How-to guide: How to draft and negotiate an exclusion and limitation of liability clause (UK)

Introduction

This guide will assist in-house counsel and private practice lawyers with the key issues to consider when drafting and negotiating limitation of liability clauses (also known as limitation clauses, exclusion of liability clauses, exclusion clauses and exemption clauses) in a business-to-business (B2B) agreement. It provides practical guidance to use for negotiating and drafting and considers common pitfalls related to exclusion and liability clauses (including the Unfair Contract Terms Act 1977 (UCTA)), common law and other statutory controls which need to be taken into consideration when using these clauses. It also considers alternative ways of mitigating risk and situations in which these may be appropriate for consideration.

This guide covers:

Reasons for limiting liability
Identifying the risks
UCTA, statutory controls and the common law
Other ways to mitigate risk and limit liability in an agreement
Drafting a limitation of liability clause – practical tips
How to approach negotiating a limitation of liability clause

This guide can be used in conjunction with the following How-to guides: How to negotiate and draft governing law and jurisdiction clauses in a commercial agreement, How to manage the risk of contracting with a company in financial difficulty and Checklists: Ensuring a contract is valid and What to consider when terminating a contract.

Section 1 – Reasons for limiting liability

1.1 Risk management

Any commercial transaction carries a certain degree of risk, ie, the occurrence of a potentially harmful or negative outcome. In B2B agreements, this is normally a financial loss to a party, although the harm can also be reputational. Some risks are direct, such as non-payment, or non-delivery; while others can be indirect or consequential – they only arise as a consequence of another risk occurring – for example, the non-delivery of a part (a direct risk) which then means that the production of completed goods is delayed (an indirect or consequential risk).

To mitigate potential risks, it is sensible for the parties to a transaction to include a limitation of liability clause in the agreement between them to allocate, exclude or limit any liabilities that may arise should a risk materialise.

1.2 Identifying recoverable risks

The question of whether a party can claim for damages (ie, whether legal causation is sufficiently strong) depends on the contractual remoteness of the damages.

Under UK law, Hadley v Baxendale (1854) 9 Ex 341 is the leading authority on contractual remoteness. The case sets out two ‘limbs’, or areas under which damages may be recovered for breach of contract:

Under the first limb, losses are recoverable if they arise naturally according to ‘the normal course of things’. These are referred to as ‘direct’ losses. For example, a supplier would be able to recover damages from a customer who receives goods but does not pay for them; the loss being the amount the customer had agreed to pay for the goods. Both parties would anticipate the loss arising from non-payment (ie, no income to the supplier from provision of the goods to the customer) as something that would happen in the normal course of things.
The second limb allows a claimant to recover additional damages where the losses were foreseeable by the parties at the time they entered into the agreement. ‘Foreseeable’ in this case means that it is ‘in the contemplation of the parties’, and that it must be foreseeable, not just as being possible, but as being ‘not unlikely’. Essentially, a court will consider the agreement to construe the losses for which the defendant can reasonably be assumed to have accepted responsibility.

1.3 Unlimited liability

Subject to any restrictions under the law of damages, and any determination by the court at the applicable time, if an agreement does not contain a limitation of liability clause there is potentially no limit (either in scope or the amount) to the damages the non-defaulting party may potentially recover.

Restrictions under the law of damages include legal constraints, financial constraints and time constraints.

1.3.1 Legal constraints

Damages are an award of money made by process of law to compensate a claimant who has suffered loss or damage because of an actionable wrong for which the defendant is responsible. A right to damages may arise under a statute as well as under the common law.

If a claimant is seeking to recover damages for a breach of contract, the elements of duty, breach, causation and loss must be proved. In addition, the claimant must show that it took reasonable steps to reduce (or to mitigate) its potential loss. The claimant cannot simply allow the losses to be incurred if it was possible for the claimant to have taken action to reduce the final loss, even if the action requires that the claimant having to incur financial outlay – (Payzu Ltd v Saunders [1918-1919] All ER Rep 219). In addition, if the claimant is seeking to recover indirect or consequential damages, it must demonstrate that the losses were foreseeable (Hadley v Baxendale) (see Section 1.2 above).

1.3.2 Financial constraints

Depending on the extent of the claim for damages, it is possible that the defendant responsible for the loss may not necessarily have the relevant assets available to pay any damages awarded to the claimant, for example, it may not have sufficient money in its bank accounts. Therefore, a successful claim against a defendant may result in it being put into an insolvency situation under section 176A of the Insolvency Act 1986. The likelihood of a claimant successfully recovering any awarded damages from the defendant is likely to be significantly hampered, as the damages would rank as the provable debt of an unsecured creditor (with, for example, secured creditors taking priority in the queue of creditors).

