Essential Contract Knowledge, INstallment 1: Limitation of Liability Clauses
This is the first installment of my series on contractual clauses that everyone should understand. Too often a panicked client has asked, “Wait, is that what that clause means?” And I have to explain, after it’s too late, “Yes, it is.” So my motivation for doing this series is to eliminate these painful conversations and, on the flip side, to teach clients to use these clauses in their favor to minimize or shift risk to the other party to a contract. After all, shifting risk is why contracts exist. If everyone understands this principle, there is no reason why everyone’s risk can’t be fairly and equitably minimized and covered with appropriate insurance.
“Limitation of Liability” clauses come in various types but the underlying point is that the parties are agreeing up front that a party’s potential responsibility for a breach or nonperformance is capped at a certain amount or to a certain type of damages.
Here’s an example:
Limitation of Liability. Except as expressly provided in this agreement, neither Party shall be liable to the other Party for any indirect, incidental or consequential damages (including without limitation, damages resulting from loss of use, loss of profits, interruption or loss of business, lost goodwill, lost revenue and lost opportunity) arising out of any of the terms or conditions of this agreement or with respect to its performance hereunder. The foregoing limitation of liability and exclusion of damages applies even if a Party had or should have had knowledge, actual or constructive, of the possibility of such damages. The foregoing limitation of liability and exclusion of damages shall apply whether a claim is based on breach of contract, breach of warranty, tort (including negligence), product liability, strict liability or otherwise, and notwithstanding any failure of essential purpose of any limited remedy herein.
This example pertains to types of damages – specifically, a party can only recover economic damages that flow directly from the breach. For instance, if a grain supplier to a pet food company failed to deliver grain on time, the company could recover the cost it incurred to obtain grain from another supplier. But due to the LOL clause, if it lost business with Wal-Mart because the delay finding a new supplier delayed filling an order to Wal-Mart, the grain supplier could claim that the company’s economic losses from the lost business is indirect and specifically excluded by the LOL clause.
Other common types of LOL clauses limit liability to:
the amount charged for the goods or services, and
the applicable insurance limits of the goods or services provider.
In my experience, the most dangerous type of LOL clause is the first - when a customer hires a professional for services and a LOL clause limits damages for any claim against the professional to the amount charged for the services.
For instance, recently a client of mine was hiring an architect for services on a $30M construction project and the architect’s contract limited damages for any claims to amounts paid to the architect - $23,000. This meant that if the architect screwed something up and it resulted in faulty construction, the most that could be recovered from the architect to fix the problem would be $23,000. Instead of agreeing to this term, my client went back and negotiated its elimination, and the architect added $4,000 to his charges to fund insurance to cover his increased risk, which my client gladly paid.
So be aware of LOL clauses when you are drafting or reviewing contracts. They can be an extremely effective tool to limit your liability for claims against you and they can absolutely devastate you if you agree to one that prevents you from fully recovering for a breach or nonperformance.
As always, should you have any questions, you can reach me at tmckee@tmckeelaw.com and 615.916.3224.