Liability caps are hard to miss. They often appear bigger than Dallas in the middle of an agreement, with ALL CAPS and sometimes bolded letters. While easy to find, these caps are often misunderstood.
This post breaks down liability caps, including their purpose, mechanics and what can be negotiated:
1. To Whom Does the Cap Apply?
Liability caps can be either mutual or unilateral. In most cases, the drafting party caps its own liability, but not the other party’s. The non-drafting party has two options when confronted with this: (1) weaken the cap with carveouts; or (2) make it mutual. Some combination of the two can also work. Trying to strike the cap entirely, however, is a fool’s errand: no one wants to sign up to unlimited risk.
The key to unlocking the decision-tree is knowing where risk actually lives. Assume your primary obligation under a contract is payment. The other side, by contrast, is delivering goods and services that could have downstream effects on your business. You likely care a lot more about carveouts to their liability cap than you do about caps on your own liability. The reverse is true for the other side. You can try both markups—making the liability cap mutual and inserting carveouts—but you should know where your bread is buttered.
2. What Carveouts Apply?
The word carveout—or, more formally, liability cap exclusions—is frequently heard in the context of liability cap discussions. But what does it mean? Essentially, a carveout is a category of liability that is not subject to a limitation of liability. An agreement may say that total damages are capped at 100% of fees payable within a 12-month period and that a party will not be liable for any indirect, consequential, special, punitive, etc. damages. Well-structured liability caps typically exclude damage types that are either high-risk or not correlated with a deal’s value: IP infringement, breach of confidentiality, indemnity obligations, failure to comply with laws, etc.
Indemnity is arguably the most important carveout, but it is frequently overlooked. Some drafters assume that indemnity relates to third-party claims, so it doesn’t need to be covered explicitly. Well-drafted contracts remove any such ambiguity. They also remove ambiguity around payments: if a party’s outstanding balance exceeds the cap, it is still liable for the full amount.
Some negotiators—particularly in commonwealth jurisdictions—insist on subjecting all liability (including indemnity) to the damages cap. The argument is that they need certainty as to value-at-risk. This is a bad idea for the indemnified party. They could only recover up to the cap. When leverage is insufficient, insurance is an important backup.
3. Insurance: You Can’t Always Get What You Want
It is important to get the details of the liability cap right. But leverage is sometimes insufficient to negotiate your preferred language, as we’ve covered elsewhere on this blog. Furthermore, even with the leverage, things go wrong. Shipments are delayed. Liquidity is tight. Third parties file lawsuits. This is where insurance can be useful.
Insurance interacts with liability caps in several important ways. Commercial general liability insurance (CGL)—the most common form of coverage—covers contractual liability. If a party’s liability is capped under the contract, CGL will not pick up the tab for any amount over the cap. Ditto types of damages that are excluded. Excess liability and umbrella coverage can help fill the gaps. For specific risk factors like IP infringement and data breaches that are not contractual—or subject to contract caps—it is best to get a separate policy.
4. Key Takeaways
Most people understand the stakes of liability caps. Essentially, they put upper limits on how much one side must pay if things go wrong. But the exclusions are frequently overlooked, as are the ways of mitigating risks when things go wrong. Perhaps most importantly, many negotiators approach limitation of liability as an issue of fairness—not risk allocation. Getting the framing right changes everything. Liability caps reward those who know their exposure—and have a plan for when the fence doesn’t hold.
Disclaimer: This blog is for informational purposes only and does not constitute legal advice. Reading or interacting with this content does not create an attorney–client relationship. You should consult a qualified attorney for advice regarding your specific situation. Mehaffy, PLLC disclaims all liability for actions taken or not taken based on this blog.