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

Limits of Liability

A Supplier may try to limit the potential liability in many different ways.
  • Limits on the type of damages that may be recovered. 
"Neither party shall be liable for incidental, consequential, special damages, lost revenue or lost profits"
  • Limits on the amount of damages that may be recovered
 This can be dollar cap, multiple of sales or percent of business.
  • Limits on various types of claims
 For example, exclusion of warranties for merchantability or fitness for a particular purpose is a form of avoiding liability for those.
  • Limits on total liability for the contract term
"Suppliers total liability for all causes during the term of this agreement shall not exceed"
  • Limits on liability for a defined period such as annual limits.
Supplier shall not be liable for any more than $______ per calendar year
  • Limits on liability per occurrence.
Supplier’s liability shall not exceed $____ per occurrence.
  • Limits on the types of costs that may be recovered/
Supplier shall reimburse Buyer’s reasonable out of pocket costs (That would preclude any internal Buyer expenses)
  • Limits on other remedies.
This shall be Suppliers sole liability and Buyers sole and exclusive remedy.
  • Limits on individual costs.
Supplier shall not be liable for more than  x times the Price for any cost of re-procurement.
  • Limits on periods when claims may be made.
"Any legal or other action related to a breach of this Agreement must be commenced no later than two (2) years from the date on which the cause of action arose"
  • Limits on individual charges.
"Supplier shall reimburse Buyer for its reasonable costs incurred". This places a reasonableness standard on cost that may be claimed
  • Thresholds that must be met before it triggers the right to claim a remedy is a form of limitation.
 If one percent of the products are defective then …. (That would have the Buyer be assuming most if not all of the cost until that threshold is met). 
  • The standard of commitment used limits what the Supplier is responsible for:
For example Supplier shall use “reasonable commercial efforts” can mean that if its costs any more to do it, it doesn’t need to be done, Best efforts can mean a requirement to use all resources available to complete it.
  • Refusing to accept certain terms and responsibilities also helps limit the Supplier’s exposure should they not be able to meet those commitments.
  • Any liquidated damages provisions also serve as a limitation on the Supplier's liability

The key point here is while there may be a specific limitation of liability section in the agreement, language used throughout the agreement can further limit the Supplier's  potential liability. In understanding what the Supplier is potentially liable for you need to read all of the terms together to make sure that they are not in conflict.  If there is potential conflict between the remedy and potential liability in one section versus the Limitation of Liability Section you need to make the intent clear.

There are two ways to make the intent clear. One would be to specifically exclude that section from the Limitation of Liability. The other is to make it clear in that section that that the limitation of liability section does not apply to that section.  If you don't make it clear the Limitation of Liability limiting the remedies in the the other section.  For example if your limit of liability limited recoveries to only direct damages and you had a section where if there was problem the Supplier was to reimburse you for all costs you incur, the two would be read together and you would only be able to recover costs associated with the direct damages you incur and not be able to recover incidental or consequential costs.

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