Setting the limit: Considerations for caps on liability in construction contracts

A mechanism frequently implemented to manage potential financial exposure in a construction contract is the cap on liability clause. As the name suggests, this clause acts as a financial shield, establishing an overall limit on a party’s financial liability for losses or damages arising from their actions or omissions under the contract, to a predetermined amount or percentage of the contracted sum. These clauses are generally effective and enforceable, provided they are clearly drafted and reasonable.

While seemingly straightforward, the inclusion and terms of a liability cap is often a point of significant negotiation and carries substantial implications for both the contractor seeking to limit their exposure, and the principal aiming to secure adequate protection against potential losses. While it is more common to see contractors seeking to limit their liability, it is important to recognise that a principal may also, in certain circumstances, negotiate for a cap on their own liability. This may seem counterintuitive at first, however there are situations where it can be a relevant consideration.

This article delves into the rationale behind liability caps, the risks they pose, and the crucial considerations for determining an appropriate limit.

Caps on the principal’s liability

A principal might seek to include a cap on their liability in a construction contract in the following circumstances:

• delays: If the project is subject to potential delays caused by factors outside of the principal’s direct control (e.g. approvals, force majeure events like natural disasters), the principal might seek to limit their liability for the contractor’s losses arising from those delays
• specific development agreements: In certain development agreements, particularly complex ones, the principal’s obligations might be tied to securing finance or fulfilling certain conditions related to land acquisition. To manage the risk of those external factors, a principal may want to seek to cap their liability to the contractor if those conditions are not met.

The contractor’s perspective: Quantifying risk

A contractor may consider inserting a cap on liability to quantify its risk exposure in a project. This is often viewed in relation to the economic benefit they stand to gain from the contract while considering the complexity of the project and the potential for unforeseeable issues. Ideally, a contractor may seek a cap that is at or even below their anticipated profit margin, ensuring that while they remain accountable for their defaults, their liability is contained within manageable boundaries, which may reduce the need to include significant contingencies in tender submissions. This allows for more accurate risk assessment, potentially facilitates obtaining necessary insurance coverage at a commercially reasonable premium and results in more competitive pricing.

A cap on liability can take several forms including:

• fixed monetary cap: This sets a specific maximum amount that the contractor will be liable for
• percentage of the contract sum: This cap is calculated as a percentage of the total contract value (e.g. 10% of the Contract Sum)
• combination: A combination of the above, such as a percentage of the contract sum, but not exceeding a fixed monetary amount.

The principal’s dilemma: Weighing protection against limitation

From the principal’s perspective, a contractor’s request for a liability cap warrants a thorough evaluation of the potential risks. Agreeing to such a limitation can have several significant drawbacks.

• restricted recovery: A liability cap inherently restricts the amount which may have been recoverable from the contractor through the operation of normal common law principles of damages for breach of contract
• disconnection from actual loss: The amount of the cap may bear no relation to the amount of any loss or claim which the principal might have suffered because of the contractor’s acts or omissions
• insurance implications: A liability cap may result in the principal’s insurer refusing coverage for a claim for loss over and above the contractor’s cap on the basis that the principal had ‘assumed’ a liability, which in the absence of the cap, would have been to the contractor’s account
• lack of essential exceptions: A critical oversight in many proposed liability caps is the absence of carve-outs for conduct that should not be shielded by a limitation. Liability for deliberate breaches, fraud, wilful misconduct, or even gross negligence on the part of the contractor are areas where a cap is often inappropriate. Other types of liability such as consequential loss can be excluded where liability for indirect losses, for example, loss of profits or business opportunities are excluded. Exclusion clauses must be express and unambiguous to avoid disputes over their interpretation.

Calculating the cap: Key considerations for both parties

Determining an appropriate value for a liability cap requires a balanced assessment of various factors. The appropriate value of a cap should be calculated with regard to the following (just to name a few examples):

• nature and value of the contract: The overall value and complexity of the project should be considered. A larger, more intricate contract with higher inherent risks may warrant a higher cap (from the contractor’s perspective) or a reluctance to agree to a low cap (from the principal’s perspective). The potential cost and difficulty for the principal in rectifying any significant issues caused by the contractor should also be factored in
• unusual or inherent risks: Are there any specific risks associated with this project that could lead to substantial losses? Identifying and quantifying these risks can inform the appropriate level of the liability cap
• contractor’s track record: The contractor’s past performance, reputation and experience provide an indication of their reliability and the potential for errors or omissions
• contractor’s insurance coverage: The extent of the contractor’s insurance coverage is a relevant factor. A well-insured contractor may be more amenable to a higher cap, knowing that their insurer will bear a significant portion of the risk
• industry standards: Are there any accepted industry norms or standard caps on liability for similar types of contracts? While not always definitive, these benchmarks can provide a starting point for negotiations.

Caps on liability in contracts represent a delicate balancing act between a contractor’s legitimate desire to quantify and limit their risk exposure and a principal’s need for adequate protection against potential losses arising from the contractor’s performance. A precisely drafted cap on liabilities is an excellent tool for parties to manage risk and assists in providing financial stability for projects. Careful consideration of the factors outlined in this article, coupled with clear and comprehensive drafting that addresses essential exceptions is paramount to achieving a liability cap that is both commercially reasonable and legally sound for all parties involved.

If you require legal advice on limitation of liability clauses or have a question, please contact our Construction, Infrastructure & Projects team or the key contacts below.

Disclaimer
The information in this publication is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, we do not guarantee that the information in this newsletter is accurate at the date it is received or that it will continue to be accurate in the future.

Published by:

Jonathan Usher

Annie Lin

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