WHAT YOU NEED TO KNOW WHEN DRAFTING A LIMITATION OF LIABILITY CLAUSE

In an international Arbitration, it may happen that a party has to face claims or counterclaims for amounts even higher than the entire value of the contract from which the dispute originates. Indeed, in complex projects where various stakeholders are involved, a contractual breach from one party may have a “cascade” effect, exposing the other party to costs, damages and penalties that the latter may attempt to recover in arbitration. This scenario may have potentially disruptive impacts for a company. One of the most common ways to minimize such a risk in commercial contracts is to include clauses that exclude or restrict the liability of the parties in the event of breach. Those clauses are commonly referred to as “exclusion” or “limitation of liability” clauses. Put this way, this may sound far too simple. It shall be considered, however, that almost all national legal systems set limits to the possibility to exclude or reduce the liability for contractual breaches. Those limits are established by provisions that, in most of the cases, are mandatory in nature, and as such cannot be circumvented by the parties. It derives that, when drafting exclusion or limitation or liability clauses, the parties shall act carefully to avoid the risk that their clause turns out to be, in whole or in part, invalid, inapplicable and/or not enforceable. This article illustrates the types of exclusion/limitation of liability clauses that may be included in a contract and provides an example of such a clause in the field of construction. Furthermore, it provides a brief overview of the limits established by some national legislations, and gives some tips on what to pay attention to in the process of drafting and negotiating those clauses.

1. Types of exclusion / limitation of liability clauses

The clauses falling within the definition of exclusion / limitation of liability clauses may have various forms and pursue different interests. As a way of example, the parties may:

• Exclude liability for certain events, qualified in advance as cases of “force majeure”;
• Exclude liability in cases of “slight” negligence;
• Exclude liability for certain categories of losses (e.g. indirect or consequential losses, loss of profit);
• Limit liability to a certain amount, providing a “cap” to the amounts that may be due in case of breach, commonly expressed as a percentage of the overall contractual price.

The clauses described above can be adopted together: for instance, the parties may agree to exclude liability for specific events or categories, and, in addition, to provide a “cap” to the amount potentially due. The choice for a certain category of exclusion/limitation of liability clause heavily depends on the goals to be achieved, and the risks to be overcome. The vaguer is the wording used in the clause, the higher is the risk that disputes may arise as to the extent and the applicability of the clause, and this should be an incentive to be as clear and as detailed as possible in determining the scope of application of the clause. Generally, it is preferable to adopt a more realistic approach rather than to try to excessively extend the scope of the clause, bearing in mind that it is impossible to have a clause covering every potential clause of liability that may arise within a contractual relationship. Focusing on the clauses that put a “cap” on the amounts recoverable, irrespectively of how specific the parties are in their drafting, they should be aware that not each and every amount that can be claimed in an arbitration may fall within the scope of application of the clause. For instance, in a recent judgement the England and Wales High Court of Justice ruled that a clause limiting the aggregate liability of the contractor could not automatically limit also the amounts due to the employer as costs for completing the works after the termination. In this specific case, the court argued that the clause applied only to liabilities incurred as a result of breaches of contractual or tortious obligations, while the termination can originate also from other causes^[1]. More generally, there are often categories of losses and expenses not directly linked to a contractual breach, which are arguably encompassed within the “cap” that the parties may have agreed.  

2. Example: the “limitation of liability” clause provided under the FIDIC Red Book

Limitation of liability clauses are widely used in the field of construction. A great contribution to the spread of those clauses in the construction contracts was given by the International Federation of Consulting Engineers (“FIDIC”)^[2], which included “limitation of liability” clauses since 1999 in three of its model contracts, and in particular in the FIDIC Red Book (for building and engineering works designed by the Employer)^[3]. The practice to agree on a limitation of liability clause in construction contracts, in most cases, derives from the need to overcome a practical problem, i.e. that the employers and contractors in the construction industry, otherwise, would not be in the position to fully insure their liabilities under the contract^[4]. This, however, is not the only purpose of those clauses. Limiting the potential liability of a party towards the other (and, most of all, fixing a cap to the amounts potentially due) is also meant to encourage the amicable settlement of possible disputes, since both parties know in advance that there is a limit to the amounts that they may expect to recover in litigation or arbitration^[5]. The limitation of liability clause included in the 2017 edition of the FIDIC Red Book reads as follows^[6]: “Neither Party shall be liable to the other Party for loss of use of any Works, loss of profit, loss of any contract or for any indirect or consequential loss or damage which may be suffered by the other Party in connection with the Contract, other than under: (a) Sub-Clause 8.8 [Delay Damages]; (b) sub-paragraph (c) of Sub-Clause 13.3.1 [Variation by Instruction]; (c) Sub-Clause 15.7 [Payment after Termination for Employer’s Convenience]; (d) Sub-Clause 16.4 [Payment after Termination by Contractor]; (e) Sub-Clause 17.3 [Intellectual and Industrial Property Rights]; (f) the first paragraph of Sub-Clause 17.4 [Indemnities by Contractor]; and (g) Sub-Clause 17.5 [Indemnities by Employer]. The total liability of the Contractor to the Employer under or in connection with the Contract, other than: (i) Under Sub-Clause 2.6 [Employer-Supplied Materials and Employer’s Equipment]; (ii) Under Sub-Clause 4.19 [Temporary Utilities]; (iii) Under Sub-Clause 17.3 [Intellectual and Industrial Property Rights]; and (iv) Under the first paragraph of Sub-Clause 17.4 [Indemnities by Contractor], shall not exceed the sum stated in the Contract Data or (if a sum is not so stated) the Accepted Contract Amount. This Sub-Clause shall not limit liability in any case of fraud, gross negligence, deliberate default or reckless misconduct by the defaulting Party.” As it can be noticed, this is an example of a “complex” clause, which excludes the possibility to claim certain categories of losses, and at the same time limits the total liability of the contractor to a certain amount. In addition, it is the same clause that excludes its applicability for losses and damages incurred in connection with certain contractual provisions, such as those on intellectual property rights. The FIDIC model clause results from an analysis of the most frequent causes of construction disputes concerning clauses of that kind^[7]. In spite of the above, it is acknowledged by scholars that such clause is not “bullet proof” in every jurisdiction, as that its limitations may well be affected by the chosen applicable law, since the various national legal systems may have different limits, or impose higher or lower liability caps in specific circumstances^[8].  

