Saturday, November 17, 2012

Liability Caps

In contracts most companies seek to put a financial cap on their potential liability. A financial cap is only one way to limit liability. To understand what your potential liability would be, or to understand what the other party’s liability to you may be, you need to look the entire agreement. That is because in addition to financial caps, there are many other ways to effectively limit liability.

For example:
You can place limits on the types of damages that may be recovered such as “Neither party shall be liable for incidental, consequential, special damages, lost revenue or lost profits”. This would limit their liability and your recover to only direct damages.

You can have limits on various types of claims that can be made. For example an exclusion of warranties for merchantability or fitness for a particular purpose excludes liability that could exist under those implied warranties and reduces the potential overall liability.

You can have limits on the types of costs that may be recovered. For example “Supplier shall reimburse buyer’s reasonable out of pocket costs. That language requires a payment of costs and would preclude any of the other party’s internal expenses.

Your can have limits on remedies in individual sections. For example, if a section states a specific remedy followed by the statement “This shall be suppliers sole liability and buyers sole and exclusive remedy." This is limiting potential liability to only the cost of providing that remedy.

There may be limits on the amount of individual costs a party could recover. For example “Supplier shall not be liable for more than one times the price for any cost of re-procurement”. So if the supplier provided a defective product and failed to meet a warranty obligation to repair or replace, the maximum you could claim would be the
purchase price.

I’ve seen companies that, in the event of an Intellectual property infringement claims, want a remedy to be to refund the depreciated value of the product as a way of reducing their potential liability for infringement claims and letting the choose the lowest cost option to them. That may be the highest cost option to you.

There may be limits on periods when claims may be made. For example: “Any legal or other action related to a breach of this contract must be commenced no later than one (1) year from the date on which the cause of action arose”. This cuts of the period for claims to limit liability.

There may be limits on individual charges claimed. For example: “Supplier shall reimburse buyer for its actual and reasonable costs incurred”. This places a responsibility on the buyer to both keep the costs reasonable and to document the actual cost. It also reduces potential liability if the cost isn’t “reasonable” or can’t be proven.

Liquidated damage provisions are a form of limitation of liability for the specific provision that allows collection of the liquidated damage. Once a liquidated damage is agreed, that caps the liability for that breach and the other party cannot recover more than that amount.

Thresholds that must be met before it triggers the right to claim a remedy is a form of limitation of potential liability. “If one percent of the products are defective then supplier shall ….”. That type of language would have the buyer be assuming most of the cost until that threshold is met.

The standard of commitment used to describe the party’s obligation limits what the supplier is responsible for and what they could be potentially be liable for. For example “Supplier shall use reasonable commercial efforts to ___”. Any commitment that is not a firm commitment to do or complete the work is a limit on liability. All the party needs to do is prove they exercised the agreed level of effort. If they did, they would not be liable for damages even though you may not have gotten what you wanted.

Insurance helps reduce a company’s potential exposure for certain liability. For example if you have a financial cap, is the amount of insurance coverage in addition to or party of that cap. If it is included within the cap the supplier has less potential liability as the insurance company is assuming certain risks.

How a financial cap is structured can either limit or expand the potential liability. Caps may be fixed, multiple of sales or percent of business. They can be limits on total liability for the contract term limits on liability for a defined period such as annual limits or limits per occurrence.

What is included or excluded from the financial cap is also important. I want financial caps to only apply to the parties to the agreement and not limit what may be recovered by third party claims.

A supplier’s potential exposure or buyer’s potential recovery will be dependent upon how you manage all of these. I’ve seen buyers negotiate high financial caps with a supplier only to be giving back what they had negotiated through the other contract terms they agreed upon. They had a high cap but all the other limitations
they agreed, it reduced the real amount they could recover to something substantially less.

Fixed amount caps are good when there is a fixed amount to the contract. In negotiating financial for business with the supplier that is expected to grow over the term of the agreement I avoid fixed caps. That is because the potential risk grows as the volume increases and with a fixed cap the protection per item purchased is reduced with the volume. I also don’t like fixed amounts as claims that occur during the term reduce the value of protection you have in the future.