Negotiating exclusion and limitation clauses
This article provides a suggested framework for structuring and negotiating clauses that avoid or cap your liability. It builds on an earlier article that explains why many businesses need to do so, and the key legal rules around doing so.
There are five key matters that you need to consider when structuring, negotiating and drafting these clauses:
Events: What events does the clause apply to? Are you seeking to exclude or limit your liability all possible events, or only specific events?
Types of loss: What types of loss does the clause apply to? Are you seeking to exclude or limit your liability for all types of loss, or only for specific types of loss?
Legal causes of action: What legal causes of action do you wish to exclude or limit?
Limitations: If a limitation clause, how are the limits or caps on your liability to be defined?
Carve-outs: Are there circumstances when the exclusion clause or limitation clause should not apply?
Most well drafted exclusion and limitation clauses contain two key parts. The first part describes the liabilities that are excluded or limited, and deals with the first 4 matters. The second part describes the carve-outs, being the fifth matter.
Within each of these five key matters, there are a number of considerations. Let’s unpack each of them in turn:
1. Events
Let’s start with exclusion clauses. You won’t be able to exclude liability for every breach of your contract, because doing so renders the promises you make under contract meaningless. If you have no liability for any breach of your contractual promises, then your promises are of no value to the other parties to the contract. In legal terms, there is no contract because it is missing the essential legal ingredient of consideration.
The same principle can apply if you seek to exclude liability for a breach of your principal or fundamental obligation under the contract — such as the obligation to provide the service, in the case of a service contract.
Accordingly, most exclusion clauses seek to either:
exclude liability for loss arising from specific events; or
exclude liability for specific types or categories of loss.
Limitation clauses, on the other hand, can be much broader in application without completely undermining the value of the contract to the other parties. It’s not uncommon for clauses that limit or cap liability in connection with a contract to be very broad in application. An example of such a clause is:
The total liability of the Contractor to the Client under or in connection with this Contract, whether in contract, in tort (including for negligence), under statute or otherwise, will not exceed the Contract Price.
Excluding liability for loss arising from specific events
Specific events for which liability might be excluded or limited include the following. Click on the arrow for an example clause.
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If the good or services are defective, we will: (a) repair the defective goods and/or re-supply the defective services; and/or (b) reimburse you for the cost of having someone else repair the defective goods and/or re-supply the defective services. To the extent permitted by law, your remedies, and our liability, for defective goods and services will be limited to these remedies.
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Provided the Contractor uses its best endeavours to complete the works by the date for completion, the Client will have no entitlement to claim damages from the Contractor for any delay to completion of the works.
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We will repair any damage we cause to your property arising from our negligence or willful default, but we will not have any other liability to you arising out of such damage.
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If, in carrying out the work, we damage the Equipment, we will not be liable to you for loss of use of the Equipment.
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I agree and acknowledge that:
· I have entered and remain on the premises of BridgeClimb Sydney and Transport for NSW, and I will participate in the Climb at my own risk.
· The Climb is a recreational activity that involves an element of risk and the Service Providers therefore cannot guarantee my health and safety. These risks include the risk of physical injury or death, the inducement or exacerbation of medical conditions, mental harm or distress, and damage to my property. I acknowledge that my health, ability and conduct will affect such risks.
2. Types of loss: Excluding liability for specific types or categories of loss
Categories of loss for which liability is commonly excluded include:
consequential or indirect loss;
loss of income, profit, revenue or business;
loss of or damage to goodwill or reputation
loss or denial of business opportunity;
loss of use or the benefit of use
loss of production;
loss of anticipated savings; or
business interruption.
Direct loss vs. indirect loss vs. consequential loss
The courts don’t draw any distinction between indirect loss and consequential loss. They treat these terms as interchangeable. Rather, the distinction that is significant is that between:
indirect or consequential loss, on the one hand; and
direct loss on the other.
Unfortunately, the legal meaning that the courts apply to these terms has differed from the ordinary meaning used by modern businesspeople. The differences are explained in the below table.
The ordinary meaning is that adopted by businesspeople. The historical legal meaning is that adopted by Australian Courts, based on the remoteness of loss concept (discussed below), before the 2008 court decision in Environmental Systems Pty Ltd v Peerless Holdings Pty Ltd (Peerless). The modern legal meaning is closer to the ordinary meaning, but differences and consequent uncertainty remain.
