Here’s a great article written by one of the top notch attorneys, Steve Summers, in NRECA’s Corporate Counsel Office. Steve takes on the always-interesting subject of limitation of liability provisions.
In most contractual relationships, the Buyer or the Seller will not want to have open-ended liability for all possible types of damages. Most standard contractual agreements will include a limitation of liability clause for those instances where insurance will not protect the parties.
A limitation of liability clause is a provision in a contract that limits the amount of exposure a company has in the event a lawsuit is filed or a claim is made. Most limitation of liability clauses cover the types of damages that may be recovered, any exclusions to the types of damages that may be recovered and any cap on the financial liability of the parties. Some states’ laws restrict what can be covered in a limitation of liability clause, which can limit its enforceability. If found to be enforceable, a limitation of liability clause can be used to cap the amount of potential damages which a company may face.
A limitation of liability clause may exclude certain types of damages from being claimed by the parties. It may carve out specific limitations on the types of damages that may be awarded and it may set a specific cap on potential liability for any remaining damages or may be used to cap liability under a specific section. The types of damages that parties often agree to exclude or carve out are incidental or consequential damages, punitive damages or special damages, like lost revenue and lost profits. After the exclusion or carve out of these types of damages, only direct damages are left to be covered by the limitation of liability clause. Direct damages are those which would be directly payable by the parties and are those caused immediately and directly from the breach. For those contract terms where direct damages do not provide an adequate remedy, the parties can exclude them from the limitation, specify that the limitation on those types of damages does not apply to the specific types and address them separately in the contract.
The limitation of liability clause can override the terms of other contract provisions and limit a party’s damage recovery to only direct damages. Using an exclusion or carve out for other types of damages helps to retain the ability to recover for those damages. When drafting a limitation of liability clause you would want to exclude those types of damages (for example, incidental or consequential damages) that could be awarded separately. Within the contract section relating to a specific damages type you could specify that recovery would not be limited by the limitation of liability clause. With these separate provisions addressing liability, when the contract provisions are read as a whole, your intent to treat them separately would be clear.
Financial caps are also important as the parties are trying to limit liability. The Seller will want to place caps to limit its exposure and a Buyer needs to be careful that agreeing to a Seller’s cap doesn’t increase the Buyer’s exposure to liability. Some provisions to consider with caps are the amount of the cap, whether it will apply to all of the damages sections of the contract or specific ones and whether to have multiple caps on liability. For example, with multiple caps, you could have unlimited liability for a general indemnification clause, a dollar cap for a defects liability clause and a separate dollar cap for all other liability. The Seller will want to cap its total liability so the amount for all types doesn’t exceed some set amount. The Buyer will want to limit the Seller’s ability to recover the amounts so it doesn’t open itself to other claims.
Whether you have one cap or multiple caps is also a consideration (for example, caps based on differing amounts of purchases). How to tie caps to the amount of goods purchased needs to be considered. If the contract is new, the amount of purchases may be small and a cap would provide limited protection. As purchases grow, your cap might not be adequate and you may want to tie it to some multiple of the purchase. If you stop purchasing from the Seller, the possibility of claims may extend beyond the term of the contract and needs to be considered as you negotiate.
Another decision regarding caps is whether the cap should apply to a specific period or the term of the agreement. Caps that apply to a specific period tend to be smaller when the cap resets with each period. Those caps that are for the term of the agreement are larger and can be based on some cumulative amount of the purchase. A cap should also have a relation to the time period for which they are effective. The parties might agree to a smaller cap if it is based on “an occurrence” rather than an extended period. The longer the period for the contract, the higher the amount that may be needed for the cap
A Seller will want to limit liability through its limitation of liability clause of its contract and will not be concerned with the Buyer’s liability. If you are the Buyer, be sure that the limitation of liability is mutual so you are protected. A limitation of liability clause is only as valuable as its ability to be enforced. You should take it section by section to make sure everything is included and you are not left liable for something your company shouldn’t be. So drafting is key to your success.
Sources: “The Sky is Not the Limit: Limitation of Liability Clause May Be the Solution to Cap Your Contractual Liability;” Sonya R. Smith and Lawrence Maxwell, Baker Donelson, Legal Update – May 2007 Knowledge to Negotiate blog; February and March 2011.