Limitation of liability clauses and their applicability in India: a judicial perspective
INTRODUCTION
Limitation of liability clauses play a crucial role in commercial contracts by allowing parties to define the scope of their financial exposure in case of a breach. In India, these clauses are primarily governed by the Indian Contract Act, 1872 (“Contract Act”), particularly Sections 73 and 74, which establish the framework for assessing damages in contractual breaches. The enforceability of such clauses depends on factors such as public policy, fairness, and the bargaining power of the parties involved. Indian courts have been instrumental in determining the validity of these clauses, ensuring they do not result in an unjust enrichment of one party at the cost of another.
In commercial transactions, businesses often rely on limitation of liability clauses to mitigate risks. These clauses are commonly found in standard form contracts, technology agreements, service contracts, and agreements involving substantial financial investments. While parties have the freedom to draft contracts as they deem fit, this freedom is not absolute. The courts assess whether such clauses violate statutory provisions, public policy, or fundamental principles of contract law. The significance of these clauses has grown exponentially with the increasing complexity of commercial relationships and the globalization of business transactions.
LEGAL FRAMEWORK
The Contract Act, particularly Sections 73 and 74, provides the primary legislative framework for limitation of liability clauses. Section 73 establishes the fundamental principle that an injured party is entitled to receive compensation for losses arising naturally from the breach or within the parties’ contemplation at the time of contracting. This section explicitly bars compensation for remote and indirect losses, establishing a clear boundary for damage claims.
Section 74 addresses liquidated damages, requiring that stipulated amounts represent genuine pre- estimates of loss rather than penalties. This provision has been instrumental in courts’ assessment of limitation clauses that specify fixed compensation amounts. The primary idea that must be observed in section 74 of the Act, if exclusion terms are carved out like the “penalty” provided in a contract, then the compensation should be reasonable and not exceed the amount that is agreed in the agreement.1Fateh Chand v. Balkishan Dass, 1963 SCC Online SC 49 Section 23 and 28 of the Contract Act also play a crucial role in determining the validity of limitation of liability clauses. Section 23 states that any contract that contravenes public policy is void. Courts have used this provision to strike down clauses that unreasonably restrict a party’s ability to seek damages, particularly in cases where there is unequal bargaining power. Section 28 before its amendment in 1997, permitted contracts to limit the time for enforcing rights. However, the amendment rendered such clauses void, except in cases involving financial institutions, thereby ensuring that contractual rights are not arbitrarily extinguished.
A brief a nalysis of Section 73
The scope of Section 73 encompasses several crucial elements that courts consider while evaluating limitation clauses:
• Firstly, when a contract is breached, the non-defaulting party is entitled to seek compensation from the breaching party for any loss or damage that naturally arises in the ordinary course of events due to such breach. This category of damages is conventionally referred to as ‘general’ or ‘ordinary’ damages.
• Secondly, in the event of a breach, compensation is also payable for losses or damages that were within the contemplation of both parties at the time of contract formation, as being likely to result from such breach. These damages are commonly classified as ‘special damages.’
• Thirdly, the statute explicitly precludes the award of compensation for any loss or damage that is remote or indirect, thereby restricting recovery to those losses that have a proximate and direct causal connection with the breach.
• Fourthly, the principles enshrined in Section 73 extend beyond contractual breaches and apply equally to obligations that, though not strictly contractual, closely resemble contractual undertakings.
• Fifthly, the provision incorporates the principle of mitigation, mandating that the non-defaulting party must take reasonable steps to minimize the losses arising out of the breach.
Classical contract law validates exclusion clauses based on the freedom of contract principle. In commercial agreements between equally powered parties, these clauses effectively allocate risks and ensure business certainty. However, the scenario becomes problematic when significant bargaining power disparities exist, with stronger parties potentially imposing unfair terms on weaker counterparts.
This creates a judicial dilemma: Should courts invalidate exclusion clauses solely based on apparent unfairness? The legal position remains nuanced, balancing two competing principles – the sanctity of contracts freely entered into, and the need to prevent unconscionable agreements that exploit weaker parties. Courts must navigate this tension while ensuring both commercial certainty and fairness.
JUDICIAL INTERPRETATION
In early judicial developments, the Hon’ble Supreme Court in Sri Chunilal V . Mehta Sons Limited v. The Century Spinning and Manufacturing Company Limited2 Chunilal V. Mehta and Sons Ltd. v. Century Spg. and Mfg. Co. Ltd., 1962 SCC OnLine SC 57 , established a foundational principle regarding contractual limitation of damages. The Court held that when a contract explicitly provides for compensation, it effectively excludes claims under general law. However, the Court made an important distinction, clarifying that such clauses do not automatically prevent claims for damages arising from other breaches unless explicitly stated.
