Businesses may encounter contract risks in the course of regular business operation. Increasingly more businesses have become aware of the importance of risk prevention and started to put focus on risk control and prevention. Liability limitation clauses are often seen in contracts. What do liability limitation clauses mean? How do they work? What about the validity of liability limitation clauses in contracts? To find answers to these questions, read this article.   

1. General liability limitation clauses

Liability limitation clauses mean contractual clauses that limit future liability of one party or both parties. Liability limitation clauses are intended to limit risks arising from claims for damages against businesses and define the scope of indemnification. Explicit and valid liability limitation clauses can effectively limit a company’s losses arising from claims for damages.

Here are some frequently used examples for liability limitation clauses:

(1) Set an upper limit on damages in liability limitation clauses:

Example 1: “Unless otherwise provided herein, for the benefit of the Parties, in no event shall the total amount of damages arising from a breach of this Agreement payable by either Party to the other Party exceed RMB 1 million”.

Example 2: “Unless otherwise stated in an agreement between the Parties, if you do not buy an insurance on the original value of the consignment, SF Express shall be liable for your actual losses that equal to no more than seven times the delivery fee.......If you buy and pay for the insurance, SF Express will pay actual losses in proportion to the insured amount in case of breakage or shortage or in case of a complete loss of your goods, no more than the value stated in the insurance bought upon the consignment being handed over to the consignor”.

(2) Include clauses stating that incidental, special or consequential damages are excluded (or set an upper limit on direct damages) in liability limitation clauses

Example: “SF Express shall not be liable for paying any indirect loss of potential profits, use, business opportunities, etc. connected with the consignment”.

(3) Limit the liability of a company to other parties to a contract in liability limitation clauses

Example: “In no event shall a company be held liable to buyers for damages caused by third parties unless the company’s action or inaction is related to a deliberate or severe negligence, fraud or deliberate illegal activity”.

2. Effect of liability limitation clauses

(1) Effect of general liability limitation clauses

Liability limitation clauses are a kind of liability exemption clauses that limit legal liability of one or more parties. Considering arbitrary and mandatory qualities of breach and infringement liabilities, the validity of liability exemption clauses is based on the principle of autonomy in private law and the principles of good faith and compliance with laws, public policies and good customs in civil law.

Therefore, the effect of liability exemption clauses varies in different situations. Generally speaking, liability exemption clauses that are in accord with public policies and completely voluntarily agreed by the parties involved after full discussions are legally accepted as valid. For example, in (2017) Z.G.F.M.Z. No.431 civil judgement of the Supreme People’s Court, (2017) J.02M.Z.No.9884 civil judgement of the Beijing No.2 Intermediate People’s Court and (2013) Y.G.F.M.Z.Z.No.00258 civil judgement of Chongqing High People’s Court all the courts decided that liability limitation clauses were valid.

However, liability exemption clauses that seriously violate the good-faith principle and public interests are prohibited by law to avoid abuses of liability exemption clauses, serious harm of interests of any of parties involved and adverse impact on contractual transactions.

Article 53 of the Contract Law of the People’s Republic of China (“Contract Law”) provides that liability exemption clauses in a contract that would cause (i) physical harm to the other party to the contract or (ii) damage to the other party’s property due to a deliberate act or gross negligence shall be deemed as invalid. This provision is basically intended to prevent adverse consequences of any violation of public policies and social ethics regardless of small differences in the above two cases.     

As liability limitation clauses are essentially used to fix and allocate future risks between parties to a contract, mainly exempting and limiting liability arising from incidents that may occur after the signing of the contract, none of the parties involved can conceal real risks that existed or continue before the signing of the contract, which is the basis on which liability limitation clauses are executed and an essential element in the good-faith principle. There are specific provisions in law against liability exemption clauses that violate the good-faith principle. For example, Article 32 of the Interpretation of Issues Connected with Application of Law to Dealing with Sale and Purchase Contract Cases (“Legal Interpretation about Sale and Purchase Contracts”) provides that if the seller fails to inform the buyer of defects in goods sold due to a deliberate act or gross negligence, the court should not decide to reduce or exempt the seller’s liability of warranty for the defects as set out in the contract. This exception to cases of reducing or exempting the seller’s liability of warranty on defects in goods sold reflects the requirement of civil law that parties involved should follow the good-faith principle.

The fifth issue in 2019 of the Official Report of the Supreme Court published a real case relating to liability limitation clauses - (2017) H.01.M.Z.No.9095 Civil Judgement of the Shanghai No.1 Intermediate Court, stating that the real estate developer concealed the existence of risks that may prevent the house transfer from being timely completed at the time of signing the contract with the ability to change the deadline for the house transfer so that the house buyer reasonably believed that the developer had committed to the deadline for the house transfer, which fully absorbed the actual conditions for performing the schedule that the developer was aware of, the original risks would disappear in time and the deadline for the house transfer would be met if there was no further cause for liability exemption. The scope of risk transfer agreed by the parties to a contract includes risks that may appear during the performance of the contract, not including actual conditions that are considered when setting the deadline for the house transfer. For this reason the liability limitation clauses did not apply to real risks that are not disclosed at the time of contract execution and the developer lost the case when the court finally decided that risks that threatened the house transfer at the time of contract execution could not be waived on the basis of the liability limitation clauses. We can see from this case that to protect the interests in trust of persons doing business with a company, the company should inform them about related liability limitation clauses, especially major risks incurred in which case the liability limitation clauses apply, or otherwise the liability limitation clauses may not be in full effect.        

Liability limitation clauses voluntarily executed through consultation between parties thereto are generally accepted as legally valid. If the clauses seriously harm public interests or violate the good-faith principle, they will be legally deemed as invalid.          

