cartoon of baseball capThe baseball cap represents the cap on a party’s contractual liability, also called the ‘limit of liability’ in contract terms.

If things have gone wrong because of one party’s breach of the contract, the other party might be entitled to seek damages, to compensate them for any losses they’ve incurred.

Conversely, the other party (usually the supplier) will be keen to limit the extent of their liability to pay such compensation. They might do this in one of two ways:

1. excluding certain categories of losses in their entirety; and
2. putting a financial cap on their liability, either for particular categories of loss, or for all losses claimed under the contract.

Losses can be categorised in many different ways, and one that you may have come across is the distinction between ‘direct’ and ‘indirect’ losses. According to contract law as taught for decades, this distinction was applied according to the level of ‘remoteness’ from the breach of the loss in question.

There are some legal principles set out in a case from 1854 (yes, we’re still working from precedents established over 160 years ago!) called Hadley v Baxendale. These have been interpreted over the years so that ‘direct losses’ are generally accepted to be ones that would ‘fairly and reasonably’ be considered to arise naturally from the breach of contract.

Under these principles, ‘indirect losses’ would be those that would not have been ‘in the contemplation of the parties’ at the time the contract was entered into.

In recent years, the Courts have been more liberal in their interpretation of what is a direct, and what is an indirect loss. Financial losses (loss of profits, for example) used to be considered to be always in the ‘indirect’ pot. But that’s no longer the case – if you want to be sure that loss of profits is excluded, you have to list it out expressly as being excluded, regardless of whether it arises directly or indirectly from the breach of contract.

When it comes to determining a sensible financial cap on liability, this should be looked at in the context of the overall contract value, and should represent a fair balance of risk and reward between the parties. For example, if I’m selling you a bag of rivets for £5, and you’re using them to attach the wings to your airliner, you might want me to accept liability for the destruction of the airliner if the rivets fail. For my part, I’d rather not have your £5, thank you very much, if it means me accepting £millions of potential liability!

The Unfair Contract Terms Act 1977 (“UCTA”) says that parties may limit their liabilities in commercial contracts only to the extent that the limitation is ‘reasonable’. While there are no hard and fast rules about what is, and is not, reasonable, and it will certainly vary according to the circumstances, a sum equal to somewhere around 125% of the total contract value would be a good place to start.

The risk of setting too low a limit of liability is that it could be rejected by a Court as being unreasonable under UCTA, which would leave you with unlimited liability. So ‘reasonableness’ pays!

It is also worth noting that some liabilities cannot be limited or excluded by law. In summary, these are for death or personal injury caused by negligence or a defective product, and for fraud or fraudulent misrepresentation.

Want to know more? Contact Devant for contract assistance!