Finer points of limiting liability
KATIE LISZKA* discusses the most common limitations on liability that are applicable to construction contracts.
01 January 2014
IT IS common practice for construction contractors to seek to limit their liability under a construction contract as part of the contractual negotiations. In the Middle East, in non-project finance projects, it is arguably not market practice to include an overall cap on liability.
Limiting liability is usually given as a reason for being able to reduce the contract sum, compared to what it would be if liability remained uncapped, on the basis that the contractor is more accurately able to quantify its potential liability and therefore able to price risk. There are several common ways in which contractors attempt to limit their liability. The three most common limitations on liability are:
• An overall cap on liability;
• A clause excluding the recovery of consequential or indirect losses; and
• Separate caps on liability for delay and/or performance liquidated damages.
Overall cap
The level of an overall cap on liability is typically by reference to a percentage of the contract sum. Care should be taken to be clear whether this is the contract sum as at the date of contract or as adjusted throughout the term of the contract. The agreed level of cap is a commercial negotiation but the potential level of losses caused as a result of a contractor breach of contract and the amount recoverable from insurances should be considered by the employer when agreeing an overall cap. Market practice in particular sectors may also dictate the levels of cap acceptable. For example, in project finance transactions, the standard approach is for construction contracts to include caps on liability. In a project financing, a breach by the construction contractor could cause the whole project to fail, and possibly trigger the repayment of debt, with losses way in excess of the contract sum of the construction contract.
Exclusions
It is typical to see a number of exclusions from an overall cap on liability. These are:
• Losses arising from death or personal injury;
• Losses arising from fraud and wilful misconduct;
• Amounts payable under third-party indemnities (typically those relating to intellectual property);
• Amounts received under insurance proceeds or which should have been received but for an act or omission of the contractor (often excluding amounts recoverable under any professional indemnity insurance);
• Losses arising from breaches of appli-cable law;
• Liquidated damages; and
• Any other amounts which by law cannot be restricted or excluded.
Under English law, a party cannot exclude or restrict liability for death or personal injury resulting from negligence and, as a matter of public policy, cannot exclude or restrict liability for fraud or fraudulent misrepresentation. In construction contracts, it is typical for there to be an indemnity in respect of any claims arising out of death or personal injury. Insurance also usually covers this risk.
In respect of fraud or wilful misconduct (or other similar concepts and wording), irrespective of whether as a matter of law or public policy it is possible to exclude or restrict liability in the case of fraud, it is difficult to commercially justify that such circumstances should be included within any cap on liability when such situations are entirely within the control of the contractor.
Exclusions from an overall cap in relation to third-party indemnities are common as the rationale for including the indemnities is to ensure that the employer has protection from exposure in respect of third-party claims as a result of default by the contractor which it cannot control or quantify.
The exclusion in respect of amounts that are received (or should have been received) under policies of insurance should be acceptable as the obtaining and maintenance of these insurances (all risks insurance, employer’s liability and public liability insurance) are contractual requirements and the employer should be an insured party under these policies. The contractor should not be able to reduce the level of cap where there is a claim under such insurances. Proceeds recovered under professional indemnity insurance policies are frequently excluded from the exclusion and included within the cap. This type of insurance is for the benefit of the contractor.
In many jurisdictions, professional indemnity insurance is not purchased as part of a project policy and it is the way in which the contractor manages its risk in respect of the design not meeting the required standard of skill and care. If amounts received under professional indemnity insurance were not included, a major risk would be uncapped. It’s worth remembering that there is no insurance available in respect of defective workmanship.
Liability for a breach of applicable law being uncapped is justified on the basis that again this is something which the employer should be protected against as it could be liable as a result of actions of the contractor that are completely outside of its control.
Whether or not liquidated damages, for either performance or delay, are excluded from or included within the cap, is a commercial decision and is determined by industry practice in the particular sector and also in light of the level of any cap on liability for liquidated damages and the value of the overall cap on liability.
Indirect & consequential losses
Another common exclusion is to prevent the recovery of indirect or consequential losses. This is an exclusion that normally applies to both parties. Great care needs to be taken in drafting such provisions to ensure that there are no unintended consequences. Any indemnities, liquidated damages and amounts payable on termination should be carved out from such exclusions to avoid arguments that indemnities, liquidated damages and compensation on termination may contain elements of consequential or indirect losses. The meaning of “indirect” and “consequential” losses should be carefully considered. In English law, at least, they do not necessarily include all loss of profit and economic losses, which may (depending on the circumstances) be regarded as direct losses. Under English law, direct losses are those naturally arising from the breach and recoverable indirect and consequential losses are those losses in the contemplation by the parties, at the time of entering into the contract, as a probable result of breach. The use of these phrases should be reviewed in context of the local law.
Delay liquidated damages
Separate caps on the level of liquidated damages may also be included. These are typically lower than the overall cap and again usually defined by reference to the contract sum. For example, there may be an overall cap of 100 per cent of the contract sum, together with a cap on delay liquidated damages of 10 per cent. The 10 per cent cap in respect of delay liquidated damages may be in or outside of the overall cap, as discussed above.
In project finance transactions, reaching the limitations on liability is usually also an event entitling the employer to terminate the contract. In relation to delay damages, such a termination event effectively acts as a longstop date as it permits only so many days of delay (with the requisite amount of liquidated damages accruing) before a right of termination arises.
Relevance of insurance
The insurance package is relevant in considering the overall commercial deal reached. If a risk that sits with the contractor is not covered by insurance, the contractor’s ability to meet any claims by the employer will, subject to any performance security such as bonds or guarantees, be met by the contractor’s balance sheet. The insurance coverage is, therefore, critical in determining what claims the contractor could meet. From an employer’s perspective, drafting any caps by reference to the amount recovered from insurance should be avoided as this could mean, depending on the wording, that there is no liability where insurance is not maintained or available through no fault of the employer.
Other issues affecting liability
Time bars could also be considered to limit the contractor’s liability. These may be contractually agreed or statutorily prescribed. A common trigger for the ceasing of liability is the issuing of the final performance certificate. Whether there is any ongoing liability after the delivery of the performance certificate is normally dictated by market practice in the particular sector.
It is also worth noting that not all losses resulting from a breach of contract, even without limitations on liability, are recoverable. They may be too remote to be recoverable if they are not foreseeable.
Another issue that is not always clearly dealt with in the construction contract, is whether compensation payable on termination is caught by and limited to any overall cap, which will depend on the interpretation of the relevant contract provisions.
In summary, the detail of the provisions excluding or restricting liability are frequently more complex than just agreeing to cap liability at a certain percentage of the contract sum. Even a purported cap on overall liability will rarely do that given that some restrictions and exclusions on liability may be ineffective due to law or public policy.
*Katie Liszka is associate at Norton Rose Fulbright (Middle East) LLP Bahrain office. Norton Rose Fulbright is a leading international legal practice with offices in Europe, the US, Canada, Latin America, Asia, Australia, Africa, the Middle East and Central Asia.
Norton Rose Fulbright has had a presence in the Middle East for more than 30 years and has advised developers, lenders, and contractors in relation to the legal aspects of construction and infrastructure projects in the region. With a combined team located in the Abu Dhabi, Bahrain, Riyadh and Dubai offices, Norton Rose Fulbright (Middle East) LLP is able to provide both contentious and non-contentious support to financiers, developers, contractors and specialist contractors in the region.
Legal queries related to the construction sector can be addressed to Norton Rose Fulbright (Middle East) LLP through Gulf Construction magazine at editor@gulfconstructionworldwide.com.