1.3.3 Time constraints

If an agreement is executed under hand (ie, not as a deed), the claim for damages must be made within six years of the event giving rise to the liability, according to the statutory limitation period set out in section 5 of the Limitation Act 1980. This applies whether or not the agreement has expired or instead, been terminated. Whilst it may quickly become apparent to a party if the other party has done something (or not) to give rise to a claim for potential damages, depending on the nature of the agreement and the goods or services under the agreement, this may not always be the case. Consideration should be given as to whether this will be the case with the risk under the relevant agreement. If there is the possibility that it may take some time for circumstances giving rise to a potential liability coming to light, it may be appropriate to instead execute the agreement as a deed, meaning that the limitation period would be twelve years, rather than six.

Section 2 – Identifying the risks

Ahead of negotiating and drafting a limitation clause, it is important to understand the risks of the transaction in order to ensure that the approach to excluding and/or limiting liability is sensible and appropriate.

2.1 Risks specific to the transaction

Some examples include:

the risk of purchasing foodstuffs that are rotten – this could lead to the risk of consumers bringing a claim against the customer as a result of illness caused by food poisoning or similar; and
the risk of purchasing virus-infected software – the virus is introduced into the customer’s network, leading to potential loss of or unauthorised access to its data and potential downtime whilst the virus is resolved, and as a result, potential loss of business.

2.2 General risks attaching to any transaction

Some general examples of risks in a B2B agreement include:

non-delivery of goods or non-performance;
non-payment of invoices;
insolvency of a counterparty;
breach of contract; and
goods or services not being of a satisfactory standard.

All these risks would normally be considered direct losses and would give rise to a claim for breach of contract, or a breach of warranty, depending on how the agreement is drafted.

Section 3 – UCTA, statutory controls and the common law

Issues relating to exclusion or limitation of liability are dealt with both under the common law and statutory provisions, for example, UCTA.

3.1 UCTA

UCTA governs clauses that purport to limit liability whether directly or indirectly. UCTA applies to most B2B agreements, although a detailed discussion of the applicability of UCTA is beyond the scope of this guide. Where UCTA applies, certain limitations or exclusions will either be considered void, or will be considered valid only if the relevant contractual provision passes the UCTA reasonableness test.

3.1.1 Contractual provisions that will be considered void under UCTA

Some contractual provisions are considered void under UCTA, for example:

limitation of liability for injury or death caused by negligence (section 2); and
supplying (or hiring) goods without the right to do so (section 6).

3.1.2 Contractual provisions that will be valid only where ‘reasonable’ under UCTA

The UCTA reasonableness test is set out in section 11(1). The test considers if it was fair and reasonable to include a term in an agreement, considering everything the parties knew, or should reasonably have contemplated, when they made the agreement.

An exclusion or limitation clause is more likely to be considered reasonable if the clause is fully negotiated and not a clause in a set of standard terms and conditions (particularly where it is not prominent or highlighted). In addition, it will be more likely to be considered reasonable where the parties have equal bargaining power and are advised by lawyers.

Note should be given to the recent Court of Appeal decision in the case of Last Bus Ltd (t/a Dublin Coach) v Dawsongroup Bus and Coach Ltd & Anor [2023] EWCA Civ 1297 which confirmed that UCTA applies where parties are contracting on one party’s standard terms. The test of reasonableness will apply where the parties are not of equal bargaining power not just in terms of size but also in respect of the terms agreed. In this case, although the parties were of similar size, the purchaser was not in a position to be able to negotiate the specific exclusion clause as there were no materially different terms available in the market. The burden is on the party relying on the exclusion or limitation clause to show that the conditions required to satisfy the reasonableness test have been met.

3.2 Other statutory controls

There are a number of other statutory controls which impact limitation of liability clauses. Below are those which apply to B2B agreements. There are others which apply to business-to-consumer (B2C) agreements in order to benefit consumers, but these are outside the scope of this note.

Late Payment of Commercial Debts (Interest) Act 1998 – this adds an implied term allowing the party owed money to claim 8% interest plus costs on overdue invoices. It can be substituted for another term which gives another substantial remedy for late payment but cannot be excluded.
In the case of goods, the Sale of Goods Act 1979, the Supply of Goods (Implied Terms) Act 1973 and the Supply of Goods and Services Act 1982 imply certain terms into the agreement about title and possession to the goods, the description, quality and fitness for purpose of the goods, and skill and care in performing the services. The implied terms as to title and possession cannot be excluded. The extent to which the other terms implied by statute can be excluded will be subject to the reasonableness test in UCTA.
In terms of the Competition Act 1998, a supplier cannot use a dominant market position to impose terms on its customers. See How-to guide: Understanding the Competition Act 1998 prohibitions.

