Legal 101: liability caps explained
One of the clauses that cause the most confusion and concern for our clients while drafting and negotiating commercial contracts is the liability cap.
But what exactly is a liability cap, and why does it matter to your business? Let us break it down for you.
What Is a Liability Cap?
A liability cap is a clause in a contract that limits how much one party can be held responsible for if something goes wrong.
In other words, it sets a ceiling on the amount of damages (compensation) one party would need to pay to the other if there’s a breach of contract or other issue.
For example, imagine you hire a software developer to create an app for your business, and something goes wrong—perhaps the app doesn’t work as promised, or it causes a data breach. Without a liability cap, the developer could potentially be on the hook for millions of dollars. A liability cap limits their financial exposure to a predefined amount, such as the total amount you paid them for the project.
Liability caps can be mutual (so both parties’ liability is limited) or one-sided (so just one parties’ liability is limited, and the other party has unlimited liability).
Example of a Liability Cap clause:
Maximum Liability: The total liability of the Developer to the Client arising out of or in connection with this Agreement, whether in contract, tort (including negligence), or otherwise, shall not exceed the total fees paid by the Client to the Developer under this Agreement during the twelve (12) months immediately preceding the date the claim arose.
Exceptions to the Limitation: The limitations of liability set forth in this clause shall not apply to:
a. Damages resulting from fraud, gross negligence, or wilful misconduct by either party;
b. Breach of the privacy or confidentiality obligations under this Agreement; or
c. Claims arising from the infringement or misappropriation of intellectual property rights.
Why Are Liability Caps Used?
Liability caps are designed to protect both parties in a contract. For the party providing goods or services, it prevents financial ruin if a worst-case scenario arises. For the party purchasing those goods or services, it provides clarity about what compensation it can reasonably expect if things don’t go as planned.
Think of it as a risk management tool. Without limits, businesses might be reluctant to work together out of fear of excessive liability. A liability cap helps foster trust and ensure everyone has a clear understanding of potential risks.
Common Types of Liability Caps
Not all liability caps are the same. Here are a few common approaches:
Fixed Amount Cap
The contract sets a specific dollar limit on liability. The amount of the fixed amount will differ depending on the value of the contract and the risks, but is commonly between £50,000 and £10 million.
Fee-Based Cap
This cap ties the maximum liability to the amount paid under the contract. For example, if you’ve paid £10,000 for a service, the provider’s liability might be capped at that amount.
Some times fee-based caps include a multiplier, like 2 x annual fees paid under the contract.
Exclusions for Certain Damages
Many contracts exclude liability for certain types of damages altogether, such as lost profits, loss of data, or “consequential damages” (indirect losses that arise from a problem).
Unlimited Liability for Specific Issues
While most liability is capped, contracts may carve out exceptions for serious issues like fraud, intentional misconduct, breaches of confidentiality, or breach of data protection obligations. For these, liability may remain unlimited.
Things to Watch For
As a business owner, it’s important to carefully review liability caps in contracts to ensure they are proportionate to the value being exchanged under the contract and align with your own risk tolerance. Here are a few tips:
Understand the Scope: Does the cap apply to all types of claims or only specific ones? For example, does it cover negligence or just contract breaches. Is it an aggregate cap, or a cap per breach / event?
Evaluate the Amount: Is the cap reasonable relative to the potential risks and the expected value of the contract? If the cap is too low, it might leave you exposed to significant losses.
Consider Exceptions: Look out for exclusions or carve-outs that might leave certain issues uncapped, such as intellectual property violations or breaches of data security.
Negotiate, if Needed: Liability caps are not set in stone - they are one of the most commonly negotiated contract terms. If a proposed cap seems unfair, negotiate with the other party to find a middle ground that works for both sides.
Why Liability Caps Are a Two-Way Street
It’s worth noting that liability caps don’t just protect the other party—they can also protect your business. For instance, if you’re the one providing services or goods, a liability cap can shield you from being held liable for losses that far exceed the value of the contract.
The key is to strike a balance. Both parties should feel that the cap fairly reflects the risks involved in the transaction.
When to Get Legal Advice
Contracts are complex, and liability caps are just one piece of the puzzle. If you’re unsure about the terms of a contract—or if a liability cap seems unusually high or low—it’s a good idea to consult a legal professional. We can help you understand your rights and risks, negotiate better terms, and ensure your business is protected.
Final Thoughts
Liability caps might not be the most exciting part of a contract, but they play a vital role in protecting your business from unforeseen risks. By understanding what they are, why they’re used, and how to evaluate them, you can make more informed decisions and avoid unpleasant surprises.
At Hemisphere Consultants, we specialise in helping business owners navigate the complexities of contracts and legal agreements. Whether you’re drafting a new agreement or reviewing an existing one, we’re here to guide you every step of the way.
Let’s work together to protect your business and set you up for success. Contact us today to learn more.
Would you like help with reviewing your contracts or negotiating terms? Reach out to Hemisphere Consultants—we’re here to help!