Using contracts to cap and avoid liability for uncommercial risks
Introduction
To be successful in business, you need to balance your risks against the potential rewards. Taking on risks that are out of all proportion to the potential rewards is a recipe for business failure.
Things may go well for a while, but one day a risk will materialise. If the liabilities that you incur as a result of that risk are disproportionate to the rewards you have been generating, that one risk event can wipe you out and force you into insolvency, causing irreparable damage to your relationships with your stakeholders.
This article explains the reasons why businesses cap and avoid uncommercial liabilities, and the key legal rules around doing so. A separate companion article provides a suggested framework for structuring, negotiating and drafting contractual clauses that avoid and/or cap your liability.
An example - liability of service providers
Let me illustrate with a real-life example.
My son Liam maintains and repairs construction equipment – excavators, lifting equipment and the like. When this equipment breaks down on the construction site, it can have a devastating impact on the contractor’s bottom line, especially if the equipment is needed to complete an activity that is on the critical path to project completion.
Liam might charge $2k for a day’s work to get an excavator working again, but if he stuffs up the repair work and causes damage to the excavator that puts it out of work for a few weeks, he could end up being liable to the contractor for tens or even hundreds of thousands of dollars, depending on the value of the project that he has delayed.
Similar situations are faced every day by contractors, consultants and other service providers who do work on business-critical equipment, and by suppliers who provide business critical supplies.
Stuff-ups by these suppliers and service providers can cause the business of the customer to cease trading until the problem is fixed. This can result in a liability for the supplier or service provider that completely dwarfs its total annual revenue, let alone the revenue that it makes from the customer in question.
Managing disproportionate risks
When you identify risks that are disproportionate to the rewards, you need to work out how you will manage those risks in order to bring them back in proportion to the rewards.
Approaches that you can take to manage disproportionate risks include taking steps to avoid the risk, or to reduce the probability of the risk occurring, such as peer reviews to double check that work has been performed correctly.
In addition, you might effect insurance cover, such as public liability insurance that covers you for your liability to third parties for your negligence.
Another approach, which is the focus of this article, is to use contracts to cap or completely avoid your liability to another party arising out of such risks.
Contracts can also be used to transfer risks to another contracting party, or to share risks between contracting parties, but that’s outside the scope of this article.
By reaching agreement with the other party or parties to a contract, that cap, avoid, transfer or share your liability for risks that are disproportionate with the rewards, you can turn business activities that would otherwise be too risky to be commercially viable into sensible long term business propositions.
Conversely, if you can’t find a method to appropriately manage risks that are disproportionate to the rewards associated with a business activity, you should probably cease engaging in that business activity.
Why would the other party agree to the liability cap or exclusion?
Clauses that avoid or cap your liability require the other party, usually the purchaser, to give up legal remedies that it would otherwise have at law. Why would it agree to do so, you may ask.
Reasons for doing so can include the following:
To attract a supplier to provide the goods or services that the purchaser requires. If the risks of doing so, absent an appropriate cap on liability, are completely disproportionate to the value of the contract to the supplier, there may be no suppliers in the market willing to take on the risk.
To reduce the price - there may be a few suppliers that are willing to take on the risk, but only at a significant price premium.
Even if the purchaser can find a supplier who will take on the disproportionate risk without a price premium, the purchaser may find that the supplier is unable to absorb the risk if it materialises, causing the supplier to become insolvent. In this scenario, the risk transfer the purchaser thought it had achieved becomes illusory.
The purchaser may be in a better position to absorb and mitigate a short interruption to its business / revenue stream than the supplier.
The purchaser may have business interruption insurance that covers the risk, or may be able to obtain it at reasonable cost.
Using contracts to cap or exclude liability
As a general proposition, courts will enforce contractual provisions that seek to cap or avoid one party’s liability to the other for specified risks or events.
And it is not just your liability under the relevant contract that can be capped or avoided. You can also use the contract to cap or avoid other sources of liability that may arise outside the contract, such as your liability for negligence or under legislation such as sale of goods legislation.
