Commercial Update 85: Take It to the Limit – How Do Limitation Clauses Work?

Limitations and exclusions of liability are often the most contentious and heavily negotiated clauses in a contract. The main reason behind this is that these clauses seek to exclude or limit a liability under a contract, managing the risk. The general rule is that a limitation clause is more likely to favour the party that drafted the contract, but under English law, limitation of liability clauses are open to scrutiny as set out below. Some examples of clauses are those that provide:

  • that one or both parties will not be responsible for certain types of loss, for example indirect loss and consequential loss, or punitive or exemplary damages;
  • a financial cap on a party’s liability; or
  • an exclusion of certain remedies that would otherwise be in the toolkit of the party that is not in breach.

Limitations on these clauses in a business to business (B2B) agreement start with the Unfair Contract Terms Act 1977 (UCTA), which confirms that, in a B2B context, a party can never exclude its liability for:

  • Death or personal injury caused by its negligence;
  • Lack of unencumbered title and quiet possession in a sale or hire purchase of goods (effectively, the seller’s right to sell the goods in question);
  • Non-conformity with certain terms implied by statute – please note that this ground is a complex one and should be considered on a case by case basis; and
  • The implied term as to title and quiet possession in section 12 of the Sale of Goods Act 1979 or section 2 of the Supply of Goods and Services Act 1982.

For reasons of public policy, a party can also never exclude or limit its liability for losses arising as a result of fraud – however outside of that, any other exclusions/limitations of liability will be unenforceable if they fail to satisfy the “reasonableness test”. Factors in the test of reasonableness include:

  • Whether the customer received any inducement to accept the clause;
  • Whether the customer knew or should have known that the clause was included,
  • The strength of the parties’ bargaining positions;
  • whether the goods were a special order; and
  • In the case of a clause excluding liability if a condition is not complied with, the likelihood of compliance with that condition at the time the contract was made;

Usually, suppliers will seek to exclude what are called ‘indirect losses’. Direct loss is loss that directly flows from the breach and arises as a natural result of the breach.

Indirect or consequential loss is loss that is more remote but can be recovered if the loss was reasonably in the contemplation of the parties at the time they made the contract as the probable result of the breach. The important point to be aware of here is that some types of financial loss such as loss of profit can be either direct or indirect loss depending on the facts of a case, so to exclude all loss-of-profit claims, an exclusion clause must clearly indicate that loss of profit is excluded whether arising directly or indirectly.

Any such financial loss exclusion or limitation will be subject to the reasonableness test in the UCTA if excluding or limiting liability for negligence, or liability for breach of implied conditions, or any exclusion of liability when contracting on standard terms.

Suppliers should also usually look at putting a financial cap on their liability, again subject to the reasonableness test in UCTA (Section 11(4) of the UCTA applies where a party is seeking to restrict its liability to a specified sum of money), if the financial cap applies to liability for negligence, liability for breach of implied conditions or any limitation of liability when contracting on standard terms. Consideration needs to be made in relation to the resources of the party seeking to limit liability and how far that party was able to cover itself by insurance.

Liquidated damages clauses also pop up in these sections. These allow an agreed measure of loss to be set out in the contract. What this cannot be, however, is a penalty, as under damages are supposed to be compensatory and a clause that seeks to impose an excessive or unconscionable payment for breach of an obligation may be challenged as a penalty and be unenforceable. Any trigger for a payment under a liquidated damages clause must be a breach of contract for the rule against penalties to apply, so if the clause is drafted so as to avoid linking the payment to a breach, it cannot be challenged as a penalty. So as an example of this, if one party terminates before the expiry of a fixed term, this would be deemed to be a breach of contract and a fixed sum must be paid by the contract-breaker, linking the payment to a breach of the fixed-term commitment. Alternatively, the clause could be drafted so that one party has an option to terminate the contract, and if that party wishes to exercise that option, the contract-breaker will pay an exit fee.

Finally, indemnities also come up as well in a limitations section of a contract. An indemnity at its most basic level is where a party agrees to pay a sum of money when the specific loss occurs. This kind of obligation (referred to as a debt claim), is different from a damages claim because the common law rules that apply to damages claims, such as the obligation on a party to mitigate its loss and the requirement that the loss is not too remote, do not apply to debt claims. If an indemnity is drafted in such a way that it enables one party to avoid its liability in damages to the other party then it will be treated as an exclusion or limitation clause and the UCTA will apply.

Given the scrutiny of these clauses as set out above, any lack of clarity or uncertainty in the wording of a limitation clause will be construed against the party seeking to rely on the clause in question – worth checking to make sure what you have and if it works.

Regards to all


Roger Margand