Limitations of liability – caps in operational contracts

When I work with law firms, I experience, more often than not, a surprising lack of insight in what is in important in their customer’s business. Moreover, preparing a simple ordinary course agreement is often horrifying. This weblog addresses some background considerations on only one aspect of this type of contracts: ‘caps’.

Limitations of liability. In addition to limitations on the permitted claim period under the warranties, a seller will normally limit its risks and exposure to liability in various other respects:

  • the damages eligible for compensation: excluding indirect (consequential) damages, only damages individually exceeding a de minimis threshold and furthermore damages that are not remedied by the purchaser.
  • matters affecting the purchaser’s compensation (i.e., scope of damages): aspects of own fault, mixed causation, claim-related benefits, recourse rights on third parties (e.g., suppliers).
  • causation: limiting eligible damages to those being the immediate and adequate consequence of a warranty being incorrect.
  • aspects managing the claim process: a purchaser’s ‘own risk’ also known as a basket, which has to filled before a first claim can be made.
  • (notification and) handling of third party claims that may give rise to a warranty claim.
  • procedures for making warranty claims must be made (e.g., not mere notifications of claims interrupting the contractual period of limitation but requiring that a lawsuit is initiated).

Providing for a ‘cap’. Many contracts contain a monetary limitation of liability (a ‘cap’). For M&A-agreements, such a cap is typically defined as a percentage of the (preliminary or adjusted) purchase price or simply a fixed amount (agreed by the same token). Normally, a cap should not apply to matters relating to ownership or entitlement to sell because it affects the entire sales transaction (and more). For operational contracts, such reference is not always readily determinable or the parties have reasons to vary. Commonly used caps are:

(a)     a simple amount (somewhat pointing to the amount ordinarily received under a purchase order).

(b)     the amount of the purchase order (under which the defective products were delivered).

(c)     the amount actually paid under the agreement during a period of time preceding the claim.

(d)     a percentage of the amount under (c).

(e)     the higher of (i) a simple amount, or (ii) a reference such as under (b), (c) or (d). The background of this is to provide substance during the initial period of time or in case of irregular deliveries.

(f)      the lower of the two references mentioned under (e). The background is of course to provide the kitchen sink conditions.

Many operational contracts in which intellectual property rights are at stake, the limitation of liability clause contains a carve-out for breach of the confidentiality provision and for IP infringement claims. A very common (and between equal parties often accepted) reference is:

…the amounts actually received by Seller under this Agreement during the twelve months period preceding the event or circumstances giving rise to a claim.

Note that in case of a claim, the purchaser will typically cease payment of its invoices (and in many industries, a seller will nevertheless continue its supplies, at least for a certain period of time), which makes twelve months preceding the claim relevant. Arguments to come to a higher amount (beyond one purchase order or the scope of the contract) are often established by reference to the amount that the parties order annually: in a good commercial relationship, a purchaser expects that for determining a cap on liability also other supplies between the parties are taken into account (i.e., no limitation merely to amounts paid under the agreement, let alone under a purchase order).

 

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