Lawyers typically refer to clauses that cap or limit your liability as limitation clauses. And they refer to clauses that avoid or exclude liability as exclusion clauses.
The companion article to this article explains how to negotiate and draft effective limitation and exclusion clauses. But before going there, it’s helpful to have a basic understanding of the law relating to such clauses, including the following two important qualifications:
First qualification: Contractual clauses only bind the contract parties; they don’t bind third parties
The first is that the contractual limitation or exclusion clauses will only apply to the parties to the contract — they won’t affect your liability to third parties that are not a counterparty to the contract.
So, if my son Liam includes a clause in his contracts with his customers that caps Liam’s liability for negligent provision of repair services to the contract price, that cap won’t alter Liam’s liability to a third-party such as an employee of a customer who is injured by the faulty repair work.
To protect himself against his liability to the injured third-party employee, Liam could do one of two things.
First, Liam could try to get his customer to agree to include in a clause in their contract that requires the customer to indemnify (i.e reimburse) Liam for any liability Liam incurs to the employee arising out of Liam’s negligence — but this which is going to be very hard to achieve. The customer is unlikely to agree to this, and Liam might lose the customer if he insists upon the indemnity.
The more likely solution for Liam will be to purchaser a public liability insurance policy that covers him for his liability in negligence to the third-party employee.
But the person most likely to suffer financial loss if Liam performs the repair work negligently is the customer. As such, by reaching agreement with the customer on a cap to Liam’s liability to the customer for loss arising from Liam’s negligence, Liam can protect himself from a liability that could be disproportionate to the fee that Liam earns by performing the repair work.
So remember, limitation and exclusion clauses can protect you against your liability to your customers and other contract counterparties, but they can’t protect you against your liability to people or businesses who are not a party to the contract.
Second qualification: Liability under some legislation cannot be excluded or capped
The second important point to remember with contractual clauses that seek to cap or avoid liability is that liability under certain legislation cannot be limited or excluded.
The most important instance of this in Australia is the liability that you have under the Australian Consumer Law if, while conducting a business, you engage in misleading or deceptive conduct.
This is an important source of liability for Australian businesses because it doesn’t matter whether you intended to mislead or deceive. Intention is irrelevant. All this is required is that the conduct was objectively misleading or deceptive.
The Australian Consumer Law gives any person who suffers loss because of such misleading or deceptive conduct, the right to recover such loss from the person who engaged in the misleading or deceptive conduct.
It has long been accepted by Australian courts that liability under this legislation cannot be excluded by contract. This is known as the no exclusion principle.
A few years ago there had been a number of court decisions that were chipping away at the no exclusion principle by giving legal effect to contractual time bar and other contract clauses that were putting additional hurdles in front of people that would otherwise have an entitlement under the legislation to claim compensation for loss arising from misleading or deceptive conduct. The Victorian Supreme Court brought a firm end to this with its decision in Brighton Australia Pty Ltd v Multiplex Constructions Pty Ltd [2018] VSC 246 when it held that provisions which create such hurdles are unenforceable on grounds of public policy.
No reliance clauses
Some businesses have, however, succeeded in avoiding liability for misleading or deceptive conduct by breaking the causal connection between their conduct and the loss. There have been numerous cases where a party that has said misleading things in order to induce another party to enter into a loss generating contract has been able to avoid liability for the loss by showing the other party did not actually rely on the misleading conduct when deciding to enter into the loss-generating contract. They were able to show that that other party’s decision to enter the loss-generating contract was unrelated to the misleading conduct.
These cases have resulted in many businesses routinely including ‘no reliance’ clauses in their contracts, under which the other party acknowledges that did not rely on any information provided to it, and that it entered the contract based on its own investigations.
Whether such a clause will be effective will depend on the actual facts and available evidence. If the other party can provide evidence that it did, in fact, rely on the misleading conduct in entering the contract, the court will give effect to this, notwithstanding a no-reliance clause.
So, that’s what you need to know about using contracts to manage your liability for misleading or deceptive conduct under the Australian Consumer Law.