However, the Court also clarified that the clause in question did not restrict or exclude the right of a party to claim damages for breach of contract in general. Instead, it merely specified a pre-determined liquidated sum as damages in the event of early termination by one party. This distinction is significant, as it indicates that while parties can limit their liability contractually, such clauses do not necessarily prevent a claim for damages arising from other breaches unless explicitly stated. This principle was further reinforced in Seth Thawardas Pherumal v. Union of India3Seth Thawardas Pherumal v. Union of India, 1955 SCC OnLine SC 65, where the Hon’ble Supreme Court upheld the validity of exclusion clauses that were expressly agreed upon. The Court emphasized that parties cannot later disregard contractual terms merely because they prove unfavourable. Further in the case of A.S Motors (P) Ltd. Vs. Union of India4A.S. Motors (P) Ltd. v. Union of India, (2013) 10 SCC 114, it was held that the damages awarded cannot exceed the sum so named in the contract it shall be a ceiling amount and similarly it was observed in Surjit Kaur vs. Nauata Singh5A.S. Motors (P) Ltd. v. Union of India, (2013) 10 SCC 114 that in a contract fixing a compensation amount must be given effect to and any award less than the amount stipulated must be accompanied with reasons. The Supreme Court’s approach to commercial contracts was notably demonstrated in ONGC v. Wig Bros. Builders and Engineers (P) Limited6ONGC v. WIG Bros. Builders & Engineers (P) Ltd., (2010) 13 SCC 377, where it set aside an arbitral award that had granted compensation despite an explicit exclusion clause. This decision, along with similar rulings in Ramnath International Construction (P) Limited v. Union of India7Ramnath International Construction (P) Ltd. v. Union of India, (2007) 2 SCC 453 and Rajasthan State Mines and Mineral Limited v. Eastern Engg. Enterprises8Rajasthan State Mines & Minerals Ltd. v. Eastern Engg. Enterprises, (1999) 9 SCC 283, established that validly agreed exclusion clauses are enforceable and prevent compensation claims that contradict their terms. Another significant development in the jurisprudence came through Simplex Concrete Piles (India) Ltd. v. Union of India9Simplex Concrete Piles (India) Ltd. v. Union of India, 2010 SCC OnLine Del 821, where the Delhi High Court addressed the fundamental question of whether contractual clauses could completely exclude liability. The Court held that clauses prohibiting claims under Section 73 Contract Act are void under Section 23, as they contravene public policy by depriving parties of statutory remedies.
The Bombay High Court, in the case of, Maharashtra State Electricity Board, Bombay v. Sterlite Industries (India) Limited10Maharashtra State Electricity Board v. Sterlite Industries (India) Ltd., 2000 SCC OnLine Bom 89, ruled that where the parties to a contract agree on particular terms and provisions governing the amount of damages that can be claimed in the case of a breach of contract, the parties are bound by such provisions, and Section 73 of the Contract Act does not apply. Courts have scrutinized financial caps on liability to ensure their reasonableness and proportionality. In Mahanagar Telephone Nigam Ltd. v. Tata Communications Ltd.11MTNL v. Tata Communications Ltd., (2019) 5 SCC 341, the Hon’ble Apex Court ascertained that specified liquidated damages serve as maximum recoverable limits, provided they represent a fair estimate of potential loss. The court emphasized that no additional compensation could be awarded beyond the agreed amount unless the clause itself was found to be unfair or unreasonable.
Similarly, in Carl Estate Pvt. Ltd. & Anr. v. Jagdish J.N. Counte12Carl Estate Private Limited v. Jagdish J.N. Counte, 2005 SCC OnLine Bom 282, the Bombay High Court reaffirmed that reasonable compensation should remain within the contractual cap, provided the cap itself was not excessively low or against public policy.
The landmark case of Central Inland Water Transport Corporation Limited v. Brojo Nath Ganguly13Central Inland Water Transport Corpn. v. Brojo Nath Ganguly, (1986) 3 SCC 156 (1986) further expanded this doctrine. The Hon’ble Supreme Court held that unconscionable clauses in contracts between parties with unequal bargaining power are void under Section 23. Notably, the Court emphasized that this principle applies particularly in situations where the weaker party has no meaningful choice but to accept unfair terms. It stated that:
“It will apply where the inequality is the result of circumstances, whether of the creation of the parties or not. It will apply to situations in which the weaker party is in a position in which he can obtain goods or services or means of livelihood only upon the terms imposed by the stronger party or go without them. It will also apply where a man has no choice, or rather no meaningful choice, but to give his assent to a contract or to sign on the dotted line in a prescribed or standard form or to accept a set of rules as part of the contract, however unfair, unreasonable and unconscionable a clause in that contract or form or rules may be….”
Furthermore, the requirement of commercial reasonableness was addressed in ONGC v. SAW Pipes14ONGC Ltd. v. Saw Pipes Ltd., (2003) 5 SCC 705, where the Hon’ble Apex Court clarified that liquidated damages must represent a fair and reasonable estimate of loss. The Court rejected the enforceability of clauses specifying exorbitant or arbitrary damages, establishing that limitation clauses cannot serve as mere penalties. The practical application of these principles is illustrated in Bharathi Knitting Company v. DHL Worldwide Express15Bharathi Knitting Co. v. DHL Worldwide Express Courier, (1996) 4 SCC 704. Here, the Court upheld a limitation clause restricting damages to Rs. 3,515/- despite the plaintiff’s much larger actual losses, demonstrating that courts will enforce clear limitation clauses when properly incorporated into contracts between commercial parties.
