Reviewing Damages and Limitation of Liability Clauses in Practice: How to Read Caps, Exceptions and Indirect Damages

Hello, I'm Noriaki Asato, Representative Attorney at LegalAgent.

In contract review, the damages clause is one of the clauses that most affects how difficult negotiations will be. In practice, however, there are cases where people feel reassured simply by confirming the general wording that a party "shall compensate for damages."

What really needs to be checked is the specific design: on the occurrence of what events, what scope of damages will be compensated, up to what amount, and subject to what exceptions. Methods for setting liability caps, the exclusion of indirect damages, and the handling of key risks such as breaches of confidentiality obligations and leaks of personal information need to be put together carefully according to the type of transaction.

Companies that want to entrust lawyers with reviewing clauses on liability caps and the scope of exclusions can use our legal outsourcing, in which lawyers with corporate legal experience take on contract review on a continuing basis.

Risk Allocation Through Damages Clauses and Their Position Under the Civil Code

A damages clause determines what monetary compensation can be claimed from the counterparty when damage arises from non-performance of obligations or the like. The main text of Article 415 of the Civil Code provides for damages for non-performance of obligations, but it also provides that the obligor is not liable if the non-performance is due to grounds not attributable to the obligor in light of the contract or other source of the obligation and socially accepted norms in the transaction. In contracts between companies, the parties take this Civil Code principle as a starting point and individually agree on the scope of compensation, the cap amount, the requirements for exemption and so on.

In this clause, the parties agree on who bears the damage associated with the transaction and to what extent.

For example, for SaaS provided at a low monthly fee, it may not be realistic, from the standpoint of business continuity, for the service provider to bear unlimited liability for damages. On the other hand, in a service agreement involving the handling of large volumes of personal information, if the contractor's liability cap is limited to one month's worth of the monthly service fee, it may not sufficiently cover the outsourcing party's damage in the event of an incident. A cap such as one month's fee is merely an example from transactional practice, not a statutory minimum. A damages clause must be evaluated by comprehensively considering the transaction amount, the nature of the outsourced work and the degree of impact if an incident occurs.

Methods of Calculating the Liability Cap and Balancing Them with the Reality of the Transaction

To prevent liability for damages from swelling excessively, contracts often set a liability cap. Formulations commonly used in practice include the following.

• A cap set at the contract amount
• A cap set at the fees for the most recent several months
• A cap set at the annual fees
• A cap set at the order amount under the individual contract
• A cap set at a fixed amount
• No cap

Which formulation is appropriate depends on the type of contract and the company's position. A contractor or provider wants to avoid unlimited liability and keep risk within a predictable range. If the risk of damages is excessive relative to the contract amount, taking on the engagement as a business becomes precarious in itself.

An outsourcing party or user checks whether the cap is set at a level that would allow actual losses to be recovered in the event of an incident. If the cap is too low for work such as maintenance of core systems or work involving trade secrets or personal information, the cap may fall drastically short of the damage that occurs.

When considering the cap amount, check not only the size of the amount but also the basis of calculation. In a continuing contract, the burden in the event of multiple incidents varies greatly depending on how many months of past payments serve as the basis, and, where multiple individual contracts run in parallel, whether the cap is set per engagement or aggregated on an annual cumulative basis. Also check whether it is appropriate to apply the same cap to high-risk work as to ordinary work, and whether the cap amount is consistent with the coverage limits of your company's or the counterparty's liability insurance. Note that insurance has exclusions and payment limits, so it does not necessarily align perfectly with the contractual liability cap.

Distinguishing Categories of Damages, and Linking Cap Exceptions with Performance Terms

Damages clauses frequently include wording that excludes indirect damages, lost profits and special damages from compensation. Note here that the legal distinction under Article 416 of the Civil Code between ordinary damages and damages arising from special circumstances (special damages) does not necessarily match the distinction between direct damages, indirect damages and lost profits commonly used in contract practice. Determine what to exclude and what to keep covered by applying the clause to the actual work.

For example, typical points of dispute are whether to include or exclude from compensation lost sales and business losses when a system failure halts a user's operations, or losses from suspended operations when defects in parts delivered under a manufacturing supply agreement stop a production line.

Even where liability is limited, it is customary to set "exceptions" that remove certain important events from the application of the cap or exclusion. In addition to willful misconduct or gross negligence, typical examples include breaches of confidentiality obligations, leaks of personal information and infringement of intellectual property rights. Depending on the contract, breaches of the anti-social forces exclusion clause and breaches of payment obligations are also added as exceptions. Note, however, that even if a liability cap or exemption is written into the contract, a court will not always uphold a limitation of liability clause as valid with respect to damages caused by willful misconduct or gross negligence.

If there are too many exceptions, there is little point in having a cap. On the other hand, if even key risks are included under a low cap, recovering damages becomes difficult. In negotiations, flexible adjustments are made, such as making only high-risk events exceptions to the cap, setting a separate cap for breaches of confidentiality and leaks of personal information apart from the ordinary cap, or excluding indirect damages and lost profits as a rule while bringing them back into coverage only for specified serious breaches.

Furthermore, a damages clause does not exist in isolation; it is directly linked to performance terms such as the description of the scope of work (SOW), the specifications and acceptance conditions for deliverables, the SLA (service level agreement), whether subcontracting is permitted and security management obligations. If the scope of work remains vague, the existence of liability and the scope of claims may be disputed no matter how precisely the cap amount is set. In addition, also setting procedural provisions such as a deadline for prompt notice when an incident occurs, cooperation in providing evidence, and the allocation of defense costs when a claim is received from a third party makes communication and cooperation easier when an incident occurs. What we offer for ongoing contract review, including limitation of liability clauses, is described in Legal Outsourcing.

Frequently asked questions

What are damages clauses and limitation of liability clauses in contracts?

They are clauses that set out the scope and maximum amount of monetary compensation that can be claimed when a default or similar event occurs, as well as the requirements for exemption. This is because the parties agree on which of them bears losses arising from the transaction, and to what extent. Based on the principle in Article 415 of the Civil Code, caps and exceptions are likely designed while balancing the contractor's interest in avoiding unlimited liability against the outsourcing party's need to recover actual losses.

Even where a limitation of liability clause is included, what grounds are excepted from the liability cap?

Besides intent and gross negligence, examples include breach of confidentiality obligations, leaks of personal information and infringement of intellectual property rights. This is because including even material risks within a low cap makes it difficult to recover actual losses. Depending on the contract, breach of the anti-social forces exclusion clause is also excepted, but it is understood that limitations of liability for losses caused by intent or gross negligence are not always upheld as valid by the courts.

Are the indirect damages and lost profits used in contract practice the same as the categories of damages under the Civil Code?

The categories used in contract practice and those under the Civil Code do not necessarily coincide. This is because the legal distinction between ordinary damages and special damages under Article 416 of the Civil Code is separate from the distinction among direct damages, indirect damages and lost profits customarily used in contract practice. It is likely necessary to determine, in line with the business, what to exclude and what to keep covered, such as lost sales during a system failure.