Other statutory liabilities that cannot be avoided
There are other statutory liabilities that cannot be avoided by contract, such as:
the consumer guarantees that are imposed by the Australian Consumer Law on suppliers and manufacturers of goods or services that are normally bought for personal or household use; and
the warranties that are implied into residential building contracts under legislation in each state and territory.
But even though it is not possible to contract out of some statutory liabilities, it is possible to contract out of many, such as the warranties that are implied into contracts under the sale of goods legislation in each state and territory.
As such, it is good practice to ensure that any limitation and exclusion clauses that you can include in your contracts also cover your liability under statute, to the extent this is permitted.
Case study: BrisConnections
Let’s now illustrate the principles we have just discussed with another real-life example.
You might remember the BrisConnections Airport Link toll road project that became insolvent in 2012, just seven months after opening. It became insolvent because it failed to generate anywhere near the traffic and toll revenue that had been forecast. In fact, actual traffic levels were about 25% of what had been forecast by Arup, the engineering firm that prepared the traffic forecasts for BrisConnections.
The lenders to BrisConnections were staring at a AUD 2 billion loss on their loan, which had been sized by reference to the toll revenue forecasts.
The receiver appointed by the lenders sued Arup, for AUD 2.2 billion, for negligence and for misleading and deceptive conduct under the Australian Consumer Law.
Arup was paid AUD 4.7 million for the traffic forecasting work, although it was able to subsequently win a further contract for design work on the project valued at AUD 130 million, in joint venture with Parsons Brinkerhoff.
Arup’s contract for the traffic forecasting work capped its liability for negligence at AUD 10 million, but this cap did not apply to liability for “gross negligence, recklessness, wilful misconduct or fraud”.
The situation became dire for Arup when its chief traffic forecaster admitted under cross examination in court that certain important assumptions in its traffic forecasts were “totally and utterly absurd” and “completely illogical”, and that “no reasonable traffic forecaster would [ever make such assumptions]”. Essentially, Arup’s chief forecaster admitted to gross negligence, one of the exceptions to the cap on liability.
At that time, Arup's Australian business was generating annual revenues of just over AUD 300 million, with profits of just AUD 2.2 million. As such, the group would have been forced into administration if the court had ordered it to pay the AUD 2.2 billion that the receiver was seeking. Four of Arup’s Australian directors resigned within days after the cross examination, and the receiver applied for court injunctions to stop Arup from dissipating its assets.
Arup thereafter promptly settled the receiver’s claim for an undisclosed sum, which was reported in the Australian Financial Review to be more than AUD 100 million. Arup’s directors promptly rejoined the board following the settlement, when the risk of personal liability for insolvent trading had been retired.
The case is an excellent example of a situation when the risks associated with a business opportunity are completely out of all proportion to the rewards. A liability of AUD 2.2 billion, or even AUD 100 million, if things go wrong is completely disproportionate to the fee of AUD 4.7 million for the traffic forecast. Arup clearly recognised this, which is why it negotiated an agreed contractual cap on its liability at a bit over 200% of the contract price for its liability in negligence in connection with the traffic forecast.
Fortunately for the lenders who relied on Arup’s traffic forecasts when determining the size of the loan that BrisConnections could afford, the lenders were able to avoid the cap by demonstrating gross negligence, which is most unusual.
The receiver also sued Arup for misleading and deceptive conduct under the Australian Consumer Law, which as I have explained is a statutory liability that cannot be excluded by contract. Accordingly, it’s likely that Arup would have been liable for the lenders loss under this legislation even if gross negligence could not be proven.
The disproportionate risk that the traffic forecaster accepted on the BrisConnections project is not an isolated example. Similar claims were brought against the traffic forecasters for Brisbane’s Clem7 tunnel toll road and for Sydney’s Lane Cove Tunnel toll road, each of which was reportedly settled for a nine figure amount, ie hundreds of millions of dollars.
These outcomes explain why several companies that once provided traffic forecasts for toll road projects have ceased doing such work. Which brings me back to one of my earlier points – that if you can’t find a method to appropriately manage risks that are disproportionate to the rewards associated with a business activity, you should probably cease engaging in that business activity.