3.3 Common law

The common law also implies certain restrictions on B2B agreements. These include the ones listed below.

Restrictions on incorporation – an exclusion or limitation clause is more likely to be held to be enforceable if the parties have negotiated it (or been given the opportunity to negotiate it). In an agreement where a party has not been given the opportunity to negotiate an exclusion or limitation clause (such as where standard terms are used), the court will consider whether the exclusion or limitation has been brought to the other party’s attention. The court will consider the clause’s position in the agreement (whether it is one of the first clauses, or is in bold text), as well as the content of the clause itself. If a court decides that an exclusion or limitation clause has not been sufficiently incorporated, it will treat it as being severed from the agreement as if the agreement never contained the provision in the first place.
Interpretation – the court may decide to apply a narrow interpretation of the clause in order to serve justice. Therefore, when drafting an exclusion or limitation clause, take care to ensure that each head of limitation or exclusion comprising the clause is not too broad in scope. The court is more likely to uphold a narrower, more specific clause drafted in relation to foreseeable problems. Also, if the wording of a clause is ambiguous, and the standard approach to construction does not give a clear answer, a court may decide to interpret the clause strictly in accordance with the wording, and to construe any ambiguity against the party seeking to rely on it.
Public policy – for example, it is a matter of public policy that a party cannot limit its liability for its own dishonesty or fraud.

Section 4 – Other ways to mitigate risk and limit liability in an agreement

4.1 Other contractual obligations

Each party should ensure that the agreement is drafted so as to reduce and manage potential risk, appropriate for each party (and in accordance with any policies or processes of that party, and appetite for risk), including that the agreement contains:

clear descriptions of what is to be provided or sold;
detailed quality control or service-level requirements; and
appropriate checking and reporting mechanisms.

In addition, it should be clear to each party when their contractual obligations will come to an end. For example, in the case of a purchase of goods, if there is a process to enable a purchaser to first inspect the goods before being deemed to have accepted them, the supplier is likely to want to limit the period during which that the purchaser can make any claims arising from the quality goods themselves. This is so the supplier’s liability for lack of quality is not potentially open-ended and open to abuse by the purchaser. See Checklist: What to consider when reviewing terms and conditions for the purchase of goods and services (buyer’s perspective) – B2B for more information.

A dispute resolution or escalation clause may be appropriate. This sets out an agreed process to be followed by the parties in the event of a dispute arising, rather than proceeding straight to making a claim, and the resulting costs, time and potential damage to any ongoing relationship between the parties as a result of making a formal claim.

4.2 Insurance

Insurance clauses are frequently included in commercial agreements (together with other risk allocation provisions) to obligate one or all parties to carry and maintain insurance for the benefit of the other party in respect of specific risks, such as potential liability for loss of, or damage to, tangible property arising under or in connection with the agreement.

Where a party agrees to insure against a risk, the party who will be relying upon that insurance should ensure that it has seen the insurance policy (or evidence that the policy is in place and current, such as an insurance certificate) and is satisfied:

that the insurance policy will cover the relevant risk;
that it is aware of what is not covered by the insurance;
as to the financial value of a potential pay out from insurance against the likely financial losses associated with the relevant risk;
that each party can comply with any requirements set out by the insurer in order to maintain the benefit of the insurance (or to promptly notify the other if it cannot);
with any timeframes specified in the insurance policy, such as the period of which claims must be notified to the insurer (and the process for doing so); and
that the agreement contains a provision setting out the assistance to be provided by the uninsured party to the insured party in the event of a claim.

The party obliged to have the insurance in place should be required in the agreement to maintain the insurance at all times during the term of the agreement and that failure to do so allows the other party the option to terminate.

4.3 Third-party guarantees

Rather than relying solely on a limitation of liability clause, a party can often, in addition, require the other party to provide a third-party guarantee in respect of the performance of certain specific obligations under the agreement. The third party is often a parent company of the party being guaranteed, or another member of its group. In the case of a partnership, it may be a personal guarantee by each of the parties. This is most often used for specific risks which each of the parties accept may occur but where a party is unlikely in reality to be able to recover damages from the other party, for example, because the other party is relatively new and unknown, or small, and does not have sufficient assets to support its business operations, performance and potential liabilities.

