Every business tries to protect their financial health, mitigate risk and insulate themselves from liability and damages. But you might be overlooking one of the most useful and important contractual provisions every time you enter a new contract: the limitation of liability clause.
A carefully negotiated limitation of liability clause is the primary tool to create a safety net in a contract so that you know what you are liable for if things go wrong. If your business engages in any kind of contract – and let's be honest, all businesses do – you should have a working understanding of the effect and importance of limitations of liability clauses and strategies.
Next time you are reviewing, or crafting an agreement, don't gloss over the limitation of liability language. Instead, be sure to understand these four fundamentals, and consult a contracts expert to ensure your business interests are adequately protected.
What is a limitation of liability clause?
Before we answer that question, we should start with a baseline understanding of what a party is liable for under a contract without a limitation of liability. In the absence of a limitation of liability, a party is liable and responsible for all of the reasonably foreseeable damages that it causes the other party. That includes any damages that a reasonable third-party would expect (generally known as direct damages) and all of the damages that the parties' themselves would reasonably contemplate or expect given their knowledge of the deal (indirect damages). Given the potential risks, parties routinely try to limit their liability with liability caps and disclaimers.
Limitation of liability clauses are an important contractual tool designed to manage overall risk by limiting a party's potential liability for damages. This clause can be the most important term in a contract and should be carefully reviewed and understood. Often, limitations of liabilities are highly negotiated.
Always consider whether (and how) to include the following when negotiating your limitation of liability clause:
- liability caps: language that limits potential liability to a stated or calculable amount, and can include a specified dollar amount, fees payable by the customer, a hybrid or shared excess liabilities;
- waiver of certain categories and types of damages, such as consequential or indirect damages;
- exclusive remedies for certain breaches; and
- potential carve-outs and exceptions to the foregoing limits which create higher or even unlimited liability for the stated exceptions.
Limitations of liability are never one-size-fits-all.
Limitations of liability could apply in virtually any contract, across any industry and for any value. For every contract you enter, it is a good rule of thumb to ask yourself: what's the worst-case scenario in terms of damages I could incur if I breach the contract or am negligent and cause harm to the other party? It's critical to understand that there's no one-size-fits-all approach here. Each agreement is highly dependent on the facts of the relationship (am I a service provider or a customer; value of the deal; importance of the deal) as well as the other terms in the agreement.
For example, there's a big difference in risk for a milk delivery company that fails to deliver four quarts of milk to a family's home when it is supposed to be delivered, and one that fails to deliver hundreds of gallons of milk to an ice cream factory on time. In the first scenario where the milk delivery company doesn't deliver to the family, damages are likely just the cost of the family driving to the store plus the cost of replacement milk – maybe only $20. Those are "direct" damages. However, in the second scenario, the ice cream factory is dependent on the milk as a raw material to produce its ice cream so the damages would be not only the direct damages of replacement milk, but also the reasonably foreseeable lost profits and lost sales because the ice cream factory's products couldn't be produced and sold. These are likely recoverable indirect damages. Also, it is possible the factory has a commitment to deliver the finished ice cream to customers by certain dates, and failing to do so could trigger contractual monetary penalties. These damages could easily reach tens or hundreds of thousands of dollars.
In other words, context matters, and in some contracts, limitations of liability may not worth worrying about (the first example), while in others, it's worth losing sleep about (the second example). In the second scenario, the milk producer would be wise to include a cap on damages to limit its overall damage to, for instance, the value of the milk sold, and to disclaim indirect and consequential damages. On the other hand, the ice cream factory would want to fight for the opposite: higher or unlimited liability for the milk producer, and the ability to recover all categories of damages.
Beyond day-to-day risk, limitations of liability could impact your market value too.
Everyone – from startups to established companies, and from investors to potential acquirers – can be impacted by limitation of liability clauses. Truly everyone entering into contracts should know what limitation of liability clauses do and should look out for the provision to make sure it appropriately allocates risk in its best interest.
At the core, limitations of liability provide a practical day-to-day benefit by contractually limiting and reducing risk. In general, parties want their risk to be tied in some rational way to their potential upside under the contract. From a practical standpoint, if I stand to earn $50,000 under a services contract, why would I want to have $1,000,000 in contractual liability to the other party? Oftentimes parties try to limit liability in some way to the value of the contract via the cap.
Limitations of liability can also have a potential impact on a company's prospective financing and acquisition opportunities. Investors and buyers of companies or assets want to invest in and buy solid assets and might shy away from a company that has many contracts with unusually high, or hard to quantify risk. In order to be due-diligence ready and attractive to investors and acquirers, a company should consider the collective risk in all of their contracts.
If a business agrees to one to two contracts with very high or unlimited liability, that means additional risk, but only with regard to a couple relationships. This risk is not only easier to quantify, but more manageable, and the business can weigh whether taking on the risk is worth the reward of closing that particular deal.
However, if a company routinely takes on high or unlimited risk in its contracts, they would have more accumulated risk that might be a red flag or deterrent for a buyer or investor. Buyers and investors may make a determination that the risk of that portfolio of contracts is high enough that it devalues the company. In that case, the buyer or investor may reduce the purchase price or valuation, ask for special accommodations to address the risk such as a special indemnification, or in extreme cases, potentially walk away.
Context always matters.
Here's the tricky part – limitations of liability are all about context. They are unique and extremely context-driven (sometimes painfully so) – and, of course, no two contracts and relationships are the same
The best way to create your limitation of liability clause is to take the time to understand the context and facts of any business relationship, and consider the risks to your business if something goes wrong. Limitations of liability often interact with other key provisions and cannot be read or negotiated in a vacuum. Pay particular attention to the limitation of liability's interaction with indemnification obligations and other remedies offered by the contract. Commonly, a party's indemnification obligations are carved-out from the limitations of liability – meaning a party has unlimited liability for indemnification obligations. Therefore, when evaluating overall risk, you will need to check to see if the indemnification obligations are carved-out, and if so, make sure the indemnification obligations are not overly broad such that the limitations of liability do not provide meaningful protection.
Be aware that the knee-jerk reaction that the limitation of liability clause should be a mirror image for each party is often incorrect. The earlier point that context matters means that it is often a rational result that the limitations of liability are often different for each party. The parties are in unique situations, and oftentimes, one party is more likely to breach or to incur damage. As a result, limitations of liability may appropriately be different.
A carefully written, contextually-driven limitation of liability clause can be one of your most important risk management tools and a safety net for your business. Taking the time to consider the context of each contract, the risks to your business and judiciously negotiate terms of the clause can help to protect your business.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.