What legal liabilities can be excluded in a contract?
Are liability cap provisions enforceable in law?
In this article, we will break down the notion of “limitation of liability clause” so you know all there is to know about it!
We will look at what a limited liability clause means, its legal definition, purpose, benefits, types of liability that can be limited, is it enforceable in law, compare it to an exculpatory clause and indemnification clause, look at clause samples and examples and more!
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What is limitation of liability clause
A limitation of liability clause (no liability clause or non-liability clause) is a contractual provision where either or both parties limit their liability for future damages.
In other words, if a contracting party causes damage to another, based on the limitation of liability clause, the non-breaching party can only claim damages up to the cap provided under the contract.
A design engineering firm enters into a contract with a general contractor to design certain elements for the construction of a hotel.
In their contract, the engineering firm includes a limitation of liability clause capping its liability for professional errors and omissions to $20,000.
Eventually, the contractor suffers $300,000 in damages due to design errors.
Further to the limitation of liability clause, the engineering firm’s total liability will be limited to $20,000 even though the non-breaching party suffered damages above that amount.
Essentially, the limitation of liability clause caps a party’s total risk or financial exposure under the contract.
Limitation of liability clause basics
To better understand the concept, let’s look at the limitation of liability clause definition.
We define the limitation of liability clause as follows:
A contractual provision based on which the parties limit their liability for future liability in such a way as to reduce the financial risk in performing their obligations under the contract.
Why do you need to limit liability in a contract?
In reality, we all want to maximize the benefits under a contract and minimize risk.
The purpose of the limitation of liability provision is to manage essentially that: contractual risk.
When you include liability restrictions and liability caps in a contract, you are limiting your legal and financial exposure (to the extent the clause is enforced by the courts).
If you do not include liability limitations in your contract, then you should be prepared to have unlimited liability.
In other words, you will potentially be held responsible to the fullest extent for the damages caused in the performance of your contract.
A limited liability contract can help you better predict your potential financial exposure so you can better assess and establish your contract pricing, better determine the level of insurance coverage you may need and assess the overall risk and reward profile of the transaction.
The top two reasons why you may want to limit liability under a contract is to:
- Provide yourself with legal protection against future liability
- Cap the total amount of money for which you can be held accountable
A consultant will be more inclined to provide consulting services to a client for $10,000 knowing that his total future liability is limited to $10,000 and not $1,000,000 or any unpredictable amount (unlimited liability).
Type of liability
Doing business involves taking risks.
Entering into legally binding contracts and having to perform obligations can be fruitful in most cases but in some unfortunate cases can lead to legal liability.
Here are some examples of situations that a person or company can be exposed to legal liability:
- Breach of contract
- Errors and omissions in performing contractual obligations
- Negligence, gross negligence or willful misconduct
- Infringement of intellectual property rights
- Acts or omissions leading to damages even though it was not done in bad faith
A person or business can be held liable for the following types of damages:
- Direct damages resulting from a contracting party’s actions or omissions (actual damages)
- Indirect damages representing damages that the parties reasonably contemplated or expected when the contract was signed
- Consequential damages
- Special damages
- Compensatory damages
It’s difficult to predict all the possible scenarios under which a person may be held liable under a contract in the future.
As a result, the limitation of liability clause is a legal tool allowing the parties to limit certain types of liability or mitigate risk in order to contractually reduce the risk of possible claims filed against them by the other party.
Contractual liability cap
Limitation of liability clauses are typically drafted in such a way as to limit liability based the following formula:
- The fees actually paid by one party to another
- The fees actually paid or payable by one party to another
- To a fixed amount as mutually agreed by the parties
- To the multiplier of the fees paid or payable by one party under the contract
- To the same limit a party has available under an insurance policy
- A combination of any of the above
When dealing with the notion of liability under a contract, it’s important to keep in mind that in most jurisdictions, the law will restrict or limit the possibility for the parties to cap certain types of liability.
As a result, even if the parties have duly negotiated a liability cap in their contract, in a fair and free manner, you may have an overriding statute or public policy rendering the provision ineffective.
For instance, in the context of a business-to-business relationship (B2B), under the Unfair Contract Terms Act (UCTA) in the United Kingdom, a party cannot limit liability related to death or bodily injuries caused as a result of their negligence.
On the other hand, a party can limit its liability for damages caused due to breach of contract, acts of misrepresentation or breach of implied duties in law provided the limitation of liability is reasonable in the circumstances.
