How to scope the liability clause in your software license agreement

Standard limit of liability clauses favour the vendor. Here's how to modify them to protect your firm from IT risk.

The limitation of liability is one of the most important clauses in a software license agreement because it limits the amount and types of damages one party can recover from the other party. For example, if the software doesn't work and your company suffers damages as a result, the limitation of liability will restrict your company's ability to recoup its loss.

Unfortunately, the forms most vendors use for licensing agreements often include limitations of liability that disproportionately favor the vendor. For example, consider the following clause:

"Licensor shall not be liable to licensee for any lost profits, lost revenues or opportunities, downtime, or any consequential damages or costs, resulting from any claim or cause of action based on breach of warranty, breach of contract, negligence, or any other legal theory, even if Licensor knew or should have know of the possibility thereof. In no event shall Licensor's aggregate liability exceed the amounts actually paid by Licensor in the 12 month period immediately preceding the event giving rise to the claim."

This clause provides no protection for the licensee other than a potential refund. From a licensee's perspective, three major problems should be corrected:

First, the clause should be made mutual. As the customer, you need your protection against damages to be, at a minimum, the same as the vendor's. For example, the first part of the first sentence could be modified to state that "Neither Licensor or Licensee shall be liable to the other party" for the types of damages listed. The first part of the second sentence could be modified to state that "in no event shall either party's aggregate liability" exceed the amount described.

Second, the limit on the amount of direct damages that are recoverable may be unreasonable. In the example above, this is the amounts paid by the Licensor in the 12-month period immediately preceding the event giving rise to the claim. If your company paid 100% of the license fee up front and hasn't paid anything additional for more than 12 months, the licensor's liability could be zero. You could fix this problem by changing the cap to a multiple (e.g., three times) of all the fees paid by licensor to the licensee under the contract.

But don't stop there, because if it's early in your vendor relationship, that cap may not be large enough to cover your company's potential damages. A better solution is to couple the multiple of fees cap with a fixed liability amount. This will establish a reasonable cap on the parties' liability even when the customer has not paid the vendor a large amount of money to establish a reasonable limitation of liability.

An example of such a limitation of liability is the following: "In no event shall either party's aggregate liability exceed the greater of (1) three times the fees paid, payable, or to be paid by licensee under this agreement, or (2) US$1,000,000."

Third, it is imperative that the limitation of liability not apply to certain damages that may arise under the contract. For example, if your company suffers damages because the software infringes (or is alleged to infringe) the intellectual property rights of a third party and the contract includes an obligation on the licensor to indemnify you for such damages, the limitation of liability should not restrict your company's ability to recover all the damages suffered.

In fact, consider excluding all of the following from the limitation of liability:

  • Breaches of either party's obligations with respect to confidential information.
  • Claims for damages for bodily injury (including death) and damages to the other party's property.
  • Claims for losses arising out of the misconduct of the other party.
  • Claims for damages arising out of the licensor's failure to pay subcontractors or failure to pay employee withholding, benefits or workers' compensation insurance (especially in a transaction where professional services are involved).
  • Claims for damages arising out of the licensor's repudiation of the agreement.
  • Claims for damages that are covered under the licensor's insurance policies.

In summary, the limitation of liability clause is one of the most important clauses of any software license agreement. Watch out for vendor forms that include one-sided limitations of liability that protect the vendor and leave your company open to excessive risk. This will likely mean that you will need to re-draft the limitation of liability in the vendor's form to be mutual, include an appropriate cap on damages and exclude certain types of damages from the cap.

This article is not a substitute for legal counsel. In any given situation, the impact of the law depends on many factors. The authors recommend engaging legal counsel to assess your legal liability.

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