Understanding Contract Terms (Post 10): Limitation of Liability
We continue the Understanding Contract Terms series by explaining limitation of liability (sometimes called “limitation on liability”) clauses. Many contracts include some form of limitation of liability clause, and they are important to understand to determine your potential liability exposure under your business’ contracts.
Limiting Your Liability
A limitation of liability clause allows parties to reduce or, in some cases, eliminate the potential for damages, including direct, consequential, special, incidental, or indirect liability. The limitation clauses can also include a cap on damages should damages flow from a breach of the contract. Often you will see these clauses in boldface type, underlined, or in larger font to make sure both parties are aware of the limitation on liability and damages, and many courts require that these clauses be bold in some manner to be enforceable.
Typically limitation of liability clauses will be broken down into three parts:
Cap on damages: generally when a cap is included one party will seek to limit their liability under the contract to a specific amount. Often this is the dollar amount of the contract, i.e. what the other party paid for the service or product. This fixes the potential liability under the contract, so that a party can better plan (and insure) for the risk. Because the default is that you may be liable for any damages that flow from a breach (with some exceptions), without a cap, you could be exposed to huge liability even on a small contract.
Exclusion of Consequential Damages: This portion of the clause focuses on the type of liability that each party will (or will not) be responsible for. Consequential damages (often called special damages) are unpredictable and virtually unlimited, which is why parties try to limit these damages as much as possible. Generally speaking damages are consequential if they would reasonably flow from a particular event, but were not necessarily contemplated by the parties prior to the event and are not a direct result of the breach. For a simplified example, John operates a website business and calls Jane to perform some maintenance on the website. Jane fails to perform the maintenance and the website crashes. As a result of the website crashing, John loses out on business from customers that landed on his site while it was down. The direct damage from Jane breaching the contract was the website crashing. The consequential damage from Jane’s breach was losing the business that resulted from Jane failing to show up and perform the website maintenance.
On the one hand, limiting (or eliminating) consequential damages can protect both parties from unpredictable liability. On the other, reducing consequential damages may result in you or the other party being without a remedy for damages suffered as an indirect result of a breach. Consequential damages are often thought of as part of the bargain even if the parties don’t necessarily know they are called consequential damages, so you should be aware if you are signing an agreement that limits them.
Exceptions: this section typically includes language that states explicit exceptions to the limitation of liability. In other words, each party’s liablility will not be limited with respect to the exceptions included in this portion of the limitation of liability clause. For example, a typical clause will include some form of the following sentence:
- “The limitations included in this section do not apply to (i) claims arising out of a breach of warranty, (ii) any infringements of third-party intellectual property, (iii) negligence, or (iv) any claims for attorney’s fees and other litigation costs either party becomes entitled to recover.”
How Enforceable Are These Clauses?
There is a long-standing debate over the enforceabiblity of limitation of liability clauses. Some states have held that these clauses are unenforceable in certain consumer and other contracts because they are adhesive and do not allow the parties to freely negotiate the clauses. However, in general the law permits these clauses unless:
- The clauses are ambiguous and unconscionable;
- The parties’ intentions were not clearly expressed;
- One party had significantly unequal bargaining power or a significantly higher level of sophistication;
- There is a public policy or statute prohibiting the enforcement of the provision.
In order to ensure your limitation of liability clause is enforceable, you should draft a conspicuous, clear, and concise clause that is negotiated and understood by both parties to the contract.
Limitation of liability clauses are not simply “boilerplate” terms in a contract. These clauses have direct and real consequences to both parties, and limitation of liability clauses should be carefully considered in every contract.