Press Articles & Comment

Allocating Risk in IT contracts: limitations and exclusions under ucta

(Paul O'Hare, Partner, Kemp Little LLP, appearing in CLSR, January 2005)

A REVIEW OF THE CASE LAW ON THE ENFORCEABILITY OF LIMITATIONS AND EXCLUSIONS UNDER THE UNFAIR CONTRACT TERMS ACT 1977

Introduction

Contracts involving the supply and installation of IT systems, particularly those involving the supply of bespoke systems or the customisation of standard systems, are inherently risky. It is common practice, therefore, for suppliers of IT solutions and services to limit their liability in supply contracts. Their ability to do so in the UK is restricted by a number of statutory frameworks. These include (i) the Unfair Contract Terms Act 1977 (UCTA), (ii) the Misrepresentation Act 1967 (MA); and (iii) in business to consumer contracts, the Unfair Terms in Consumer Contract Regulations 1994 (UTCCR)[i] .

The past decade has seen a number of cases in the IT sector in which the UK courts have had to consider the enforceability of contract limitations and exclusions under UCTA. The courts' approach in these cases, starting with the landmark decision in St. Albans District Council v ICL [ii], can broadly be characterised as increasingly pro-customer and interventionist. This interventionist approach appears to have reached a high water mark with the Court's decision in Pegler v Wang (UK) Limited [iii]; subsequent cases suggest a marked change in the courts' approach to enforcing limitations and exclusions, with the courts showing a much greater reluctance to intervene in agreements reached between experienced commercial organisations.

As will be seen below, this change in approach has had a significant impact on how customers and suppliers approach the drafting and negotiation of IT contracts. In this article, Paul O'Hare looks at these case developments and the lessons that suppliers and customers can learn from them.

Background to the statutory framework

Under UCTA: (i) terms which exclude or restrict liability for death or personal injury caused by negligence are wholly ineffective (s2(1)); and (ii) terms which exclude or restrict liability for other loss or damage caused by negligence are enforceable only to the extent that they satisfy the UCTA 'requirement of reasonableness' (s2(2)). These rules apply whether or not a supplier is dealing on standard terms.

In addition, in consumer contracts, and in business to business contracts where the supplier is dealing on its 'standard terms of business', terms which seek to allow the supplier to: (i) limit or exclude liability for contract breach; (ii) render a contractual performance substantially different to that which was reasonably expected of him; or (iii) render no performance at all, are enforceable only to the extent that they satisfy the UCTA 'requirement of reasonableness'.

Meaning of 'standard terms of business'

UCTA does not provide a definition of, and gives no guidance as to what constitutes, a party's standard terms of business. However, the English courts have shown that they will give this term a wide meaning.

Case law has established that not all of the terms need to be fixed by the supplier for him to be regarded as dealing on standard terms: even where some clauses have been heavily negotiated, the parties can still be treated, for the purposes of UCTA, as dealing on the supplier's standard terms if the limitations and exclusions in the contract have been left untouched [iv]; even where changes have been made to the limitations and exclusions, UCTA may still apply if those changes are not material. In Pegler v Wang (UK) Limited , for example, the parties were held to be dealing on Wang's standard terms, despite the fact that (i) Pegler had managed to incorporate into the contract many of its own standard terms, (ii) the parties had agreed that those terms would take precedence over the other terms of the contract, and (iii) Wang had agreed (minor) changes to the limitations and exclusions.

These judgments indicate that the UK courts are likely to find that a supplier is, for the purposes of section 3 of UCTA, dealing on its standard terms of business unless there have been material changes to the limitations and exclusions in the contract.

The UCTA 'reasonableness test'

Where UCTA applies, contract terms which exclude or limit liability, and similar terms, are enforceable only to the extent that they satisfy the UCTA 'requirement of reasonableness'. A contract term which is subject to the requirement of reasonableness must be "a fair and reasonable one to be included having regard to the circumstances which were, or ought reasonably to have been, known to or in the contemplation of the parties when the contract was made" (s11(1)).

UCTA sets out a non-exhaustive list of guidelines to be taken into account in assessing whether or not a term satisfies the requirement of reasonableness. While, under s11(2) of UCTA, these factors are strictly only relevant in assessing the reasonableness of terms which seek to limit or exclude liability for breach of the terms implied under the Sale of Goods Act 1979 (broadly, implied terms that goods conform with their description, are of satisfactory quality and are fit for purpose), the UK courts have shown that they are prepared to apply these guidelines to all terms seeking to restrict or exclude liability.