You can also expect that in most jurisdictions, liability limitations to be unenforceable in business-to-consumer relationships (B2C).
Limitation of liability clause within contracts
If you are in business, you surely come across a limitation of liability provision in contracts.
When entering into a contract, contracting parties will almost always think about their liability exposure.
- What happens if things go wrong?
- How much will I be held liable for if I don’t deliver on my promise?
- Can I limit my liability in any way?
- Is this contract worth the risk?
A limitation of liability clause can be found in many types of contracts or commercial agreements, such as:
- Service agreement
- Development agreement
- License agreement
- Subscription agreement
- Distribution agreement
- Insurance policy
- Construction contracts
- Transportation agreements
- Consulting agreements
Having a liability restriction in a contract is valuable to the extent it is enforceable by law.
As a result, you must make sure you properly negotiate and draft such a provision.
Drafting limitation of liability clauses
To draft an enforceable liability clause, you need to make sure you draft the provision properly and in accordance with the requirements of the applicable jurisdiction.
Typically, you can increase the chances that a court will enforce a limitation of liability provision when you observe the following parameters:
- The clause must appear in capital letters, bold print or underlined so that it stands out
- Make sure you clearly draft what type of liability you are limiting or when will the liability cap get triggered
- Make sure you clearly indicate the maximum threshold of your liability
- Make sure that it is clear to whom the limitation of liability applies
You should also draft the provision in light of your commercial risk or liability that you intend to limit.
What are the possible risks under the contract that may lead to liability?
- How risky is the contract?
- How much can your liability turn out to be?
- Does the potential liability exceed the insurance coverage that you have?
- Do you want to limit certain categories of damages like indirect and consequential damages?
- Do you want to include an exclusive remedy in your contract?
- Did you price your contract to reflect the level of risk being taken?
You want to make sure that you strike the right balance between the contract value or benefits that you are getting versus the risk that you will assume.
Negotiating limitation of liability clauses
To determine whether or not the limit of liability negotiated by the parties in their contract should be enforced, the courts will also look at the pre-contractual negotiation context.
- Did the parties have equal bargaining power when negotiating limits of liability?
- What was the level of sophistication of the parties?
- Is the provision adhesive?
- Did the party have a true and fair opportunity to negotiate the terms?
If the court considers that the liability terms were adhesive or that a party has abused the vulnerability of the other party to impose disproportionate liability exposure, the courts may refuse to enforce the clause.
What is usually recommended is that you keep records of your limitation of liability clause negotiation so you can potentially demonstrate the negotiation context.
Mutual vs unilateral clause
You can have a mutual limitation of liability clause or a unilateral one.
Mutual limitation of liability clauses are those that apply to both parties to the contract.
In essence, both parties benefit from some form of liability limitation.
Unilateral limitation of liability clauses are those that only limit the liability of one party towards the other.
Only one party to the contract will have limited liability while the other one will have unlimited liability exposure.
In this section, let’s dig deeper into assessing the enforceability of limitation of liability clauses in contracts.
Typically, in the United States, most states recognize and enforce the limitation of liability clause although some do not consider them enforceable.
The limitation of liability clause can be considered as a shift of commercial risk between the parties.
As such, if the parties intended to limit their exposure, cap their liability, limit the amount for which they could potentially be held liable in the future, the courts in most cases will consider that to be a reasonable contractual provision and enforce the clause.
However, the courts will exercise care in assessing the overall context surrounding the inclusion of the limitation of liability clause to ensure that it was freely negotiated and does not violate public policy.
The limit of liability clause is generally found to be enforceable when:
- It is clearly drafted
- The limitation of liability category or types of liability excluded are clear
- The parties clearly expressed their intention to limit their liability
- The parties had the ability to freely negotiate the limitation of liability clause
- The clause does not violate specific laws
- The clause does not violate public policy
Said differently, the liability clause will not be enforceable if its terms are ambiguous, unconscionable, the parties had unequal bargaining power, one party was much more sophisticated than the other or it does not comply with local statutes.
Exclusion of liability clause
Limitation of liability clauses can be drafted in such a way as to limit liability for certain types of liability while excluding others from the limitation.
In the legal space, we call this the limitation of liability carve-outs or liability exclusions.
