LOL! Limitation of Liability Basics for Contract Negotiations

Although most software- and IT-related contracts include a limitation of liability clause, limitations of liability are written into contracts used in all different kinds of settings.  In the hands of discerning business people and lawyers, limitation of liability provisions are key contract terms to be scrutinized and negotiated.  The conversation can easily become jumbled if one or both sides don’t grasp the basic concepts, and these misunderstandings can sometimes lead to a seriously bad deal. 

To help avoid that situation, start becoming fluent in the “language of liability” so you’re more prepared for the next sticky limitation of liability conversation.

For starters, what is a limitation of liability?  It’s a term in a contract that answers the question—“If this goes wrong, how much will you owe me?”  The goal of a limitation of liability clause is to narrow down the type and amount of recoverable damages to reach a manageable, predictable amount of risk that’s acceptable for the parties to do business together.  Your basic limitation of liability provision is two sentences long and usually appears in ALL CAPS WITH SCARY SOUNDING WORDS.   

Disclaimer of damages.  Limitation of liability provisions usually start with what’s called a disclaimer of damages.  The disclaimer is intended to limit the scope of liability to damages that are an immediate and reasonably predictable result of breaching the contract (i.e., direct damages).  Here is a basic disclaimer of damages from a SaaS contract:

IN NO EVENT WILL COMPANY BE LIABLE FOR ANY INDIRECT, PUNITIVE, INCIDENTAL, SPECIAL, OR CONSEQUENTIAL DAMAGES, INCLUDING WITHOUT LIMITATION DAMAGES FOR LOSS OF PROFITS, GOODWILL, USE, DATA OR OTHER INTANGIBLE LOSSES, ARISING UNDER OR RELATING TO THIS AGREEMENT OR FROM THE USE OF, OR INABILITY TO USE, THE SERVICE.

As you can see, a disclaimer lists certain types of damages that are considered to be extraordinary and not recoverable if the parties end up in court against each other.  Although there is a centuries-old debate about what these terms mean, here’s a shorthand explanation:

·         Indirect damages.  Losses that can be factually traced back to the breach of contract but are too far removed or loosely connected to be considered a predictable result of the breach.

·         Punitive damages.  Punitive damages are awarded by a jury and are made available to punish exceptionally bad behavior.  Punitive damages come up in the context of misuse of trade secrets and misrepresentation (fraud).

·         Incidental damages.  Losses triggered in response to a breach of contract in order to avoid incurring additional losses.  The cost of hiring a professional to deal with the breach (e.g., an attorney, accountant, PR firm, etc.) is a classic example of an incidental damage.

·         Special and consequential damages.  Losses flowing from a breach of contract that are due to some special circumstance of the non-breaching party.  It’s often argued that lost profits and loss of use are types of consequential or special damages.

·         Other miscellaneous damages.  It’s not uncommon to call out certain kinds of extraordinary damages in the disclaimer that, depending on the context, may not fall into the generic categories of indirect, incidental, or consequential damages but which the parties intend to specifically disclaim anyway.  For example, it’s common to see “lost profits” specifically called out, as there are situations where lost profits may be a direct damage.  In the world of software and IT contracting, it’s not unusual to see “loss of data” called out in the disclaimer for this reason as well.    

Cap on Damages.  After the disclaimer, what usually follows is a sentence about capping the total amount of damages a party could possibly be liable for under the agreement.  This is usually the focus of limitation of liability negotiations because (in my opinion) it is the easiest part for everyone to understand.  Here is a basic cap on damages provision from a SaaS contract:

IN NO EVENT WILL COMPANY BE LIABLE FOR ANY CLAIMS, PROCEEDINGS, LIABILITIES, OBLIGATIONS, DAMAGES, LOSSES OR COSTS IN AN AMOUNT EXCEEDING THE AMOUNT YOU PAID TO COMPANY UNDER THIS AGREEMENT.

The cap on damages is intended to be absolute, which is meant to be a comfort that no matter what goes wrong, the maximum potential fallout can be pegged to an agreed upon dollar amount.

Indemnification v. Breach of Contract Damages.  Indemnification is a drastic remedy designed to protect one party (the “indemnitee”) who as a result of a given transaction may be exposed to risks that only the other party (the “indemnitor”) can reasonably be expected to prevent or control. 

Example: A common provision in technology-related contracts is for the provider to indemnify its customers for lawsuits brought against customers by a third party alleging that the provider’s solution infringes that third party’s intellectual property. The reason for this is the provider (not the customer) controls the components of its technology and so the customer is fairly entitled to rely on the service provider to be sure it has the rights necessary to use and sell that technology.

What makes indemnification a drastic remedy is that it takes the concept of a limitation of liability and turns it upside down.  Instead of narrowing the scope of liability, the goal of indemnification is to make the indemnitee whole for any type of loss it suffers because of the failure that triggered the indemnification obligation, including third party claims brought against the indemnitee (e.g., infringement of a third party’s patent).  So, that could mean everything from attorney’s fees to government fines to punitive damages could be in bounds.   In this way, an indemnification obligation is very much like providing insurance coverage and significantly broadens the scope of liability you are assuming by contract.

This is an area where business people and their counsel often get confused. There are many times where I have negotiated a contract where one side or the other has demanded to be indemnified for losses resulting from an ordinary breach of the contract. Folks should consider these arguments carefully as it may potentially and seriously undermine the protections created by a limitation of liability clause.       

Common Misconceptions to Avoid.  There are many but let’s touch on just a few glaring ones that I have seen or heard now and again. 

Assuming your insurance coverages will protect you from having to pay anything out of pocket if you breach the contract.  Be careful as many insurance policies specifically exclude coverage for liability assumed by contract, such as indemnification obligations. 

Assuming that you’re better off if the contract is “silent” on the amount of damages recoverable for a breach.  If the contract is “silent” on the cap on damages, it means it doesn’t say anything and there is no cap on damages.  

Assuming that a company who insists on having a limitation of liability clause is untrustworthy or wants to avoid responsibility for their actions.  Not true, and you should be more wary of the folks who blithely agree to take on unlimited or extraordinary liability.  Limitations of liability are supposed to be an efficient way of pegging the risks of a given transaction to the actual value the parties take away from it.  The easiest way to express that is in terms of the amount of money that changes hands in the transaction.  And the reality is most folks price their products and services to cover their costs and to make a reasonable profit—the potential liability if things go wrong doesn’t even factor in (and rightly so).  If the opposite were true, the premium folks would need to charge to cover the risk of doing business would be unacceptable.     

Need advice related to writing or negotiating contracts?  You can reach me by phone at (608) 469-3427 or by email at tripp@trippstroud.com.

Tripp Stroud