20 Sep Limitation of liability clauses: Why you should not settle down when negotiating with service providers
Updated on September 22, 2024 by David Lalire
When entering into a business relationship with a service provider, especially a SaaS provider, one of the most critical components of the contract is the limitation of liability clause.
These clauses specifically cap the financial responsibility of the provider in the event of a failure, breach, or service disruption. While many companies focus on pricing, deadlines, or deliverables, overlooking this aspect can lead to severe financial exposure.
In this article, we’ll explore why limitation of liability clauses deserve special attention during negotiations, and how a carefully considered approach can help protect your business from unforeseen damages, particularly in the context of SaaS services.
1. Understanding limitation of liability clauses
A limitation of liability clause establishes a cap on the amount of damages or losses for which a service provider, including SaaS providers, can be held responsible.
These clauses are vital in defining the maximum compensation a business can expect if the service provider fails to meet their obligations.
Here are the common elements of these clauses:
Financial caps: These place a limit on the total amount a provider can be held liable for. SaaS providers and other service providers typically attempt to cap their liability at the value of the contract or the fees paid over a specific period, such as one year.
Types of damages covered: Limitation clauses often distinguish between different types of damages, such as direct, indirect, and consequential. Providers frequently exclude indirect or consequential damages, which can leave businesses unprotected in the event of significant losses.
Exclusions: These outline specific situations where the provider is not liable, such as force majeure events or third-party failures.
Although these clauses are common, they can expose your business to significant risk if not properly negotiated, especially when the cap on liability is much lower than the potential losses you could incur—something particularly relevant for SaaS solutions that may impact critical business operations.
2. Why limitation of liability clauses involve significant risks and how to negotiate them
SaaS providers and other service providers often seek to minimize their liability by setting low caps on compensation.
This can be problematic for several reasons:
Low financial caps: If the cap is tied to the fees you’ve paid for their services (e.g., the annual contract value), it may be far lower than the potential damages caused by a failure. For example, a SaaS provider may cap liability at $100,000, while your business could face millions in losses due to service outages, missed deliveries, or data breaches.
Exclusion of indirect damages: Indirect or consequential damages, such as lost profits, reputational damage, or operational downtime, are often excluded from liability coverage. These are frequently the most financially damaging aspects of a SaaS service failure.
One-sided provisions: Providers often structure these clauses to protect themselves without offering reciprocal protections to their clients, shifting the majority of the risk to the business receiving the service.
Given these risks, it’s essential not to accept the default limitation of liability clause proposed by a service provider or SaaS provider.
Here’s what to focus on during negotiations:
Raise the cap on liability: Ensure that the cap is high enough to reflect the potential impact of a service disruption. If the service is critical to your operations, the liability cap should be substantial, not merely tied to the value of the contract.
Include indirect and consequential damages: Push to include compensation for indirect and consequential damages. If the provider refuses, consider whether the risk of such damages outweighs the value of the contract.
Review exclusions carefully: Understand the exclusions within the clause and determine whether they unfairly leave your business exposed. Ensure that you have the right to hold the provider accountable for scenarios within their control, such as negligence or operational failures.
Failure to properly negotiate these clauses can have serious consequences. The implications of insufficient liability coverage can be devastating, especially when your business depends on critical services provided by SaaS providers or other service providers.
Many businesses only realize the importance of this issue after a significant service failure, at which point it’s often too late to renegotiate the contract. By focusing on limitation of liability clauses early in the negotiation process, you can better protect your business from unexpected financial harm.
Clear and fair liability clauses also set the expectations for both parties, reducing the likelihood of disputes and ensuring that both you and the service provider understand the risks involved.
3. Examples of limitation of liability clauses in action
The CrowdStrike outage in July 2023 offers a clear example of why limiting liability to a small fraction of potential losses can be perilous. After a routine software update, the cybersecurity SaaS provider experienced significant service disruptions, affecting clients in critical industries such as airlines and finance. In the case of the airline industry, system failures led to flight delays, cancellations, and financial losses.
Many affected businesses may have found that their contracts with CrowdStrike limited the provider’s liability to an amount far below the damages they experienced. As we noted in a previous article, the extent of compensation would depend on how each contract was negotiated, with some businesses potentially left with insufficient coverage due to low liability caps.
For example, if an airline had a liability cap based on a year’s worth of service fees, they could have been eligible for only a fraction of their actual losses, which could easily reach millions due to flight cancellations, compensation to passengers, and reputational harm.
In another scenario, consider a logistics provider that fails to deliver essential goods on time, leading to production downtime and missed deadlines. If the liability cap in the contract was limited to the cost of the delivery service, your business might face severe financial losses with minimal compensation. Without sufficient liability coverage, companies may struggle to recover from operational disruptions that have cascading effects on their business operations.
Finally, imagine a SaaS provider whose platform handles customer relationship management (CRM) for a company. If the provider suffers a prolonged outage, the company could face not only operational downtime but also significant damage to its customer relationships. However, if indirect damages such as loss of reputation or future business are excluded from the liability clause, the company could be left without recourse to recover from the broader impacts of the outage.
These examples demonstrate why it’s critical to negotiate liability caps that adequately reflect the risks your business faces, and to ensure that consequential damages are covered.
4. Verifying insurance coverage
Alongside negotiating strong limitation of liability clauses, verifying your provider’s insurance coverage is crucial. Robust insurance policies can offer additional financial protection if the liability cap is insufficient.
Always ensure that the provider’s coverage is substantial enough to cover potential damages, and insist on including minimum coverage thresholds within the contract.
5. Practical steps for legal teams and business leaders
To protect your business from the risks associated with limitation of liability clauses, it’s essential for legal teams and business leaders—those responsible for overseeing negotiations with service providers—to consider the following steps:
Engage internal or external legal experts: Ensure that legal professionals, whether in-house counsel or external advisors, are involved in contract negotiations to assess and negotiate terms that align with the company’s risk tolerance and strategic objectives. Collaboration between legal teams and operational teams ensures that contract terms are both protective and practical.
Review past incidents: Legal professionals and business leaders should analyze past service failures, either involving the provider or similar services, to understand how liability was handled and whether the contract terms provided adequate protection. This information is vital for informing future negotiations.
Consider worst-case scenarios: Legal teams and operational teams should work together to model potential worst-case scenarios, such as operational downtime, security breaches, or service failures, and ensure that the liability cap reflects the company’s risk exposure.
Verify insurance coverage: Require proof of insurance coverage and confirm that the policy limits are substantial enough to cover the risks associated with the service. Legal teams and operational teams should ensure that the insurance aligns with contractual obligations and provides sufficient protection in case of significant service failures
Whether you are negotiating with traditional service providers or SaaS providers, it can be tempting to focus on price, delivery schedules, or quality guarantees.
However, the limitation of liability clause should never be an afterthought. Take the time to fully understand the potential risks and ensure the terms are balanced and fair. Involving a legal expert who can assess the specific risks of the transaction is crucial to avoid signing a contract that exposes your business to undue harm.
Negotiating liability clauses may not be the most glamorous part of finalizing a contract, but it’s one of the most important steps you can take to protect your business from unexpected financial and legal consequences. Don’t settle quickly—protect your business by negotiating limitation of liability clauses that fit your risk profile and operational needs.
Photo by Kamil Pietrzak, Unsplash
