In Sourcing and Licensing Agreements Governed by New York Law, Think Twice About a Gross Negligence Carve-out to a Limitation on Liability | White & Case LLP International Law Firm, Global Law Practice
In Sourcing and Licensing Agreements Governed by New York Law, Think Twice About a Gross Negligence Carve-out to a Limitation on Liability

In Sourcing and Licensing Agreements Governed by New York Law, Think Twice About a Gross Negligence Carve-out to a Limitation on Liability

White & Case Technology Newsflash

Limitations on liability and disclaimers of damages for breach of contract claims are commonplace in outsourcing, licensing and procurement agreements. These provisions can create contentious negotiations as the parties seek to allocate the monetary risks of loss if the business relationship were to go awry. Vendors do not want the monetary risk associated with any one contract to have material consequences on their business as a whole. Accordingly, vendor-drafted contracts typically disclaim all liability or otherwise limit the customer's possible recovery to a small sum, usually based on a portion or multiple of fees paid under the contract. Customers, on the other hand, want the vendor to bear the entire risk of liability for damages arising out of matters completely within the vendor's control. Customers therefore often seek to carve out those types of claims from vendors' limitations and disclaimers of liability. Even without such carve-outs, however, New York law may not permit the parties to disclaim or limit liability associated with their own misconduct in certain situations. This post briefly describes the law of New York with respect to parties' attempts to allocate the risks of loss arising from their gross negligence or willful misconduct.

As a general rule, New York common law instructs courts not to uphold liability disclaimers or limitations of liability for gross negligence or willful misconduct as a matter of public policy, but a study of the relevant case law shows it to be extremely difficult for a plaintiff to succeed on having these provisions set aside by a court when economic motivations for a defendant's behavior are implicated. As an alternative to negotiating the language described above, parties seeking certainty from a disclaimer of liability covering certain conduct might instead rely on insurance provisions and waivers-of-subrogation.

The Foundational Case Law
Unless there is a public policy reason not to do so, New York courts allow a party to insulate itself from liability resulting from its own negligence by way of an exculpatory clause.[1] Courts do not, however, allow a party to insulate itself from damages arising from its "grossly negligent conduct."[2] This policy-based prohibition may apply even when parties to a contract contemplated specific conduct and intended their exculpatory clause to apply to it. That was the situation in the seminal Kalisch-Jarcho case, where the court refused to accept the argument that, because the parties had anticipated the potential for unreasonable delay in performance, the public policy exception should not override their contract's exculpatory clause.[3] Later cases have even shown New York courts' willingness to read the public policy exception into an exculpatory clause that is otherwise silent as to gross negligence or willful misconduct.[4]

Proving the Defendant's Culpability
Courts consider "gross negligence" and "willful misconduct" to be tort-law terms of art, even when used in contracts, so a plaintiff seeking to rely on the public policy exception must show that the defendant exhibited some degree of wrongful intent.[5] Willful misconduct conjures a notion of bad behavior, or, as the court in Kalisch-Jarcho explained, behavior that is "fraudulent, malicious or prompted by the sinister intention of one acting in bad faith."[6] Gross negligence, however, requires a more subjective assessment of the facts in each case, and it is thus the more heavily litigated allegation. In New York, gross negligence requires a showing of misconduct that demonstrates a reckless disregard for the rights of others "or [that] otherwise 'smacks' of intentional wrongdoing."[7] Using these definitions, courts have set aside disclaimers or limitations of liability in cases based on a defendant's misrepresentation, abandonment, unlawful interference, willful interference, and refusal to perform necessary acts in furtherance of the contract.[8]

As a practical matter, arguments seeking to set aside limitations of liability are often dismissed early in litigation because the plaintiff fails to allege behavior sufficiently egregious to invoke the public policy exception.[9] For example, in Metropolitan Life, the court considered whether the defendant's intentional "defective performance and ultimate breach" of its contractual obligations to develop and install a software system was "willful" such that the behavior fell outside the contract's exculpatory provision.[10] The New York Appellate Division held that, absent a showing of fraud or other willful intent toward the non-breaching party, "the voluntary and intentional failure or refusal to perform a contract for economic reasons" does not constitute willful misconduct. A plaintiff is still limited to the damages specified in the contract even when the defendant entered the contract intending never to perform.[11] Most opinions on this issue follow Metropolitan Life, "illustrat[ing] the far higher mark at which New York courts place the bar . . . demanding nothing short of . . . a compelling demonstration of egregious intentional misbehavior evincing some extreme culpability."[12]