The relevant factors laid down by UCTA are, broadly:-

The relative strength of the parties' bargaining positions;
Whether the customer received an inducement to agree to the term in question, or whether the customer had an opportunity of entering into a contract with other persons without having to accept a similar term;
Whether the customer knew (or ought to have known) of the existence of the term;
Where the term excludes or restricts liability if some condition is not met, whether it was reasonable at the time of the contract to expect that compliance with that condition would be practicable;
Whether the goods were manufactured, processed or adapted to the special order of the customer.

In addition, in relation to liability caps and other contract provisions which limit liability to a specific amount, the courts will take into account "(a) the resources which the person seeking to rely on the limitation could expect to be available to him for the purpose of meeting the liability should it arise and (b) how far it was open to [that person] to cover himself by insurance" (s11(4)).

While the UK courts have, in most cases, placed at least some emphasis on the UCTA guidelines in assessing the reasonableness (or otherwise) of the relevant limitations and exclusions, it is apparent from the case law that the significance that the courts will place on these guidelines will vary from contract to contract and the courts have shown that they will take into account additional factors in making its assessment as to the reasonableness of those terms where they consider it appropriate to do so.

St Albans District Council v ICL

The first case of significance in which the application of section 3 of UCTA and the UCTA guidelines on reasonableness were considered in the context of an IT project was St Albans District Council v ICL . This case demonstrates the importance that the UK courts will place on the insurance cover that the contracting parties have available to them in assessing whether the risk of project failure has been fairly allocated under the contract. In this case, in addition to the unequal bargaining positions of the parties, and the fact that, in the Court's view, ICL had the Council "over a barrel" because of the tight timescale which the Council had in which to implement the new system, one of the key factors in the Court finding a liability cap of £100,000 to be unreasonable was that ICL had in place product liability insurance of £50 million, and was therefore in a much better position to bear the risk than the Council, who would have had to recover the loss from the local population through increased taxation. In the Court's view, ICL had called no evidence to show that the £100,000 cap was "fair and reasonable" given the level of insurance that was available to it.

South West Water v ICL [v]

St Albans District Council v ICL was followed a couple of years later by another case involving ICL . South West Water v ICL involved a contract for the supply of a customer information and billing system. ICL 's solution was based on a third party product owned by Custima International (CI), a company in which ICL had a 30% share. ICL 's ability to deliver a system which would meet South West Water's requirements was dependent upon ICL entering into a back-to-back contract with CI. CI felt that the contract timetable which ICL was intending to sign up to was unrealistic and so refused to enter into a back-to-back contract with ICL . ICL nevertheless assured South West Water that it would be entering into a back-to-back contract with CI and, on the basis of that assurance, South West Water awarded the contract to ICL . Perhaps not surprisingly, the project failed and South West Water brought a claim against ICL for breach of contract and misrepresentation.

ICL argued that it had not committed a contract breach and, in any event, sought to rely on the limitations and exclusions in the contract. These included: (i) a term limiting ICL 's liability for delivering a system which failed acceptance testing to the price paid under the contract (roughly £2.2 million); (ii) a term limiting ICL 's liability for all other breaches to £250,000; and (iii) an entire agreement clause, under which ICL sought to exclude all statements and representations not set out in the contract.

The Court held that the limitations were UCTA unreasonable. In addition to the fact that the £250,000 cap bore no relation to the total contract value, the Court also placed significant emphasis on:

the 'manifest unreasonableness' of the contract terms - these meant that South West Water was in a worse situation where ICL failed to deliver anything under the contract (since ICL 's liability in those circumstances was limited to £250,000) than it would have been had ICL delivered a system which failed acceptance testing (where ICL 's liability was limited to the contract value); and
the 'reckless' pre-contract misrepresentation which ICL had made about entering into a back-to-back contract with CI. The Court rejected ICL 's argument that this pre-contract representation was excluded by the entire agreement clause - the Court followed the decision in Thomas Witter Ltd v TBP Industries Ltd [vi], to find the entire agreement clause unenforceable on the grounds that, because it failed to distinguish between innocent, negligent and fraudulent misrepresentation, it impliedly sought to exclude liability for fraudulent misrepresentation and was, therefore, unenforceable.

