Risk Management
Limiting liability using Letters of Engagement
Article by Karen Eckstein
Founder Lake Legal LLP
April 2010
What is a liability cap?
It is a term included in the contract between a professional adviser and his client which can limit the amount that the client can recover against the adviser in the event of a negligence claim arising out of the work undertaken pursuant to the contract. In other words, professionals can, through proper use of liability caps, minimise their potential risk and exposure to substantial claims.
A prudent professional will consider the use of liability caps, and the level of the cap to be imposed, and would be unwise to agree a liability cap exceeding the level of his professional indemnity cover.
Proper use of a liability cap can therefore be a very powerful tool in minimising risks for professionals. However, a liability cap is not something that can be imposed without careful thought and proper process.
The Unfair Contract Terms Act 1977 will apply to strike out a liability cap if it is held to be unreasonable. If the cap is held to be unreasonable for any reason, the cap will be deleted in its entirety and not reduced to a more reasonable level. Careful consideration should therefore be given to the principle of limitation of liability, how it is to be applied in different cases, the reason for selecting the limit put forward and the type of cap to be imposed.
What types of cap can be imposed?
There are various ways by which a professional’s liability may be limited. The simplest is by reference to a simple monetary cap. Another alternative is to limit liability proportionately. If more than one adviser is acting in a matter, the liability cap imposed by the professional could state that that professional’s liability will only be for, say, 50% of any loss, whether the other person responsible for the loss can be sued or not. Some people impose a liability cap by reference to a multiple of the fee arising in the transaction (although in my view, caps set by reference to a multiple of fee are vulnerable to being struck out for being unreasonable).
How does someone impose a liability cap?
First of all, they need to consider the terms of the Unfair Contract Terms Act 1977.The test for reasonableness is contained within the Act and the Court would have to consider whether the term is fair and reasonable having regard to the circumstances which were reasonably known or in the contemplation of the parties when the contract was made.
It is important therefore, when considering whether or not to limit liability, that the professional takes into account the strength of the parties’ respective bargaining positions, other sources of advice available to the client, the extent to which the term will be brought to the attention of the client, the resources available to each party to meet any liability and the extent to which each party could protect themselves by insurance.
Against that background the professional should consider the limit to be applied by reference to factors such as the amount at stake, the assets likely to be available to the client to meet any liability or to meet any loss if the adviser’s liability is limited as proposed, and the insurance cover available to the professional.
Before imposing a limit, the professional should ensure that the client is given a clear explanation of the limitation and its effects, the reasons for limiting liability should be expressed explicitly and an opportunity should be given to the client to consider the limit, to negotiate the limit if he wishes to do so, and to take independent advice before agreeing the limit.
Where a relatively standard limit is applied, it is unlikely that much further negotiation will be practical and desirable and it is therefore important that such terms are drawn clearly to the attention of the client.
The liability cap has to be reasonable in the context of the scale and nature both of the assignment in question and the practice. The professional will need to be able to demonstrate that the liability cap is fair and reasonable. I am often asked by practitioners whether they could apply a limit which bears a close relationship to the actual level of indemnity cover that the professional is carrying. My view is that that is a risky stance to take. Cover is provided on a claims made basis. Any claim arising from an engagement may not be made until several years later, by which time the level of cover may be significantly higher (or lower). Indemnity limits often include sums payable to the Claimant for his costs, and claims may be aggregated where simple errors are made on more than one occasion for the same, or depending on the policy wording, different clients.
If the limit of liability required by the client is greater than the cover available to the professional, the professional should consider carefully whether or not to accept the engagement or to purchase reinsurance in order to protect himself. Any liability cap should be set below the level of the professional’s limit of indemnity.
As well as getting the level right and discussing it with the client, the professional needs to think about how he imposes the cap. The contract term should be set out clearly in writing. In my view, the limitation should be included within the standard terms and conditions, but the specific provision should be included in any engagement letter.
Limitations of liability contained only in standard terms and conditions would be far more susceptible to a challenge than those which are included within a specific engagement letter. It will be easier to justify the limitation of liability if it is defined elsewhere than the standard terms and conditions.
If the engagement letter is in the form of a covering letter, a schedule of services and standard terms and conditions, then there is a risk that the client will look only at the schedule of services. Therefore, I would recommend that the schedule of services refers to the limitation of liability, and that that limitation of liability is then set out in detail in the covering letter so that the specific details are highlighted to the client.
Is a liability cap the answer to risk?
A professional who has carefully considered the limitation of liability to be applied, has agreed this with the client, and set it out clearly and drawn it to the client’s attention in the engagement letter may think that he has done all that he needs to protect himself. Sadly, that is not strictly true.
All too often, a claim is brought against a professional and, when I ask to see the engagement letter, there is no signed engagement letter on file. All too often, there is not even a file copy of the engagement letter indicating that an engagement letter was sent to the client for agreement. The lack of a signed engagement letter back from the client is not necessarily fatal to an argument that a liability cap should be imposed, but it does make the evidential burden (of proving that the term has been agreed with the client) more difficult.
One of the other areas that has to be considered carefully is whether or not the engagement letter actually covers the work undertaken. All too often I see cases where an engagement letter has been issued at the outset, but the work undertaken by the professional has expanded substantially since the engagement letter was originally drafted. The work in respect of which any claim is brought may not therefore fall within the terms of the engagement letter. Again, it may be possible to argue that the terms and conditions applicable in the engagement letter apply to all work undertaken by the professional for that client, but the lack of an engagement letter covering the specific work in question which gives rise to the claim makes it harder to defend the imposition of a liability cap in that respect.
Another problem area is that all too often an professional will draft an engagement letter for a client (for example a company) and then undertake work for third parties (perhaps the directors in their personal capacity) and does not issue a fresh engagement letter for those individuals. Those individuals are not party to the contract between the professional and the company and therefore not subject to the terms and restrictions included, including the liability cap. In those cases, the professional is then exposed to potential claims beyond the limit of the indemnity cover.
Further, the liability cap is a contractual term between the parties. If a third party therefore relies on the advice of a professional and is able to pursue a claim against the professional as a result, that third party is not subject to the contractual terms agreed between the professional and his client, and is not therefore subject to the limitation of liability contained therein.
Therefore, whilst liability caps are a useful tool in minimising and mitigating risk for professionals, they are not a panacea or a substitute for proper risk management.
Karen Eckstein