Carve-outs to a limitation of liability clause can lead to a limitation of liability clause being ineffective. It is important to understand the impact of each individual carve out on the limit of liability.
In this article, we will explain the different types of carve-outs that are often used in a limitation of liability clause, and how they can impact the effectiveness of a limit of liability.
Author: Farrah Motley, Legal Principal of Prosper Law.
What is a carve-out to a limit of liability?
A carve-out is simply an exclusion to a limitation of liability clause. They are the events or types of loss that parties to a contract agree to exclude from the limit of liability. They may be written so that each carve-out has its own limit of liability or there will be no limit of liability that applies to that carve-out.
The different types of carve-outs
Personal injury and death
A limitation of liability carve-out for loss arising from personal injury or death is fairly common.
If a party to a contract is supplying goods and/or services that have a low risk of causing personal injury or death, this carve-out may be appropriate. However, if a party is supplying goods and/or services where there is a possibility that personal injury or death could result, it is important to consider whether a carve-out for personal injury and death should be deleted from the limit of liability.
This may be the case, for example, where a business supplies extreme sports experiences.
Property damage
A carve-out for property damage is also a common exclusion from a limitation of liability clause.
It is important to understand that the concept of property damage is very broad. Without being specific about what kinds of property damage the carve-out applies to, a business may unintentionally agree to an exclusion that the other party can exploit to overcome the limitation of liability clause.
For instance, an engineering company agrees to a limitation of liability of $10 million. The limit includes a carve-out for property damage. If the engineering services relate to property (for example, a bridge, a building, or equipment), and the engineering firm is negligent, the kind of damage that is likely to result is property damage.
This means that the limitation of liability, even though it might be written so that it applies to negligence, may be circumvented by the other party. That party can simply claim that property damage has occurred and therefore the limit of $10 million does not apply.
Amounts recovered or recoverable under a policy of insurance
Sometimes, limits of liability are written as a multiplier of the fee paid, or a set amount that is low, but with a carve-out for insurance proceeds. A carve-out for insurance proceeds may be written so that the carve-out applies to amounts that are:
recovered; or
recoverable
under a policy of insurance held by the supplier.
There is a difference between the terms 'recovered' and 'recoverable'. If an amount is recovered, it means that the insurer has actually paid out an amount and the supplier does not have to pay the amount, then seek reimbursement from the insurer.
On the other hand, recoverable means that the supplier has the right to be reimbursed by its insurer, but it may not have actually been reimbursed.
Insurance follows liability
It is important to remember that a policy of professional indemnity policy responds to the liability of an insured. That is, insurance comes after liability, rather than insurance informing a party's liability.
Because insurance follows liability and not the other way around, it is possible that a limit of liability that has a carve-out for insurance proceeds still means that the amount set as the limit will apply to that carve-out. This is because the monetary limit of liability represents the insured's total legal liability under the contract, and professional indemnity insurance will not provide reimbursement for amounts that extend beyond an insured's legal liability.
You can read more about the concept that insurance follows liability here.
Amounts recovered or recoverable from third parties
Just like the carve-out explained above in relation to insurance proceeds, a carve-out for amounts recovered or recoverable from third parties is also fairly common.
However, this limitation of liability exclusion also has broad potential to water down a limitation of liability and render it ineffective.
The party whose liability is limited may have a right to seek recovery from a third party (for example, an overseas supplier or a subcontractor), however:
it does not mean that those amounts will actually be recovered;
the steps that may be required to recover those amounts may require significant expense; and
the other party to the contract may be disincentivising the party whose liability is limited, from pursuing recovery if the limit is not reduced because of the amount(s) recovered.
Infringement of intellectual property rights
Loss arising from infringement of intellectual property rights is not usually covered by insurance policies. Nevertheless, it is common for limitation of liability clauses to exclude loss arising out of the infringement of intellectual property rights.
It is, however, important to ask the question - which party has infringed intellectual property rights? If the carve-out is worded such that the party seeking to avoid the limit of liability may be the one infringing on intellectual property rights, and there are broad indemnities for infringement of intellectual property rights, the party seeking to apply to limit of liability may face uninsured liability for the loss they did not cause.
An example of this is where:
there is an indemnity in the contract whereby Party A agrees to indemnify Party B for any infringement of intellectual property rights (without saying who the infringing party is) - this is also known as a 'reversionary indemnity'
infringement of intellectual property is a blanket exclusion from the limitation of liability clause
Breach of confidentiality
Exclusion of loss caused by a breach of confidentiality is a common and reasonable exclusion from a limitation of liability clause.
Because it is within each party's control not to disclose or share confidential information, liability for breach of confidentiality is often uncapped.
Fraud, wilful misconduct, and deliberate breach
It is firmly within a party's power to avoid engaging in fraud or deliberating breaching the contract. Because of the level of control a party has in avoiding and preventing this behaviour, an exclusion of loss arising from fraud, wilful misconduct, or deliberate breach is fair and reasonable.
Reckless disregard and gross negligence
Unless the terms 'reckless disregard' and 'gross negligence' are specifically defined within the contract, exclusions for these types of default may significantly water down the effectiveness of a limit of liability clause.
Because the terms 'reckless disregard' and 'gross negligence' have no set legal definition, it is possible that they may inadvertently apply to matters that the limit of liability was supposed to cover.
For instance:
at what point is being negligent considered to be gross negligence?
what is the difference between reckless disregard and negligence?
what is the difference between reckless disregard and gross negligence?
None of these questions have been specifically answered by Australian courts and because of that, it is open to the party seeking to avoid the application of the limit of liability to use these terms to circumvent the limit.
How can Prosper Law help?
Prosper Law is Australia's online commercial law firm. We have unparalleled experience in drafting, reviewing and negotiating limitation of liability clauses and ensuring that any exclusions from the limit are appropriate to the particular business transaction.
Contact us today for a free, fixed-fee quote for legal advice.
Farrah Motley | Legal Principal
PROSPER LAW - A Commercial Law Firm for Businesses
M: 0422 721 121
A: Suite No. 99, Level 54, 111 Eagle Street, Brisbane, Queensland Australia 4000
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