In contracts, parties typically seek to limit their liability to each other, both in terms of the types of damages or actions for which a party will have liability and the amount of damages that can be recovered, as well as, in certain cases, the remedies that can be pursued. The parties often negotiate exceptions from these limitations, including for gross negligence or willful misconduct. During this podcast, Chris Houpt, Linda Rhodes and Anja Watt along with host Julian Dibbell will examine the definitions of gross negligence and willful misconduct, recent court holdings on the ability of contracting parties to limit liability and the implications for contracts. For purposes of this podcast, we focus on New York law, commonly selected as the governing law in contracts.
Transcript
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Julian Dibbell:
Hello and welcome to Tech Talks. Our topic today is exceptions to
contractual limitations on liability. A topic with implications far
beyond the world of tech, of course, but one that comes up in
nearly every technology transaction agreement. More specifically
we're going to be talking about the interplay between contract
terms and legal principles and what that means for contract
negotiations. I'm your host, Julian Dibbell. I'm a senior
associate in Mayer Brown's Technology Transactions practice.
I'm joined today by Linda Rhodes, Anja Watt and Chris Houpt.
Linda is a Technology Transactions partner in our Washington DC
office. Anja is an associate in the Litigation & Dispute
Resolution practice based in our New York office. Chris is co-chair
of Mayer Brown's Banking & Finance Litigation group in New
York. All right, let's jump right in. Linda, you first wrote an
article on the topic of limitations on liability
exceptions for gross negligence and willful misconduct back in
2013, and it is still getting hits on the Mayer Brown website to
this day. I think even more hits than most articles on the website.
Why is this issue still relevant?
Linda Rhodes:
Thank you, Julian and hello, everyone. So, the issue of limitations
on liability is negotiated in virtually every deal. Limits on
liability and damages are a common way of allocating and managing
risk and contractual relationships, including not only tech
transactions, as you mentioned such as outsourcing SAS agreements,
software data and digital, but also in other types of agreements,
including financing.
Julian Dibbell:
Okay. Could you provide some clarity on what you mean by
limitations on liability?
Linda Rhodes:
Sure. When I refer to limitations on liability, I am referring to
several types of limitations. First, there are certain types of
damages or acts that might be excluded entirely. For example, it is
quite common for a contract to provide that neither party is liable
for consequential, incidental, punitive or other indirect damages.
Thus, if party A breaches the contract and party B brings a claim
against party A, party A will be responsible for party B's
direct damages, but not any of these consequential damages such as
lost profits. Alternatively, a contract might provide that party A
will have no liability for actions taken in good faith based upon
the directions of party B. Thus, in this example, as long as party
A takes action and good faith based upon party B's direction,
party A will not have any liability to party B for any damages
party B may suffer as a result thereof, and regardless of whether
the resulting damages are indirect, direct consequential or
otherwise.
Secondly, when you talk about limitations of liability, it also includes parties agreeing to cap their damages. So, for example, it might mean if party A were to breach the contract and it causes party B damages, party B is then able to recover its damages, but up to a limitation, and any damages that party B may suffer above that cap would be borne by party B. And then finally, I'd also like to mention that limitations of liability may also take the form of limited remedies for a breach, and I think a common example in the tech trans world is a SAS provider that might try to limit its liability for SLA failures by saying that SLA credits are the sole and exclusive remedy. So in that case, if there were a failure to meet service levels, a customer could get the credits but couldn't recover for any additional damages that it might suffer. Another example might be repair or replacement as an exclusive remedy for a warranty breach.
However, what is even often more heavily negotiated than what the limitations of liability are, are what the exceptions to those limitations are. The exceptions to both the excluded damages, meaning, you can't recover consequential or punitive, etc., as well as the exceptions to the liability cap when you can recover them as above the cap. They're often the same but they don't necessarily need to be the same. There could also be exceptions to the sole and exclusive remedy provisions. While the parties pretty much readily agree to exceptions for willful misconduct, gross negligence is more often a topic of negotiation in large part due to the lack of clear understanding as to what conduct actually constitutes gross negligence. Further, the determination of whether or not conduct constituted gross negligence depends highly on the facts of each case.
Julian Dibbell:
All right. Okay. So let's get into that. These are contract
terms that we've been talking about here, and the parties will
have their own understandings of what those mean, but then if push
comes to shove, so to speak, and a court has to apply those
contract terms to the facts of an actual case, how does that play
out? And I want to clarify here, for our listeners, that we'll
be talking about legal principles based on New York law. Mainly, so
that we can be as precise as possible about what the law actually
says but also because so many commercial contracts are governed by
New York law. So, having said that, again, what is the interplay
between contract terms and legal principles once a contract case
gets into court?
