Limiting damages: how to set your limits before you get into trouble

What does limitation of damages mean under the NCC and why is it used

Limitation of damages is a contractual arrangement whereby the parties limit in advance the maximum extent of their liability for any damage that may occur. In practice, it is often used in commercial relationships, particularly in the IT, construction or service industries, where there are high risks and potentially significant damages. The New Civil Code (NCL) allows for such a procedure and respects the principle of freedom of contract, according to which the parties may adjust their rights and obligations at their own discretion.

Limiting damages can take various forms. For example, it may be a determination of the maximum amount that the obliged party is willing to pay, a definition of the types of damages to be compensated or the exclusion of compensation for so-called consequential damages (e.g. lost profits). However, the key point is that any such arrangement must be clear, understandable and agreed before the damage occurs.

In practice, the use of limitation of damages has two main effects: first, it provides the parties with certainty that any financial impact will not be liquidating, and second, it helps to allocate risks fairly between the parties to the contractual relationship. A well-designed cap can thus become an important preventive tool to avoid disputes and increase legal certainty for both parties.

For the sake of simplicity, we use the term ‘damage’ in this article, although the Civil Code generally uses the broader term ‘injury’, which includes both pecuniary damage and non-pecuniary damage (e.g. interference with personality rights).

When limitation of damages is permissible under the NPL

The NPL is based on the principle of autonomy of will and therefore generally allows parties to agree on a limitation of their liability. In practice, limitation of damages is most common in commercial relations between businessmen where the parties can be assumed to be in a relatively balanced position. However, the Civil Code allows for the limitation or exclusion of the obligation to compensate damages in general, subject to the limits in particular in section 2898 of the Civil Code and consumer protection regulations. The law does not prescribe the exact form of such an arrangement, so it is left to the parties to determine how they construct the limit.

However, in order to be valid, the limitation of damages must meet several essential conditions. The arrangement must be unambiguously worded and be part of a contract or terms and conditions that have been demonstrably presented to the other party. Otherwise, it could be a so-called surprise arrangement, which is invalid.

The scope of the limitation should also be appropriate to the nature of the obligation, the value of the performance and the distribution of risks. An unreasonable or extreme limitation may be considered void for breach of good morals. It is also important to take into account whether there is inequality between the parties – for example, consumers have significantly stronger legal protection. In their case, the possibility of limiting liability is significantly narrower.

Limits which the NPL does not allow to be crossed

Although contractual limitation of damages is generally permissible, the NPL also provides for several clear exceptions where such an arrangement does not apply. The essence is the protection of fundamental rights and the prevention of abuse of the position of one of the parties.

1. Intentional infliction of damage

Any limitation that applies to damage caused intentionally is invalid. The Civil Code expressly states that liability for intentional breach of duty cannot be limited or excluded. Therefore, the parties cannot agree in advance that the guilty party will not be liable for damages in the event of a deliberate breach of contractual obligations.

2. Gross negligence

Arrangements which seek to exclude liability for damage caused by gross negligence or intent are also usually invalid. They are expressly disregarded by the courts.

3. Restrictions on consumer protection

In consumer contracts, the possibilities for limitation are significantly limited. Arrangements which derogate from specific provisions for the consumer’s protection to the consumer’s detriment are disregarded under the law, and arrangements which exclude or restrict the consumer’s rights to defective performance or compensation for damage are expressly regarded as abusive.

4. Obligations under the law

In certain specific legal sectors (e.g. construction, transport, occupational safety), the law imposes obligations whose breach cannot be excused or limited by contract. An arrangement that attempts to exclude liability for breach of statutory obligations is void ab initio.

5. Injury to the natural rights of man

The law expressly prohibits the prior exclusion or limitation of an obligation to compensate for injury to a person’s natural rights (e.g. health, dignity, honour). Such an arrangement is not taken into account at all.

6. Weaker party

An arrangement which limits or excludes in advance the right of a weaker party to compensation for any damage is expressly disregarded by law (Art. 2898 CC). The weaker party may be not only the consumer but also a business in an unequal position.

One badly written sentence in a contract can make a million-dollar difference in who pays the damages.

