Why limit liability? In many jurisdictions, it is common to limit exposure to liability under a contract. There are good reasons to do so:
- The supplier would otherwise be exposed to liability that may exceed the value of its entire business. In most cases, value added increases considerably as you move through the value chain: a supplier of raw materials receives little payment compared to a vendor who supplies to consumers. For example, a manufacturer receives a few euro for electronic wiring, which interconnects components in a smart phone that may cost hundreds of euro.
- The customer is in a position to manage and mitigate any liability, but this does not apply to the supplier (who usually has no contact with the end-customers).
- The customer, who does have direct contact with the end-customer, is often in a much better position to provide for solutions or for compensation (e.g. free supplies in kind or a higher service level). Moreover, if prompt action is desirable, a customer may worsen an event that caused liability by doing nothing, whereas failure to act promptly as such is not legally attributable to the customer.
- The customer is also typically in a better position to obtain coverage under insurance policies than its supplier for the type of fact or circumstance leading to the claim.
Elements for limitation. A supplier will normally limit its risks and exposure to liability in various respects:
- Scope of damages eligible for compensation:
- excluding indirect (consequential) damages, only damages individually exceeding a de minimis threshold and furthermore damages that are not remedied by the buyer;
- a buyer’s own risk, also known as a basket, which has to filled before a first claim can be made;
- aspects of own fault, mixed causation, claim-related benefits, recourse rights on third parties (e.g. suppliers);
- a cap (an absolute maximum liability);
- Permitted warranty claim period;
- Causation: eligible damages limited to those that are the immediate and ‘adequate’ consequence of a warranty being incorrect;
- Remedies (e.g. replacement or repair, at the supplier’s option, stipulated as the sole remedies available to the customer);
- Management of the claim process:
- constraints on (notification and) handling of third-party claims that may give rise to a warranty claim;
- procedures for making warranty claims that must be followed (e.g. not mere notifications of claims interrupting the contractual period of limitation but requiring that legal proceedings are initiated).
Limiting the type of damages. One way to limit the liability of a party is by reducing the scope of damages eligible for compensation. The most common limitation excludes indirect or consequential damages. Although this is a somewhat vague and uncertain legal concept, it is clear that remote consequences of a breach of contract will be excluded from compensation. Whether or not any damages are ‘indirect’ or ‘consequential’ may be subject to discussion and may divert the parties to related questions such as the ‘foreseeability’ of the alleged damages. If the parties agree that only reasonably foreseeable damages incurred by one party are eligible for compensation by the other party, then a framework for discussion is created. This may not be preferable for the party facing the damages (in hindsight!), but at least it allows the parties to find a middle ground.
ITC Model Contracts. The parameters for limiting liability mentioned above are reflected in the ITC Model Contract for the international commercial sale of goods (standard version), Article 14.
General limitation of liability, a ‘cap’. Many contracts contain a monetary limitation of liability (a ‘cap’). For merger and acquisition (M&A) agreements, such a cap is typically defined as a percentage of the (preliminary or adjusted) purchase price or simply a fixed amount (agreed by the same token). Normally, a cap should not apply to matters relating to ownership or entitlement to sell because it affects the entire sales transaction (and more). For operational contracts, such a reference is not always readily determinable or the parties may have reasons to vary.
Commonly agreed ‘caps on liability’. Commonly used limitations of liability are:
- a designated amount (perhaps related to the amount ordinarily received under a purchase order);
- the amount of the purchase order (under which the defective products were delivered);
- the amount actually paid under the agreement during a period of time preceding the claim;
- a percentage of the amount indicated under (c);
- whichever is higher: (i) a designated amount, or (ii) a reference such as indicated under (b), (c) or (d); or
- whichever is lower: (i) or (ii) as indicated under (e).
Explanation. The types of liability caps (listed above) serve different purposes. A designated amount has an obvious effect: it provides for at least some substance, preventing a court from establishing that a complete exclusion of liability leads to a void limitation (as this may be the case in various jurisdictions, especially if a party is a relatively small company). The amount can be chosen to correspond to the value of one or more purchase orders, to match the anticipated profit over the expected turnover from the relevant customer or the annual expected turnover from that customer.
A harsh but fairly common limitation of liability is mentioned under (b) in the list above: the customer may expect compensation of its damages but to the amount paid for what it bought. If the parties have an established and continuing commercial relationship, such a reference would be inconsistent with the way they do business (except of course if the loyalty of the customer is limited or if the best orders are submitted to competitors).
A cap that is linked to the volume of deliveries between the two parties during a certain period of time is very suitable. Both between large companies and in cases involving small companies, this is a fair limitation. In other words, if the customer orders large volumes of product, it is much better protected against damages than customers that buy only occasionally. The period of time is then typically 12 months: one financial year of exposure.
The two last types of caps serve other purposes. Having a cap defined as whichever is higher, a designated amount or, for example, the amount corresponding to 12 months turnover, would provide substance during the initial period of time or in case of irregular deliveries. Such a cap may induce the customer to start ordering. Having a cap defined as whichever is lower, a designated amount or an amount corresponding to turnover, may be useful if turnover is not an adequate reference value, for example because the profit margins are low. In such cases, increasingly higher turnover could endanger the supplier. Providing for the lower-amount alternative prevents a claim from exceeding the financial capabilities of the supplier. In both alternatives, the referenced amount could be linked to the profit plus a fixed cost element of the anticipated annual supplies to that customer (although disclosing such rationale is often undesirable).
Further differentiating the cap. Any limitation of liability established in accordance with one of the amounts mentioned above, will almost invariably be subject to further discussions. A solution may be to further distinguish the risks involved (rather than applying a standard, one-size-fits-all clause). For example:
- three times X for any damages that arise during the first three months after whichever comes later: the Signing Date, or Milestone 1 having been delivered and accepted;
- two times X during the nine months thereafter; and
- one time X thereafter until whichever comes later: 24 months after the Signing Date, or 12 months after Milestone 5 having been delivered and accepted.
In the above example, the factor X could be defined:
- as a fixed amount;
- as the amount actually paid by the customer to the service provider during the 24 months preceding any claim; or
- in any other convenient way.