3. Statutory limits to party autonomy and tips for drafting a valid and enforceable exclusion / limitation of liability clause

The contractual exclusions or limitations of liability are a highly sensitive issue in almost every legal system. There are cases when the safeguard of the principle of party autonomy may conflict with public policy considerations – specifically, the need to protect the weaker party in the transaction and to avoid the risk that the parties to a contract may feel exempted from any duty of care in the performance of their obligations^[9]. This is the reason why the legislator, or in some cases the national case-law, feels compelled to “step in” and establish thresholds to the parties’ freedom. Each legal system has its own solutions for setting limits to the parties’ autonomy on this matter.  Focusing on Italian law, the Civil Code provides that any agreement which excludes or prevents in advance the debtor’s liability in case of fraud or gross negligence is null and void. The same sanction is provided in case of any limitation of the debtor’s liability for acts in breach of public policy duties^[10]. It is widely accepted under Italian doctrine and case law that, in case of fraud or gross negligence, the nullity encompasses only the exclusion / limitation of liability clause, and not the entire contract. In addition, the nullity of the clause is “relative”, meaning that the clause continues to apply to all the other liabilities included within its scope and not deriving from fraud or gross negligence^[11]. As to the reference to the “public policy duties”, the prevailing view is that the provision is aimed at avoiding exclusions / limitations or liability in all cases when the parties’ obligations are relevant not only in the context of the specific transaction, but serve also general public interests. Consistently, case law has ruled that exclusions and limitations of liability are generally not admissible in contracts concerning medical treatments, or for passenger transport, or in cases when the party’s breach is relevant also as a violation of criminal or administrative law provisions^[12]. The solution adopted by the Italian legislator is not unique: there are various other legal systems that do not allow exclusions or limitations or liability when fraud or gross negligence comes into play. For instance, similar provisions can be found in the Spanish Civil Code and in the Swiss code of obligations^[13]. As an example of how the issue is deal with in common law jurisdiction, reference can be made to English law. In such jurisdiction, the general principle expressed in the leading case “Photo Production v Securicor Transport” is that “… Parties are free to agree to whatever exclusion or modification of all types of obligations as they please within the limits that the agreement must retain the legal characteristics of a contract …”^[14]. The freedom of the parties is, however, limited by statutory provisions. In particular, limits on the extent to which civil liability for breach of contract can be avoided are imposed by the “Unfair Contract Terms Act” of 1977, which applies to consumer contracts and those based on standard terms^[15]. According to such act, a person cannot exclude or restrict his liability for death or personal injury resulting from negligence, and, in case of other loss or damage, liability for negligence cannot be excluded except in so far as the term or notice satisfies the requirement of “reasonableness”^[16]. This is just an overview of the general rules concerning the statutory limits to exclusion / limitation of liability clauses, but it shall be borne in mind that typically the various legal systems have different statutory provisions for specific types of contracts, such as sales contracts or contracts for the carriage of goods. Moreover, in most legal systems, different (and typically stricter) limits are provided within contractual relationships where it is possible to identify in advance a “weak” party, e.g. standard forms of contracts and consumer contracts. In sum, the picture is extremely varied. For companies that negotiate with counterparties located in various legal systems it is utopian to have a “fit-for-all” clause that can be used for each and every contract. Furthermore, considering the variety of (often mandatory) national legal provisions, this is a matter for which relying on model clauses may work, but only up to a certain point. In order to ensure that the exclusion / limitation of liability clause to be included in a contract is valid and enforceable, it is necessary to:

• First, carry out an assessment of the law governing the contract, to determine whether the clause is valid under such legal system, and then
• Check the presence of any mandatory rules in the jurisdictions where the clause may be enforced that may conflict with the agreed exclusions or limitations.
• In case a dispute arises, a wrongly-drafted exclusion / limitation of liability clause would end up giving rise to discussions between the parties as to its applicability and validity, thus frustrating the very purpose of the clause and bringing the parties exactly in the situation they wanted to avoid.

In sum, the support of the counsels since the drafting phase is crucial to make sure that the choice is made in favour of the most appropriate exclusion / limitation of liability clause, and, most of all, to avoid the risk that, at a later stage, such a clause may turn out to be a ground for disputes rather than a tool for preventing them.

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