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Direct loss is loss that is directly or immediately caused by the breach or other event. Whereas indirect loss is loss that is not caused directly by the breach or other event, but which is a consequence of the direct loss. Indirect loss is loss that is related to the breach only because of some intervening event or circumstance.
Examples
Liam is engaged by the owner of an excavator to carry out a routine service on the excavator for $1000. The service is to take one day. Liam drains the oil out of the excavator’s engine but forgets to refill it before running the engine, causing it to seize up. The damage to the engine caused by Liam’s failure to exercise due care in performing the service is direct loss.
The owner of the excavator is unable to use the excavator for three days while the damage that Liam has caused is being repaired. Had the excavator been available for use the owner would have generated additional profit of $5,000. Businesspeople would consider the loss of profit to be indirect loss.
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The historical legal meanings of direct loss and indirect loss were based on the legal “remoteness of loss test” used by courts to determine whether loss is too remote to be recoverable by way of damages for breach of contract.
Direct loss is loss that is not too remote to be recoverable for breach of contract.
Loss is not too remote to be recoverable if it:
arises naturally or ordinarily from the breach (first limb); or
may reasonably be supposed to have been within the contemplation of the parties, at the date of the contract, as the probable result of the breach (second limb).
Indirect loss is loss that is too remote to be recoverable for breach of contract.
Loss is too remote to be recoverable if it doesn’t fit within the first limb or the second limb.
Examples
If Liam was told, or ought reasonably to have realised, that the excavator owner would suffer loss of profit if the excavator was not ready for use the following day, the loss of profit will fall within the second limb (so long as the quantum is not disproportionate with what Liam ought to have contemplated), and so the court historically treated this as direct loss. Repair costs fall within the first limb.
The excavator was to be used the next day on a time critical excavation project. The excavation is delayed by three days due to the repairs. The excavator owner is liable to pay its client liquidated damages (LDs) of $10,000 for every day the excavation is delayed. Liam was not aware of the owner’s potential liability for LDs when Liam agreed to carry out the service. The liability for LDs is too remote to be recoverable, and so the courts historically treated this as indirect loss.
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Direct loss is loss that every plaintiff in a like situation would suffer. It is loss that flows naturally from the breach, without other intervening cause.
Whereas indirect loss is loss that is not direct loss.
Examples
Liam knows that the owner of the excavator is in the excavation business and uses the excavator to generate revenue and profit for the owner. Every excavation business is likely to lose an ordinary level of revenue (ie the usual daily rate for an excavator) when the excavator is out of action for repairs. So, the direct loss is the cost of the repairs plus lost profit (to the extent the profit lost does not exceed the ordinary level).
If the excavator owner was paid in full for the excavation that it completed late it hasn’t lost any fee revenue on that job, but its profit has been reduced by $30,000 due to the LDs. Also, it wasn’t able to apply the excavator to another job, and earn the usual daily rate of profit, for three days due to the repairs. The direct loss would be the cost of the repairs plus three days lost profit at the ordinary level. The $40,000 of LDs is indirect or consequential loss.
Remoteness of loss
The remoteness of loss test was developed by English courts in the middle of the 19th century to protect contract breakers from unpredictable liability.
The courts came to recognise that to require a contract breaker to compensate the other party for all loss arising from the breach could expose the contract breaker to liability that is out of all proportion to the risks he or she might fairly be expected to have accepted when entering into the contract.
Building on the above example, let’s say it turns out that the excavator that Liam has damaged was to be used the next day on a time critical excavation project, where the owner is liable to pay its client $10,000 for every day the excavation is delayed. Let’s assume that Liam knew the excavator was to be used on the project, but did not know that the excavation was on the critical path or that the owner of the excavator would be liable for LDs of $10k per day. Although the liability to pay the LDs has been caused by the Liam’s breach, that liability can be regarded as completely disproportionate to the nature of the obligation that Liam accepted when he agreed to perform a routine service on the excavator for $1,000.
To address this issue, the courts developed their own limitation on the amount that the excavator owner can recover, by requiring that the loss must not be too remote a consequence of Liam’s breach. To be recoverable by way of damages for breach of contract, the loss must be of a kind that falls within the first limb or the second limb of the test for remoteness from Hadley v Baxendale.
The cost of repairing the engine, and the loss of a normal level of profit, would not be too remote to be recoverable and would historically be treated by the court as direct loss for the purpose of the exclusion clause. But the LDs for which the excavator owner is liable would be too remote to be recoverable, and so would historically be treated by a court as indirect or consequential loss for the purpose of the exclusion clause.