4.4 Due diligence

It is essential that the parties undertake thorough due diligence of the other party (or parties) in order to establish that they are able to and likely to meet their contractual obligations. For example, a small limited company may agree a generous position around its liability for losses, knowing full well that it has no assets to be able to pay any damages if they arose, or oblivious to whether it can do so. It is important in this scenario to be clear about a party’s ability to meet its contractual obligations (both in terms of performance and financially).

4.5 Product and customer documentation

Where the risk is not just financial but also reputational, or where a party suffering losses is likely to also incur claims from its own customers under their agreements with that party, it is sensible to ensure that any product and customer documentation contains suitable disclaimers and exclusions of liability.

Example

A contracts with B to provide components which will become part of A’s goods to be sold to its customers. B provides the goods but they are not of a sufficient standard, meaning that A’s goods will break within a short period of time. A may only be able to recover damages from B covering the difference between the value of the components it paid for, and the value of the components it actually received. Meanwhile, A receives claims from all its customers whose goods break within 12 months because its customer documentation offers a generous three-year warranty period. The total value of these claims outweighs the losses recoverable from B. In such a case, it would have been prudent to ensure the customer documentation excluded liability under the warranty for certain specific component failures, thereby limiting the claims which could be made by customers against A.

However, take care to ensure that any such disclaimers and liability between A and its customers do not themselves fall foul of any rules on exclusion and liability clauses (as set out throughout this note) and, when dealing with B2C agreements, ensure any exclusions and limitations are not prohibited under applicable laws related to B2C agreements. This is outside the scope of this note.

Section 5 – Drafting a limitation of liability clause – practical tips

5.1 Accept, exclude or cap the liability?

A limitation of liability clause will normally cover the three areas listed below.

Accepted liabilities - those liabilities that the parties are willing to accept, usually because, as a matter of law, they cannot be excluded or limited (capped) – for example, death or personal injury caused by negligence, or because the parties agree that the risk is acceptable (based on that party’s risk appetite and other commercial considerations, such as balancing the legal risk versus the commercial reward). In addition, the parties may have agreed to accept other specific liabilities on the basis that management of the risk is wholly within each party’s control – for example, liabilities between the parties arising under the Transfer of Undertakings (Protection of Employment) Regulations (TUPE) 2006.
Excluded liabilities – those liabilities which the parties agree can be excluded. These are normally set out as specific categories of indirect or consequential loss (or certain sub-categories of those categories, for example, a general exclusion for loss of profit. As it is possible that a court could find that a general exclusion is not valid, it is usual to set out excluded liabilities as separate heads of exclusion, and to ensure that there is a severability clause, so that failure of any particular exclusion is less likely to run the risk of invalidating the entire limitation of liability clause.
Capped liabilities - those liabilities in respect of which damages will be capped (ie, limited to a specific amount or percentage based on the potential price for the goods/services being paid under the agreement). The cap can be in relation to each liability, or can be limited to a total amount across all liabilities, or can be limited to an annual value. How caps are applied and the amounts specified will normally be a matter for negotiation, based on the relative bargaining position of the parties, the nature of the agreement and other relevant factors. Note that any cap may be subject to the reasonableness test in UCTA so take care to ensure that the cap is sensible and appropriate to the potential risks and responsibilities under the relevant agreement (see note 5.3 below).

5.2 Other potential contractual approaches used to strengthen a party’s position

During negotiations, it is common for a party to employ one or more of the tactics listed below:

Specifying that a time bar applies to claims, ie, stating that claims must be brought within a certain timeframe otherwise the right to claim is waived. The timeframe can typically start from the date of delivery (which is quite an aggressive approach from a supplier/seller), from the date a breach occurs, or (as is preferable from the customer’s perspective) from the date a loss is suffered as a result of the breach (if there is likely to be a delay between the breach occurring and a party incurring a loss as a result).
From the supplier’s perspective, it makes sense to require all claims to be notified promptly (or the buyer loses the ability to claim), so that the supplier is better able to control and have an awareness of the amount of potential liabilities at any given point in time.
Excluding any rights to set off losses against other sums owed - a common approach, particularly in more complex agreements where multiple types of goods or services are being provided under one agreement. This can mean that the party seeking to recover damages does not need to prove its claim in court and can retain what it believes is owed. Whether this is accepted will depend on the negotiating strength of the party seeking the exclusion.

5.3 Why it is not possible to try and exclude all liabilities

Generally, the courts will not uphold a clause in an agreement which leaves a party without any meaningful remedy for a breach of contract. If UCTA applies to the agreement, such a clause would fail the reasonableness test set out in section 11 of UCTA meaning that it would be void. The risk of this is that the liabilities of the party seeking to rely on such a clause in the position could potentially be unlimited, rather than entirely excluded.

