October 1, 2008

Limitation Of Liability Clauses

One businessman shakes hands with another. They have just struck a deal and signed a contract. Each guy thinks he’s going to get something out of the transaction. But one guy could be dead wrong about what he’s getting.

You see, the cagey guy of these two has built an escape hatch into the contract. He’s limited his downside risk by stacking the deck in his favor. If he breaches his obligations under the contract, he’s got it set up so that the other guy can’t do much about it. He’s slipped in a provision that says the most he can liable for is the equivalent of the fees he was paid in the deal. Perhaps the provision even restricts that further to just a month or so of the fees that have been paid. So if it happens that the other guy loses out on $5 million in profits because the cagey guy did not perform as promised, all the other guy can claim under the terms of the contract is the $999.95 that the cagey guy charges every month for his services (which, of course, he fails to actually perform).

Is this legal? Can Mr. Nanny-Nanny-Boo-Boo really skate out of his responsibilities that way? As with many other areas of the law, the answer is a resounding MAYBE!

swiss_cheese.jpgIn looking at this problem, you have to start with the assumption that the limitation on liability is going to be upheld, unless there is some specific exception that can be found. The law still recognizes freedom of contract, more or less. If you want to make this kind of a deal, the law will let you, as long as you don’t step into some recognized exception.

There are a long list of exceptions, though. In a transaction for the sale of goods, the Uniform Commercial Code (UCC) applies. The UCC lets a seller limit the warranties given and the remedies allowed for breach of a warranty. (At least it allows this in a non-consumer deal.) But the UCC does not let a seller leave the buyer with his hindquarters completely hanging out there flapping in the breeze. The UCC says that a remedy limitation will not be honored if the circumstances cause the remedy to “fail of its essential purpose.” In other words, if the limited remedy provides for no real remedy at all, it won’t be upheld.

But the UCC does not apply when a contract is one for services. So are service contracts the land of the free and the home of the brave when it comes to limitations of liability? Not always. The free and the brave can get their choke chains pulled up short when they aren’t looking. YOWCH!

For example, the Alaska Supreme Court has said that it is not going to permit limitation of liability clauses in a construction contract, or even in any contract that is a first cousin to a construction contract, like a construction manager’s contract, or an architect’s contract, or an engineer’s contract. It took an expansive reading of the Alaska Anti-Indemnity Statute (AS 45.45.900) to get to this result, but the Supremacies got there nonetheless.

Another example. A limitation of liability clause in a contract may not apply when a tort claim can be based on the exact same conduct. The court may just ignore the contractual limitation and apply the regular tort rules regarding a recovery.

This very thing happened to the poor title companies who tried to limit their liability for goofing up a title report. The title report said that the title company was only liable for the amount stated in the report, which was a measly $250. The Alaska Supreme Court jerked the title company’s choke chain on that one. The Supreme-O-Mites effectively said:

“Fine, you can limit the damages that can be recovered in a breach of contract action. But there’s a tort claim here too, for negligent misrepresentation. Under the tort claim, you -- Nanny-Nanny-Boo-Boo Title Company -- are liable for the full amount of the loss your foul up caused.”
(OK, OK. It was actually First American Title Insurance Co.)

My approach to these things is to advise business folk to think twice before doing a deal with someone who insists on a limitation of liability clause. If they aren’t going to stand behind their word, is this really someone you want to do business with? I mean, who really needs a Swiss cheese contract full of holes. Sometimes you have to just live with it, but it's something that you should only accept with eyes wide open.

And if my client happens to be the Mr. or Ms. Nanny-Nanny-Boo-Boo in the transaction? I tell them that this is still the land of free and the home of brave so you can charge right ahead. But you better not always count on being able to skate out your obligations, lest the choke chain of the law get pulled up rather smartly.