Why do I need a limitation of liability in my contract?

Limitations of liability contracts

Limitations of liability (or LOLs) are no laughing matter. Often misunderstood, poorly written or just not there - this is one contractual clause that is guaranteed to be the subject of discussion and, probably, negotiation.

A well written limitation of liability clause protects a business and prevents a contract claim from wiping out (or reducing) shareholder value. Put simply, it works by placing a cap on a party’s liability to pay damages. This means that if a party breaches a contract AND the other party suffers a loss, the one in breach is only liable to pay up to the cap.

Let’s look a theoretical example so see where a LOL might come into play.

Imagine you’re a business supplying software as a service (SaaS) via the internet, more specifically, providing your retail customer with an online marketplace which allows them to trade online. 

The contract with your customer contains a warranty that the SaaS will be fit for purpose and comply in all material respects with its specification.

The customer has been using the software for a few months before discovering that a significant proportion of sales have not been completed due to a fault in the system.

The customer estimates that it has lost a significant amount of money as a result of the fault, evidenced by both sales revenue figures and system reports detailing the abandoned transactions. Not only does it want you to fix the problem but also to reimburse it for its losses.

A well drafted limitation of liability clause will provide an ultimate backstop and limit the damage that the customer’s claim will do to your business financially. It is far easier to stand firm and resist these claims when you have something clear in writing. 

Without a limitation of liability, while there are other ways you could try to defend against those claims, the ultimate cost could fall on your business and both sides are likely to incur legal costs when arguing these issues.

What should be in a limitation of liability clause?

The most straightforward option is to ask a legal expert to assist you with drafting the clause. Whether or not you take legal advice, you should always seek to include:

An exclusion of the types of loss you should not be responsible for

Quite often this will include ‘consequential losses’ such as loss of profit, loss of contracts, loss of revenue and damage to goodwill (more on these another time).

A list of all items you are not seeking to exclude or cap

This should always include death and personal injury caused by your negligence and fraud or fraudulent misrepresentation (as any attempt to limit or exclude your liability for these is unlawful and may mean the whole clause becomes invalid). Depending on the other party and their requests, you might agree that your liability for breaches of other provisions should not be capped, e.g. breach of confidentiality provisions or liability under any indemnities given. 

An ultimate cap on your liability, worded to capture any claims relating to the contract

It’s very common to see a cap set at the contract price, or a percentage of that price, but if you want your cap to be valid and enforceable, it should be set at a level that is "reasonable in all circumstances".

But what's reasonable? In short, that’s something to be decided on a case-by case-basis. The value of the contract would certainly be relevant, but of more importance is likely to be: the extent to which both parties have insurances in place to meet claims; the bargaining power of the parties; whether the contract was negotiated or was built on one party’s standard terms; and whether the contract provided other remedies for breach.

There are other factors which could also be taken into account, although they’re given lower priority.

In an ideal world, all limitation of liability clauses should be reviewed by your legal team or contract specialist and this is essential in high-risk or high-value contracts. The flip side should not be overlooked - what is your counterparty's ability to pay a claim (cap or no cap)?  Since a cap on liability does not of itself require your counterparty to insure against the contractual risk, consider adding this as a related requirement where you have any concerns.

comical lawyers at thrings

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