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Avoiding Limitation of Liability Clauses in Contracts: Lessons from Two International Arbitrations

Limitation of liability clauses in contracts are approached very differently in Canadian law and U.S. law.  Under Canadian law, such clauses are almost always enforced in commercial transactions, and are exceedingly difficult to get around for plaintiffs whose claims exceed the stipulated damages.  Under U.S. law, by contrast, such clauses are not enforceable in contracts for the sale of goods if the result would be a “failure of essential purpose”.  This difference between the two legal regimes has important implications for the drafting of contracts for cross-border transactions, and for litigating cross-border contractual disputes.

Two personal experiences as counsel in international commercial arbitrations well illustrate the difference between the two legal regimes.  In both cases I acted for Canadian entities that purchased from American suppliers and suffered losses due to defects in what was supplied.  In both cases the contracts were governed by U.S. law (from two different states, but the relevant statutory provisions were identical) and provided for international arbitration.  In both cases the American suppliers sought to rely on limitation of liability provisions to restrict their liability to sums far below my clients’ actual losses.  In both cases arbitrators held the limitation of liability provisions to be unenforceable under the failure of essential purpose doctrine, allowing my clients to recover their actual losses.  This outcome almost certainly would not have been achievable had Canadian law applied.

In Canada, the test for interpretation and enforceability of limitation of liability provisions is the three-part test enunciated by the Supreme Court of Canada in Tercon Contractors Ltd. v. British Columbia (Transportation and Highways), 2010 SCC 4.  First, as a matter of interpretation, does the limitation of liability provision apply to the circumstances established in the evidence?  Second, was it unconscionable at the time of contract formation?  Third, is there an overriding public policy reason to refuse enforcement that outweighs the very strong public interest in the enforcement of contracts?  The result is that in commercial cases, limitation of liability provisions are almost always enforced in accordance with their terms – unconscionability and public policy are very narrow exceptions that rarely apply.

In the United States, the Uniform Commercial Code or UCC has been enacted in all 50 states.  Under section 719, an agreement for the sale of goods “may provide for remedies in addition to or in substitution for those provided in this title and may limit or alter the measure of damages recoverable under this title”.  But there is an important caveat: “where circumstances cause an exclusive or limited remedy to fail of its essential purpose, remedy may be had as provided in this act”.  There is a wealth of case law that defines what constitutes a failure of essential purpose – and it varies somewhat from state to state – but in general terms there must be a minimally adequate remedy in the circumstances which have arisen, such as a functioning replacement of the defective good.  If there is no minimally adequate remedy, the limitation of liability provision is unenforceable.  This is a far broader exception to enforceability of limitation of liability provisions than the Tercon test’s unconscionability and public policy exceptions.

The difference between Canadian and U.S. law on this point has profound implications for cross-border business and litigation.

In terms of contract drafting, it is natural that a party to an international transaction will want the law of its own jurisdiction to govern the deal’s contracts, but Canadian purchasers dealing with American suppliers may want to suppress that urge.  If things go wrong and a claim needs to be asserted, having greater scope under U.S. law to avoid a limitation of liability provision may prove to be very useful.  Conversely, Canadian suppliers wanting the protection of a limitation of liability clause should be leery of having U.S. law govern.

In terms of litigation, a limitation of liability provision in a U.S. law governed contract for the sale of goods should not be regarded as preclusive of a claim.  A close examination of the facts and the case law from the particular state is warranted to determine if there is a chance of overcoming the limitation of liability clause under the failure of essential purpose doctrine.  And if there is an arbitration clause, a Canadian client can often use its own Canadian counsel for the arbitral proceeding, even if the proceeding takes place in the U.S. (as occurred in both of my cases).



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