Pegler v Wang (UK) Limited [vii]

As noted above, the pro-customer, non-interventionist approach of the UK courts appears to have reached a culmination in Pegler v Wang (UK) Limited . This case also serves as a useful illustration of the application of the contra proferentem rule of construction, under which any ambiguities in a contract term are construed against the party who drafted the term.

The case involved a contract for the supply of an integrated computer system and related services. The project suffered serious problems right from the start and the judge went as far as describing Wang's performance under the contract as "disastrous". Wang did not deny that it was in breach (in fact, it formally admitted to over 500 individually identified breaches of contract, amounting to a wholesale failure to provide Pegler with the computer system and related services). However, Wang sought to rely on a number of exclusions and limitations in the contract. These included a clause excluding liability for "any indirect, special or consequential loss, howsoever arising (including but not limited to loss of anticipated profits or of data) in connection with, or arising out of, the supply, functioning or use of the [system].".

The Court held that Wang could not rely on this exclusion in these circumstances:

first, because the exclusion specifically referred to loss arising out of the "supply, functioning or use" of the system, the Court took the view that it applied only after the system had been supplied - it did not apply to a failure to deliver the system in the first place (as was the case here); in the Court's view, if the parties had intended the clause to apply to a failure to deliver the system, the clause should have referred to this scenario; and
second, because loss of anticipated profits had been included as an example of indirect and consequential loss, the clause did not exclude liability for direct loss of profits. It is now well established that loss of profits (and other forms of 'economic' loss) can be and, in many cases, is a form of direct loss under English law [viii

Although the Court in this case did not need to do so (since the relevant provisions did not cover the liability in question in the first place), it went on to consider whether the limitations and exclusions in the contract were UCTA reasonable. The Court decided that they were not. One of the key factors in the Court reaching this conclusion was the degree of oversell by Wang as to the fit between its solution and Pegler's requirements: Wang had informed Pegler that its solution was a perfect fit for Pegler's requirements, despite the fact that Wang's internal analysis had shown that several modifications to its solution would be required. The Court in this case drew a distinction between attempts to limit or exclude liability for breaches that were not "readily foreseeable" on the one hand, and attempts to do so in circumstances where the degree of oversell by a supplier meant that contractual breaches were "not unlikely": the exclusions and limitations in a contract were much less likely to be reasonable in these latter circumstances.

A change in direction?

The decisions in the above line of cases was interpreted as a clear indication of the UK courts' willingness to intervene in contracts in relation to which the courts considered that the supplier had acted 'unfairly'. This approach led many suppliers to question whether it would ever be possible, in practice, to limit their potential liability in failed IT projects. It also led to a significant change of tack by customers in relation to the negotiation of IT contracts: rather than attempt to negotiate acceptable exclusions and limitations in a contract, many customers accepted whatever terms were put forward by suppliers (the more draconian the better) on the basis that, if the contract were ever litigated upon, the exclusions and limitations would be held to be unenforceable by the UK courts.

There have now been a couple of IT cases in which the limitations and exclusions in a supplier's standard terms have been held to be UCTA reasonable. The judgments in these cases suggest that the UK courts are currently much less prepared to intervene in commercial contracts, particularly those in which the parties are of equal bargaining power, and suggest that the customer practice of accepting whatever limitations and exclusions that are put forward by suppliers on the grounds that they can later be challenged as UCTA unreasonable is now a dangerous one.

The first IT case in which this less interventionist approach was seen was Watford Electronics v Sanderson CFL Ltd [ix]. The case involved a contract for the supply of a mail order processing and database marketing computer system for use by Watford in its computer mail order business. The system delivered by Sanderson failed to meet Watford 's requirements and, after several unsuccessful attempts by the parties to resolve the problems, Watford terminated the contract and brought a claim for breach of contract and misrepresentation.

Sanderson sought to rely on a contract term which (i) excluded its liability for indirect and consequential loss and (ii) limited its liability in any event to the price paid under the contract. The contract also contained an entire agreement clause by which the parties acknowledged that they had not relied on any statements or representations not set out in the contract.

