Drafting to limit or exclude liability: allocating risk without hollowing out the bargain
Introduction: proportionality of risk and reward
To be successful in business, parties must balance the risks they assume against the rewards they expect to receive. Most commercial disputes about limitation and exclusion clauses ultimately reflect a failure to strike that balance at the contracting stage.
Accepting risks that are out of all proportion to the potential rewards is a recipe for business failure. That imbalance may not be apparent when the contract is entered into. A business relationship may function smoothly for years, until a single risk event occurs. When it does, the resulting liability can dwarf the revenue earned under the contract and threaten the survival of an otherwise viable business.
This problem frequently arises where goods or services are business‑critical. A modest fee for repair, maintenance, design or professional advice may sit alongside the risk of extensive downstream loss if something goes wrong. The supplier’s mistake may cause the customer’s operations to cease, projects to be delayed, or revenue streams to be interrupted. The potential liability can be many multiples of the contract price.
Contracts can play a critical role in managing these disproportionate risks. By capping or excluding liability for certain events or losses, parties can bring risk back into proportion with reward. This allows suppliers to participate in markets they would otherwise avoid, and allows customers to obtain goods and services at prices that reflect realistic, insurable risk.
Most disputes about these clauses reflect a failure to balance risk and reward at the contracting stage. When the clause is tested against a real loss scenario, one or both parties end up disappointed by the outcome.
This article focuses on the drafting of limitation and exclusion clauses. It is not intended to provide an exhaustive review of case law. Rather, it aims to provide a practical framework for negotiating and drafting clauses that are likely to be enforced by courts, align with commercial reality, and preserve the value of the bargain for both parties.
Two important limits on contractual risk allocation
Contractual limits bind only the parties
Contractual limitation and exclusion clauses operate only as between the parties to the contract. They do not affect liability to third parties who are not bound by the contract. As a result, contractual caps cannot eliminate all risk.
This distinction matters commercially. In many transactions, the party most likely to suffer significant financial loss if something goes wrong is the counterparty, not a third party. Contractual caps can therefore be an effective tool for managing the largest source of exposure, even though they do not address all potential liabilities.
Liability to third parties is typically addressed through insurance rather than contract drafting. Understanding the boundary between contractual risk allocation and insurance is essential when designing limitation clauses.
Some liabilities cannot be excluded or capped
Certain statutory liabilities cannot be excluded or limited by contract. The most important example in Australia is liability for misleading or deceptive conduct under the Australian Consumer Law. Any attempt to exclude that liability directly will fail.
Other statutory regimes also constrain contractual risk allocation. Consumer guarantees and the unfair contract terms regime impose limits, particularly in standard form contracts and contracts with small businesses. These regimes reinforce the need to ensure that limitation and exclusion clauses are reasonably necessary to protect legitimate commercial interests. Protecting yourself against risks that are disproportionate to contract rewards certainly falls into this category.
A well‑drafted limitation clause must therefore be ambitious but realistic. It should extend as far as the law permits, while recognising the points at which contractual risk allocation must yield to statutory policy.
The core drafting framework
Most effective limitation and exclusion clauses share a common structure. They are drafted in two parts. The first part is the exclusion or limitation provision, which defines the scope of the protection. The second part is the list of carve‑outs, which identifies circumstances where the protection does not apply.
Within the exclusion or limitation provision itself, four drafting decisions must be addressed consciously:
what events or conduct trigger the clause;
what types of loss are covered or excluded;
what legal causes of action are captured; and
how the limitation mechanism operates in practice.
Many drafting failures occur because these issues are conflated or addressed inconsistently. For example, a clause may exclude certain types of loss without considering whether those losses are the very benefit the customer expects to receive. Or a cap may be stated without clarity as to whether it applies per claim or in aggregate.
Using a structured framework helps avoid these pitfalls. It forces the drafter to consider each element separately, and to test whether the clause allocates risk in a way that makes commercial sense when read as part of the contract as a whole.
Events: what does the clause apply to?
A party cannot exclude liability for every breach of contract without undermining the contract itself. If contractual promises carry no consequences, they lose legal and commercial value. Similar issues arise where liability is excluded for breach of a fundamental obligation, such as the obligation to provide the contracted goods or services at all.
For this reason, exclusion clauses tend to focus on excluding all liability for specified categories of loss – most commonly consequential loss – or excluding all liability arising from specific events, such as delay, defects, loss of use of equipment, or damage caused during performance. By contrast, limitation clauses are often drafted more broadly, capping all liability arising under or in connection with the contract.
The distinction is important. An exclusion clause that is too broad may be vulnerable to challenge on the basis that it deprives the other party of the substance of the bargain. A limitation clause, which preserves liability but limits its extent, can often achieve similar commercial protection without undermining the contract.
When drafting event‑based exclusions, care must be taken to ensure that the clause does not inadvertently exclude liability for the very outcome the customer is paying for. The trigger language should be tested against realistic failure scenarios to ensure that it operates as intended.