Insurance and Waivers-of-Subrogation as a Limitation of Liability
While an exculpatory clause will not be upheld in cases where a plaintiff proves gross negligence or willful misconduct, the inclusion of an insurance obligation and a corresponding indemnity might effectively provide a breaching party with substantially the same protection. New York courts have clarified that when, instead of insulating themselves from all liability, parties designate one party to insure both of them against losses (and then limit contract damages accordingly), public policy will not override that decision, even in cases of gross negligence.[13]

In 2012, the New York Court of Appeals enforced a waiver-of-subrogation clause despite the defendant's alleged gross negligence in the context of a security services agreement. Subrogation is an equitable doctrine that allows a party to stand in the shoes of another party and exercise the latter's rights. Contracts containing insurance obligations sometimes include a waiver of subrogation whereby the insured party promises to look only to its insurer, and waives its insurer's right to look to the counterparty, for reimbursement of a loss.[14] In Abacus Federal Savings Bank v. ADT Security Services, Inc., the plaintiff had contracts with two security services companies, Diebold and ADT.[15] Abacus alleged that both companies were grossly negligent in their provision of security services and that such gross negligence resulted in the security systems' failure to prevent a theft from Abacus's vault. In ruling on whether the security companies' motion to dismiss had been properly granted, the Court of Appeals allowed Abacus's allegation of gross negligence to proceed against ADT, but affirmed dismissal of claims against Diebold.[16] The contracts between Abacus and ADT and between Abacus and Diebold both limited each security company's liability to $250. However, the Abacus-Diebold contract expressly required Abacus to insure against losses in the event of theft and to "look solely to its insurer for recovery of its loss . . . [and waive] any and all claims for such loss against Diebold." The contract further required Abacus to obtain a policy that expressly allowed such a waiver. In contrast, the Abacus-ADT contract stated only that "insurance, if any, covering [loss]" was Abacus's responsibility.[17] Citing the public policy exception, the court allowed Abacus to proceed in its case for damages based on allegations of ADT's gross negligence despite the contract's limitation of liability.[18] With respect to Abacus's claims against Diebold, however, the Court of Appeals upheld the granting of Diebold's motion to dismiss. Citing decades-old precedent, the court held that, in contrast to exculpatory clauses, indemnification provisions are unenforceable on public policy grounds only "to the extent that they purport to indemnify a party for damages flowing from the intentional causation of injury."[19] The Abacus Court accordingly distinguished between a contract provision that seeks to exculpate a party from liability from one that "simply require[s] one of the parties . . . to provide insurance for all of the parties,"[20] finding that the latter provision withstands even allegations of gross negligence.

Given this legal landscape, it appears that a contract drafted like the Abacus-Diebold one may be effective in shielding a defendant from liability for its own gross negligence. It is not clear whether a court would uphold a similar insurance and waiver-of-subrogation provision in a case of willful misconduct.[21] As for the traditional carve-out to disclaimers or limitations on liability, customers should consider whether that carve-out would be helpful in litigation, and vendors should consider whether such a carve-out actually exposes them to any additional risk.

 