Shift to ordinary meaning of consequential loss
This historical approach of the courts to contractual references to indirect or consequential loss resulted in a disconnect between what businesspeople intended, and the ultimate outcome if the matter went to court.
Using the above example, if Liam and the excavator owner agree that Liam will not be liable for any consequential loss arising from the performance of the service, Liam will be surprised and disappointed when a court decides that the excavator owner’s loss of profit is direct loss and therefore recoverable.
Until about fifteen years ago, businesspeople were regularly surprised by court decisions of this nature. In particular, they were surprised to learn that loss of profit and loss of revenue would be treated by the court as direct loss if it was a reasonably foreseeable consequence of the breach.
Consequently, the courts began to change their approach to this issue, by giving the term “consequential loss” its ordinary meaning as understood by ordinary businesspeople, starting with the 2008 Victorian Court of Appeal decision in Environmental Systems Pty Ltd v Peerless Holdings Pty Ltd (2008) 19 VR 385.
But this has not meant that loss of revenue and loss of profit is always treated as consequential loss, nor has it meant that additional costs are always treated as direct loss. In several cases since Peerless, the court has found the loss of profits claimed by the claimant to be “normal loss” that every claimant in a like situation would suffer, and therefore a direct loss.
Accordingly, there remains a significant risk that a court will consider a claim for loss of profit or loss of revenue to be a claim for direct loss to the extent that the amount claimed does not exceed what the contract breaker ought reasonably to have foreseen, when it entered the contract, as a likely consequence of the breach.
Likewise, there is also a significant risk that a court will consider a claim for additional costs to be a claim for indirect loss to the extent that the amount claimed exceeds what the contract breaker ought reasonably to have foreseen, when it entered the contract, as a likely consequence of the breach.
Given this uncertainty, the recommended approach is that parties that are seeking to exclude liability for specific types or categories of loss don’t use the terms consequential loss or indirect loss without being very precise about the meaning that they intend those words to have.
If the parties agree that the contract breaker should not be liable for any loss of profits suffered by the other because of the contract breaker’s breach, then the exclusion clause should be drafted in those terms.
But please remember that in many cases, the primary reason why a supplier of goods or services has entered a contract is to make a profit on the goods or services that it supplies under the contract. If the buyer fails to pay for those goods or services, the supplier will almost certainly wish to be compensated for revenue or profit it has lost.
Conversely, if a party wants to be able to recover specific losses that may not be normal loss that every plaintiff in like circumstances would suffer because of the breach, then it should expressly state in the contract that such losses could arise from the relevant breach and that, if they do, they will be recoverable.
3. Legal causes of action: What legal causes of action do you wish to exclude or limit?
The below expanding table lists your main potential legal sources of liability (causes of action). Click on the plus for examples and advice on whether it is possible to exclude or limit such liability by contract.
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Example: Liability to counter party for your breach of contract
Can liability be capped or excluded?
Yes, by contract.
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Examples:
Liability to others for loss or damage caused by your negligence.
Other torts that can give rise to liability include private and public nuisance, defamation, assault, battery, false imprisonment, trespass to land or goods, conversion of goods, intimidation and deceit.
Can liability be capped or excluded?
Yes, by contract or via a risk warning
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Examples:
Liability to others for loss or damage caused by:
• your misleading or deceptive conduct under the Australian Consumer Law;
• your contravention of a consumer guarantee under the ACL; or
• your contravention of a warranty implied in your contract by Sale of Goods legislation
Can liability be capped or excluded?
Yes, by contract, unless the relevant statute prohibits you from limiting or excluding your liability.
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Examples:
Unjust enrichment
Breach of trust
Can liability be capped or excluded?
Yes, by contract.
If you are wanting to exclude or limit liability for legal causes of action other than breach of contract, then it is best practice to expressly state this in your contract.
An example of a limitation of liability clause that seeks to cover all potential causes of action is as follows:
The Contractor’s liability arising out of the performance or non-performance of the services, whether in contract, in tort, under statute or otherwise, will be limited to $1 million.
Excluding liability for negligence
Historically, courts have taken a restrictive approach to the exclusion of liability for negligence, by requiring very clear words to this effect. But the modern approach is less restrictive.
