The Safety Net for Commercial Contracts

Would you drive your car without car insurance?

Would you embark on a car journey without wearing a seat belt?

In the main, the vast majority of us, would never dream of doing the above, for fear of what could happen if things went wrong.  Yet despite being careful and taking preventative action in many areas of life, most business owners enter into commercial contracts on a regular basis without ensuring that the most important safety net for any business, the limitation of liability clause, is included in there.

Before looking in more detail at what a limitation of liability clause is, lets consider what a party is liable for under a contract without a limitation of liability clause…

What are the consequences on a breach without a limitation of liability clause?

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 etc.  In the absence of an effective limitation of liability clause, the party in breach of the agreement, will be liable, without any financial cap, for all of the reasonably foreseeable damages that its breach causes the other party.  That will include any damages that a reasonable third party would expect (direct damages) and all of the damages that the parties themselves would reasonably contemplate or expect given their knowledge of the deal (indirect damages).

At the very least this can lead to significant financial pain but at the very worst can mean an end to your business entirely.  Given the potential risks, it is very important to ensure that the commercial contract that you are entering into contains some form of limitation, and further that those limitations are both effective and enforceable.

What is a limitation of liability clause?

A well drafted limitation of liability clause protects a business by limiting the amount the other party can claim. Put simply, it works by placing a cap on a party’s liability to pay damages.  This means that if a party breaches a contract and the other party suffers loss, the breaching party is only liable up to the amount of the cap.

Drafting a limitation of liability clause

So how should a limitation of liability clause be drafted?

In order to draft such a clause, it is important to identify precisely the risks attached to the contract and the subsequent losses that may arise from those risks.  Ask questions such as:

  • What could go wrong in this arrangement?
  • If it did go wrong what would be the likely costs and could I afford that?

Once the risks have been identified the clause must be drafted with clear and unambiguous wording.

When it comes to drafting or negotiating limitation of liability clauses, the best option is to give the commercial team at Baines Wilson LLP a call as there are many pitfalls!!  However, an effective clause should always deal with the following:

  1. Statutory restrictions

The law imposes restrictions on the application of limitation of liability clauses.  The extent to which you can limit or exclude your liability will depend on whether the contract involves a consumer:

Business Contracts – Under the Unfair Contract Terms Act, a Business to Business contract cannot exclude the following:

  • Death and personal injury caused by negligence;
  • Fraud or fraudulent misrepresentation.

Any attempt to do so would be unlawful and could render the entire clause invalid.

However, in relation to breach of contract, misrepresentation and breach of implied terms, it is possible to limit your liability, if the clause is considered to be reasonable.  When considering what is reasonable the court will look at various factors such as the parties bargaining positions, the information available to a party when the contract was made, whether the contract was negotiated, whether the contract provides other remedies for breach.

Consumer Contracts – any limitation of liability clauses in business-to-consumer contracts are less likely to be enforceable.  In fact, anything that creates an imbalance between the parties, to the detriment of the consumer is usually considered to be unfair and is prohibited.

  1. An exclusion on the types of losses that you will not be responsible for

This will quite often include ‘Consequential losses’ such as loss of profit, loss of contracts, loss of revenue and damage to goodwill

  1. An ultimate cap on your liability

The clause should list which losses will be capped and what the cap should be (the cap can be different for different types of loss).  The cap may be determined according to the party’s level of insurance, the value of the contracts or the potential amount of damage a breach of contract may cause.

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; or
  • The higher of a fixed sum and a percentage of the sums paid under the contract

A cap may also apply to each claim (or a series of connect claims) or it may be an overall cap.  Alternatively, there can be a combination, i.e. a cap per claim, subject to an overall cap.

Consider Indemnity clauses

When drafting a limitation of liability clause, you must also look to see how it interacts with any indemnity clauses within the contract.

An indemnity is usually inserted to protect the indemnified party from all possible loss that may arise from a specified cause.  If the indemnity clause is not reviewed or considered, then the likelihood is that it will be exempt from any limits that are drafted into the limitation of liability clause.  However, if the contract does contain an indemnity then when you are either drafting or negotiating the limitation of liability, ask:

  • 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?

If you are drafting or reviewing commercial contracts for your business, then please contact our corporate and commercial team on 01524 548494 or 01228 552600.

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