Every commercial transaction begins with the contract through which they structure their relationships with each other. Parties mention each other’s rights and obligations which are the result of intense negotiations and often involve a huge consideration. The parties endeavour to identify issues that are vital to them and balance those issues with entity’s risk and obligations. One of the chief goals of these negotiations is to limit an entity’s liability in case relationships go downhill.
What is the limitation of a liability clause?
The purpose of this clause is to limit personal liability when it’s obligated to pay under the agreement. It may result from a failure to perform an action as stipulated in the contract or as a result of breach of the terms and conditions of the contract. In such situations defaulting parties are generally liable to pay a compensation to the non-defaulting party. This allows non-defaulting parties to recover cost and damages incurred due to non-performance by the defaulting party.
The chief aim of this clause is to limit the amount and damages a defaulting party will be liable to pay to the other party. These are a system of risk management incorporated in a contract to limit a party’s potential ability to pay for damages.
For example, if a dry cleaner business accidentally destroys expensive designer clothes, paying a full market price as a compensation may lead to bankruptcy of the small business owner. In such cases, the service limits their liability by capping their liability to the amount paid for the service by the customer. These are often mentioned as terms and conditions on the slip.
Law relating to liabilities and damages in India
Section 73 and 74 of the Indian Contract Act,1872 provides for damages. As per the Section 73, when a contract is breached, the party who suffers in the usual course of things by such breach is entitled to receive from the defaulting party compensation for damages. If no fixed damages are mentioned in the contract i.e. unliquidated damages, then the courts decide quantum of damages to be granted in such cases. As per the Section 74, if a contract has specified a compensation to be paid in case of breach or non-performance, these are called liquidated damages.
However, there is no express provision or law which regulates the limitation of liabilities or provides for exclusion of liabilities. These are left to the best judgement of the parties since every situation is different.
Common liabilities in technology contracts
Every technology contract requires different types of damages to cover their loss. No two technological contracts are the same. However, following types of liabilities that are commonplace in technology contracts:
- Delayed liquidated damages
Where the contractor doesn’t prepare the software or the website as per the adhered timeline for completion. It specifies the rate payable per day of delay. This rate is usually calculated on the basis of revenue lost or extra cost that is incurred due to delay.
- Performance Liquidated Damages
These are usually paid where the contractor/consultant has failed to adhere to the agreed quality or quantity which may affect the whole output of work. Examples of situations when these clauses can be triggered are inadequate deliverables, defects, major bugs and functionality issues.
For example, the financial management software ordered by the bank made by X Company freezes every time a new entry is inserted. X will be legally responsible for performance liquidated damages since it critically disturbs the business of the bank.
- Consequential Damages
Also known as indirect damages or secondary damages, these damages go beyond the contract. These damages are suffered as an indirect adverse impact caused due to primary breach of the contract. These often manifest in the form of loss of profit, loss of revenue, loss of business, loss of goodwill etc.
For example, in the last example, X may also be indirectly liable to the bank for loss of goodwill or business lost due to X’s defective software.
- Data Breach
Nowadays, we hear about the major data breaches almost every day. From credit cards to user’s personal data, data is being stolen by hackers and being used for their own gain. An entity may be responsible for negligence which caused data breach. Customers expect the entity to protect the data they entrusted to them. The EU has specified huge compensation that must be paid in case of data breaches.
How are limitation and exclusion clauses drafted?
There are various methods for limiting the liability:
- Capping the Maximum amount
Developers and sellers routinely try to limit their maximum exposure to the liability under the contract by capping the maximum to which they will be liable. These protect the entity from heavy burden that may result from the breach of the contract.
In high stake contracts, a huge liability may even bankrupt the entity. These clauses are usually drafted to protect from unlimited liability arising from data breaches or due to IPR infringement of the third parties.
- Time Cap
Another way to limit liability is through time cap. This can exclude one party’s liability if a claim is not brought to notice of another party within a specified time frame as stipulated in the contract.
