Limitation of Liability Clause: What they should cover

Introduction : Contracts being mutually decided obligations between parties are enforceable by the court of law. This means once entered as per the statutory requirements, the defaulting party has to make good of losses incurred by an aggrieved party due to failure to perform such contractual obligation. Including a liability clause, in a contract, ensures the inclusion of liquidated damages, decided by the parties themselves. Such a liquidated damage is entitled to the party aggrieved by the contract. Although, a liability clause is not something infallible; such failure results in multitude of disputes in the faith of a contract. This blog attempts to answer what factors to keep in mind with regards to dealing with liability clauses. What all damages or losses be included in the liability clause and when courts may interpret a particular breach exception to the liability clause. What liability can be capped, super-capped, or shall remain uncapped even after the liability clause. Practical implications at the end of this blog underscore such insights to facilitate an in-house counsel, a negotiator, or a contracting party, to be better informed and tailor liability provisions to deal value.

Legal Provisions

Contracts in India have to be coherent with the provisions of The Indian Contract Act, 1872 (Act of 1872). Section 73, is of particular importance when talking about liability for breach of contract. In layman terms it mandates that the party having breached the contract has to make good of the other party who is aggrieved by the breach. This is achieved by the means of providing compensation to the aggrieved party.

When the question arrives how much the compensation shall be, we turn to Section 74 of the Act. It allows parties to the contract to decide the penalty amount for breach. This amount now acts as an upper limit of the liability in a contract. This section ensures a reasonable compensation not exceeding the mutually decided cap, whether or not the actual damage or loss happens to the aggrieved party, they shall be entitled a reasonable sum for the breach. Generally, when one party is Government or in related instances the whole of the stipulated sum shall be the compensation.

Now that a stipulated compensation is allowed by the statute, can the parties decide the compensation amount so high that a court finds it unconscionable? Morally, the compensation decided shall justify itself and not be wrong, exploitative, or immoral per say. Section 23 of the Act, bars certain consideration or objects of an agreement. Of course compensation can not be against public policy or involves injury to a person or property or for that matter forbidden by law or if allowed defeats the provision of law or is fraudulent.

It is for the reasons above mentioned, a liability clause of a contract shall first and foremost not be violative of Section 23 of the Act of 1872. If the parties stipulate the compensation then a reasonable amount not exceeding the amount so stipulated shall be entitled to the aggrieved party of the contract is breached. This way the law regulates people creating obligation for themselves by allowing the benefit of trade as consideration and at the same time keeping checks and balances to regulate dishonour of such obligation by means of compensation. 

Legal Analysis 

Section 73, acts as a statutory limit to the liability arising out of breach. It attempts to answer whether a party claiming consequential loss due to breach should be entertained or not. This reasoning was originated by this following landmark case: 

A. Direct and Consequential Loss: Hadley v. Baxendale

Hadley sued carrier Baxendale for lost profits when delayed delivery of a broken crankshaft kept his mill closed. The question before the court was whether Baxendale stood liable only for breach of contract or can it be extended to the lost profits due to such breach? If later be allowed, then to what extent the consequential damages should be compensated? This may lead to malice, if allowed to expand for remote claims. Likewise, the case was decided as the damages for breach of contract were to be limited to those that are reasonably foreseeable by the parties at the time the contract was made.

Applying the same logic in the liability clause, if it says Neither party shall be liable for indirect, incidental, special or punitive damages, including loss of profits, on the face of it, such statement may appear to clarify intention to limit consequential damages. Use of such generic words actually does create ambiguity as to ascertain whether to consider reasonably foreseeable losses by the parties when the contract was made, under the head of loss of profits. Thereby rendering the permissible carvings outside the scope of application. 

B. Tussle of Aggregate Claim over Per-Claim Caps

A standard Liability clause where continuous commitment exists, the clause may include Cap or the upper limit for the stipulated compensation in case of breach. One way is to allot an aggregate liability cap, for the entire duration of contract, setting a cap to liability. In other words, it is a clause setting a cumulative monetary ceiling for all claims arising throughout the life of a contract. One drawback here is, aggregate cap once exhausted, subsequence claims fall back. Such clause favours the Performing party, where the possibility of breach is of Low Frequency, and High risk. This way of capping allows subsequence compensation to be adjusted to the Aggregate Claim Cap mutually accepted. For the receiving party, annual renewal of such aggregate claim cap, if contracted, proves to be a safer option where there are chances of earlier exhaustion of Aggregate Claim Cap.

