"L" is for "Limitation" and "Liability"

It’s a provision found in almost every commercial contract:
“Vendor shall be liable only for direct damages, in an amount not to exceed $X. In no event will vendor be liable for indirect, special, consequential, exemplary, or punitive damages or for lost profits.”

Although the actual words may vary, the meaning is the same:

•  The most vendor will pay is $X;
• For certain claims, vendor has NO liability.
  

Such provisions raise a number of issues: 

•  They are unfair. Vendor’s liability is capped, but customer’s is not. In other words, vendor knows his or her own maximum liability under the contract, while customer’s liability is unlimited.

• Vendor’s maximum liability - $X – may be inadequate. For example, “X” may be “no more than customer paid under this contract” or “no more than customer paid in the xyz months preceding the event giving rise to the claim for damages.” If we assume customer is paying 10 grand a month, and “xyz” is 12 months, then vendor’s liability is capped at $120,000. While that is not pocket change, is it adequate to cover damage that vendor could cause?
  

How much damage can a vendor cause?

•  How much is the contract worth?
• How much is the over-all project worth?
• Will the vendor have access to sensitive/valuable information?
• Will the vendor have access to sensitive systems or facilities?
  

Being good business persons, vendors will resist expanding their potential liability, and they will offer a variety of arguments in opposition. Some of these arguments carry more weight than others:

•  “We cannot accept unlimited liability.”
  

Customer is not asking for unlimited liability, just responsibility. Customer should not bear a loss resulting from errors or omissions of vendor. Curiously, standard language routinely exposes customers to unlimited liability.

• “Our pricing tied to the amount of liability we can accept.”
  

Again, customer is simply looking for responsibility. In addition, a great price combined with an unacceptable level of risk is not a good deal. A customer who is concerned only with price may be persuaded by this argument. Customers willing to assess the project as a whole may decide that the “great price” is not a good deal after all. There is nothing wrong with telling a vendor “No.”

• “We need a sum certain, so we can manage our risk and buy our insurance, etc.”
  

Customer has the same concerns, so it is only fair to make the limitation mutual. Also, customer has no objection to a sum certain; customer merely wants an ADEQUATE sum. Which is one of the questions we began with.

It may not be possible to determine with certainty how much protection is enough; in which case it is better to ask for too much rather than too little. A number of tools are worth consideration: 

• X times the fees paid and payable under the contract. Three times is a good starting point. Vendor cannot object that they cannot quantify the risk. But, is it adequate to cover the exposure?
• Vendor will be responsible for direct damages incurred. Vendor will object that “direct damages” cannot be quantified. But:
  
  • “Direct damages”- damages that are foreseeable and which flow directly from the breach or action – are the traditional measure of damages under contract law. This is the amount vendor, and customer, would be liable for if the contract did not contain a limitation of liability;
    
  • Presumably vendor carries insurance. (If they do not, why are you doing business with them?)
    
  • Is it unfair to ask the vendor to make good any harm that it causes?
    
  • One caveat. As with any legal term, the meaning of “direct damages” is open to interpretation, and debate, and debate.
    
  
  
• Vendor will be responsible for up to $X. We began with this approach, which is perfectly reasonable, provided X is sufficiently large. A $500,000 cap is terribly insufficient if the exposure is $2 or 3 million. In addition, with a specified cap, vendor cannot claim unknown and potentially unlimited exposure, AND Vendor can obtain the necessarily insurance more easily.
  
• Vendor will be responsible for up to the limits of its insurance. This approach removes the objection that the risk cannot be quantified and that it cannot be insured against. BUT:
  
  
  • The insurance limits must be sufficient to cover the possible risk;
    
  • Customer must require certificates of insurance, evidencing the existence of insurance (not to mention that the insurance must be from reputable companies, licensed to do business in your state);
    
  • Customer must monitor Vendor’s compliance.
    
  
  

All in all, focusing on the limits of vendor’s insurance may be the most productive approach. It overcomes most standard vendor objections AND it helps ensure that sufficient assets are available if things to wrong. Without insurance, vendor may not have sufficient liquid assets to cover the damages. A judgment against a vendor is of little value if it cannot be enforced.
A word about the types of damages to be covered. Contract law traditional protects against direct, foreseeable damages, not those that are so remote that they cannot be reasonably foreseen. The test of “reasonably foreseeable damages” is perhaps misleading. If vendor knows that dropping the ball will interrupt customer’s core business processes, vendor should reasonably expect that customer suffer lost profits. But what would those profits have been had the vendor delivered as promised? Would customer have earned the millions it expected, or would mistakes by customer, or changes in the market, have produced substantially less revenue? Better to exclude special, exemplary and punitive damages – which are awarded by the court (or jury) and have little direct relation to the value of the contract or the harm done, and specify a comfortable limit on damages – all damages, however described or characterized.
Too much protection costs vendor little or nothing. Too little could cost customer dearly.

Copyright 2010, Thomas J. Hall.  All rights reserved.