These are commonly used to draft warranty clauses. Time period within which claims can be brought to notice is known as the warranty period. For example, a GPU (Graphics Processing Unit) from Nvidia usually comes with the warranty of one year. If a card suffers from an inherent defect, the company will repair or replace the GPU.
- Indirect Losses Disclaimer
This disclaimer is put to protect the entity from consequential damages. This clause is typically found in EULA and Terms of Services. Sometimes, these liabilities end up being very huge. These disclaimers are put to reject all the liabilities that may arise as a result of consequential damages.
That being said, this clause is not a fool proof one. Sometimes, courts may hold the defaulting party liable even if this clause is present and wording of the clause is likely to be scrutinised carefully by the court.
- Delay on part of the Owner
These are essential in consultant/development/maintenance or similar agreement. Sometimes, delay might be caused on the part of the owner when they are required to take some action first, leading to further delay to another party when it comes to action on their part. In such a situation, another party should exclude their liability.
For example, in an IT security implementation contract, consultants may usually ask for login information from the owner. If there is a delay on part of the owner in providing the information, then the contractor will not be liable for delay in implementation of security.
- Limited Warranties and Disclaimers
These clauses are widely used in End User License Agreement (EULA) governing software or service such as SaaS usage. Through these clauses service provider and seller strictly limits its liability in case of software breakdowns or malfunctions. These are generally boilerplate contracts and cannot be negotiated by the buyer. They exclude all other implied promises concerning the quality and durability of the software.
For example, SaaS services or software are provided on an “as-is” basis. “As is” infers that the seller is selling a software or service in whatever conditions it currently occurs and buyer assents the software will have all defects which may or may not be apparent. These software don’t guarantee that software would be fit for a particular purpose and may have some inherent defects or problems. They often stipulate that the customer will solely be responsible for determining the software’s suitability for his or her particular purpose and use the software at its own risk.
Common pitfalls while handling limitation of liability clauses
Good contract drafters never forgets to put limitations on liability clauses. Great drafter even mentions under which situation these clauses get triggered. Stating this clause ensures there will not be uncertainty and misunderstanding between the party relating to what incorporates a breach. As a result, parties won’t enter into undesirable litigation saving them huge costs and time.
It is also beneficial to keep in mind how courts have beforehand interpreted damages clauses. The idea behind the purpose of granting the damages is to place the innocent party in the same position it would have been if breach had not occurred.
In numerous cases, the courts have laid down case laws governing liquidated damages. In Fateh Chand v. Balkishan Dasplaintiff made a claim to forfeit some money that was paid by the defendant as early payment against the delivery of possession of property. Justice SC Shah for the constitution bench observed that “Section 74 does not justify the award of compensation when in consequence of the breach no legal injury at all has resulted”. The plaintiff’s claim to forfeit the early amount paid was rejected.
The courts have held that the court will only award reasonable damages and the clause should not be used to cause unjustified gain to a non-defaulting party at the cost of the defaulting party. The Supreme Court in Oil and Natural Gas Corporation Ltd vs Saw Pipes has held that the terms of the clause should be clear and unambiguous and should not be unreasonable or be in the nature of Penalty. To rephrase it, the process for determination of damage should be bona fide. It was also held that “Jurisdiction of the Court to award compensation in case of breach of contract is unqualified except as to the maximum stipulated”.
Moreover, parties cannot exclude the following liabilities from the contract:
- Liability for fraud, criminal misappropriation, dishonesty or offences that are tried by Criminal Courts
- Liability for personal injury or death caused due to negligence or other torts
- Liability arising from wilful misconduct
- Liability for breach of confidential information
- Liability which has been prescribed under other rules, regulations and laws
- Liability under Consumer Protection Act, 2019
Drafting these clauses is an art that necessitates experience and an intimate knowledge of the subject matter. Although the limitation of liability is a tremendously valuable tool to defend ourselves from unrestricted liability, this tool’s power is not unconstrained. Courts have continually stressed that the draft should not be unambiguous and should not be in the nature of a penalty. Keeping these things in mind will help us effectively protect client’s liability in future.
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