5.4 Why it can be better to accept obvious risks

In a situation where a party (usually the supplier) is in a position to control or manage a particular risk, or if a risk is covered by that party’s insurance, or if it is market practice for that party to accept that particular risk, it may be better to accept the risk (potentially subject to a financial cap), and to expressly provide for this in the limitation of liability clause. This avoids wasting time negotiating a risk which, in practice, is not a risk to one party, encourages good relations between the parties from the outset in not arguing over points unnecessarily during contract negotiations.

5.5 Ensuring the clause holds up in a dispute

Whilst there will always be a degree of uncertainty as to the situations that may occur to give rise to a dispute, and how the courts are likely to interpret any exclusion or limitation clause in light of the circumstances surrounding the dispute, the parties should:

ensure that the basics of contract enforceability are met by ensuring that the final agreed version is properly signed (see Checklist: Ensuring a contract is valid);
make sure that each party was given the opportunity to negotiate the limitation of liability clause, and that the clause (or separate provisions which would normally comprise an exclusion or limitation of liability clause) is very clear, and has not been buried or hidden away in the contractual documentation, particularly under a misleading clause heading or in a separate schedule. If the limitation clause is not in the contractual documentation (but instead in any of the supporting documentation for example), then it is unlikely to be deemed incorporated into the agreement;
beware of long, specific lists of exclusions, which may be interpreted narrowly by the courts so as not to apply to the circumstances of the dispute, and also short, generalised lists which may be considered too broad to apply to specific circumstances; and
use the recitals of the agreement to provide the background justification to the position reached by the parties. However, note that recitals do not form an operative part of the agreement; they are there to aid interpretation only.

Section 6 – How to approach negotiating a limitation of liability clause

6.1 Understand the most likely risks – how consequential are they?

Be clear about the potential risks and know whether there are strategies already in place to deal with them (eg, insurance policies and/or back-up suppliers, or other operational processes to mitigate the effects of any risk). There will always be theoretical risks (those that could occur but are unlikely to do so in reality), and actual risks (those that are highly likely to occur). This may allow a certain amount of leeway in terms of not needing to push too hard during negotiations for an exclusion or limitation in the agreement especially for theoretical risks.

Consider whether there are other contractual ways to deal with risks before a loss occurs. For example, including re-performance/replacement or service credit clauses in relation to unsatisfactory quality. A re-performance/replacement clause would typically be connected to the provisions setting out quality standards of the goods or services being provided under the agreement. Here is some example wording:

Should the standards set out in clauses X, Y and Z not be met in the reasonable opinion of the purchaser, the purchaser has the right to [require re-performance of the services]/[return the relevant goods to the supplier] and require the supplier to provide replacement goods of the specified quality], at the supplier’s expense, within X days of the original [performance/delivery] date.

Service credits are often used where it would not make sense to require re-performance of services or replacement of an entire shipment of goods – for example, where services are provided but not within the timeframes specified in the agreement, or where a shipment of goods may contain a few broken goods but without affecting the remaining goods. As the service has been provided or the goods provided, but with a delay or some breakages, a service credit expressed as a percentage of the cost is typically applied to the supplier’s next invoice, or a refund given to the customer. The amount of the credit is usually calculated on the basis of the difference between what would normally be charged for the goods or services that were actually provided, and what is being charged for the goods or services promised in the agreement. Calculating appropriate levels for service charges is a complex area and, in particular, care should be taken that, where the goods or services turn out to be materially deficient, the volume of service credits does not reach the point where a provider is effectively providing the goods or services for free. It is better to set a threshold and, if and when that threshold is reached, the other party has the option to terminate the agreement for breach by the supplier and, if appropriate, find another supplier.

6.2 Mutuality

Consider the areas where the parties agree that liability can be excluded or limited, or where the parties may have the same risk and make those areas mutual in order to be able to focus on the areas which are more critical.

6.3 Challenge selectively and give specific examples

Be ready with specific examples of how risks may arise, and discuss what is likely to happen in the context of the transaction. From a commercial and pragmatic perspective, it is advisable, and a better use of everyone’s time, if the parties can avoid adopting an extreme negotiating position (whether because of their respective sizes of business or otherwise), or trading repeated ‘mark-ups’ of the same clauses without including sensible justification as to why the amendments have been made.

Accept that it is virtually impossible to enter into any commercial transaction with zero risk; it is about being aware of the potential risks, assessing how, if at all, the risks are able to be accepted, managed and minimised, and what risks simply should not be accepted at all].