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The business world is inherently fraught with risks and uncertainties, and even the most carefully drafted contracts cannot anticipate every possible twist and turn. A limited liability clause exists mainly for this reason: to shield contracting parties from bearing the full brunt of financial losses in the event of business failure or legal disputes.

However, a limited liability clause is not a blanket protection. Its effectiveness hinges on a complex interplay of multiple factors, and getting it wrong can expose your organization to far-reaching legal and financial consequences.

In this guide, we have explained everything you should know about the limited liability clause, including standard terms and factors that impact its enforceability.

Also read: 5 Most Negotiated Terms and Clauses in a Contract

What is a limitation of liability clause?

Imagine you run a software company that develops a sophisticated inventory management system for businesses. You're about to sign a contract with a large retail chain. Before signing the contract, you and the retailer agree to incorporate the "limitation of liability clause."

This clause provides a layer of security for both of you. Think of it like this:

  • The safety net—The clause sets a maximum amount of money your company would have to pay the retailer if the software malfunctions or causes problems. For instance, if the software glitches and causes the retailer to lose sales or mismanage inventory, the clause might state that your company will only compensate them up to a certain amount, even if the actual financial losses are higher.
  • Why it's important: This clause protects your company from potentially catastrophic financial losses if the software unexpectedly causes significant disruptions to the retailer's business. It also provides clarity for both parties, outlining the extent of your company's financial responsibility in the event of software-related issues.
  • Exceptions to the rule: The clause might not apply in certain situations, such as if your company intentionally misrepresents the software's capabilities or knowingly provides faulty code. In those scenarios, you might be liable for the full extent of the retailer's damages.

From this example, a limitation of liability clause can be described as a provision in a contract that “limits” the amount of damages or the types of remedies one party can recover from another party in the event of a breach of contract or other specified events.

It allows parties to agree in advance on the maximum amount of financial exposure they are willing to accept in case something goes wrong with the contract.

Standard terms present in a limitation of liability clause

The specific terms and language used in a limitation of liability clause can vary depending on the nature of the contract, jurisdiction, and the bargaining power of the parties.

Here, we’ve discussed the standard terms commonly found in limitation of liability clauses.

#1 Scope of limitation

This defines the types of liabilities or damages that are subject to the limitation. It may include direct damages, indirect damages, consequential damages, or a combination of any.

Example: "This limitation of liability applies to all claims, losses, damages, and expenses (including attorney's fees) related to this Agreement, whether from its performance or breach."

#2 Liability cap

This sets a maximum limit on the amount of damages that one party can recover from the other. The cap can be a fixed amount, a multiple of the contract value, or some other calculation.

Example: "Company A’s liability to Client B, regardless of the nature of the claim or how it arose in connection with this Agreement, shall not surpass the total fees paid by Client B to Company A in the 12 months prior to the incident leading to the claim."

#3 Exclusions

Certain types of liabilities may be excluded from the limitation, such as those arising from gross negligence, willful misconduct, or intentional breaches of contract.

Example: "This limitation of liability shall not apply to any liability arising from Party A's deliberate or reckless misconduct, comprising but not limited to deliberate falsification of information or intentional breaches of this Agreement. Reckless misconduct shall be defined as an act or omission intentionally done or omitted outside the reasonable scope of activity contemplated by this Agreement, with a willful disregard for the safety or rights of others."

#4 Consequential damages

This term refers to damages that aren't directly caused by the breach of contract but are a consequence of it, such as lost profits or business opportunities. Many limitation clauses specifically exclude or limit liability for consequential damages.

Example: "Neither party shall be held liable for outcomes arising from any indirect or consequential damages, including loss of business, profits, or data."

#5 Time limit

Some clauses may specify a time limit within which a claim must be brought. This can help to prevent stale claims and ensure that disputes are resolved promptly.

Example: "Any claim arising out of or in connection with this Agreement must be filed within one year after the cause of action accrues, or such claim shall be permanently barred. The parties agree that this time limitation is reasonable and not unduly burdensome."

#6 Survival of the clause

This provision clarifies whether the limitation of liability will continue or cease to apply after the termination of the contract. It is important to consider whether certain liabilities may arise after the contract has ended, such as those related to confidentiality or intellectual property.

Example: "The provisions of this Limitation of Liability section shall survive the expiration or close of this Agreement for a duration of three years, but only with respect to claims from events that occurred during the term of this Agreement."

#7 Severability

“Without a severance clause (sometimes called a “savings” clause), a voided clause may cause the entire agreement to fail.

~
Sterling Miller, CEO and Senior Counsel for Hilgers Graben PLLC
Ten Things: I Know It’s Only Boilerplate (But I Like It)!

This provision states that if any part of the limitation of liability clause is found unenforceable, the remaining parts of the clause will still be enforceable to the full extent permitted by law. This ensures the clause's overall intent remains intact even if a specific provision is nullified.

Example: "If any provision of this Section [Limitation of Liability] is held to be void, such provision shall be erased from the Agreement, and all other terms and conditions of this agreement shall remain in full force and effect."

#8 Governing law

This provision specifies the jurisdiction whose laws will govern the interpretation and enforcement of the limitation of liability clause. This helps avoid conflicts of laws and ensures that the clause is interpreted consistently with the legal framework intended by the parties.

Example: "This Agreement and any disputes resulting from or related to it shall be regulated by and translated in accordance with the laws of Virginia, without regard to its conflict of laws provisions."

