Limits on Contractual Limits of Liability — Part I

While the term "LOL" in an Internet chat environment denotes a jocular sentiment (i.e., "laugh out loud"), in the context of legal contracts an "LOL" clause is no laughing matter. Rather, the "Limitation of Liability" clause is of central importance in any agreement for the acquisition of tech-related products or services. LOL language, however, can also be found in a range of other commercial agreements. Therefore, several recent cases that address LOL contract matters discussed below (and next edition) will be of keen interest to companies buying or selling tech products and services.

Tech LOL Clauses

It is extremely rare for the supplier of IT equipment, software and services to a customer not to limit supplier’s liability in the contract between supplier and customer. While it is difficult to generalize, most LOL provisions look something like this: "direct" damages are limited to some percentage of the revenue paid by customer to supplier; there is a general exclusion of "indirect and consequential" damages; and there are a few exceptions to both of these limitations.

The rationale for the LOL in most situations is understandable. For example, if a supplier sells a customer a laptop computer for, say, $1,500, and the customer installs the laptop as the key control device in a nuclear plant, then in return for the $1,500 in revenue, the supplier does not want to take on the huge liability that may ultimately result if the laptop does not work properly.

Moreover, by limiting its liability for such a scenario, the supplier is signalling to the customer that the customer should take appropriate measures to "de-risk" the situation as much as possible, including: procuring more than one unit of the hardware to ensure that adequate redundancy/back-up is built into the design of the control system; instituting other back-up mechanisms; and buying enough appropriate insurance to cover the risks of non-performance of the equipment.

Non-Tech LOL Clauses

The practice of suppliers of goods and services limiting their liability contractually has spread to a number of non-IT-related industries. In a leading Ontario Court of Appeal decision, for instance, the supplier of a remote security system monitoring service stated in its customer subscription agreement that regardless of the breaches in performance by the supplier, the customer could not recover damages in an amount greater than 12 months of fees paid by the customer to the supplier. While the trial court refused to enforce this LOL clause (and awarded damages of $50,000 to the small town jewellery store plaintiff when thieves made off with its inventory because of the negligence of the security service supplier), the Ontario Court of Appeal reversed, upholding the LOL clause that limited the compensation of customer to $890 (being one year’s services fee).

In a Supreme Court of Canada (SCC) decision that was the leading case on contractual LOL clauses until recently, the supplier of gear boxes for large conveyor belt equipment in Alberta’s tar sands had an LOL in its sales contract with customers. And again, the clause (in this case, a warranty disclaimer) was upheld to shield a supplier from liability when the equipment proved defective. In short, whenever the particular product or service presents specific legal risks to the underlying customer, suppliers are keen to limit their liability contractually.

Recent Supreme Court Guidance

Recently, the SCC readdressed the important issue of the enforceability of LOL clauses. In Tercon, the SCC generally affirmed the ability of business counterparties to agree in advance, in a contract, to limit their respective liabilities to one another in the event activity under the agreement was to give rise to a damages claim.

This approach to enforcing contractual LOL clauses, however, was made subject to three very important exceptions in the Tercon decision.

Ambiguous LOL Clauses

First, it is necessary that the LOL speak clearly, and that as a matter of interpretation, it clearly applies to the relevant scenario of liability. In a similar vein, if the court finds that the LOL is ambiguous, the court may well decline to enforce the clause.

On the other hand, if properly drafted, the contractual LOL can even be crafted in a way to limit liability not only for breach of contract but also in respect of tort/negligence claims. That is, when a supplier fails to perform under an agreement, in addition to a contract claim, customer may well also be able to bring a negligence claim if the supplier’s conduct fell below the requisite standard of care. The SCC however, years ago, held that so long as the LOL is properly worded, it can serve as an effective shield against negligence claims as well.

Unconscionable LOL Clauses

In Tercon, the court also decided that an LOL clause could be invalid if it was unconscionable at the time it was entered into. This second basis on which LOL clauses can be found to be unenforceable generally turns on whether there was an inequality of bargaining power between the respective parties at the time of contract formation.

For most situations involving two (or more) corporate entities, each with professional management, and typically represented by legal counsel, it would be difficult to vitiate the LOL clause for reasons of unconscionability. It is a very different story, however, in the "consumer space," where businesses usually present take-it-or-leave-it contracts of adhesion to their customers, particularly in "click consent" agreements concluded over the Internet. When these contracts contain LOL clauses, they can run the real risk of being held unenforceable, especially if they are drafted in an overbearing, difficult-to-understand manner. In Canada over the past few years, more than one company was surprised (and dismayed) when the LOL provision in its standard online agreement was found to be ineffective by a judge.

The lesson from these cases is that, especially in the consumer environment, LOL clauses have to be drafted very, very carefully and even-handedly. Corporate Canada would do well to aim for a middle-of-the-road clause that serves to adequately protect suppliers, while at the same time providing some scope of redress for the user as well.

The Fundamental Death of Fundamental Breach

There is a third ground under which a court can find an LOL clause to be unenforceable. Traditionally this centred around the doctrine of "fundamental breach"; namely, that if a supplier’s breach of performance was so fundamental as to go to the very heart of the bargain between the parties, a court could elect not to let the supplier take advantage of the protection afforded by the LOL clause.

In colourful language, the SCC in Tercon has now proclaimed the death of the doctrine of fundamental breach: "We should again attempt to shut the coffin on the jargon associated with ‘fundamental breach.’" In its stead, the SCC provides that, essentially, a court can always decide to decline to enforce a LOL clause if there is a compelling public policy rationale to do so. For example, the SCC points out that conduct approaching "serious criminality or egregious fraud" are but two examples where a court might override the public policy of freedom to contract, and not permit a party to rely on an LOL clause.

One example given by the SCC involved a case where a supplier knowingly sold defective products, rather than telling customers about the defects. The supplier’s strategy was to rely on the ostensible shield provided by an LOL clause in customer contracts to block any product liability claims (rather than be forthright with customers). The court in that decision refused to allow the supplier to rely on the LOL clause, and the SCC indicated that it is a good example of the type of scenario where the courts would decline LOL enforcement in order to protect the public interest.

The core lesson on LOL clauses provided by the SCC in Tercon is that these important liability-limiting provisions can indeed serve a central objective to the parties to a contract (particularly to the company charged with supplying products and services that may be inherently risky), but they must be drafted and negotiated with care, and they will not save the defaulting party in all circumstances. In a similar vein, the next edition will consider a couple of cases that illustrate further limits to these LOL provisions.