Liability caps

Always make sure that liability caps are a key part of engagement letters, says Karen Eckstein

This is the second in a series of articles which looks at how engagement letters can be used to protect a professional firm. This month the focus is on the use of liability caps.

Always make sure that liability caps are a key part of engagement letters, says Karen Eckstein

This is the second in a series of articles which looks at how engagement letters can be used to protect a professional firm. This month the focus is on the use of liability caps.

A liability cap is an agreement (usually contained within the engagement letter) which limits the amount for which a professional may be sued by his client in the event of any negligence/breach of contract. A liability cap is therefore a very useful element in a firm's risk management toolkit. The case studies demonstrate how valuable an effective liability cap can be if correctly assessed and implemented.

Any liability cap will be subject to the test of reasonableness set out in the Unfair Contract Terms Act 1977. Therefore, for any cap to defeat a challenge brought by the client after the event, the court will have to be satisfied that the liability cap is fair and reasonable having regard to the circumstances which were reasonably known or in the parties' minds when the contract was made. The factors that the court will take into account will include the parties' relative bargaining positions, other sources of advice, the extent to which the term is brought to the attention of the client, the resources available to any party to meet any liability, the extent to which each party could protect themselves by insurance and whether or not the client was given the opportunity to negotiate/challenge the cap being imposed.

Setting the liability cap

All these factors need to be taken into account when setting the liability cap. Some professionals like to set a liability cap based on a multiple of the fee charged to the client. However, such caps are vulnerable to challenge, because they do not appear to take into account the factors that a court will consider when determining if the term is fair and reasonable.

Others like to set a cap by reference to a proportion of the overall liabilities (for example, where more than one adviser is acting, one of the advisers can set a cap limiting his liability to a percentage only of the overall loss that may arise). Again, so long as that proportion is determined taking into account the factors referred to above, it may withstand a challenge.

The simplest way to impose a cap is to have a simple monetary cap. For example, some like to set the cap at the extent of their professional indemnity cover. The availability of professional indemnity insurance is a factor that the court may take into account when determining if a cap is likely to be reasonable.

However, imposing a cap at the exact level of a professional indemnity insurance may mean that the professional is exposed, because the liability cap will relate to the claim alone (costs would be payable in addition), whereas the professional indemnity policy may relate to the claim inclusive of costs. Therefore, it may be sensible to consider a cap slightly below the overall level of a professional's insurance cover.

In each case it is important to consider the amount at stake, the assets likely to be available to the party to meet any liability, the insurance cover available to the adviser, as well as the likely level of any claim. The latter point is relevant. Many people under-estimate the risk of a claim and the likely value thereof. A very small task may give rise to a substantial loss, particularly if it is in the tax arena and HMRC imposes penalties (which can be up to 100% of the tax in issue).

Imposing a liability cap

One of the factors that a court takes into account is the extent to which the cap is drawn to the client's attention and what opportunity there is to negotiate the terms. It is recommended therefore that the liability cap is not included within any terms of business (as that would indicate that the liability cap is fixed in every event and is unlikely to be brought to the client's specific attention).

The liability cap needs to be included within the engagement letter (ideally identified in bold). Any covering letter to the client should highlight the existence and extent of the cap, and that the client is given the opportunity to challenge the cap if needs be.

It is advisable that, for each file where a liability cap is imposed, there is evidence that the adviser has considered the level of cap to impose, the reasons for the cap and that the client has had his attention drawn to the cap and has been given the opportunity to challenge the same. Evidence will also be required to show that the client has agreed to the cap. If an engagement letter is sent to the client containing the cap but the client does not sign and return the engagement letter, there may be no evidence that the cap has been agreed to.

If an adviser cannot persuade a court that the client has agreed to the cap, the cap will fall away. It is recommended therefore that, in any case where a client is being asked to agree to a liability cap, steps are taken to ensure that the either the engagement letter is signed by the client and returned prior to commencing work or there is evidence (perhaps by way of e-mail trail) that the client has received the engagement letter and has not challenged the same.

Risk factors

A liability cap can be very useful in protecting a professional firm against excessive claims beyond the limit of their professional indemnity cover. However, if the liability cap is challenged by a client and the court upholds that challenge, the cap is struck out. A more reasonable cap is not imposed in its place; it is deleted in its entirety, meaning that the professional's liability is unlimited. The case studies show an extreme example (case study 2) but it is not unknown for professional advisers to be faced with a substantial claim, an invalid liability cap, and end up losing their homes as a result.

Liability caps can be invaluable in protecting firms against the consequences of excessive claims. However, great care must be taken to ensure that the cap is held to be reasonable and drawn to the client's attention. Further, professionals should take care to ensure that all work undertaken by them is covered within their engagement letter. If a firm acts for a client outside the scope of its engagement letter (providing additional services which were not previously envisaged for example) the liability cap will probably not apply to that additional work and the adviser's exposure will again be unlimited.

Taking care to ensure that the appropriate thought is given to the imposition of a liability cap and the amount thereof, and obtaining the appropriate evidence of agreement by the client, can reap dividends in protecting the professional against the adverse consequences of an excessive claim.

In practice

ABC is an accountancy partnership, the partners being Albert and Bonny. ABC has professional indemnity cover, set at £500,000 per claim. ABC act for 123 Limited and give tax and accountancy advice. The fee charged to 123 Limited is £10,000. ABC unfortunately makes an error in its advice. 123 Limited suffers a loss and obtains judgment against ABC for £1,250,000.

Case study 1 – no liability cap

The insurers agree to pay £500,000 (the limit of their exposure) leaving ABC/Albert and Bonny to find the remaining £750,000 themselves. ABC has insufficient funds and Albert and Bonny end up having to sell their houses to fund the deficit.

Case study 2 – fee-based liability cap

ABC imposes a liability cap in their engagement letter, limited to three times the fee charged, in this case, £30,000. The reasonableness of the cap is challenged by 123 Limited. The Court agrees that it is unreasonable and sets the cap aside. ABC's liability therefore is unlimited (as for case study 1).

Case study 3 – liability cap of £250,000

ABC negotiate with 123 Limited and agree a liability cap of £250,000, which is then included in the engagement letter. 123 Limited subsequently challenge the cap. The Court, having considered all the relevant circumstances, upholds the liability cap. ABC's liability is therefore limited to £250,000 and their insurers pay that sum to 123 Limited (together with 123 Limited's costs).

Case study 4 – proportionate liability cap

'Tax expert Mike' was also involved in the advice given to 123 Limited. He charged a fee to 123 Limited of £90,000. ABC negotiated with 123 Limited and agreed to include within their engagement letter, a liability cap, limiting their exposure to 10% of any loss. The cap is upheld and ABC's exposure is therefore limited to £125,000, which is paid by the insurers.

Karen Eckstein is a partner at Lake Legal LLP and member of ATT Council


Karen Eckstein |Partner, Lake Legal LLP

Karen Eckstein is a partner at Lake Legal LLP and specialises in contentious tax, trust and probate cases as well as tax related pro...

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