How to limit liability for a breach of contract

Commercial contracts often contain clauses which seek to limit the liability of one party if a breach of contract occurs. As Robert Goodard, commercial law expert with Thackray Williams explains, it is important to understand how limitation of liability clauses work and in what circumstances this type of provision may be unlikely to be enforceable in the event of a dispute.

“The aim of a limitation of liability clause is to limit the amount of compensation that can be claimed when a breach of contract occurs. They can also be used to restrict the types of losses for which compensation is payable, and so are a useful damage limitation tool”, says Robert.

What constitutes a loss?

Losses are divided into two types: direct and indirect.

A direct loss is something that has arisen as a direct result of the breach of contract; for example, having to purchase replacement goods because those ordered under the contract did not arrive.

Indirect loss (often referred to as consequential loss) is a loss that has arisen indirectly because of the breach, but is something the parties contemplated as a possible consequence if things went wrong. For example, a company purchases a large scale solar power system which is defective. The company claims not only for the cost of having to replace the system, but also for the loss of revenue it had expected to make from that system, the cost of the electricity they had to use in the meantime, the cost of staff time and contractors hired and the expenses associated with trying to mitigate the loss.

Claims for compensation for indirect losses are often disputed because questions are raised about what was and was not known at the time the contract was made, and therefore whether it is reasonable to hold the breach of contract responsible. Using the above example, if the company also claimed for maintenance of the replacement solar panel system this may well be challenged as too remote a loss to be reasonable.

To what extent can liability be limited?

Sometimes contracts include clauses which seek to exclude all liability for certain matters, for example an exclusion of ‘any loss, however caused, including negligence’. The law protects parties from unfair terms, so the court will only uphold an exclusion clause if it is clear and unambiguous and the other party knew about it at the time the contract was made.

Clauses which seek to limit a party’s liability to a certain sum are far more likely to be upheld by the court than those which seek to exclude liability entirely. In commercial contracts, it is not unusual to see limitation of liability clauses which restrict liability to the cost of the goods or services being provided or to the amount of any insurance cover that may have been put in place.

It is important to be aware that some types of liability cannot be excluded, such as in the case of negligence which causes death or personal injury.

When does a limitation of liability clause become unfair?

Some contracts go too far in trying to limit or exclude liability, whether in a business or consumer context.

For businesses, the Unfair Contract Terms Act 1977 extends to nearly all types of commercial contracts and one of its most important functions is to restrict limitations and exclusions of liability.

Terms which are not rendered ineffective by the Unfair Contract Terms Act are subject to a test of reasonableness to determine whether they should be enforceable.

The Consumer Rights Act 2015 protects consumers from unfair terms including limitation or exclusion of liability clauses. There are additional protections in consumer contracts, such as a ban on excluding liability for the inaccurate description of goods.

What can be recovered?

The losses that can be recovered will vary depending on the circumstances of each case. The distinction between direct and indirect losses is particularly fact-specific, which means that it is important when negotiating the terms of a contract that you consider the risks you would face if a breach was to occur. It really is worth spending time identifying likely losses and negotiating hard on what you could recover where appropriate.