To wrap up this discussion of the key legal rules relating to exclusion clauses and limitation clauses, there are two more aspects of the Australian Consumer Law you should be aware of.
Consumer guarantees can apply to goods and services bought for business purposes
I mentioned before that there are basic guarantees that apply to consumer products and services under the Australian Consumer Law, and that these consumer guarantees can’t be limited or excluded by contract.
Consumer products and services are those that are normally purchased for personal or household use. They don’t include products ordinarily acquired for business purposes, such as construction equipment, farm machinery and factory equipment.
But the consumer guarantees will apply to a product or service that is purchased by a business for business purposes if it meets one of the following conditions:
it costs less than AUD 100,000 (including GST);
it is a product or service that is commonly purchased for personal or household use; or
it is a vehicle or trailer acquired to mainly transport goods on public roads.
In these circumstances there is an exception to the prohibition against contracting out of the consumer guarantees that permits businesses to limit their liability to one or more of:
replacing or repairing the product; or
re-supplying the service; or
reimbursing the purchaser for the cost of having someone else do so,
so long as it is fair or reasonable for the supplier to rely on the limitation. If the supplier would otherwise be exposed to liability that is disproportionate to the rewards under the contract, without these limitations, then this fairness requirement should be met.
Accordingly, businesses that supply goods or services to other businesses — like my son Liam — should consider including a limitation clause that complies with this exception in their contracts.
Before we move on to how to negotiate and draft limitation and exclusion clauses, there’s one final aspect of the Australian Consumer Law that I should mention, and that’s the unfair contract terms regime.
Unfair contract terms
The unfair contract terms regime is particularly relevant to clauses that limit or avoid liability because such clauses are listed in the regime as an example of the type of clause that can be deemed unfair.
The unfair contract terms regime applies to businesses that use ‘standard form’ contracts in their dealings with consumers and small businesses.
The laws were amended in November 2022 to, amongst other things, expand the definition of small business contract and the circumstances in which a contract will be considered a standard form contract. The amendments will commence on 9 November 2023.
Under the amendments, a small business is now defined as one that employs fewer than 100 persons or has a turnover for the last income year of less than AUD 10 million. The old contract value threshold has also been removed, which means many more businesses will qualify as small businesses and therefore have the protection of the regime.
A contract term is unfair under the regime, and therefore unenforceable, if each of the following requirements are met:
it would cause a significant imbalance in the parties’ rights and obligations arising under the contract;
it is not reasonably necessary to protect legitimate interests; and
it would cause detriment to a party if it were to be applied or relied upon.
If you are using the clause to protect yourself from risks and liabilities that are disproportionate to the rewards that you expect to receive under the contract, then you should be able to demonstrate that it is necessary to protect your legitimate interests.
In addition to the risk of the clause being declared by a court to be void, the recent amendments also allow a court to impose fines on people that include an unfair contract term in a standard form consumer or small business contract.
You should also be aware that the ACCC is actively enforcing the unfair contract terms regime. Two recent examples follow:
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In August 2022 the Federal Court held in ACCC v Fujifilm Business Innovation Australia Pty Ltd [2022] FCA 928 that many terms used by Fujifilm in several of its standard form small business contracts were unfair and therefore unlawful, including terms that capped, reduced or limited Fujifilm’s liability to its customers in circumstances where the customer’s liability has no limit.
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In September 2022, the ACCC obtained a court-enforceable undertaking from a subsidiary of TabCorp to amend potentially unfair contract terms in its standard form contracts with small business gaming venues, including terms excluding Maxgaming from liability for negligent or wilful acts.
Conclusion
As mentioned at the outset, to be successful in business, you need to balance your risks against the potential rewards. Taking on risks that are out of all proportion to the potential rewards is a recipe for business failure.
This article has explained how contracts can be used to cap or exclude liability for risks that are disproportionate to the rewards available under a contract.
The companion article will explain how to adopt a structured approach to the negotiation and drafting of such clauses.