Linda Rhodes:
Thanks, Julian. I think you summed that up nicely. So you know the
extent to which a party to a contract can limit their liability is
not only a question of what the contract terms and conditions say,
but it is also a question of whether a court will enforce the
limitations. While limitation on liability clauses usually are
enforceable under New York law, there are exceptions regardless of
what the contract says. Anja and Chris will go into further detail
as to how New York courts have dealt with this issue of
enforceability of limitations on liability and contracts.
Julian Dibbell:
Okay, then. Well. Let's turn to Chris and Anja. Starting with
you Anja, can you give us an overview of New York law on limits of
liability?
Anja Watt:
Sure. Hi, Julian. Hi, everyone. Generally, these clauses are
enforceable. Parties can generally exclude their liability for
certain acts or types of damages, as Linda explained. Parties can
also generally limit the amount of damages for which they are
liable, limiting the other party's recovery to either specific
amounts or recovery based upon a certain formula. So, for example,
contracting parties typically limit their liability to an amount
equal to the fees paid or payable under the contract over a
specified period of time. However, courts will not uphold these
clauses when they attempt to completely shield the party from
liability for conduct that rises to the level of either gross
negligence or willful misconduct. But as we'll discuss later in
the podcast, the law on whether liability for gross negligence can
be capped or otherwise limited is evolving.
Julian Dibbell:
Okay. So why won't courts generally uphold limitations of
liability for gross negligence and willful misconduct?
Anja Watt:
So this comes from New York's public policy and, at a more
fundamental level, basic principles of contract in tort law. As
explained in the restatement second of contracts, a party cannot
completely exempt themselves from liability for harm that is caused
either intentionally or recklessly. Animating this policy is the
concern that allowing parties to exempt themselves from liability
for this type of conduct increases the risk that the general public
will be harmed. And similar to complete exclusions of liability,
the same public policy principles I just mentioned also
historically apply to capping liability for gross negligence and
multiple misconduct. But like I said, recent cases in New York
courts have indicated that caps of liability for gross negligence
may be enforceable provided that the cap is meaningful. This is the
same rule courts will apply to indemnities. In general, indemnities
for the indemnified party's gross negligence or willful
misconduct are unenforceable.
Julian Dibbell:
Could you help us understand the practical effect of contractual
and legal prohibitions on limiting liability for these categories:
willful misconduct and gross negligence?
Anja Watt:
Sure. So, given the relatively high bar a party needs to clear to
prove either willful misconduct or gross negligence, in practice,
this exception is quite narrow and, as Linda mentioned, is often
fact-specific. New York courts have interpreted willful misconduct
to require things like intentional acts for failures to act,
knowing that the party's conduct will probably result in injury
or damage. Acts in so reckless in manner or failures to act in
circumstances where an act is clearly required so as to indicate
disregard of the party's action or inaction. Or, intentional
acts of unreasonable character performed in disregard of a known or
obvious risk so great as to make it highly probable that harm would
result. Now, gross negligence is a bit of a confusing term because
it sounds like it just means very negligent but, under New York
law, it's more akin to willful misconduct. Gross negligence
generally requires reckless indifference to the rights of others or
a failure to use even slight care or conduct that is so careless as
to show complete disregard for the rights and safety of others.
Thus, a deviation from a standard of care—even a major
deviation—isn't enough to constitute gross
negligence.
Julian Dibbell:
All right. So, Chris, Anja mentioned recent developments in cases
examining the enforceability of limitations of liability. Could you
give us an update?
Chris Houpt:
The most recent important development was a decision by the New
York Court of Appeals, which is New York's highest court, in a
case involving mortgage-backed securities and that decision
addressed some broader questions of the enforceability of limits on
liability, including caps on liability and damages and limits on
remedies. The case is called, "In re Part 60 Putback
Litigation", and just to give you a little bit about the
claim, the way a mortgage securitization works is that a sponsor
bank puts loans into a trust for the benefit of investors and they
make representations and warranties to the trustee about the
quality of the loans and the underwriting standards. And a typical
provision in these contracts is that if a representation is
breached as to a particular loan, the trustee can sell that loan
back to the sponsor at its outstanding principal balance. So
that's called a "put-back."
Julian Dibbell:
Okay. So why was gross negligence even an issue there? Was there a
limit on liability?
Chris Houpt:
Well, the case wasn't about an explicit limit on liability or
damages. It was about what's called "the sole remedy"
clause. The contract said that the trustee's right to put the
loan back to the sponsor is the sole remedy for a breach of a
representation. And that case is a little bit unusual in this
context because I think that the real reason that the plaintiff
wanted to challenge the sole remedy clause was just that it made
litigation so much more expensive. It required that they approve a
breach of a representation on a loan-by-loan basis, so they had to
go through the underwriting file for each loan and have an expert
testify that the underwriting standards were breached on each loan,
and it's just a very tedious and time-consuming and expensive
process. So what the trustee plaintiff did instead was argue that
the sponsor had just reached so many representations on so many
loans that its conduct amounted to gross negligence so that the
sole remedy clause was not enforceable. If it had succeeded, what
they were trying to do was to just recover general damages to the
trust as a whole based on pervasive evidence of breaches rather
than having to go through loan by loan.
