Contract Drafting: Limitations of Liability & Exceptions

One of the most important functions of a contract is to reduce uncertainties and mitigate risks. That is why almost all professional or personal services contracts contain “limitations of liability” provisions. Although they may seem like densely-worded, “boilerplate” provisions, and often overlooked, these provisions broadly affect a party’s ability to bring a claim, show liability, and prove damages that can be recovered.

A limitation of liability clause is a provision in a contract that limits the amount of exposure a company faces in the event a lawsuit is filed or another claim is made. As a preliminary observation, it is important to note that enforcement of limitation of liability provisions vary from state to state. The general rule in contract law is that in the commercial context, many states have found these clauses to be a mere shifting of the risk and enforce them as written.

Limitations of Liability generally address two areas of concern. First, the types of claims that may be barred. Second, the amount or scope of liability for claims that are not barred.

Limiting The Type Of Claim

A typical limitation of liability clause may look something like this:

“IN NO EVENT SHALL A PARTY OR ITS DIRECTORS, OFFICERS, EMPLOYEES, OR AGENTS, BE LIABLE FOR ANY CONSEQUENTIAL, INCIDENTAL, SPECIAL, PUNITIVE, EXEMPLARY, OR INDIRECT DAMAGES, INCLUDING BUT NOT LIMITED TO ANY DAMAGES FOR LOST PROFITS. IN NO EVENT SHALL THE TOTAL LIABILITY OF A PARTY EXCEED THE AMOUNTS PAID BY CLIENT, IF ANY, FOR THE SERVICES.”

This clause limits the types of damages that may be claimed, prohibiting claims for:

• Consequential damages (damages resulting naturally, but not necessarily, from the defendant’s wrongful conduct, BUT they must be foreseeable and directly traceable to the breach)
• Incidental damages (includes costs incurred in a reasonable effort, whether successful or not, to avoid loss, or in arranging or attempting to arrange a substitute transaction)
• Special damages (often treated the same as “consequential” by courts, “special” damages have been defined as those that arise from special circumstances known by the parties at the time the contract was made)
• Punitive damages (damages that may be awarded which compensate a party for the exceptional losses suffered due to egregious conduct; a way of punishing the wrongful conduct and/or preventing future, similar conduct)
• Exemplary damages (See “Punitive damages”)
• Indirect damages (See “Consequential damages”)
• Lost Profits (Cases in New York (and elsewhere) have a held that a clause excluding “consequential damages” may no longer be enough to bar “lost profits” claims; therefore, consider including more specific provisions in contracts- if parties want to exclude lost profits for breach of contract, a clause specifically excluding “lost profits” should be included.)

Lost profits that do not directly flow from a breach are consequential damages, and thus typically excluded by a limitation of liability clause like that above. But lost profits can be considered general damages (and thus recoverable) where the non-breaching party bargained for those profits, and where the profits are a direct and probable result of the breach.

Limiting The Amount Of The Claim

If found to be enforceable, a limitation of liability clause can “cap” the amount of potential damages to which a party is exposed. The limit may apply to all claims arising during the course of the contract, or it may apply only to certain types of claims. Limitation of liability clauses typically limit the liability to one of the following amounts: (i) the compensation and fees paid under the contract; (ii) an sum of money agreed in advance; (iii) available insurance coverage; or (iv) a combination of the above.

Parties can and typically do agree in their contract that liability is capped at some dollar amount. If liability exists and if damages can be proved, then the aggrieved party recovers those damages, but only up to the agreed cap. Sometimes these are mutual; other times they are one-sided. Sometimes the cap is a fixed sum (e.g., “the amounts paid for the services” or “$100,000”). Other times, the parties may choose to tie the cap to the type of harm, (e.g. personal injury, property damage, violations of confidentiality obligations).

However, sometimes that parties may agree that certain types of harm should not be limited. These “exceptions” put the parties in the same position they would have occupied if there was no limitation of liability provision in effect. For example:

• exposure for violations of intellectual property (copyright, trademark, trade secret, patent) or proprietary rights (right of publicity, right of privacy, contractually-defined proprietary information)
• in the event of an obligation to indemnity and defend for 1) breach of intellectual property representations, and/or 2) third party intellectual property or proprietary rights
• in the event of an obligation to indemnify because a party didn’t have the right to provide data or information
• in the event of an obligation to indemnify and defend for non-compliance with data security standards
• exposure for violations of confidentiality obligations
• personal injury or property damage due to negligent acts or omissions

Best Practices

Businesses that rely upon limitation of liability clauses should periodically reexamine those clauses. Questions that you should be asking include: “what’s my maximum recovery if the other party breaches,” and “what’s my maximum liability if I breach?”

These are only effective if enforceable, that’s why drafting is key. According to many courts, following certain drafting guidelines will help reduce the likelihood that a limitation of liability clause will not be enforced. Such guidelines include:

• Make the clause conspicuous: set the clause in bold face print or underline or otherwise place the clause apart from the rest of the text on the page on which it appears so that the other party is aware of its existence.

• Make the language clear and concise: make sure that the clause is concise and unambiguous as it relates to the contract as a whole.

• Identify specific risks: be specific in identifying the types of damages you think should be excluded.

• Negotiate the clause: discuss the clause with the party that is signing the agreement and negotiate if there is a discrepancy.

• Retain drafts of revisions: keep drafts of any revisions made to the limitation of liability clause so that you have proof that the clause was negotiated.

• Add language stating that these damages are not recoverable even if they were, or should have been, foreseeable or known by the breaching party.

• Recite that the limitation of liability clause is an agreed benefit of the bargain, and that it remains in effect even if any remedy under the contract fails of its essential purpose.

• Consider including a liquidated damages clause for specific breaches, which would replace a damages claim.

DISCLAIMER: THIS IS NOT LEGAL ADVICE. Please consult  qualified attorney to discuss your specific situation.

If you are concerned about how to tighten your contracts, we may be able to help. We can review your contracts, your business practices, and advise on whether there is room for improvement.

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