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Unlimited Liability

October 21, 2010

Whether right or wrong, there seems to be broad consensus that the risks we face in business today are increasingly hard to predict. There is a sense also that the financial consequences of many risks are potentially very large and difficult to estimate. One result of this appears to be an attempt by buyers to simply allocate the risks of failure to their suppliers through broad-brush application of ‘burdensome’ terms, such as onerous liability and indemnity provisions.

To the extent that trade has globalized (taking us to less familiar and perhaps more vulnerable markets) and also the degree to which ‘interdependencies’ have grown, these feelings of greater risk may be valid. Certainly, organizations (both public and private) today often rely on a wide portfolio of trading partners to enable or deliver their business capabilities. A growing number of relationships are based on the delivery of outputs or outcomes, moving away from the time when most acquisitions were product (or input) based.

Suppliers have of course encouraged this trend towards services and solutions, in order to avoid the commodity pricing trap. But with that move comes increased responsibility for performance – and suppliers are generally not so keen on the increased liabilities this implies.

One area of growing friction is around unlimited liabilities (with consequential loss also sometimes thrown into the mix). As recent lively debates on the IACCM contract management forum have shown, buyers and sellers see this topic very differently (even though within each company it is the same Law department driving this rather schizophrenic debate).  It seems to me valid that a supplier should be asked to ‘put their money where their mouth is’. If I promise an outcome – and charge a premium for delivering it – then there should be pain for failure. But how much pain? And at what level of ‘premium’?

The problem with unlimited liability is that (at least in some jurisdictions) it may be precisely that – i.e. unlimited. Unlimited liability is not in general insurable, so the value of such a term of course depends on the size and assets of the company bearing the risk of loss. But more broadly, any unthinking attempt to apply such clauses is intellectually lazy and should be avoided.

The legal theory is that a ‘penalty’ clause will act as a negative incentive to perform. There is limited evidence that this works especially well and plenty of evidence to suggest there is a law of diminishing returns. Indeed, some would argue that there is a point at which such terms become counter-productive. In addition, the value of such a clause varies dramatically. For example, when dealing with overseas markets, it will vary in its enforceability and, depending on the jurisdiction of the contract, it will also vary widely in its value and application.  Regardless of jurisdiction, the actual realizable value will always depend on the underlying assets of the company providing the undertaking.

How often are such clauses exercized? How frequently are they upheld? What is the economic value realized from them, versus the economic costs of including them (extended negotiation time, strained relationships, more cautious suppliers, less delivery of innovation, higher prices to cover the risk etc.)? Is the party agreeing to the term capable of fulfilling it? When an organization or its lawyers prescribe these onerous terms, to what extent do they consider these wider questions? Far too often, the answer appears to be ‘not enough’; so long as there is compliance, the quality of that compliance doesn’t really matter.

IACCM professionals – buy side and sell side – should not accept such positions. We must insist that the terms we are negotiating make sense, are proportional and that they drive the successful results that caused us to form a contract in the first place.

  1. Stephen Lewis permalink

    There is certainly a game that is played with unlimited liabilities and “indemnify and hold harmless” provisions that keeps commercial managers and lawyers well occupied. It is only necessary to look at the distance between a contracting party’s standard conditions of purchase and standard conditions of sale in respect of liabilities to validate this point.

    Of course, the accommodating of excessive liabilities means insuring where it is possible to do so, intensifying management action or flowing the pain down to the next party in the chain. Each stronger party will exploit its relative bargaining power to coerce the weaker party into compliance. The consumer is normally protected by statute, so the effect of flow down is that the buck stops with the SME who is least able to accommodate a substantial claim for “unlimited loss”.

    The contractor who will not comply with the purchaser’s conditions may be considered to be a “difficult customer” or “the only customer who is non-compliant” and this is a difficult place to be when business is tight. Most top decision-makers will yield to outrageous demands and will seek to off lay the liabilities upon others in their position further down the chain. The status quo position is that from government down each purchaser will exploit its bargaining power against the weaker party.

    The draft Unfair Contract Terms Bill (2005) makes for some interesting reading.

    The draft Unfair Contract Terms Bill is included as Appendix A to a Law Commissions joint paper Cm 6464 SE/2005/13 on “Unfair terms in contracts” (full version – 251 pages) February 2005

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