Limitation of Liability Clause
A Limitation of Liability Clause is a contractual provision that restricts the amount and type of damages one party can recover from the other in the event of a breach, negligence, or failure to perform contractual obligations. This clause is commonly found in commercial contracts, service agreements, and technology contracts to mitigate financial risk and ensure predictability in business dealings.
The primary objectives and purposes of this clause are to ensure risk allocation, i.e., to clearly defines each party’s financial exposure in case of a dispute, to protect from excessive claims whereby it prevents one party from facing unlimited liability, to encourage business transactions by limiting potential losses, so that businesses can confidently enter into agreements.
Common Elements of a Limitation of Liability Clause
Types of Damages Covered:
Direct Damages: Typically allowed but often capped at a certain amount (e.g., total fees paid under the contract).
Indirect, Incidental, or Consequential Damages: Often excluded (e.g., lost profits, reputational damage).
Punitive or Special Damages: Generally excluded.
Monetary Cap on Liability:
Liability is usually limited to a fixed amount (e.g., a percentage of contract value or total fees paid).
Some agreements allow different caps for different types of liability.
Exceptions (Carve-Outs):
Gross negligence, fraud, or willful misconduct.
Violation of laws or regulations (e.g., government fines).
Indemnification obligations (e.g., covering third-party claims).
Sample Limitation of Liability Clause
“Except as otherwise provided in this Agreement, neither party shall be liable for any indirect, incidental, special, consequential, or punitive damages, including lost profits or revenue, arising out of or related to this Agreement, even if advised of the possibility of such damages.
Each party’s total liability under this Agreement shall not exceed the total fees paid under this Agreement in the 12 months preceding the event giving rise to the claim.
This limitation shall not apply to liabilities arising from (i) a party’s gross negligence, fraud, or wilful misconduct, (ii) indemnification obligations under this Agreement, or (iii) a party’s violation of applicable laws and regulations.”
Third-Party Claims and Government Fines
In commercial contracts, third-party claims and government fines are critical considerations that often require separate treatment from direct contractual liabilities. While parties may include limitation of liability clauses, such clauses generally do not protect against third-party claims or government imposed penalties due to legal and public policy reasons.
Third-Party Claims
A third-party claim arises when an external entity (not a party to the contract) initiates legal action against one of the contracting parties due to alleged harm, losses, or violations.
Examples
- A software provider’s failure to secure customer data leads to a data breach lawsuit filed by affected users.
- A defective product manufactured under a contract causes injury to end-users, resulting in a product liability lawsuit.
- A vendor’s negligence in performing services leads to litigation by a subcontractor or a client’s customer.
Legal Considerations
They are not automatically covered by a limitation of liability clause. Third-party claims often fall under indemnification provisions, which override liability caps in many cases. If a third-party claim results from fraud or gross negligence or wilful misconduct, courts may reject any contractual attempt to limit liability. Many contracts require parties to maintain liability insurance to cover third-party claims.
Government Fines
Government fines and penalties are imposed by regulatory authorities when a party violates legal, tax, environmental, or data protection laws. Unlike contractual damages, these fines are not private claims and serve as deterrents against non-compliance.
Examples
- Data Protection Violations: A company violating the General Data Protection Regulation (GDPR) faces fines of up to 4% of its annual global turnover.
- Environmental Law Breach: A factory exceeding pollution limits is fined by the environmental agency.
- Tax Evasion Penalty: A business failing to pay taxes is penalized by tax authorities.
Legal Considerations
It Cannot Be Limited by Contract, i.e., Most jurisdictions prohibit companies from contractually waiving or limiting liability for regulatory fines. Courts do not allow businesses to escape legal responsibility for non-compliance with statutory obligations, in lieu of public policy doctrine. There are Compliance Obligations wherein, Contracts often include compliance with laws clauses, ensuring that both parties adhere to applicable regulations.
Example Clause:
“Notwithstanding any limitation of liability, neither party shall be responsible for fines, penalties, or regulatory sanctions imposed by any governmental authority due to its non-compliance with applicable laws, nor shall any limitation of liability apply to third-party claims covered under this Agreement’s indemnification provisions.”
Conclusion
Limitation of liability clauses protect businesses from excessive financial exposure. They typically exclude indirect and consequential damages while capping direct damages. Some liabilities, such as fraud, gross negligence, and government fines, are often not covered by these clauses. Courts evaluate enforceability based on fairness, jurisdictional laws, and the nature of the contract.
Third-party claims arise from external lawsuits and are often covered under indemnification provisions rather than limitation of liability clauses. Government fines are regulatory penalties that cannot be contractually limited due to public policy concerns. Contracts should explicitly carve out government fines and third-party indemnification obligations from general liability limitations. Insurance and compliance clauses help mitigate risks associated with third-party claims and regulatory penalties.
This article is written by Keerthana D as part of Advanced Certificate Course in Contract Life Cycle Management.