Importance of having a limitation of liability clause in your contract

"If someone said you can only work on one section of a contract, I would always pick the section dealing with indemnification, limitation of liability, and warranty. Or, as I call them, the "Big Three."  While usually falling in the boilerplate section of the agreement, there is little that is standard about these three clauses. They are also typically the most heavily negotiated clauses in the entire agreement. Why? Because they shift and cap/uncap exposure when things go wrong under the contract."

~Sterling Miller, CEO and Senior Counsel for Hilgers Graben PLLC

Ten Things: I Know It’s Only Boilerplate (But I Like It)!

A limitation of liability clause is an important risk management tool, offering several advantages for businesses and individuals alike. Here's a closer look at five key reasons why incorporating them into your contracts is vital:

#1 Predictability and risk allocation

A limitation of liability clause provides a clear and predictable framework for allocating risks between parties. By setting a predetermined cap on damages, businesses can better anticipate potential losses and factor them into their overall risk assessment. This predictability allows for more informed decision-making and negotiation of contract terms.

Also read: Legal Risk Management: From the Playbook of 11 GCs & Leaders

#2 Financial protection

One of the primary benefits of limitation of liability clauses is their ability to protect businesses from catastrophic financial losses. By limiting their exposure to a specified amount, companies can avoid being held liable for damages that far exceed their expectations or ability to pay. This is especially important in high-risk industries or for businesses with limited resources.

#3 Encouraging contract formation

Limitation of liability clauses can make parties more willing to enter into contracts. By knowing their potential liability is limited, businesses may be more inclined to take on projects or partnerships that they might otherwise consider too risky. This can result in increased business opportunities and mutually beneficial arrangements.

#4 Dispute resolution

“While it is always very exciting to enter into a new agreement with another party, I always remember that you need to plan for the divorce.  The time to do that is at the beginning of the relationship.”

~Sterling Miller, CEO and Senior Counsel for Hilgers Graben PLLC

Ten Things: I Know It’s Only Boilerplate (But I Like It)!

When disputes arise, limitation of liability clauses can help facilitate a more streamlined resolution process. The predetermined cap on damages can simplify negotiations and avoid protracted litigation over the extent of liability. This can save both parties time and money in resolving contract disputes.

Also read: Finding Common Ground: How to Resolve Contract Disputes

#5 Balancing risk and reward

A limitation of liability clause enables parties to balance the risks and rewards associated with a contract. By agreeing to a cap on damages, one party may be willing to offer more favorable terms in other areas of the contract. This can lead to a more equitable and mutually beneficial agreement.

Factors that impact the enforceability of a limitation of liability clause

While limitation of liability clauses are valuable tools, their enforceability is not guaranteed. Courts and legal systems have developed various factors to assess whether a specific clause is valid and will hold up in a dispute.

Understanding the interplay of these factors is important for both drafting practical clauses and anticipating potential challenges to their enforcement.

#1 Unambiguous language

The language used in the limitation of liability clause plays a significant role in its enforceability. Clauses that are ambiguous, vague, or use overly broad language may be interpreted against the party seeking to enforce them.

The clause must clearly define the types of liabilities it covers, the applicable limits, and any exclusions.

For example, courts often scrutinize clauses that attempt to exclude liability for "indirect" or "consequential" damages, as these terms can have different interpretations.

A well-drafted clause will provide clear definitions of these terms to avoid ambiguity.

#2 Equality of bargaining power

Courts may scrutinize limitation of liability clauses more closely in situations where there is a significant imbalance in bargaining power between the parties. If one party has substantially more leverage, the court might view the clause as unconscionable or unfairly imposed.

Also read: Mastering the Art of Contract Negotiation—Strategies for Success

#3  Governing law and jurisdiction

The binding nature of a limitation of liability clause can also be influenced by the governing law and jurisdiction specified in the contract. Different legal systems have varying approaches to these clauses, and parties should be aware of any relevant statutory or case law restrictions.

Here’s an example from the Code of the District of Columbia:

“Damages may be limited by a term in the bill of lading or in a transportation agreement that the carrier’s liability may not exceed a value stated in the bill or transportation agreement if the carrier’s rates are dependent upon value and the consignor is afforded an opportunity to declare a higher value and the consignor is advised of the opportunity. However, such a limitation is not effective with respect to the carrier’s liability for conversion to its own use.”

#4 Proportionality

The limitation of liability should be reasonable and proportionate to the risks involved in the contract. If the cap is set too low compared to the potential damages, a court might consider it unfair and unenforceable.

#5 Public policy considerations

Courts may also refuse to uphold a limitation of liability clause if it contravenes public policy. This typically arises when the clause attempts to limit liability for certain types of misconduct that are considered particularly harmful or reprehensible.

For example, a clause that seeks to limit liability for injuries caused by a faulty product may be deemed unenforceable as it would undermine product safety regulations and discourage manufacturers from taking necessary precautions.

Draft better limited liability clauses with VerifAI

VerifAI is an AI-powered contract review tool by SpotDraft designed to help contract-facing teams review contracts more efficiently and at scale.

VerifAI analyzes your legal documents against established guidelines, highlighting various areas of non-compliance and risks within your clauses.

For each area it highlights, VerifAI will support you with a detailed explanation alongside a source reference for extra clarity.

Leveraging the collective knowledge of over 100 top legal professionals, VerifAI is capable of suggesting redlines, helping you incorporate the right language into your limited liability clause.

Its Natural Language Processing (NLP) capabilities also make it the ideal digital legal assistant, as it can answer open-ended questions about different sections of your contract.

The result? You achieve limitation of liability clauses that are more precise, comprehensive, and legally sound, offering optimal protection for your organization and its partners.

Interested in a free trial? Click here to begin!

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