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Any commercial transaction carries the risk of liability to the parties. In order to mitigate the risk commercial contracts nearly always contain a contractual term known as an exemption clause. The purpose of exemption clauses is to attempt to exclude or restrict a party’s liability to the other in the event of a breach of contract.
There are two categories of exemption clauses: exclusion clauses and limitation of liability clauses. The difference between the two is that in the former, the liability of a party may be completely excluded (an example may be a clause that establishes that the party will not be legally responsible in the case of late delivery of goods); whilst in the latter, the liability may be limited to a certain extent but not completely excluded. An example of such a clause would state that the party would not be liable for an amount greater than the purchase price if the goods are defective.
Examples of limitation/exclusion of liability clauses
Limitation or exclusion of liability clauses can pursue different interests and take different forms, for example, the parties may:
- Exclude liability for specific events that are identified in the contract as cases of ‘force majeure’.
- Exclude liability for some categories of losses, such as indirect or consequential losses or loss of profits.
- Limit liability to a specific amount, setting a ‘cap’ to the sums payable in damages related to a breach. This limit is sometimes represented as a percentage of the overall contractual price.
- Exclude liability by specifying a time limit before the expiry of which the other party must make a claim or give notice of a breach.
- Exclude or limit any right or remedy in respect of the liability—an example is excluding the right to set-off.
Clauses that are considered not to constitute limitation or exclusion of liability clauses, include agreed or liquidated damages clauses and arbitration clauses.
Khizar Arif, a partner, commented “limitation clauses or exclusion of liability clauses are absolutely essential tools for allocating the risk of contracts between the parties and promoting commercial effectiveness.” Khizar further pointed out “however, the general principle of freedom of contract must be weighed against public policy considerations, which state that a party that voluntarily accepts a binding contractual obligation shouldn’t also be allowed to renege on that obligation.”
In order to strike a balance, English law establishes that exemption clauses are binding upon the parties and enforceable in the following situations:
Generally, limitation and exclusion of liability clauses are incorporated in the contract on the understanding that they have been fairly and reasonably communicated to the other party. There are three methods for incorporating a clause:
- Incorporation by signature – in this case, the clause will be included in a written document signed by all parties.
- Incorporation by notice – in this instance, the party seeking to restrict or exclude its liability must take reasonable steps to ensure that the other party is made fully aware of the existence of the clause by notifying them. More notice will be needed if the clause is deemed to be uncommon.
- Incorporation by course of dealings – here, a previous continuous course of dealings between the parties and familiarity with each other’s terms and trade, may be allowed.
When the clauses pass the test of construction
Construction has a major role in determining the effectiveness of exemption clauses.
To determine if an exemption clause can be effectively relied on, the question to answer is: is the liability in question covered by the clause? When answering this question, the court assesses if the exemption clause, on its true construction, extends to cover the obligation or liability that it seeks to exclude or restrict. To this extent, the wording used in the clause must be completely clear and unambiguous, it must not be too broad in scope, and must unequivocally cover what is intended to cover (the type of breach and type of loss that has occurred).
The statutory limits of the Unfair Contract Terms Act 1977 (UCTA)
UCTA imposes restrictions regarding the enforceability of exemption clauses. Incorporation of such clauses is prohibited under UCTA in the following circumstances:
Death and personal injury caused by negligence
Thus, liability for death or personal injury resulting from negligence cannot be excluded or restricted.
Misrepresentation
Equally, any clause excluding or restricting liability for pre-contractual misrepresentations or attempting to limit the remedies available for misrepresentation has no effect.
Breach or non-performance of a contract
Section 3 of UCTA prohibits the use of clauses that exclude liability for breach of contract, permit to render a contractual performance substantially different from what is expected, or in respect of the whole or any part of a contractual obligation, allow no performance at all.
Breach of terms implied by law, not expressly mentioned in the contract
Under the Sale of Goods Act 1979 (as amended by the Sale and Supply of Goods Act 1994) for instance, the quality and fitness for purpose of goods should be guaranteed even if there is no express term in the agreement). In this respect, section 6(1A) of UCTA, imposes that liability for breach of the above-mentioned implied warranties cannot be excluded or restricted at all.
The ‘reasonableness’ requirement
In the circumstances of a breach of contract, misrepresentation, and breach of terms implied by the law, if the limitation clause or exclusion clauses are deemed ‘reasonable’ (UCTA section 3(2)(b)) they can be retained and not be considered ineffective. When determining the reasonableness of a clause, the courts will consider on a case by case basis the relative strengths of the parties’ bargaining positions on the information available to them at the time of the contract’s formation. A clause that caps liability to the contract’s value, for instance, is more likely to be considered reasonable than one that completely excludes liability. The use of small print or drafting that is overly complex for example is likely to be considered unreasonable (Stag Line Ltd -v- Tyne Shiprepair Group Ltd [1984] 2 Lloyd’s Rep 211). It also seems that reasonableness is more likely to be established where the clause seeks to restrict rather than exclude liability. However, when drafting an exemption clause, reliance on prior judicial decisions as to whether the clause is likely to be judged as reasonable should not be used. The reasonableness of a clause must be evaluated on a case by case basis in light of the specific circumstances of the parties in question at the time the contract was executed, even when the clause is in the same form as a clause that has previously been considered by the courts. The clause becomes useless as a whole if the reasonableness test is unsuccessful.
In conclusion, the general category of exemption clauses can take a variety of forms. While limitation of liability clauses seek to limit the types of losses that can be recovered or the remedies that are available, exclusion of liability clauses explicitly exclude liability. These types of clauses are governed by complex legislation. Therefore, when drafting and negotiating exemption clauses, a thorough understanding of the relevant legal framework is crucial as is the use of precise and clear wording when drafting such clauses.