Another way of Capping the liability is Per-Claim Cap, also known as per-occurrence or per-event cap. This restricts the amount that can be claimed at a particular instance of breach. Idea here is that the claim amount resets automatically for every distinct claim or occurrence. As against the aggregate cap, per-claim cap favours the receiving party across multiple breaches. Caps like this are often opted for the circumstances High in frequency and Low in risk. Common ambiguity in such a cap is whether a particular occurrence or event to be counted as a single event or as multiple events. More often than not, when multiple problems stem from one root cause, one party prefers to argue for separate claims while other, as a single occurrence.

To prevent such ambiguity, elaboration is often included in the Per-claim capping clause. For instance- For the purposes of this clause, a series of related, repeated, or continuous breaches, acts, or omissions arising from the same underlying cause or origin shall be deemed to constitute a single claim and a single occurrence. A crucial point to note here is, the bargaining power by the parties is the cornerstone of any clause. Take-it-or-leave-it or unequal bargaining power was the highlight of the case Cent. Inland Water Transp. Corp. v. Brojo Nath Ganguly, (1986) 3 S.C.C. 156.

C. Uncapped Liabilities: Non-Negotiable Carve-Outs

Can it be possible to put a cap on liability where statute itself imposes liability? There are exceptions to the liability clause, meaning if an occurrence falls in the ambit of these exceptions then there will be unlimited Liability. In other words, even if mutually contracted to put a cap, there may still be liability. Death or Personal injury caused by negligence is one example where liability may go separate to the liability which is capped. It is for this reason Non-Negotiable carve-outs are universally included in the liability clause. Commercial contracts also have carve-outs for Gross Negligence, Willful Misconduct or intentional Breach. Gross Negligence in comparison to Negligence, has the highest degree of recklessness. Other Carve-Outs are Fraud as defined in section 17 and Misrepresentation in section 23 of the Indian contract Act, 1872.

D. Super Cap: A Higher liabilities for certain cases

Liability clauses more often than not, imposes higher liability than ordinary, for certain sensitive circumstances. Depending on what matter is crucial for such a party, there may be a dedicated super cap. For instance, in case of breach of confidentiality or in case of Data Privacy and Security breach the liability can be something like 3x to 5x of contract value or a pre-decided amount like 5-50 Cr. Rather than keeping such conditions as Uncapped, parties often negotiate to a super cap. This prevents the contracting party from getting scared of the imposition of an unlimited liability and at the same time lowering the liability ceiling for him to comfortably contract. Moreover, it eliminates the barrier preventing a contract and provides sufficient and reasonable protection for high stake operations. These capping are ordinarily valid in the eyes of law, unless such super cap provisions are held to be unconscionable by the court of law.

E. Discussions with regards to Liability Cap and Indemnity

An indemnity contract is one in which one party agrees to protect the other from loss resulting from the promisor's or any other party's actions, as stated in Section 124 of the Indian Contract Act, 1872. The indemnity-holder is entitled to recover all damages, litigation costs, and allowable compromise payments under Section 125 as long as they act within the bounds of their jurisdiction. A Section 73 claim for damages requires proof of breach, proof of actual loss, and satisfaction of the remoteness requirements. A claim under an indemnity is a separate, primary contractual obligation. Operation of liability clause which imposes upper ceiling for compensation, creates fiction between these two concepts. Therefore, demarcating what is included in the liability clause and what is beyond its scope turns out to be crucial to consider.

Ordinarily, the third party indemnity sits outside this liability clause while Direct or bilateral liabilities are included in the liability clause. This is to protect the contracting party from becoming liable only for the compensation involving their failure to the obligation made in the contract by them and not as a consequence of some third party to the contract. For illustration purposes, let's say a start-up contracts with an IT company for the development of software architecture for their business for ₹50 Lakh, capping the liability to 1x the Contract value, that is ₹50 Lakh. Later a tech company sues the business, for damage ₹1 Cr, claiming that the said software architecture was developed by their patented technology. Now if in the liability clause of the contract between the business and IT company, it includes the third party claims. The maximum liability of IT Company is limited up-to ₹50 Lakh only. This is the reason why in most occasions, liability clauses are excluded from such third-party claims, because third-party exposure cannot be predicted or controlled by the Aggrieved party. Hence, it becomes pivotal to clarify what falls in the ambit of liability clause and what stands outside of it. 

Relevant Case Laws

Cent. Inland Water Transp. Corp. v. Brojo Nath Ganguly, (1986) 3 S.C.C. 156

An unconscionable, unfair, or grossly one-sided term in a standard-form contract entered into between parties with unequal bargaining power is void under Section 23 of the Indian Contract Act, 1872, being opposed to public policy.

