Limitation of Liability Clauses in IT Agreements

This article discusses circumstances where the standard limitation of liability clause may not be enough to minimise the liability contracting parties may become exposed to when dealing with IT contracts.

It has become common practice for software vendors to include a limitation of liability clause in all software development or license agreements. The purpose of the limitation of liability clause is to assist software vendors to restrict the maximum liability to which they are exposed, in the event that a project goes wrong. This would also allow software vendors to estimate the risk of a project and therefore price the agreements accordingly. However, the interplay of the UK Sale of Goods Act (‘SGA’) and the UK Unfair Contract Terms Act (‘UCTA’) often affect the validity of these clauses.

As demonstrated in the case of St Alban v ICL [1997] FSR 251, computer software is considered as ‘goods’ if it is supplied on a physical media. Therefore the supply of computer software is generally governed under the SGA. The case seems to suggest that, if a computer program were supplied by direct installation, it may be possible to argue that the SGA is not applicable.

Section 12(2) of the SGA and IP Infringement

Section 12(2) of the SGA states:

In a contract of sale, other than one to which subsection (3) applies, there is also an implied warranty that:

(a) the goods are free, and will remain free until the time when the property is to pass, from any charge or encumbrance not disclosed or known to the buyer before the contract is made; and

(b) the buyer will enjoy quiet possession of the goods except so far as it may be disturbed by the owner or other person entitled to the benefit of any charge or encumbrance so disclosed or known.

Section 12(2)(a) and (b) essentially state that a purchaser of goods should enjoy the right to use the goods unless the purchaser is informed that the goods are subject to other third party rights. If any third party rights are involved, the seller must inform the buyer of the third party rights prior to the contract of purchase being made. Hence, in the context of a software agreement, the software vendor must ensure that licensee’s licensed use of the software must not infringe any existing third party intellectual property rights.

The operation of s 12(2)(b) is demonstrated in the case of Microbeads AG v Vinhurst Road Markings [1975] 1 WLR 218 where the goods sold were, at the time the property in them was to pass to the buyer, not subject to any patent. Subsequently, a third party patent specification was published and the patent was granted. The third party claimed against the buyer for patent infringement. The United Kingdom Court of Appeal held that the seller was in breach of the implied term of quiet possession under s 12(2)(b) of the SGA.

Section 14 of the SGA

Section 14 of the SGA also states that where the seller sells goods in the course of a business, there is an implied condition that the goods supplied under the contract are of satisfactory quality. Goods are considered to be of satisfactory quality if they meet the standards that a reasonable person would regard as satisfactory, taking account of any description of the goods, the price and all the other relevant circumstances. Aspects of the quality of goods considered would include the state and condition of the goods, the fitness for the purpose the goods of the kind are commonly supplied for, the appearance and finish of the goods, whether the goods are free from minor defects, the safety in using the goods and the durability of the goods. In the context of software agreements, it imposes a burden on the software vendor to ensure that the software is of satisfactory quality and fit for the purpose that the software is sold.

UCTA and Limitation of Liability Clauses

Prima facie, the burden imposed on the software vendor by s 12 could not be excluded or limited as the UCTA prohibits the exclusion of this implied term. Section 6(1)(a) of the UCTA clearly states that liability for breach of the obligations under s 12 of the SGA could not be excluded or restricted by reference to any contractual term.

The UCTA would only permit the exclusion or limitation of liability arising from breach of s 14 of the SGA if the exclusion or limitation satisfies the test of reasonableness. In relation to software agreements, in deciding the issue of reasonableness, the court in Salvage Association v CAP Financial Services [1995] FSR 654 considered the following factors:

the relative bargaining strength of the parties: is the court dealing with a one-off situation between parties of equal bargaining power? If so, the requirement would be more easily discharged than where the disclaimer is imposed on a purchaser who has no effective power to bargain;
the nature of the task undertaken: a high risk of failure would be a pointer towards the reasonableness of excluding liability as a condition of doing work. However, where the task should present no difficulty with reasonable skill and care, it is less appropriate to exclude or limit liability; and
the practical consequences of the decision on the question of reasonableness, having regard to the sums of money potentially involved and the availability of insurance to meet such losses. If the software vendor were able to insure the risk, the software vendor would be in a better position to meet such losses.

In recent years, the English courts have provided decisions where the test of reasonableness was applied in varying degrees of stringency. The case of St Alban v ICL demonstrated a very stringent test of reasonableness, which was in favour of the software purchaser.

However, the Court of Appeal decision in Watford Electronics Ltd v Sanderson CFL Ltd [2001] EWCA Civ 317, has shifted the equilibrium towards the software vendor.

In Watford Electronics Ltd v Sanderson CFL Ltd, Watford purchased an inventory management software from Sanderson. The system failed to perform and Watford sued Sanderson. The agreement excluded all liability for indirect and consequential losses arising from negligence or otherwise, and also limited liability for all damages to the contractual value paid by Watford. The Court of Appeal found that the clauses were not unreasonable as:

the software was customised and therefore posed a greater risk to the supplier should the software not perform to the customer’s satisfaction;
the parties had contemplated the risk of the software not functioning properly;
Sanderson was in a better position to assess the likelihood of software failure and Watford was in the better position to assess the amount of the potential loss if the software failed to perform; and
the risk of loss was insurable and the identity of the party who was to bear the risk of loss (or to bear the cost of insurance) was a factor which would be taken into account in determining the price at which Sanderson was willing to supply the product and the price at which Watford was willing to purchase.

A review of the above cases seems to suggest that validity of the limitation of liability clause is very much dependent on the facts of each case. This affects the commercial interest of software vendors as they are not able to put a value to their potential exposure from each software agreement. In addition, the patentability of business methods has increased the risk for software vendors as it may not be possible to limit liabilities arising from the breach of s 12 of the SGA.

Instances Where Sections 6 and 7 of the UCTA are Not Applicable

In certain circumstances, it is, however, possible to circumvent the operation of the UCTA. Section 26 of the UCTA states that the restriction to exclude or limit liability does not apply to international supply contracts. Section 26(3) and (4) state that international supply contracts are agreements where the parties are from different contracting countries and:

the goods supplied are, at the time of the conclusion of the contract, in the course of carriage, or will be carried, from the territory of one country to the territory of another;
the acts constituting the offer and acceptance of the agreement have been done in the territories of different countries; or
the contract provides for the goods to be delivered to the territory of a country other than that within whose territory those acts were done.

Hence, in a situation where the performance and delivery of the software is between parties of two different countries, the software agreement may fall within the ambit of an international supply contract. In such circumstances, the limitation of liability clause may still operate to limit liability arising from intellectual property rights infringement.

The other exception lies in s 27(1) of the UCTA, which states:

Where the proper law of a contract is the law of Singapore only by choice of the parties (and apart from that choice would be the law of some country outside Singapore) sections 2 to 7 do not operate as part of the proper law.

The provisions in the UCTA restricting the exclusion or limitation of liability (in this case s 6) do not apply to a contract where the law of a contract is the law of Singapore only by choice of the parties, and apart from that choice, the proper law would be the law of another jurisdiction.

Conclusion

Software vendors ought to be aware of the potential pitfalls in relying extensively on limitation of liability clauses. It would be folly for software vendors to assume that the limitation of liability clauses found in their standard term agreements are valid in all circumstances. Such clauses ought to be reviewed on the basis of the factual matrix of each agreement.

Cyril Chua
Alban Tay Mahtani & de Silva
E-mail: cyrilchua@atmdlaw.com.sg