The exclusions to the liability cap can:
- Exclude certain category of liability such as death, bodily injury or any other types of personal injury
- Exclude specific type of liability such as losses resulting from data loss or the loss of specific equipment or property
What is carved out from the liability cap can be without limit (unlimited liability carve-outs) or limited at a different cap (typically a higher cap than the baseline liability cap).
Limitation of liability clause vs exculpatory clause
It’s important to distinguish a limitation of liability clause from an exculpatory clause.
A limitation of liability provision is a contractual clause putting a cap or limit on how much a contracting party may recover from the other party in the event damages are suffered.
An exculpatory clause is a contractual clause that fully exonerates a party from future liability.
In a construction contract, a contractor may negotiate a limitation of liability clause for negligent acts up to $200,000.
This means that the contractor will have some liability but up to a maximum of $200,000.
On the other hand, with an exculpatory clause, the contractor can potentially be free from any liability whatsoever.
The limitation of liability clause is generally seen more favourably than an exculpatory clause.
In general, the courts are reluctant to enforce a contractual provision limiting a person or company’s liability for future negligence.
With a limitation of liability clause, the courts can view that as a balancing of contractual risk or commercial risk between the parties.
If parties dealing at arm’s length have negotiated a liability cap in a free and voluntary manner, the courts are more likely to enforce it.
Limitation of liability and company valuation
A topic that is important to discuss is the impact of liability exposure on a company’s overall market value or “valuation”.
Entrepreneurs, startups and growing businesses may want to sign as many contracts as possible to demonstrate market adoption of their product or services.
However, signing a contract and being exposed to unlimited liability in all contracts may not work well for future investors.
Investors, venture capitalists and financing organizations tend to prefer investing in companies where they can better quantify their overall exposure to risk and potential liability.
The more you are able to reasonably control liability under your contracts, the more your company can be enticing to investors.
Limit your company’s overall exposure to risk so you can increase your company’s attractiveness for future financing.
Limitation of liability clause examples
To get a better sense of how the limitation of liability clause appears in different types of contracts, let’s look at some sample clauses.
Clause sample 1: Mutual limitation of liability clause
The Parties hereby agree that their total aggregate liability for claims asserted by the other Party under or in connection with this Agreement, regardless of the form of the action or the theory of recovery, will be limited to $300,000 per calendar year.
Clause sample 2: Liability exclusion for small losses
Seller shall not be liable to Buyer any liability or damages caused below an aggregate amount of losses of $50,000.00 (the “Lower Limit”). The Seller shall only be required to pay or be liable for losses in excess of the Lower Limit. In no event shall the aggregate amount of all losses for which Seller shall be liable under this Agreement exceed three (3) times the Purchase Price (the “Liability Cap”).
Clause sample 3: Limitation of liability with a carve-out
Nothing in this agreement excludes or limits Party A’s liability to the extent that any applicable law precludes or prohibits any exclusion or limitation of liability. Except in connection with each Party’s indemnification obligations hereunder, neither Party shall be liable to the other Party for any indirect or consequential damages, including, but not limited to, lost time, lost money, lost profits or good-will, whether in contract, tort, strict liability or otherwise, and whether or not such damages are foreseen or unforeseen.
Limitation of liability clause FAQ
What is the difference between limitation of liability and indemnification
A limitation of liability clause is a contractual provision allowing a party to “limit” the exposure to future liability.
In other words, a company can set a maximum or total cap defining how much money it can potentially have to pay to the other party in the event certain types of damage or events occur.
It’s sort of an agreement “not to pay” for certain damages.
An indemnification clause is a contractual provision where a party agrees to “indemnify” or cover the losses for another.
Said differently, with an indemnification clause, a contracting party contractually agrees to “pay” for damages under certain specific conditions.
A typical indemnification clause will state that if due to a party’s breach of contract, the other party suffers damages resulting from third-party claims, the indemnifying party agrees to pay for what the indemnified party for the losses.
Can companies limit their liabilities
In most jurisdictions, companies can limit their liability under a contract.
Some common law and civil law jurisdictions may impose stricter rules surrounding the enforceability of limitation of liability provisions or perhaps prohibit them, but in most cases, they can potentially be enforced.
Limiting liability should in fact be considered for every contract.
To limit liability is to evaluate and balance commercial risk between the parties.
You will generally find disclaimers or provisions where the parties define the boundaries of damages they may have to pay one another.
Companies in any industry and of any size should consider limiting their liability under a contract to the extent authorized by law.
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