What do contractual limitations on liability mean for your business?

Just about every commercial contract you sign has a contractual limitation on liability. And, even if you do not sign a contract, a limitation on liability will frequently be included in the terms and conditions attached to purchase orders for the goods and services that you buy.

The overwhelming majority of contracts and purchase orders are fulfilled without a major issue, but what impact does the limitation on liability have for your business when there is a problem? Depending on the circumstances, the impact can be significant.

There are two types of limitation of liability.

Consequential damages
The first limitation is on the type of damages you can claim if there is a breach of contract. The most common damages to be waived or limited in contracts are indirect or consequential damages and lost profits. Consequential damages can be likened to the ripple effects that a contractual breach can have on your business.

For example, the supplier of a key component that you use in your business either fails to deliver on time or provides you with a defective product. The immediate impact on your business is the need to find replacement goods and usually in a hurry. This is direct damage because you contracted to pay $100 a unit for 1,000 units, but now you may have to go out and pay $130 a unit in the open market — and that is if you are fortunate enough to have alternate suppliers available.

So, your direct damages are $30,000. But let’s say that there is no immediately available replacement or that there is a significant delay in getting a replacement product. Now you may not be able to fulfill orders with your own customers or you may lose the opportunity to make sales because you have no inventory. There is a consequence to the breach: you may now be in breach of your own contracts and be liable for damages to third parties.

The losses that you incur as a result of these breaches may significantly exceed $30,000. Similarly, if you do not have sufficient inventory to sell, you will lose the opportunity to make a profit on those sales and that is lost profits. If that occurs during a busy season, you could lose a substantial portion of your profits for the year and the ability to generate cash flow. If you have a limitation on consequential damages and lost profits, you will not be able to recover these damages.

Dollar limitation
The second type of limitation on liability is a dollar limitation or cap. It is very common for the dollar limitation to be the amount paid for the products or services that are subject to the contract or purchase order. So, essentially, you are limited to a full refund and nothing more.

This type of limitation usually trumps any other clause you have in the contract, such as a warranty, if the cost to fulfill the warranty would exceed the dollar limitation. This can particularly be a problem if a product or a vendor providing services causes an accident or does damage to your employees or property.

Although the vendor may have insurance coverage, the dollar cap in the limitation on liability can be used by the insurer to limit the amount of recovery. If you are paying $50,000 for services and a negligent vendor causes $100,000 worth of damage, this limitation could leave you with $50,000 in damage that comes your of pocket unless you have your own insurance coverage.

It would not be practical to negotiate these limitations in every contract. But it is important to consider those contracts where a potential breach by the other party could do serious harm to your business and ensure you take this into account when negotiating the terms.

This article first appeared in the Whittier Daily News online on June 22, 2019. Republished with permission.

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