Limitations on Liability Exceptions for Gross Negligence and Willful Misconduct and the Implications for Outsourcing Agreements

The definitions of gross negligence and willful misconduct vary by state and the conduct that courts consider as falling under those definitions depends on the facts of each case.

Limitation of Liability Provisions

Outsourcing agreements typically prohibit each party from being held liable for any incidental, consequen­tial, punitive, special or other indirect damages. In addition, these agreements typically place a cap on the total amount of damages for which either party can be liable in connection with the agreement. The result is to disallow a party from recovering the full damages caused by the actions of the other party. While such an allocation of risk may be acceptable in the case of an ordinary breach of contract by the other party, the allocation of risk is not typically considered acceptable when damages result from egregious action on the part of the other party or where the stakes of nonperfor­mance by the other party are so high that appropriate incentives need to be put in place to ensure that the other party fulfills its obligations under the agreement.

In such cases, the parties usually want the right to recover special, consequential and incidental damages and damages in an amount greater than the liability cap. Examples of exclusions from limitations of liability include losses resulting from a breach of confidentiality, refusal to provide services, death, bodily injury, damage to tangible property, violation of applicable law, gross negligence or willful misconduct.

While certain of the above exceptions may be proved relatively easily, prov­ing that a party’s conduct constitutes gross negligence or willful misconduct is often more difficult. By understand­ing the definitions under the laws of the state governing the agreement and the courts’ decisions on what conduct falls under the definitions, customers can better understand their rights and risks and the implications for a particular outsourcing agreement.

By understanding the definitions under the laws of the state governing the agreement and the courts’ decisions on what conduct falls under the definitions, customers can better understand their rights and risks and the implications for a particular outsourcing agreement.

Enforcement of Limitation of Liability Provisions

With certain exceptions, courts enforce express agreements between parties that limit damages to be recovered in the event of a breach of contract.¹ Parties are free to “bargain against liability for harm caused by their ordinary negligence in performance of contractual duty.”² Nevertheless, courts will not enforce an exemption from liability if it applies to “harm willfully inflicted or caused by gross or wanton negligence.”³

New York courts generally enforce limitation of liability provisions since such provisions represent “the parties’ Agreement on the allocation of the risk of economic loss in the event that the contemplated transaction is not fully executed.”⁴ However, even when parties limit liability but do not specifically exclude damages caused by willful misconduct or gross negligence, New York courts will not enforce the provision if the “misconduct for which it would grant immunity smacks of intentional wrongdoing”⁵ or if the provision will insulate a party from damages caused by its own grossly negligent conduct.⁶ Nevertheless, a party trying to overcome a limitation of liability provision by claiming that the other party engaged in willful misconduct or gross negligence must meet the standards described below.

What Are the Standards for Gross Negligence and Willful Misconduct?

The standards for proving gross negligence and willful misconduct are high.

Gross Negligence. Under New York law, miscon­duct that rises to the level of gross negligence must show “reckless indifference to the rights of others.”⁷ The conduct must show a “failure to use even slight care or conduct that is so careless as to show com­plete disregard for the rights and safety of others.”⁸ The gross negligence standard focuses on the sever­ity of a party’s deviation from reasonable care.

Willful Misconduct. In New York, willful miscon­duct occurs when a “person intentionally acts or fails to act knowing that (his, her) conduct will probably result in injury or damage.”⁹ Willful misconduct can also occur when “a person acts in so reckless a manner or fails to act in circumstances where an act is clearly required, so as to indicate disregard of (his, her) action or inaction.”¹⁰ A party claiming willful misconduct must show an “intentional act of unreasonable character performed in disregard of a known or obvious risk so great as to make it highly probable that harm would result.”¹¹ The willful misconduct standard is similar to the gross negligence standard; however, it focuses more on the harm that a party’s action or inaction caused.

What Conduct Meets the Standards of Gross Negligence and Willful Misconduct?

What conduct do New York courts consider as meeting the standards for gross negligence or willful misconduct? The determination depends highly on the facts of each case. The following cases provide some insight into the decisions of New York courts making this determination.