The judiciary has shown particular vigilance in protecting consumer interests, especially in insurance contracts. The recent judgment in M/s Texco Marketing Pvt. Ltd. v. TATA AIG General Insurance Company Ltd.16Texco Marketing (P) Ltd. v. TATA AIG General Insurance Co. Ltd., (2023) 1 SCC 428 represents a significant development in this area. The Court emphasized:
• The importance of transparent disclosure in adhesion contracts
• The invalidity of exclusion clauses contradicting the contract’s main purpose
• The application of the doctrine of blue pencil to sever repugnant clauses
• The duty of insurers to provide clear information about policy terms
Examples of limitation of liability clauses
Limitation or exclusion of liability clauses can pursue different purposes and take various different forms, for example:
• Contracts may exclude liability of ‘force majeure’ occurrences.
• Exclude liability for certain type of losses, such as indirect or consequential losses or loss of profits.
• Limit liability by placing a “limit” on damages for a breach. This restrict is frequently expressed as percentage of the total contract value.
• Specify a time limit for the other party to file a claim or provide notice of a breach to avoid responsibility.
• Limit any liability-related rights or remedies, such as the right to set off.
Non-Excludable Liabilities
In contract law, certain categories of liability are recognized as non-excludable, meaning that parties cannot contractually limit or exclude their liability in these areas. The judiciary has established several key categories where such exclusions are deemed void:
• Death or Personal Injury: One of the most stringent prohibitions against exclusion clauses pertains to liability for death or personal injury. Under the Unfair Contract Terms Act (UCTA) in common law, any attempt to exclude liability for death or personal injury resulting from negligence is automatically void.
• Contractual Breaches: In Simplex Concrete Piles (India) Limited v. Union of India17Supra at 7, the contract appeared to contain a bar against the contractor’s remedy insofar as it barred the admission of a claim for compensation. The ratio in this decision, that a clause which bars a contractor from claiming damages which it is entitled to under Sections 55 and 73 of the Contract Act will be void by virtue of Section 23 of the Contract Act, is generic and may have far-reaching consequences. The court noted, “the issue therefore boils down to whether rights created by Section 73 and 55 of the Contract Act can or cannot be contractually waived. If there is a public policy or public interest element in these Sections, then the rights under these sections cannot be waived.”
• Statutory Rights: Lastly, limitations cannot override rights granted by specific legislation, including rights under consumer protection laws. For example, under various consumer protection statutes, consumers are afforded certain rights that cannot be waived or excluded by contractual terms and can pursue remedy available in law. In Bharathi Knitting Company v. DHL Worldwide Express Courier Division18Supra at 13, the Hon’ble Supreme Court held that limitations on liability could not be enforced if they pertain to fundamental breaches.
PRACTICAL IMPLICATIONS
Why is the exclusion clause preferred?
The reasons for the emergence and widespread use of exclusion clauses are multi-fold.
• First, the exclusion of liability for breach reduces the prospective costs and risks attached to a contractual transaction and thus, enhances economies of scale of a business enterprise.
• Second, the move from Hadley v. Baxendale ’s19 Hadley v. Baxendale , 9 Ex 341 : 156 ER 145 premise of ‘foreseeability’ to the doctrine of ‘sufficient cause’ has resulted in greater damages for breaches.
• Third, exclusion clauses bring certainty in the post-breach situation and allows the parties to correctly anticipate the damages to be incurred on breach. It acts as a defence to a legal action for the breach of the contract.
• Fourth and last, an ‘exception clause’, enables a party to delimit or qualify its duties arising out of a contract, which helps them in reasonable distribution of risks by clearly marking out the conditions when a liability shall arise.
Drafting Considerations
The evolving jurisprudence suggests several key considerations for drafting effective limitation of liability clauses:
• Clear and Unambiguous Language: Avoid ambiguity that could lead to judicial interpretation against the drafter
• Reasonable Financial Caps: Ensure caps are proportionate to the contract value and potential losses
• Express Acknowledgment: Clearly state non-excludable liabilities
• Risk Allocation: Clearly define and fairly allocate risks between parties
• Compliance Framework: Ensure alignment with statutory requirements and industry regulations
CONCLUSION
The Contract Act emphasizes the need of ensuring that compensation for breach, as indicated as liquidated damages or a penalty, is appropriate and not exorbitant. It is obvious that the amount stipulated in a contract for breach should not exceed a fair and just number, with the knowledge that liquidated damages are meant to be a set sum rather than an arbitrary penalty. Furthermore, limitation of liability clauses in contracts are legal if they are not unreasonable or unconscionable, especially when there is an imbalance of negotiating power between the parties. Courts have generally found that such terms cannot be enforced if they are seen to exploit the weaker party, as this would be against public policy. Finally, while parties may define the scope of damages or responsibility in their agreements, these provisions must always be consistent with fairness and reasonableness criteria in order to be enforceable.
The authors would like to extend appreciation to Mr. Syed Moosa, an intern at PSL Advocates & Solicitors, for his valuable research and inputs
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