Types of loss: the central battleground
Why consequential loss clauses cause difficulty
Clauses excluding liability for indirect or consequential loss are ubiquitous in commercial contracts. Despite their prevalence, their legal effect remains uncertain. Australian courts have moved between narrow and broader interpretations of these terms, producing outcomes that are highly context‑dependent.
Historically, consequential loss was equated with loss falling beyond ordinary loss under the remoteness principles established in Hadley v Baxendale. Under that approach, because ordinary loss can include loss of profit and additional costs, such clauses excluded relatively little beyond remote loss that was not recoverable in any event.
Subsequent court decisions starting with Peerless in 2008 gave the words consequential loss a more literal meaning, by capturing losses beyond what is considered normal in the circumstances. Later cases have moderated that approach, recognising that loss of profit, loss of use and loss of anticipated savings can constitute normal loss in some contexts. The result is a body of law that is difficult to reconcile and difficult to predict.
At the end of this article is a link to a separate article that provides a detailed analysis of this body of law.
The modern drafting response: specificity
In response to this uncertainty, parties increasingly seek to describe excluded heads of loss expressly. Definitions of consequential loss commonly list categories such as loss of profit and loss of anticipated savings.
This approach improves certainty, but it introduces new risks. The more specific the exclusion, the greater the risk that it will exclude losses that the customer reasonably expects to recover if the contract is not performed.
The commercial danger of over‑exclusion
Most businesses enter contracts in order to generate profits or reduce costs. Excluding liability entirely for loss of profit or anticipated savings may therefore strip the contract of its commercial value for the purchaser.
This danger is often overlooked during negotiations. Parties may focus on the label attached to a category of loss, rather than on the role that loss plays in the overall bargain. An exclusion that appears standard or innocuous can, in practice, leave one party with no meaningful remedy.
A pragmatic compromise: caps and liquidated damages
In practice, suppliers are often more concerned about the quantum of potential liability than about the type of loss. Open‑ended exposure to unpredictable losses is commercially unacceptable, even where those losses are foreseeable.
A common compromise involves combining:
a capped liquidated damages regime that partially addresses the purchaser’s loss of profit or savings and incentivises performance; with
an exclusion clause that excludes all other liability arising from the performance failure.
Capped liquidated damages provide the customer with predictable compensation, while protecting the supplier from disproportionate exposure.
This approach reflects the underlying objective of limitation clauses: not to eliminate liability altogether, but to ensure that liability remains proportionate to reward.
Legal causes of action
Limitation and exclusion clauses should address not only liability for breach of contract, but also liability arising in tort and under statute. Drafting that focuses solely on contractual liability may leave significant exposure untouched.
Historically, courts required clear words to exclude liability for negligence. Modern courts are less restrictive, focusing instead on whether the language, read in context, is wide enough to capture negligence. Even so, ambiguity invites dispute.
Best practice is to state expressly which causes of action are intended to be covered, subject to statutory limits. This approach reduces uncertainty and helps ensure that the clause operates as the parties intended.
The limitation mechanism: how caps actually work
Liability caps may take many forms. Common approaches include fixed monetary caps, caps expressed as a percentage of the contract price, or caps linked to fees paid over a defined period.
Caps may apply per claim, per event, annually, or in aggregate over the life of the contract. The choice can have a dramatic impact on the level of protection provided. Seemingly minor drafting differences can result in materially different outcomes.
Caps linked to insurance require particular care. Liability should not be limited to amounts actually recovered under insurance, as this can result in no liability arising at all. If alignment with insurance is desired, the cap should be aligned with the limit of indemnity, not with insurance recoveries.
Clear drafting of the limitation mechanism is essential to avoid unintended results and post‑contract disputes.
Carve‑outs: negotiated risk allocation
Carve‑outs identify circumstances where exclusions or caps do not apply. Common carve‑outs include liability for fraud, wilful misconduct, gross negligence, infringement of third‑party intellectual property rights, breach of confidentiality, liability for liquidated damages and liabilities that cannot be excluded by law.
Some carve‑outs, such as the one for fraud, are legally unnecessary but commercially expected. Others are essential to prevent the limitation clause from undermining other contractual risk allocation mechanisms, such as liquidated damages regimes, or the limitation clause itself.
Each carve‑out should be assessed by asking which party is best placed to control, insure or absorb the relevant risk. Carve‑outs should be deliberate, not copied mechanically from precedent.
Conclusion
Contracts cannot eliminate risk, but they can allocate risk in a way that makes commercial sense. Limitation and exclusion clauses play a critical role in ensuring that liability remains proportionate to reward.
By adopting a structured approach to drafting — focusing on events, types of loss, legal causes of action, limitation mechanisms and carve‑outs — parties can avoid many of the common pitfalls that undermine these clauses.
The objective is not to avoid liability at all costs, but to allocate risk in a way that is predictable, enforceable and capable of being priced and insured. Achieving that objective requires commercial judgment, not just templates.
