Serious game of consequences
Kim Kardashian and Kanye West sent the rumour mill into a frenzy last week with revelations that their pre-nuptial agreement is a staggering $1 million (£600,000) for each year the couple are married.
While pre-nups and celebrities go together, the principle behind them is commonly used for commercial contracts. Most contracts will set out, while parties are still friends, what will happen if they fall out. What will be the consequences of a party not delivering on its commitments?
The starting principle is that a party in breach of contract, is liable for all losses that “flow naturally from that breach”. No-one knows what that means or where it ends until it is put to the test.
Take a case a few years ago. An electricity provider was sued for the cost of demolishing and rebuilding a substantial part of a viaduct over Edinburgh City by-pass because of a power cut it caused. The electricity company was not liable because those costs were not “within the reasonable contemplation” of parties to an electricity supply agreement, ie when the parties signed the contract the electricity company couldn’t reasonably be expected to pay for demolition and rebuilding costs because of a fault with the electricity supply.
That’s why catering up- front for what a party will be responsible for removes or at least reduces the uncertainty.
Another way to reduce uncertainty is to include a liability cap, which may simply be a financial limit on the amount a party in breach has to pay regardless of the nature of its breach. Another type of cap is excluding recovery of certain types of losses, eg loss of profit. What cannot be excluded is liability for personal injury or death.
Under the Unfair Contract Terms Act, it can be argued that a liability cap is not fair and reasonable but, generally, in a business to business contract that does not arise. Parties are considered to have understood at contract negotiation stage what was happening regarding allocation of risk.
And that is what a cap is all about – it’s about allocating risk. Parties agree up front who will bear the pain in the event that losses go above a certain limit or are out of the ordinary. And if the type or amount of loss is outside the cap, the loss will be borne by the party who initially suffers. It will not be able to pass it on to the other party.
Fixing the level of a cap can be tricky. One method is to limit it to the contract price or a multiplier of it, eg “the supplier’s liability shall be limited to £[ ]/or the fee”.
Where the potential consequences of a breach go way beyond the original price, different considerations arise. The party delivering the product will, when bidding, be intent on limiting its exposure. Take a contract for the supply of software or a computer system – the consequences of a problem with such a system is likely to go well beyond the original price
The party delivering the contract will try to exclude liability for business interruption, ie loss of business revenue and therefore profits. If the contract it’s offered does not limit its liability, the supplier will probably reduce its price or not bid at all.
Finally, insurance is relevant when negotiating a contract. The sensible approach is that the party which has to bear the risk covers that with insurance, if available.
Otherwise, regardless of what the contract says, if the party which is liable is unable to pay up, the innocent party may bear the loss anyway.
It has long been said that passing risk on to a party that can’t bear it is not proper risk transfer. That’s why all parties should, before signing contracts, consider all the potential consequences, good or bad, dealing with potential problems up-front rather than after they develop.
•Lindy Patterson QC is a partner specialising in construction and energy disputes with Dundas & Wilson. Dundas & Wilson is joining CMS, Europe’s largest law firm, on 1 May. 2014: www.dundas-wilson.com