A clause does not necessarily need to expressly mention negligence in order to effectively exclude or limit liability for negligence. Rather, you should ask yourself whether the words are wide enough to cover negligence, if given their ordinary meaning (in context). For example, reference to:
”all liability” is usually insufficient, but
“whatever the cause” or “howsoever caused” is usually sufficient.
Courts will also consider whether there are other plausible bases for liability. If negligence is the only plausible basis for liability, then a general exclusion of liability will exclude liability in negligence.
Even so, it remains prudent practice for a party that wishes to exclude or limit liability for negligence to do so expressly.
You will note the clause referred to above doesn’t expressly refer to negligence, but it does refer to liability in tort. Given the cost common tort is the tort of negligence, this wording should be sufficient to exclude liability for negligence.
4. Limitations
If you are negotiating a limitation clause, rather than an exclusion clause, then the further key issue is how are the limits of liability or liability caps to be defined.
The most common form of limitation is a monetary amount, stated as a fixed dollar amount or as a percentage of the total contract price or the annual revenues paid during the 12 months preceding the claim.
Liability caps may be either on a per incident basis, or over a period of time, such as annually or the life of the contract.
Other common forms of limitation include:
in the case of liability for defective products or services, limiting your liability to one or more of:
replacing or repairing the product; or
re-supplying the service; or
reimbursing the purchaser for the cost of having someone else do so.
limiting your liability by reference to the insurance proceeds that that are available or received in respect of the liability event.
Limiting your liability by reference to insurance proceeds can be tricky, and needs to be done very carefully. You should remember that insurance always follows the liability, and there are significant difficulties in attempting to make liability follow the insurance.
You should never fall into the trap of stating, in your limitation of liability clause, that a party’s liability is limited to the amount actually recovered under its liability insurance. Because liability insurance follows the liability, the insured party will have no entitlement to recover any amount under the policy unless and until the insured party is made legally liable. But if the insured party has no liability under the contract until such time as insurance proceeds are actually recovered, there is no liability for the insurance to respond to, and the insurer won’t be obliged to pay anything. The end result is the wrongdoer’s liability is capped at nil.
The better approach is to specify a dollar amount that aligns with the limit of liability under the relevant policy, or to describe the liability cap as being equal to the limit of indemnity under the policy.
For completeness, I should also mention that it is also possible to qualify your liability in scenarios where exclusions or limitations are permitted by:
including time-bar provisions in your contract require claims to be made within specified time limits, and by excluding liability upon claims that are brought outside the specified time frame; and
including minimum claim value thresholds below which claims cannot be made.
Such qualifications are common for claims for breach of warranty in sale of business contracts.
Capping specific liabilities vs. overall liability
Consider this scenario:
A purchaser enters into a contract for the development and supply of software by the supplier to the purchaser. The supplier fails to achieve agreed milestones for the development and delivery of the software, resulting in the purchaser lawfully terminating the contract. The losses suffered by the purchaser as a result of the breach and termination of the contract total $8m. The supplier is owed about $800,000 at termination for services performed.
The supply contract contains the following limitation of liability clause:
“… the total liability of either Party to the other under this Agreement shall be limited in aggregate for all claims no matter how arising to the amount of $5m.”
The purchaser argued that the cap is to be applied after the $800,000 it owes the supplier has been set off against (i.e deducted from) the $8m that the supplier owes it, resulting in a net debt of $7.2 million which is then reduced to $5m by applying the cap.
The supplier argued that its $8m liability to the purchaser should be capped at $5m before the $800,000 is deducted, resulting in a final liability of $4.2m.
This was the scenario that played out in the recent English TCC court decision of Topalsson v Rolls-Royce Motor Cars (2023] EWHC 1765 (TCC). The court held that the purchaser’s position was right, and that the cap in this case was to be applied at the end, after the two amounts had been set off.
What if the cap on liability had been drafted differently, and had applied to a specific type of liability? Consider instead this scenario:
A dry-cleaning business has a clause that limits its liability for any article of clothing that is damaged or lost to $1, and the customer agrees to this.
The customer drops off 10 business shirts that the dry cleaner washes and irons at the agreed rate of $2 per shirt resulting in a dry-cleaning fee of $20, but it loses one of the shirts which is worth $100.
In this scenario, we don’t deduct $100 for the lost shirt from the $20 dry cleaning fee before applying the cap, which would result in an $80 debt from the dry cleaner to the customer being reduced to $1. Instead, the $1 cap on liability for lost clothing is applied to the value of the shirt, before it is deducted from the $20 dry cleaning fee, resulting in a net payment of $19 from the customer to the dry cleaner.