(2) Effect of format clauses of liability limitation

More things need to be considered if liability limitation clauses are found as format clauses.

According to Article 39.1 of the Contract Law, format liability limitation clauses should be in accord with the fairness principle, reasonably told to the other party at the time of signing the the contract and explained at the other party’s request. For instance, format contracts are common in the express delivery industry. Article 19.2 of the Express Delivery Management Rules restates that corporate liability exemption or limitation clauses and compensation for damages connected with express (mails) should be clearly specified and noted in delivery documents.

Parties to a format contract are usually a corporate entity and a natural person, especially when the contract is signed by the natural person through the online platform of the corporate entity. According to Article 6.1 of the Interpretation (II) of Several Issues Connected with the Contract Law of the People’s Republic of China (“Legal Interpretation II of the Contract Law”), entities can highlight and add appropriate notes to liability limitation clauses in bold, underlined or accented forms to make them more noticeable, strengthen the validity of the clauses and keep evidence for future actions.    

For instance, the (2014) Y.Z.M.Z.Z.No.05346 civil judgement of Beijing No.1 Intermediate People’s Court stated that the English language training contract between Liu Fengqing and Disney English Language School (Beijing) Ltd. was a format contract drafted by the latter, in which liability limitation clauses was highlighted in a bold form and Liu Fengqing signed and confirmed that she had read, understood and agreed to abide by conditions and terms in the contract and should not be deemed as invalid as Disney English Language School (Beijing) Ltd. had reasonably fulfilled its duty of notification and explanation upon execution of the contract.   

Without the notes and explanations, liability limitation clauses would be revocable by the opposing side according to Article 9 of the Legal Interpretation II of the Contract Law. Article 152 of the General Principles of the Civil Law of the People’s Republic of China provides that the right to cancel liability limitation clauses that is not exercised within the one-year period of time from the date when the person having the cancellation right knows or should know the cause of cancellation no longer exists and have no effect on the validity of the liability limitation clauses.  

3. Relationship between liability limitation clauses and the full compensation principle

Liability limitation clauses are originally intended to limit the amount of damages. Article 113.1 of the Contract Law provides that compensation for damage arising from failure to perform or fully perform contractual obligations equal to damages arising from the default, including benefits that could be acquired from the performance of the contract, and in no event will it exceed all losses resulting from the default that could or should be predictable by the breaching party upon execution of the contract. Damages payable under liability limitation clauses and the full compensation principle are different considering their nature, cause and details. Are they related to each other in terms of applicability? In what circumstances do liability limitation clauses preclude the applicability of the full compensation principle?

First, in the absence of a specific law or agreement, the full compensation principle should apply to payment of statutory damages for breaches. Based on this, the breaching party should pay all losses, including direct and indirect losses. Direct losses mean direct decreases in assets. Indirect losses mean loss of profits that are predictable upon execution of a contract.  

Second, the relationship between liability limitation clauses agreed in contracts and the full compensation principle is as follows.

(1) If actual losses are less than the limit on liabilities agreed in liability limitation clauses, the losses should be paid according to the full compensation principle to recover the losses to the extent estimated by parties involved. If actual losses are more than the liability limit, liability limitation clauses will be helpful to secure the responsibility for payment of damages and the legal full compensation principle will not apply. In this circumstance, although actual losses are not effectively recovered, as the parties have discussed and agreed to the liability limitation clauses, the agreed limit should accord with future losses estimated by the parties, which to some extent reflects the applicability of the rule of predictability.  

(2) If losses recoverable are limited to direct losses under liability limitation clauses, the full compensation principle will not apply and only direct losses, not including indirect losses need to be paid. In this case the parties involved exempt the liability of compensation for indirect losses and preclude the legal compensation principle.

Third, if the full compensation principle, liability limitation clauses and breach clauses are included in the same contract, circumstances are more complicated. To make it more accessible to readers, I take the following two circumstances for example.

(1) If a breach penalty or calculation of the breach penalty is specified in breach clauses and a limit on damages is agreed under liability limitation clauses, the breaching party should pay damages as agreed in breach clauses. If the breach penalty is unreasonably much more or less than actual losses, the breaching party can claim that the breach penalty should be changed according to Article 114.2 of the Contract Law. Eventually, the breach penalty should not exceed the limit on damages. Liability limitation clauses have no effect on contract risk control unless the breach penalty exceeds the limit on damages.

(2) If a breach penalty or calculation of the breach penalty is specified in breach clauses and losses recoverable are limited to direct losses under liability limitation clauses, the breaching party should pay damages as agreed in breach clauses. If the breach penalty is unreasonably much more or less than actual losses, the breaching party can claim that the breach penalty should be changed according to Article 114.2 of the Contract Law. To decide if the breach penalty is unreasonably much more or less than actual losses, actual losses only include direct losses, not including indirect losses. If liability limitation clauses apply, the full compensation principle would not apply and the meaning of losses would be different. Unreasonably large or small amounts of breach penalties should be changed on the basis of direct losses defined in liability limitation clauses.  

The Contract Law explicitly provides based on the full compensation principle and the rule of predictability that the amount of breach damages is limited to possible losses arising from such breach that any party to the contract could or should predict upon execution of the contract. However, the benefit of performing such clauses are quite uncertain for the opposing party. Without liability limitation clauses, claims arising from breach of a contract would be unpredictable and the opposing party might claim a larger amount of damages, increasing the cost of resolving the claim. Contractual liability limitation clauses are very important.  

To sum up, liability limitation clauses in contracts between businesses are generally valid. Even in format contracts liability limitation clauses are valid as long as appropriate notes and explanations are given. For risk control reasons businesses can can include liability limitation clauses in contracts to limit risks and make future claims more predictable.