At first instance, the exclusion was found to be UCTA unreasonable. Sanderson appealed and the Court of Appeal overturned the earlier decision and held the exclusion to be reasonable. In reaching this decision, the Court of Appeal found that the judge at first instance had made three key errors: first, the judge was wrong to assume that the exclusion applied to negligent pre-contractual misrepresentations - this was not correct, since the parties had acknowledged (through the entire agreement clause) that they had not relied on any pre-contract representations. The fact that the entire agreement clause had been drafted as an acknowledgement of non-reliance and not a blanket exclusion of pre-contract representations was significant and was something that the judge at first instance had overlooked; second, Watford had managed to negotiate an addendum to the contract requiring Sanderson to use best endeavours to minimise any losses that may arise from a contract breach: again, the judge at first instance was wrong to dismiss this addendum as insignificant - its inclusion meant that Sanderson could not rely on the exclusion unless it had met this 'best endeavours' obligation; and third, Watford had similar liability provisions in its own standard terms - this was relevant to the assessment of whether or not Watford understood the term and the commercial reasoning for its inclusion.

With the exception, perhaps, of the wording of the entire agreement clause, the above factors are relatively case-specific and are likely to be of limited use in assessing the merits of future cases. However, in addition to these specific facts, the Court of Appeal, in deciding that it should not intervene in the agreement struck between the parties, placed considerable emphasis on the fact that the parties in this case were of equal bargaining power and went on to make the following statement:

"Where.substantial companies of equal bargaining power negotiate an agreement [they should] be taken to be the best judge of the commercial fairness of the agreement which they have made; including the fairness of each of the terms in that agreement. They should be taken to be the best judge on the question whether the terms of the agreement are reasonable.Unless satisfied that one party has, in effect, taken unfair advantage of the other - or that term is so unreasonable that it cannot properly have been understood or considered - the court should not interfere".

It is likely that this statement will be seized upon by suppliers in future cases, particularly in contracts where the customer is of broadly equivalent bargaining power, to argue that the courts should not intervene in the agreement reached by the parties.

The non-interventionist approach by the Court of Appeal in Watford Electronics v Sanderson CFL Ltd was followed in the latest IT case in which exclusions and limitations have been considered in the context of UCTA. SAM Business Systems Ltd v Hedley & Co [x] involved a contract for the supply of a transfer settlement system to Hedley, a firm of stockbrokers. The system was beset with technical problems following installation and, eventually, Hedley gave up on the system and looked for an alternative solution. Hedley refused to pay SAM what it believed was due, SAM issued proceedings for the unpaid amount and Hedley counterclaimed for damages, breach of contract and misrepresentation.

The contract contained what the judge described as a "belt and braces collection of overlapping exclusions and limitations". These included: (i) an entire agreement clause, which SAM sought to rely on to defeat the misrepresentation claim; (ii) an exclusion of all warranties, including the statutory implied terms; (iii) a clause excluding liability, not only for indirect and consequential loss, but also for direct loss and (iv) a clause limiting liability "to which SAM might otherwise be exposed" to the licence fee paid.

The Court held that the contract was on SAM 's standard terms and that s3 of UCTA, therefore, applied. Significantly, the Court held that s3 of UCTA applied not only to the exclusions and limitations in the contract, but also to the entire agreement clause, on the grounds that, by virtue of that clause, SAM claimed to be entitled to render a contractual performance substantially different from that which was reasonably expected of it. The Court drew a distinction between the form of entire agreement clause used in this contract - which sought to exclude pre-contract representations and which was therefore an exclusion to which s3 UCTA applied - and the form of entire agreement clause considered by the Court of Appeal in Watford Electronics v Sanderson CFL Ltd - which was effectively an acknowledgement by the parties that they had not relied on any representations not set out in the contract and so took effect as an evidential estoppel and not as an exclusion.

Having decided that UCTA applied to the entire agreement clauses and the exclusion and limitation clauses, the Court went on to find that all three clauses were UCTA reasonable. In reaching this decision, the Court took into account (i) that the parties were of equal bargaining power, (ii) that other companies like SAM had similar terms and (iii) that Hedley had not tried to negotiate more favourable terms. This last point is significant in that it calls into question the customer tactic of accepting whatever limitations and exclusions the supplier puts forward on the basis that their enforceability can be challenged at a later date.