5. Carve-outs
The fifth and final key issue to consider is whether there may be circumstances when the exclusion or limitation on liability should not apply. If there are, then these may need to be expressly carved out from the limitation or exclusion clause.
Common carve-outs from exclusion and limitation clauses include liability for the following. Click on the plus sign for observations regarding each common carve-out.
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Historically not covered by an exclusion clause absent express provision.
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Wilful and deliberate have the same meaning.
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Misconduct is clearly broader than conduct that constitutes a breach of contract. Misconduct is more apt to extend to a breach of duty in tort or under statute.
Wilful misconduct refers to conduct by a person who knows that they are committing, and intends to commit a breach of duty. It involves a conscious choice as to the person’s course of conduct in circumstances where the person knows or ought to know that such conduct both creates an unreasonable risk of harm to another and involves a high probability that such harm will actually result.
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Reckless misconduct refers to conduct by a person who makes a conscious choice about their course of conduct in circumstances where they know or ought to know that such conduct both creates an unreasonable risk of harm to another and involves a high probability that such harm will actually result. It differs from wilful misconduct in that the person committing the act may not necessarily intend for a breach of duty to occur. They are, or ought to be, aware of the risk but disregard it, acting recklessly in the sense of not caring whether or not they commit a breach of duty.
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But when does ordinary negligence become gross negligence? How severe or extreme must the carelessness be?
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The supplier should stand behind all intellectual property incorporated into the products or services it provides under the contract, and fully compensate the purchaser for any third-party IP infringement claims.
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Unless carved out, the main damages that flow from a breach of confidentiality obligations (eg loss of revenues and profits) might otherwise be excluded in their entirety
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Subject to applicable statutes, liability for bodily injury and death should not be subject to a liability cap but may be excluded entirely.
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If the insurance policy is liability based, this common carve out suffers from the same problem mentioned above.
The contract breaker’s liability is capped, subject to the carve out. But it will only be entitled to recover more than the capped amount under the policy if it is liable to the other contract party for more than the capped amount. But it won’t be liable to the other contract party for more than the capped amount unless and until it receives or is entitled to receive more than the capped amount from the insurer. But the insurer won’t pay or be liable to pay more than the capped amount.
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Why should the innocent party’s legal entitlement to recover loss be excluded or limited if the defaulting party is able to recover the relevant amount from a third party?
But the defaulting party may have good business reasons why it does not wish to commence proceedings against its supply chain for amounts in excess of the agreed cap/exclusion.
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Purchasers should not rely on the liability cap as a defence against non-payment of supplier claims for non-payment of invoices.
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Interest is compensation for the loss of use of money. Unless carved out, interest may fall within the exclusion.
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An example would be a clause that allows the owner to perform an unperformed obligation of the contractor, such as the obligation to correct defects, and recover the costs incurred in doing so as a “debt due and payable”. This carve out is designed to ensure that the exclusion or limitation clause doesn’t cut across such clauses.
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LDs will often represent a pre-estimate of types of loss that are excluded by an exclusion clause, such as loss of revenue and loss of production. Without a carve out for LDs, the contractor could run an argument that it is not liable to pay the LDs to the extent that the LDs cover excluded loss. Whether such an argument would succeed is debatable, but it is nonetheless good practice to draft out the possibility of such an argument.
In contracts that provide for LDs, it is not uncommon for the contract to provide that the owner is still entitled to recover general damages if the liquidated damages provision is held to be unenforceable. In these circumstances, the contractor’s ability to argue that the general damages should not include any amount on account of excluded loss will be stronger, absent an express carve out.
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This carve out is designed to reduce the risk of the exclusion clause being void for reason of offending statutory prohibitions against contracting out, so unlike the other carveouts, this one is for the benefit of the party that wants to rely on the exclusion clause.
Exclusion and limitation clause to survive contract
Finally, you should make sure it clear that your exclusion and limitation clauses survive termination of the contract and apply to any claims raised post termination.
Conclusion
As mentioned in the companion article, to be successful in business, you need to balance your risks against the potential rewards. Taking on risks that are out of all proportion to the potential rewards is a recipe for business failure.
The companion article explained how contracts can be used to cap or exclude liability for risk that are disproportionate to the rewards available under a contract.
This article has explained how to adopt a structured approach to the negotiation and drafting of such clauses.
