Exclusion and limitation clauses: latest developments

Just before Christmas last year, His Honour Judge Bowsher handed down his judgement in SAM Business Systems Limited v Hedley and Company. The case was not in itself unusual; it arose from a dispute between a software supplier and its dissatisfied customer. However, it illustrates some points on the interpretation of exclusion and limitation clauses which are equally applicable to construction contracts.

The facts

SAM was a supplier of computer software. Hedley's were stockbrokers. In mid 1999 Hedley's formed the belief that its existing computer system was not Year 2000 compliant. In order to remedy this, Hedley's entered into an agreement with SAM in October 1999 under which SAM undertook to supply and install new application software to replace Hedley's existing system. The contract, which took the form of a licence agreement, contained "acceptance criteria" for the performance of the software. Detailed provisions for acceptance were set out: thirty days from delivery, Hedley's were to carry out acceptance tests and advise SAM of any instances of failure to achieve the acceptance criteria. If within ninety days of delivery there remained any acceptance criteria which had not been achieved, Hedley's were entitled to initiate procedures for rejecting the software; and SAM were entitled to refer the matter to a dispute resolution process if they considered the rejection unreasonable. There then followed the following clause: "In the event of the application software not being accepted according to the obligations and procedures outlined in sections 2.9 and 2.10, client shall have the right at its entire discretion to rescind this agreement and to be repaid all sums which have previously been paid to SAM in respect of the licence under this agreement. This shall be the sole and exclusive remedy available to client in the event of the application software not being accepted."

By clause 3.2, SAM warranted that it had the right to licence the use of the software and that such use would not infringe the intellectual property rights of any third party. The clause then continued: "Except as set out in the preceding paragraphs of this section 3.2, there are no warranties, either expressed or implied, by this agreement. These include, but are not limited to, implied warranties of merchantability or fitness for a particular purpose, and all such warranties are expressly disclaimed to the extent permissible by law."

By clause 3.3, the agreement continued: "Except as provided in clauses 3.2 and 3.3, SAM will not be responsible for any direct, incidental or consequential damages such as, but not limited to, loss of profits resulting from the use of the software, even if SAM have been advised of the possibility of such damage. Except as provided in clauses 3.2 and 3.3, any liability to which SAM might otherwise become subject shall, in aggregate, be limited to the licence fee paid."

SAM delivered and installed the new software just before Christmas 1999. But there were numerous problems with the software and the acceptance criteria were never satisfied. However, Hedley's never implemented the procedures for rejection set out in the agreement. Eventually, after numerous complaints by Hedley's and numerous attempts by SAM to fix the defects, and over a year after the delivery date, Hedley's decided not to continue with the implementation of the software but to outsource their "back office" functions to another firm.

The proceedings

SAM claimed sums which it alleged were owing to it under the agreement and for post installation support. Hedley's counterclaimed substantial damages for breach of contract and for misrepresentation. One of the things which the judge had to decide was the effect of the clauses set out above. Firstly, he held that the only remedy available to Hedley's on the software not being accepted under the machinery set out in the contract was to reject it. Secondly, he held that the general exclusion and limitation provisions of clauses 3.2 and 3.3 excluded liability for damages of any kind, both direct and consequential, not only for breach of contract but also for misrepresentation. Clause 3.3 excluded any damage "resulting from the use of the software". The judge gave effect to this very wide language and held that all the clauses in combination excluded "every form of liability likely as a matter of practice to arise". Hedley's only remedy lay in the rejection of the software under the acceptance procedures. Accordingly, their counterclaim failed. However, the judge also held that SAM could not claim sums for work done in order to remedy its own breaches of the agreement. The upshot was that judgment was given for SAM for a very small amount and each side had to pay its own costs of the action, including the three week trial.

The Judge's acceptance of a broad effect for the exclusion and limitation clauses in this case reflects an increasing willingness by the courts to abandon the "contra proferentem" principle when interpreting exclusion clauses; this is the principle that such clauses will be construed narrowly against the interest of the party seeking to rely on them. The judiciary have been encouraged to proceed in this direction by the House of Lords: in Bank of Credit and Commerce International SA v Ali & Ors (in 2001) Lord Hoffman said that he considered that the "artificial rules for construction of exemption clauses" had been discarded in 1998 in the case of Investors Compensation Scheme Ltd v West Bromwich Building Society, and replaced with Lord Hoffman's restatement of the general rules for the interpretation of contracts set out in that case.

Construction contracts

It is not unusual to find exclusion clauses in construction contracts, particularly in contracts for the supply and installation of plant. For example, the standard form of contract published by the Joint IMech E/IEE Committee (MF/1) contains an "exclusive remedies" clause which says that the rights obligations and liabilities provided for in the contract are exhaustive of the rights liabilities and obligations of the parties arising out of the contract or the works. Like the exclusion clause in the SAM case, it is widely drawn. It is expressed to apply not only to breaches of contract but also to claims in tort (including negligence) and for breach of statutory duty. MF/1 also contains a provision similar to the acceptance and rejection clause in the SAM contract. The term relating to tests on completion allows the engineer to reject the works and the purchaser to terminate the contract if the tests have not been passed within any time stipulated in the contract.

Obviously each case depends on its own facts and there are many differences between the wording of the MF/1 contract and the contract in the SAM case. Nevertheless, perhaps we can expect the courts to take a similar overall approach to their interpretation to that taken by His Honour Judge Bowsher in the SAM case.

Unfair contract terms

In the SAM case, the contract was on SAM's standard terms of business and therefore the exclusion clauses had to satisfy the so called "test of reasonableness" under the Unfair Contract Terms Act 1977. The judge held that the effect of these clauses was that if the software did not perform, Hedley's could reject it and get their money back but would not have any other remedy. Having regard to the enormous potential liabilities to which SAM might otherwise be exposed, the judge held that these arrangements were reasonable. The parties were of similar size and resources. There was evidence that other software companies had similar exclusion clauses in their standard contracts. Hedley's were in a difficult negotiating position of their own making because of their lateness in tackling the problem of Year 2000 compliance, and did not even try to negotiate terms more favourable to them.

Construction contracts are not usually concluded on the standard terms of business of one party (a standard form of contract published by a trade or professional association is not one party's standard terms of business unless that party conducts its business in such a way as to make it so). However, it is worth remembering that the reasonableness test applies to terms in business to business contracts which purport to exclude or restrict:

• liability for negligence (other than liability for death or personal injury – which cannot be excluded at all);
• liability under terms implied by law as to quality or fitness for a particular purpose of goods supplied; and
• liability for misrepresentation, irrespective of whether the terms are included in a party's written standard terms of business.

Whether or not the reasonableness test is passed will depend upon the particular facts surrounding the contract at the time it was entered into. However, the court's acceptance of the exclusion clauses in the SAM case is to be contrasted with the abhorrence of similarly wide exclusion clauses shown by the Court of Appeal earlier last year in Britvic Soft Drinks and others v Messer UK Ltd and another.

A fair result?

All this makes it much more difficult to advise upon the effectiveness of such clauses. It allows the courts, perhaps, greater flexibility to do justice in particular cases. Whether justice was done in the case of SAM v Hedley's, however, is a matter which it would perhaps be futile to debate.

For further information please contact Peter Long at [email protected] or on +44 (0)20 7367 2507.