[1] - Sommer v. Fed. Signal Corp., 593 N.E.2d 1365, 1370 (S.D.N.Y. 1992). The public policy exception applies with equal force to provisions seeking to limit liability for direct damages and consequential damages. See Metropolitan Life Ins. Co. v. Noble Lowndes Int'l, Inc., 643 N.E.2d 504, 506-07 (N.Y. 1994); Net2Globe Int'l, Inc. v. Time Warner Telecom of New York, 273 F.Supp.2d 436, 451-52 (S.D.N.Y. 2003).
[2] - Sommer, 593 N.E.2d at 1370 (public policy exception applies both to limitations and disclaimers of liability). Most courts discuss the public policy exception using the terms "limitations on liability" and "exculpatory clause" interchangeably; as such, it seems the public policy exception would apply both to cases involving a liability cap and those involving a total disclaimer. See, e.g., Abacus Fed. Svgs. Bank v. ADT Sec'y Svcs., Inc., 18 N.Y.3d 675 (N.Y. 2012); Bank of Am. Sec., LLC v. Solow Bldg. Co. II, LLC, 847 N.Y.S.2d 49, 53 (N.Y. App. Div. 2007).
[3] - Kalisch-Jarcho, Inc. v. City of New York, 58 N.Y.2d 377, 385 (N.Y. 1983).
[4] - See Global Crossing Telecomm. Inc. v. CCT Commc's, Inc., No. 07-10210 (SMB) at *14 (Bankr. Ct. S.D.N.Y. 2010) (citing, inter alia, Net2Globe Int'l, 273 F.Supp.2d at 451, 452 n.8.
[5] - See Kalisch-Jarcho, 58 N.Y.2d at 386; cf. Metropolitan Life Ins., 643 N.E.2d 504, 508-09 (N.Y. 1994) (noting in dicta that if the parties had drafted a less-stringent meaning than the tort-law definition of "willful" into their contract, their definition would have applied instead and thus could have captured less-culpable conduct).
[6] - Id. at 385.
[7] - Colnaghi USA Ltd. v. Jewelers Protection Services, 595 N.Y.S.2d 381, 383, (N.Y. 1993).
[8] - Kalisch-Jarcho, 58 N.Y.2d at 385 n.7. Note that the Kalisch-Jarcho and Colnaghi decisions do not clearly delineate when conduct amounts to gross negligence and when it amounts to willful misconduct, but the theme of intent runs through the jurisprudence on both types of behavior.
[9] - The District Court's discussion of gross negligence and willful misconduct cases in the Net2Globe Int'l decision highlights the fact that many efforts to overturn a limitation of liability clause do not survive a motion for summary judgment. For that discussion, see 273 F.Supp.2d at 452-57 and cases cited therein.
[10] - Metropolitan Life Ins. Co. v. Noble Lowndes Int'l, Inc., 600 N.Y.S.2d 212, 215-16 (N.Y. App. Div. 1993), aff'd 643 N.E.2d 504. Note that on review, the Court of Appeals affirmed the Appellate Division's construction of the term "willful" in this case, but clarified that rules of contract construction would supersede tort law principles if the parties had defined "willful" in a broader way than tort law construes the word (as mentioned above). Not surprisingly, however, subsequent case law refers more frequently to the Appellate Division's opinion, since in most cases the parties are not litigating the meaning of "willful" unless they left it undefined.
[11] - Id.
[12] - Net2Globe Int'l, 273 F.Supp.2d at 454.
[13] - See, e.g., Bd. of Educ., Union Free School Dist. No. 3, Town of Brookhaven v. Valden Assoc., 46 N.Y.2d 653, 657 (N.Y. 1979)(indemnity and waiver-of-subrogation upheld despite allegations that the contractor's own negligence caused the fire that damaged the building under contract); see also Austro v. Niagara Mohawk Power Corp., 66 N.Y.2d 674, 676 (N.Y. 1985) (indemnification provision upheld in personal injury action despite allegations that defendant-employer was negligent, because plaintiff had not alleged that defendant intentionally caused plaintiff's injury).
[14] - Kaf-Kaf, Inc. v. Rodless Decorations, Inc., 687 N.E.2d 654, 660 (N.Y. 1997).
[15] - 18 N.Y.3d 675, 681 (N.Y. 2012).
[16] - Id. at 684-85.
[17] - Id.
[18] - Id. at 683-84.
[19] - Id. at 684 (citing Town of Brookhaven and Austro, supra, n. xiii). Note that both cases cited by the Abacus Court dealt with claims only as to defendant's negligence, but the Abacus Court applied their holdings to plaintiff's claim of gross negligence.
[20] - Id. See also, Valden Assoc., 46 N.Y.2d at 657; accord Great Am. Ins. Co. v. Simplexgrinnell LP, 60 A.D.3d 456, 457 (N.Y. App. Div. 2009) ("We discern no public policy basis for limiting freedom of contract so as to preclude parties from agreeing that a waiver of subrogation bars no only claims of negligence but also claims of gross negligence." (internal citation omitted)).
[21] - Cf. Austro, 66 N.Y.2d at 676 (drawing no distinction between the two types of conduct in upholding the contract's indemnity provision).

 

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