Thursday, March 3, 2011

Limitation of Liability Sections

In most cases neither the Buyer or the Supplier will want to have open ended liability for all possible types of damages that could result from the contractual relationship, so most standard agreements will include a limitation of liability provision.  Since agreements are read together to establish obligations, the commitments made in individual sections or documents that make up the entire contract can wind up being limited by the Limitation of Liability

A Limitation of Liability provision will normally do three things.
1.     First it will exclude certain types of damages from being claimed by the parties. For example, typical limitation of liability provisions will exclude claims for lost revenue; lost profits, and incidental ,consequential, special or punitive damages.
2.     It may carve specific sections out of the limitation on the types of damages that may be awarded because of the nature of damages that may be sustained under those section, 
3.     Third the Limitation may establish a specific cap on potential liability for any remaining damages or may be used to cap liability under a specific section.

In the exclusion of certain types of damages many times the parties may agree to exclude:
·       Incidental Damages: Incidental damages are paid to reimburse the cost of mitigating the damages sustained. Generally includes expenses related to costs of storing, shipping, returning and reselling goods which result from of a breach of the Agreement.
·       Consequential Damages:  generally includes additional losses that result indirectly from breach of the Agreement.  Consequential damages are for indirect injuries caused by the breach that were foreseeable and can be determined with certainty. Cost of a service call or cost of rework to remove a defective item would be considered as consequential damage.
·       Punitive Damages such as those imposed by courts as a form of punishment or penalty.  For example under IP Law, a willful infringement of a patent makes you subject to treble (3X) damages. This would be a special damage
·       Special Damages such Lost Revenues: Lost Profits

This leaves Direct Damages which would be damages directly payable by the parties. Direct damages are caused immediately and directly from the breach . The cost of “cover” to re-procuring an item is a direct damage or Liquidated Damages which are pre-agreed by the parties as to the amount that will be paid for the breach. Liquidated Damages will be upheld if they are reasonable.

There may however be certain contract terms that, by their nature, direct damages may not provide an adequate remedy. For example personal liability indemnifications, and intellectual property indemnification may not be directly and proximately caused by the breach and as such, you would want to exclude those from such limitations. In addition for a situation such as epidemic defects, the cost of replacing products from the field or the cost of re-work of the product to replace the defective item would not be direct and proximate caused by the breach.
To exclude them from the limitation you would do what’s called a carve out where you make it clear that the limitation on the types of damages does not apply to those specific sections.

With respect to financial caps on potential liability, there are a number of variables. One is the amount. The second is whether it applies to a specific section or all sections.  The third is the unit of measurement for the cap.  For example its possible to have multiple different caps on liability. You could have unlimited liability for General Indemnification. A dollar cap for Intellectual Property Indemnification.  A separate dollar cap for Epidemic Defects liability and a different cap for all other liability. A supplier may want to cap their total liability so the sum or all does not exceed a specific amount. A Buyer would traditionally also not want to limit their ability to recover the amount of the indemnifications as there isn’t a way to limit the amount the third party may claim and the Buyer may not be able to manage against the risk. Another reason why Intellectual Property indemnification would traditionally be excluded from the limitation is because willful infringements of Intellectual Property can be subject to the court awarding special or punitive damages,,

When you deal with specific amounts in capping liability, the unit of measurement is important.  For example is the cap per incident, per month, per year, or for the life of the contract. If you deal with a cap that is tied to a multiple, such as a multiple of revenue, you always need to have a floor amount for the liability cap. For example:
“Supplier liability for Epidemic Defects shall be 1 times the prior years sales, or $_______, whichever is greater.”
The not greater than amount provides a minimum level of protection should there not be any prior year’s purchases or in the event the claim arises at a point when prior purchases may have fallen off.  An alternative could be an average of a number of measurement periods.

Where should caps be included in your contract if you agree to a include a cap.  The first suggestion would be to not include any cap in a master agreement, as that cap would apply to all business.  By including it in an operational document each time you have new business you can decide if the circumstances require some new or different amount. The second issue is whether to include all caps in a single Limitation of Liability section or have specific caps be included in individual section. As the type or approach for the cap may not be the same, its better to address it in individual sections, however if the other party wants to address all caps in one location you could include separate caps for each.

Several last words of caution when negotiating limitations of liability.

1.     Suppliers frequently will want to cap their entire liability at a single amount. In that type of situation, any prior claims that would go against the cap will decrement against the amount of the cap that will be available for future claims. If the Supplier is insistent on a single total amount the measurement period becomes more important. What you want to avoid is having a situation where you have continuing business with the cap having already been exhausted or so small it not longer protects you. A way to avoid that is to link the cap to a shorter period, so the cap resets back to the full amount or have the term of your agreement be for a shorter period.
2.     If the agreement does not include a cap, the amount of liability will be unlimited. As both the Buyer and the Supplier can be liable for breach, as the negotiator for the Buyer you always need to make sure that Buyer’s liability is capped.  Under most Procurement Agreements Buyer’s sole obligation is to pay for the Products or Services ordered, so a common cap for Buyers is the value of any open Purchase Orders that have not been paid.  

3.   As a Buyer, you always want to make sure that Buyer's liability is also capped and the limitation on the types of damages that may be claimed also applies to the Buyer. In most cases the Buyer's main obligation is to pay for products or services that are provided and any
      liability in the event of termination, so any financial amount should take that into account.

Want to learn more? The companion book "Negotiating Procurement Contracts - The Knowledge to Negotiate" is now available on


  1. After reading your blog on limitations of liability, I re-read those clauses and saw that one of our vendors included at the end of their indemnification clause "Until completion of the term, (supplier) shall maintain, at all times at its own expense, products liability coverage of at least $2,000,000 issued by a carrier with an AM Best rating fo "A" or better." Does this limit their coverage for third party claims to that amount?

  2. Frank, there are always several things to check as many of there issues are related. First, do you have an indemnification from the supplier against third party claims caused by their negligence. Second, is the indemnification carved out of the limitation of liability so it can be potentially unlimited (as you have no control over what a third party can sue for). If you have both of those, all those insurance amount does is limit the amount you could recover from their insurance company if you were an additional or named insured. Any amount above that the supplier would have to pay as they agreed to indemnify you. If they failed to indemnify you, the next route would be for your company to go against the supplier's assets. Insurance provides some financial protection and then you have to look to the supplier's assets. If the insurance and their assets won't cover the award, you could still have to pay under the theory of agency where the Principal is liable for the acts of the agent. The "until completion of the term" would not be a problem as coverage is based upon when the injury occurred, not when the claim was made. A good reason to require and keep insurance certificates.