In one case, a computer software developer licensed its base software to the customer and was under an obligation to provide enhancements thereto.¹² The customer rejected two sets of enhancements provided by the developer and a fee dispute arose, after which the developer discontinued performance under the agreement. Under the agreement’s limitation of liability clause, the developer was absolved from any liability for certain indirect damages. There was an exception to the limitation of liability for, among other things, damages arising out of the developer’s willful acts or gross negligence. The court found that parties to the agreement did not intend for the developer’s discontinuation of services to constitute a willful act or gross negligence and, therefore, upheld a decision to enforce the limitation of liability clause.

In another case, an airline entered into an agree­ment for the installation of infrastructure for in-flight Internet service.¹³ The airline alleged that, with the encouragement of the Internet service provider, it invested millions of dollars in installing the Internet service infrastructure while the service provider secretly considered terminating the in-flight Internet service. The service provider ultimately decided to terminate the service. The airline claimed that the service provider’s actions constituted gross negligence and that, therefore, the contractual limitations on liability should not apply. The court found that the service provider’s conduct did not meet the “reckless disregard” standard required to prove gross negligence and, accordingly, upheld the contract’s limitation on liability provisions.

If a customer wants to ensure that a specific type of misconduct by a service provider falls outside of the limitation of liability clause, the customer should specifically describe such misconduct in the outsourc­ing services agreement.

A New York court found that a home inspector’s failure to identify problems in a house constituted gross negligence in another case.¹⁴ The services agreement limited the home inspector’s liability for any consequential, exemplary or incidental damages in the event of a breach or negligent inspection; however, the limitation did not apply to any grossly negligent conduct or willful misconduct. The home inspector failed to identify hazardous conditions during the inspection that endangered the lives of the homeowners. The court determined that the home inspector’s conduct showed a complete disre­gard for the safety of the homeowners and, thus, the homeowners were entitled to obtain damages outside of the limitation.

Implications for Outsourcing Agreements

Customers need to carefully consider the excep­tions to the limitations on liability included in their outsourcing agreements. Although state law may imply an exception for gross negligence or willful misconduct, losses arising from such conduct should be an express exception to the limitations on liability in the outsourcing agreement in order to avoid the need to establish the public policy exception and research the issue under each state law. Moreover, a customer needs to consider how difficult and costly it will be to prove to a judge or jury that a service provider’s conduct meets the high standards required to establish gross negli­gence or willful misconduct.

If a customer wants to ensure that a specific type of misconduct by a service provider falls outside of the limitation of liability clause, the customer should specifically describe such misconduct in the outsourcing services agreement. In two of the cases described above, excluding the service provider’s refusal to provide services from the limitation of liability would have provided a clearer standard for the customer to prove. Since the limitation of liability provision has a significant impact on the allocation of risk between parties to an outsourcing agreement, customers should ensure that any specific losses or misconduct that should not be subject to contractual limitations on liability are clearly and sufficiently identified as exclusions to the limitation of liability provisions.

Endnotes

1 5 Corbin on Contracts § 1068 (1964).

2 6A Corbin on Contracts § 1472 (1962).

3 Id.

4 See Metropolitan Life Ins. Co. v. Noble Lowndes Int’l, 643 N.E.2d 504, 507 (N.Y. 1994).

5 See Kalisch-Jarcho, Inc. v. New York, 448 N.E.2d 413, 416 (N.Y. 1983).

6 See id.

7 See id.

8 See Johnson v. Smith, 2006 N.Y. Misc. LEXIS 2618 at **37-38 (City Ct. of N.Y. (Jefferson County) Sept. 8, 2006).

9 See id. at *3 (quoting New York Pattern Jury Instructions § 2.10A).

10 See id. at *3 (quoting New York Pattern Jury Instructions § 2.10A).

11 See McDuffie v. Watkins Glen Int’l, Inc., 833. F. Supp. 197, 203 (W.D.N.Y., Sept. 3, 1993).

12 Metropolitan Life Ins. Co. v. Noble Lowndes Int’l, 643 N.E.2d 504 (NY 1994).

13 See Deutsche Lufthansa AG v. Boeing Co., 2007 U.S. Dist. LEXIS 9519, 2007 WL 403301 (S.D.N.Y. Feb. 2, 2007).

14 See Johnson v. Smith, 2006 N.Y. Misc. LEXIS 2618 (City Court of New York (Jefferson County) Sept. 8, 2006).