How to correctly set the limitation of damages in a contract

In order for the limitation of damages to serve its purpose and stand up in court, it is essential to pay maximum attention to its wording. In practice, we often encounter overly general or incomprehensible wording that can lead to invalidity or subsequent litigation.

The first step is to be aware of the risks inherent in the contractual relationship. On this basis, it can be determined what is appropriate to limit – whether a financial limit, a limitation to specific types of damages or a complete exclusion of indirect damages. It is important that the scope of the limitation corresponds to the actual value of the performance and does not act as a unilateral exclusion of liability.

For the purposes of legal certainty, it is useful to define terms such as ‘direct damage’, ‘indirect damage’, ‘consequential damage’ or ‘loss of profit’, as it is in their interpretation that the most frequent disputes arise. A well-formulated clause should be clear enough to be enforceable without complex legal interpretations.

It is also essential in commercial terms and conditions to ensure that they are actually presented to the other party and demonstrably accepted. Otherwise, the limitation clause may be considered surprising and therefore invalid. From our own experience, we recommend that the contract explicitly declares that both parties know and agree to the terms and conditions.

What to avoid when negotiating the limitation of damages

One of the most common mistakes is to define the limitation too generally, for example, a clause such as “a party is not liable for any damages”. Such a clause is usually invalid because it contravenes the law and the principle of good morals.

Another problem arises when parties fail to distinguish between intentional breach, gross negligence and ordinary negligence. If the contract does not deal with these concepts precisely, it may be unclear what situation the limitation actually applies to.

It is also common for the maximum amount of compensation not to be specified or to be set in a way that does not reflect the reality of the contractual relationship. If, for example, a contract with a performance value of millions provides for liability up to only a few thousand crowns, such an arrangement may be considered unreasonable.

It is also a big mistake to rely on copying foreign clauses or models of limitation of damages found on the internet. Each contractual relationship is specific and generic models often do not take into account the specific risks, nature of performance or current legislation. A poorly drafted clause may end up having more legal risk than no limitation at all.

Finally, situations where parties neglect to document the transmission of terms and conditions or other formalities should be mentioned. Although these are seemingly minor details, they can make the difference between a court upholding the limitation or not.

Our recommendations on limiting damages

In our practice, limitation of damages arises in a wide range of contracts – from IT projects to leases to business-to-business sales contracts. Each sector has its own specificities. For example, in the IT sector, it is common for a service provider to limit its liability to an annual fee or lump sum. This is because the real consequential damages may be significantly higher than the value of the service itself.

Experts recommend that a realistic risk assessment should always be used. A well-designed limitation of damages should protect both parties, not just avert the risks to one of them. At the same time, the clause should be flexible enough to withstand unforeseen situations. This often means a combination of a type limitation (e.g. exclusion of indirect damages) and a financial limit.

It is also advisable to include an obligation to notify the damage without undue delay in order to minimise its consequences. Many disputes arise precisely because the injured party reported the damage late and the other party did not have the opportunity to avert or mitigate the damage.

Last but not least, we must also mention the updating of contractual documentation. Legal conditions and the business environment may change and outdated contractual provisions may no longer reflect current legislation or business reality.

Summary

Limitation of damages is a contractual instrument that allows the parties to define in advance the maximum extent of liability for damages and thus to allocate risks fairly, which is particularly useful in the commercial, IT or construction sectors; the NCC allows such an arrangement but requires that it be clear, reasonable, agreed before the damage occurs and not surprising. A limitation is only valid if it is appropriate to the value of the performance and the nature of the obligation, and it must never cover damage caused by intent, gross negligence, breach of statutory duty or be used to disadvantage the consumer. When negotiating it, it is essential to define precisely the types of damages, set a realistic financial limit, not adopt poor quality ‘model’ clauses and ensure that the terms and conditions are properly communicated and accepted. Experts recommend to base the limitation on a realistic risk assessment, combine financial limits with a type of claim limitation, negotiate an obligation to notify claims quickly and update the documentation regularly. A properly set limitation increases certainty, protects both parties and prevents disputes; otherwise it may be invalid or completely unworkable.