Julian Dibbell:
Okay. So what did the court in fact hold?
Chris Houpt:
The court found in favor of the defendant. It said that the sole
remedy clause was enforceable and the test that it applied was
pretty straightforward. It said that the sole remedy clause was not
an exculpation of the sponsor's conduct. It didn't say the
sponsor shall not be liable for something. Nor did it cap damages
at what the court called a nominal level and it said unless it
falls into one of those two categories, it'll be enforceable
even in the face of gross negligence. The court reasoned that the
parties had just decided on a particular remedy for a breach of
representation, but it wasn't the limit on the recovery, and
especially among sophisticated commercial parties, the court said
we're not going to interfere with those voluntary
decisions.
Julian Dibbell:
Okay. So Anja, what do we learn from that? Does the Part 60
decision provide real clarity in the law?
Anja Watt:
So yes, and no. The court in Part 60 did not reach the issue of
whether the specific allegations in that case constituted gross
negligence, but it did clarify that more broadly speaking clauses
seeking to limit a party's liability will not become
enforceable just because there are allegations of gross negligence
unless the clause is either an absolute bar on liability or a limit
to just nominal damages. But the facts of the case do leave some
questions open. So, for one thing, the put-back remedy was a sole
remedy provision. It didn't limit the amount of damages the
other party could recover, and it did not absolve the sponsor orfor
liability for its conduct. Rather, it limited the types of remedies
that were available in the event of a breach. In some ways the
put-back remedy was more favorable to the parties than normal
contract damages. Upon proof of any breach of representation, the
sponsor was required to buy back the loan at full face value,
essentially taking on 100% of any loss. Without this contractual
remedy, the plaintiff would have had to prove that the breach
caused the damages and would have to prove the amount of damages
arising from that breach in order to recover those damages from the
defendant. So while establishing a breach of a warranty required
significant effort by the trustee, once that breach was
established, the put-back remedy provided a potentially greater or
more certain recovery than straight contract damages would have
provided. The decision also left open a question regarding remedy
provisions that turn out to be illusory. While the court addressed
the argument that the provision at issue may be illusory and
possibly unenforceable, it found that the provision was not
actually illusory based upon the facts of that case. So this leaves
open the question of whether a court would enforce a sole remedy
clause that meaningfully limited a plaintiff's recovery and at
what point a limit on the plaintiff's ability to recover is
meaningful enough to prevent a court from striking down that
limitations clause. Finally, the court also left open the question
of how the holding would apply to sole and exclusive remedies in
light of allegations of intentional misconduct. However, since the
"In re Part 60" decision, cases that have come out
interpreting that case have found the decision does not apply for
allegations of willful misconduct.
Julian Dibbell:
Well, a lot to think about, there. Interesting developments. Linda,
what are some of the practical takeaways for contracting parties
here?
Linda Rhodes:
Listening to the details of the Part 60 decision highlights how
important it is to carefully consider the liability and remedy
terms included in agreements.
Although a court may strike down limitations on liability for gross
negligence or willful misconduct, it appears New York leaves open
the possibility that liability for, at least gross negligence,
could be subject to a cap or limited by exclusive remedies, as long
as the plaintiff's ability to recover damages is meaningful.
Therefore, for example, a customer under an technology services
contract will want to expressly exclude gross negligence from the
limitations on liability, as well as exclusive remedy
provisions.
If a customer wants to ensure that a specific type of misconduct by
a service provider falls outside of the limitation of liability
clause, the customer should specifically describe such misconduct
in the agreement. For example, excluding the service provider's
refusal to provide services from the limitation of liability,
breach of customer policies, violation of laws, breach of
confidentiality, etc. and the like would provide clearer standards
for the customer to prove, rather than relying on the exception for
gross negligence. In other words, give thought up front to what
behaviors you want to drive and incentivize – or more
appropriately in the case of exclusions to limitations on liability
– dis-incentivize that conduct.
Since the limitation of liability provision has a significant
impact on the allocation of risk between parties to tech
transactions and other agreements, customers should ensure that any
specific losses or misconduct that should not be subject to
contractual limitations on liability are clearly and sufficiently
identified as exclusions to the limitation of liability
provisions.
Julian Dibbell:
Well, very helpful, Linda, thank you so much. And thank you, Anja
and Chris, for filling us in on the details of the law and the
latest developments. Listeners, if you have any questions about
today's episode or an idea for an episode you'd like to
hear about anything related to technology transactions and the law,
please email us at techtransactions@mayerbrown.com. Thank you for
listening
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