Limitations of Liability: What, Why & How (2024)

This month, I want to dive into a topic that causes endless confusion and angst: limitations of liability.

A liability cap is the “just in case” safety net that you hope you’ll never need. But if the awful moment ever arrives, it might be the thing that saves your business. So it’s much more than a “nice to have.” When I advise about contracts, I usually name it the highest priority amendment — particularly if my client is on the supply side.

WHAT ARE THEY, AND HOW DO THEY WORK

A limitation of liability is an agreed-upon cap on the amount one party has to pay the other if a loss is suffered due to the contract. The cap will apply regardless of what causes the loss, whether it is a breach, negligence, or some other cause. I like to see it near the indemnity and insurance clauses.

It’s common for the cap to be expressed as “100% of the Contract Sum.” Sometimes, it’s another multiple, like “5 times the fee”. Whatever the amount, it should be proportionate to the supplier’s commercial return on the project and the practical risk. If a boutique consulting engineering firm does a $20,000 design job, it isn’t reasonable to be exposed to $20 million in liability.

I also strongly recommend a mutual exclusion of all consequential losses for most transactions. These are the more remote, indirect financial and economic losses that are difficult to control and insure.

IS IT OK TO AGREE TO CARVE OUTS?

Yes. Often, the client will agree to a cap, provided the supplier agrees to specific “carve-outs” or exceptions. That means the cap won’t apply in the specified excepted circ*mstances. In my view, it’s reasonable to carve out personal injury, IP, confidentiality, third-party property damage, and insurance proceeds (up to the insurance cover required by the contract). These kinds of losses are either controllable or inappropriate to cap, and it’s reasonable for the buyer to be able to draw down on the insurance that the contract requires.

WHAT ABOUT THE UNFAIR CONTRACT TERMS LEGISLATION?

Historically, negotiating liability caps has been difficult. In recent years, however, it has been easier as it has been a supplier’s market. Also, the 2023 reform of the unfair contract terms legislation has improved tolerance for liability caps. This law prohibits unfair and unreasonable contract terms, adding statutory compliance to why a large buyer should agree to limit its suppliers' liability.

COMMON CONFUSIONS

Two areas of confusion crop up over and over.

Firstly, the limit of liability is different from the amount of insurance required. The buyer may ask the supplier to provide professional indemnity cover of $5 million. Even if the words “insurance with a limit of indemnity” are used, this does not mean liability will be limited to $5 million. It simply means the supplier must have at least that much insurance. The liability will be whatever it is… and we all know that perceived risk, fee and insurance may bear no relation to the actual amount of loss suffered.

This leads to the second area of confusion. The liability limit the supplier asks for does not need to be related to the potential liability the buyer may suffer. It’s not necessarily (or at least not entirely) relevant that the cap may not reflect the potential liability. It’s a commercial decision based on the exposure the supplier will tolerate in return for doing the project.

TIPS AND TRAPS

1. Too Broad or Too Narrow: Too broad or poorly defined, and the courts might not uphold it; too narrow, and you're not adequately protected. Finding the balance is key.
2. Understand that there are statutory limits: Australian law has rules on what liability can be limited. You can't contract out of everything. Know the boundaries.
3. Professional Indemnity Insurance: The cap itself and any carve-outs must align with your insurance coverage. Don’t agree to a liability limit beyond what your insurer will cover.
4. Clarity is King: The limitations clause must be clear, unambiguous and in plain English. No one should need a law degree to understand it.

KEY TAKE AWAY

Limitations of liability aren't just legalese; they're a safeguard against the storms of business. They protect the supplier’s assets and remind everyone to strive for fairness and compliance in their contracts.

Before you sign your next contract, give the limitation of liability clause the attention it deserves. It might just be the most important part of your agreement.

ABOUT GEMMA

I help construction, engineering and consulting businesses create and negotiate clear contracts so they can make more profit and achieve great project outcomes.

I founded SoundLegal to help SMEs in the engineering, construction, consulting and light industrial sectors manage their risk to support business growth, by finding practical, common sense solutions to contractual and other legal challenges.

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