The Court also relied heavily on the fact that the contract included a mechanism under which Hedley could obtain a full refund of all sums paid under the contract if the system had failed acceptance testing. In an obiter part of the judgment, the court expressed the view that, had the contract not included this right of refund, it would have found the exclusion of direct, indirect and consequential damages to be unreasonable but that it would have considered a limitation of liability to the amount of money paid under the licence to be reasonable.

Summary and Conclusions

It is apparent from the above cases that the question of whether the limitations and exclusions in contract will be enforceable under UCTA will depend to a large extent on the individual circumstances relating to the contract in question and that what is enforceable in one set of circumstances may not be in others.

As mentioned above, the judgments in Watford Electronics v Sanderson CFL Ltd and SAM Business Systems Ltd v Hedley & Co have been interpreted as an indication by the UK courts that they will generally be reluctant to intervene in agreements between two experienced commercial organisations. While this is undoubtedly correct (as evidenced by the Court of Appeal's statement in Watford Electronics v Sanderson CFL Ltd ), it should not be assumed that the courts will never intervene in agreements of that nature. It needs to be borne in mind that many of the previous cases were 'bad facts' cases: in Pegler v Wang (UK) Limited , for example, the supplier had deliberately oversold the degree of fit between its solution and the customer's requirements. It is by no means certain that the UK courts would reach a different decision in similar cases in the future even in light of the judgments in Watford Electronics v Sanderson CFL Ltd and SAM Business Systems Ltd v Hedley & Co .

That said, there are some useful lessons, for supplier and customer, which can be extracted from the cases mentioned above:-

The judgments in Watford Electronics v Sanderson CFL Ltd and SAM Business Systems Ltd v Hedley & Co mean that the customer tactic of accepting whatever limitations and exclusions are put forward by a supplier, without any attempt to negotiate changes, is now a dangerous one, particularly for commercially experienced customers - in light of these decisions, the Courts will take a dim view of customers who do not attempt to negotiate an acceptable allocation of risk in the contract;
It is clear from Watford Electronics v Sanderson CFL Ltd that the UK courts will generally give effect to properly drafted entire agreement clauses; customers should therefore ensure that any pre-contract representations made during the sales process which they have relied on in selecting the supplier are recorded in the contract - failure to do so could mean that the customer cannot rely on these at a later date if they turn out to be untrue;
Likewise, suppliers will want to ensure that any entire agreement clauses in their standard form agreements are drafted as an acknowledgement by the parties that they have not relied on any representations not included in the contract, rather than as a blanket exclusion of any pre-contract representations. Suppliers should also ensure that the entire agreement clause (and any exclusions and limitations) do not expressly or impliedly exclude liability for fraudulent misrepresentations, to avoid the risk of those provisions failing on a legal technicality;
Finally, the impact that deliberate oversell can have on a court's approach to the enforceability of limitations and exclusions cannot be over-emphasised. Where a supplier's sales staff have been guilty of deliberate oversell and the customer has relied on that oversell in selecting the supplier, there is a significant risk that the courts will look for a way in which to deprive the supplier of the benefit of contractual limitations and exclusions where it believes it would be unreasonable for the supplier to rely on these.

[1]There are other laws that restrict suppliers' ability to limit their liability including, for example, the Consumer Protection Act 1987. These are not considered further here.

[2] St. Albans City and District Council v ICL [1995] FSR 686; [1996] 4 All ER 481

[3]Pegler v Wang (UK) Limited (2000) 70 Con LR 68

[4] St. Albans City and District Council v ICL [1995] FSR 686; [1996] 4 All ER 481; South West Water v ICL T97 ORB 232

[5]South West Water v International Computers Limited QBD, Technology and Construction Court, 1997 ORB 232

[6]Thomas Witter Ltd v TBP Industries Ltd [1996] 2 All ER 573

[7]Pegler v Wang (UK) Ltd (2000) 70 Con LR 68

[8]See, for example, Hotel Services Ltd v Hilton International Hotels (UK) Ltd [2000] 1 All ER (Comm) 750

[9]Watford Electronics Ltd v Sanderson CFL Ltd [2001] All ER (Comm) 696

[10]SAM Business Systems v Hedley & Co [2003] 1 All ER (Comm) 465