Every business aims at making profits, and profits can be made in multiple ways. One of the most common ways of making profits is by protecting the financial health of your business, and incorporating strategies to mitigate potential risks and protect yourself from any liability or damages. However, considering that you are often not sure to what extent these liabilities might extend to, it becomes important for businesses to have a safeguard for their protection in the form of a limitation of liability clause.
Let’s understand their importance through an example – You give your blazer for drycleaning services, but the person ends up damaging your blazer which costs you about $200. In an ideal situation, you would ask the service provider to compensate you with the cost of the blazer, considering that you would not be able to use it any longer. However, to avoid such potential risks, your drycleaning agreement might already have a limitation of liability clause, which limits the liability of the service provider to the cost of services. Therefore, if the dry cleaning service was worth $20, then the service provider would only be liable to pay you that amount.
Therefore, limitation of liability clauses acts as a safety net in the contract, which helps in ensuring that your liability is limited to the minimal extent, if things go wrong. Unfortunately, despite its importance, this clause does not attract a lot of attention from those reviewing the agreement. However, this article aims at providing you with the much-needed insights into this concept, to ensure that you are able to understand the fundamentals and do not gloss over this clause henceforth.
What is a limitation of liability clause?
Limitation of liability clauses act as important contractual tools which assist in providing a safety net, by clearly outlining the extent of your liabilities beforehand. Therefore, the negotiating parties are able to understand the limitation, restriction, and cap on the quantum of damages in case of breach of contract.
If there is no limitation of liability clause, the party responsible for the breach is responsible for compensating for any reasonably foreseeable damages that it causes to the other party. This is inclusive of any damages that the parties can reasonably contemplate, given their knowledge about the purpose of the contract. In simple language, if you are aware about the worst-case scenario about your deal, and that worst-case scenario ends up taking place, then this shall be considered to be reasonably foreseeable damage, which would be required to be adequately compensated. However, through the presence of a limitation of liability clause, this liability is capped at a certain amount.
Key negotiation points for a limitation of liability clause
Negotiating a limitation of liability clause requires a balance of coming to a mutually beneficial agreement, along with protecting your individual interests. Some key considerations that must be taken into account are:
Types of liabilities
Damages that arise due to a breach of contract are mainly divided into 2 categories – direct and indirect. Direct damages are damages which logically flow from a party’s non-performance (negligence or wilful misconduct) of the contract. Example – failure to deliver the products or defectively manufacturing a product. On the other hand, indirect damages deal with more incidental or consequential damages.Example – loss of profits to a company due to the breach of the contract.
Generally, the limitation of liability clause is not inclusive of any indirect damages (such as loss of profits, insurance premium payments, attorney fees, etc.) considering that they are often speculative and difficult to quantify. However, if the contract specifically mentions that indirect damages shall also be included within the ambit of liabilities, then they shall also be considered. Therefore, ensure that you crosscheck the types of liabilities that have been covered through the clause.
This is one of the most important parts of the limitation of liability clause, considering that it provides the extent of liability imposed on the defaulting party and the financial exposure provided to them. Usually, through the mutual negotiations between the parties, they can come up with a fixed amount ceiling for limiting their financial responsibilities, by taking multiple factors into consideration. These can include the financial size of the transaction, the nature of the transaction, the bargaining power of the parties involved, etc.
Depending upon the negotiations between the parties, they can decide to exclude certain types of claims from liability caps. This means that the parties shall not have any limitation of liability on certain kinds of transactions. Some common examples of excluded claims are – gross negligence, wilful misconduct, IP infringement, data breach, and/or indemnification obligations. Here, considering that the consequences of these breaches is large, parties avoid having any limitation for them.
Mutual v. Unilateral
Another important point of negotiation between the two parties is whether the limitation of liability should apply mutually to both parties, or whether it shall apply only to one of the parties. Usually, this decision is dependent on the bargaining power of the two parties along with the context of the agreement itself. The party with more risk exposure is more likely to ask for a limitation of liability clause, and limit the possibility of a mutual clause. Similarly, a party with less risk exposure might favor a mutual clause, than a unilateral one. Therefore, it becomes the responsibility of the parties to enter into a common understanding and decide what is best for their future arrangement.
Indemnification clauses and limitation of liability often go hand-in-hand and are often negotiated together. This is to ensure that the limitation of liability clause does not end up conflicting or undermining the indemnification clause.
An indemnification clause is a promise from one party to accept the risk of certain losses and damages that the other party may suffer. A limitation of liability clause on the other hand limits the extent to which a party can be held accountable. Therefore, if the liability cap has been set at a lower threshold, it undermines the use of the indemnity clause, which otherwise could have been a good way to cover the losses that one party faced due to the other party.
Important Drafting Considerations
Once you have properly negotiated the clause, ensure that you are able to convert your understanding into a draft in a proper manner. Some common tips that you should consider focusing on are:
- Using clear and unambiguous language.
- Clearly identify the types of liabilities that are excluded (example – negligence).
- Focus on where you use the words “other” and “including” and ensure that they do not mislead the understanding.
- Keep the clause conspicuous, and ensure that it is bolded, underlined, or both. Ensure that it is visible in the contract draft.
- Keep drafts of all revisions that you might make to the clause in the future.
- Prefer using separate sub-points to breakdown the main issues and considerations of the clause.
- Prefer keeping record of the fact that the clause has been adequately negotiated and why they reached a certain understanding.
To conclude, almost all contracts are inclusive of a limitation of liability clause and the clause is necessary to mitigate and prevent exposure to significant damages. Therefore, it becomes important for the parties to properly negotiate the contents of the clause and come to an understanding that it is the most suitable for them.
If you are someone who is concerned about how to decide and incorporate a limitation of liability clause, or have any other concerns related to their contractual arrangement, the experienced team of LegaMart is capable of providing you with the required assistance in reaching a beneficial contractual relationship. Reach out to us today!
Frequently Asked Questions (FAQs)
Can the enforceability of a limitation of liability clause be challenged?
In some cases, it is possible to challenge the enforceability of a limitation of liability clause. Usually, it is done if the clause is unconscionable, against public policy, or if there are legal provisions within the legislation of a jurisdiction which indicate that enforcing the law is not allowed.
In which industries are these clauses common?
The limitation of liability clause is most common in industries like construction, manufacturing, technology, and professional services. Contracts having high stakes are most likely to have such clauses.