To highlight key challenges consider this example of ABC Corporation.
Our friend Ramon, who owns ABC Corp, a meat packing plant, purchased a warehouse to store his meats and from where product could be shipped to customers. As part of the project, Ramon entered a software subscription agreement with another corporation—let’s call it XYZ Inc. For a standard monthly fee, XYZ makes available to Ramon’s company software that is supposed to enable him to track product and shipments.
The software platform, which is made available through a web-portal managed by XYZ, also enables Ramon to regulate the temperature and humidity of different sectors within the facility, each dedicated to a different meat product. Critical to Ramon is that the arrangement includes a comprehensive service level agreement which obligates XYZ to super-prioritize software failures so that they can be addressed immediately.
In reviewing ABC’s contract with XYZ, Ramon came across a capitalized and bold-faced provision that puzzled him. It read as follows:
“XYZ SHALL NOT BE LIABLE FOR ANY LOSSES OR DAMAGES, INCLUDING ANY INDIRECT OR CONSEQUENTIAL DAMAGES CAUSED BY THE PERFORMANCE OR NON-PERFORMANCE OF OBLIGATIONS IMPOSED BY THIS CONTRACT OR BY NEGLIGENT ACTS OR OMISSIONS BY XYZ.”
On its face, the provision seemed to relieve XYZ entirely for any damage incurred by ABC as the result XYZ’s failure to respond to an emergency in a timely manner. Specifically, what if the meat spoiled as a result of the software’s failure to adequately regulate the warehouse environment?
To answer his questions, Ramon does what all good businesspersons should do when they come across legal language they do not understand. He phoned his lawyer.
The enforceability of this contract provision, called an exculpation clause, which is intended to relieve a service provider from all liability, and its cousin provision—the limitation of liability clause, which is intended to limit the liability of a vendor to a specific figure, excluding consequential or indirect damages, depends on the law of the jurisdiction that governs the agreement.
For example, most state laws are very reluctant to enforce exculpatory clauses where the conduct at issue rises to the level of gross negligence or willful misconduct.
More complicated to evaluate are how various state laws view limitation of liability provisions, which can limit a vendor’s liability to a specific amount of damages, such as the subscription fees paid to the vendor in the previous 12 months—a common limitation one sees in software subscription agreements.
As for this type of provision, state courts have articulated a range of views.
The Supreme Court of the State of New Jersey, for instance, held that limitation of liability provisions can be enforced, subject to the following conditions:
(i) the parties have relatively equal bargaining power, i.e., it is not a situation where the customer has little choice but to accept the terms of the arrangement.
(ii) the limitation is not out of proportion to the value of the contract or the amount of damages one would reasonably expect to occur as the result of a breach.
(iii) there is no state policy in place that would require the vendor to perform the service at a certain professional standard.
In the state of California, not only is it important that the parties have equal bargaining power, but there must be evidence that the parties specifically negotiated the limitation of liability clause. Also, California, like many other states, has identified specific types of contracts where limitations of liability provisions may be allowable.
In the State of Florida, a court held that where a vendor’s negligence was the cause of the damage, a limitation on the vendor’s liability for negligent acts could only be enforced if the contract “clearly” listed “negligence” claims as being subject to limitation: general blunderbuss, “any liability,” limitations would not be enforceable.
At least one survey of state laws on the subject reveals some standard rules of thumb to consider in evaluating the enforceability of exculpatory and limitation of liability clauses:
(i) the limitation provision should be set off from other provisions, usually by way of being in bold, capitalized type.
(ii) there should be evidence that the provision was negotiated, usually by way of a separate signature line associated with the provision.
(iii) the limitation should bear some reasonable relationship to the damages that could be reasonably expected to occur in connection with a contract breach or negligent conduct.
(iv) the parties are of relatively equal bargaining power so that meaningfully negotiating limitation/exculpatory provisions is in prospect.
(v) the type of damage to be limited is “clear” and “unambiguous” under the language of the agreement.
Finally, it should be noted that limitation of liability provisions may not necessarily prevent a customer from suing a negligent vendor for contribution should the customer’s own patrons sue the customer for damages resulting from the vendor’s own negligence. For example, were the failure of XYZ’s software to result in ABC’s failure timely to ship product resulting in its customers suing ABC for breach of contract, many states would allow ABC to sue XYZ to recoup that percentage of damages for which XYZ is responsible, even where there exists a limitation of liability provision that would preclude ABC from suing XYZ based on damage ABC, itself, suffered.
What does all this mean as far as Ramon’s company is concerned? Consider these three insights:
- Ramon should have his attorney research the rules of the state law being selected to govern the contract, to see if the contact limitation on liability is even enforceable. Many times, a vendor will select the law of its own state without even knowing how its state law may affect its ability to enforce its own contract provisions.
- If it is found that a limitation of liability provision could materially, adversely affect ABC’s interests, Ramon should call out the provision and try to limit it by way of defining a more reasonable limitation of liability.
- In connection with item (2), Ramon may want to try to link any liability limitation to its vendor’s general liability insurance policy. If a vendor’s insurance would cover up to $500,000 in damages, the effort should be to use this as a benchmark for evaluating the reasonableness of the proposed limitation.
Limitation of liability and exculpatory clauses have crept into many service contracts to limit a vendor’s liability. Very often they are found in form contracts and frequently accepted by customers without much question, but, their enforceability is not assured and customers should be wise to them and try to limit their scope so that vendors can meaningfully be held accountable for the work they do.