Fateh Chand v. Balkrishan Das, (1964) 1 S.C.R. 515

Section 74 of the Indian Contract Act, 1872 dispenses with the English common law distinction between liquidated damages and penalties; the court will award only reasonable compensation not exceeding the stipulated penalty or sum.

Earnest money (a genuine guarantee of performance) can be forfeited upon breach, but any advance payment towards the purchase price cannot be forfeited arbitrarily without proving actual loss or demonstrating that the forfeiture represents reasonable compensation.

Gajanan Moreshwar Parelkar v. Moreshwar Madan Mantri, (1942) 44 Bom. L.R. 703

An indemnity holder need not wait until they have suffered actual loss or discharged the liability out of pocket; if an absolute liability has been incurred, the indemnity holder is entitled to call upon the indemnifier to satisfy that liability and relieve them from it.

Practical Implications

A blanket liability cap in commercial transactions across India creates serious statutory and operational friction. In-house counsel, negotiators and arbitral practitioners should structure risk allocation in accordance with the strictures of the Indian Contract Act, 1872 (ICA), and settled judicial precedent:

Routine Performance Breaches

Vendors generally want to limit financial exposure for operational delays or service defaults to an aggregate amount, while customers are better with annually renewing aggregate amount or per-claim cap. Under the terms of section 73 (ICA), liability is strictly confined to direct and proximate loss arising in the normal course of events, and remoteness or indirect loss is expressly excluded. Indian practice has a standard commercial compromise of 100% of fees paid or payable in the last 12 months. Said sum is in the nature of a statutory cap and not an automatic entitlement by virtue of Section 74. The consumer has still to prove the actual loss suffered till the said limit. (Fateh Chand v. Balkrishan Das)

Infringement of third party’s intellectual property

Vendors will typically want to limit IP exposure to the contract value and exclude legal defense costs. This creates an unmanageable risk for the Indian licensee or enterprise buyer – third party infringement suits under the Copyright Act, 1957 or the Patents Act, 1970 brought by outside parties against the end user on account of proprietary code in which the customer had no hand. The licensee is better at having such IP Exposure to separate indemnity clauses. An indemnity entitles the holder to be saved from loss as soon as the liability becomes absolute, as interpreted through the equitable doctrine in Gajanan Moreshwar Parelkar v. Moreshwar Madan Mantri. Under Indian contract law, standard market practice is of, fully uncapped indemnity covering all damages, legal fees and settlement sums, balanced.

Gross Negligence & Willful Default

Vendors try to carve out “gross negligence” or to carve in intentional defaults within the general liability cap. However, Section 23 of the ICA declares a contractual term void if its object or consideration is fraudulent, injurious to another or opposed to public policy Cent. Inland Water Transp. Corp. v. Brojo Nath Ganguly, (1986) 3 S.C.C. 156. Section 23 is contravened by a clause that pre-licenses bad faith, deliberate non-performance or intentional breach. Under Indian law, in drafting practice, the carve-outs for Fraud (Section 17, ICA), willful misconduct, intentional breach and gross negligence must remain strictly uncapped to avoid the entire limitation clause being struck down as being contrary to public policy.

Conclusion

Liability clauses shall be in accordance with statutory regulations. It should not be against the public policy and not be regarded as immoral, unconscionable by the courts of law. Such liabilities may be regarded as uncapped. Liability caps help in taking an informed decision while contracting, it can be aggregate claim cap or per-claim cap or super-cap, but has to be maintaining balanced bargaining power between contracting parties. The above discussions highlight a practical matrix assisting an in-house counsel, a negotiator, or a contracting party, to be better informed and tailor liability provisions to deal value.

Author: Amit Swopan Karak in case of any queries please contact/write back to us via email to content@khuranaandkhurana.com or at  Khurana & Khurana, Advocates and IP Attorney

Endnotes

1. The Indian Contract Act, 1872, § 23.

2. The Indian Contract Act, 1872, §§ 73-74.

3. The Indian Contract Act, 1872, §§ 124-125.

4. Cent. Inland Water Transp. Corp. v. Brojo Nath Ganguly, (1986) 3 S.C.C. 156.

5. Fateh Chand v. Balkrishan Das, (1964) 1 S.C.R. 515.

6. Gajanan Moreshwar Parelkar v. Moreshwar Madan Mantri, (1942) 44 Bom. L.R. 703.

7. Hadley v. Baxendale, (1854) 156 Eng. Rep. 145.