Types of exemption clause in contracts

Exemption clauses

It is common practice for parties, at the time of entering a binding contract, to regulate the consequences if one or both parties broke the terms of that contract. Those clauses are known broadly as exemption clauses. Such restrictions may be in respect of terms implied into the contract by law or may extend to express terms agreed at the time of formation.

The effect of the breach could mean, depending on the term breached, that the innocent party has the right to treat its future obligations under the contract as terminated. However, this does not mean that the contract is extinguished by the breach. On the contrary, it is then when the terms relating to the consequences of a breach come into effect.

Incorporation into the contract

Exemption clauses could be incorporated into a written contract when the party seeking to rely upon the term has done what may reasonably be considered sufficient to give notice of the clause to the other party. Notice is to be given prior to the formation of the contract or at the time of formation.

But a clause may also be incorporated by an established course of dealing between the parties or because both parties are aware that it is the ordinary practice in the particular trade area. 

The types of exemption clauses

There are three types of exemption clauses and those are exclusion, limitation and indemnity clauses. They are mainly distinguished on the basis of the effect they purport to have on the contract and the ability of the injured party to recover for the breach. 

  • Exclusion clauses generally seek to exclude or cut down the defaulting party’s duties under the contract. Those duties can be defined by looking into the subject matter of the particular contract.

For example, such could be achieved by excluding express or implied terms, or limiting liability to causes of wilful neglect or even default, or by binding the buyer of goods or land in the respective contract to accepting the goods subject to faults or defects.

A party can purport to restrict liability even where the breach is caused by the negligence of the party in default. However, for such clause to be enforced, the term needs to have been sufficiently communicated to the injured party before the formation of the contract. Further, it needs to be construed in such a way to show that the parties intended, in the context of their agreement that the exclusion is to be valid. And even then, very high standards of construction are applied, where the clause purports to absolve the party of altogether liability for negligence. 

  • Secondly, limitation clauses seek to qualify the rights of the innocent party upon the breach. Examples are denying or limiting the right to rescind for breach or limiting the amount of damages recoverable. Further, such clauses could be specifying a time limit for the right to rescind or claim damages to be exercised. On the expiry of such time limit such right would be taken away from the innocent party.

In practice, one of the most common uses of exemption clause is to limit the amount payable for damages resulting from a breach. If the clause is held valid then irrespective of whether the loss sustained was valued higher than the agreed amount, the innocent party will receive that amount.

Taking into consideration the other type of indemnity clauses, which provide a time-limit within which the innocent party may pursue a cause of action, the length of such limit is of crucial importance in consideration of the validity of the term before the court. If it is considered that the period is insufficient, then the party in default would not be able to rely upon the clause.

  • The third type is indemnity clauses. They are applicable for example where A and B form a contract which specifies that in the event of A defaulting under the contract and becoming liable to a third party, it is provided that the other party- B will indemnify A for their breach.

When dealing with business-consumer contract all those clauses would be subject to the reasonableness test in section 11 of UCTA 1977. Therefore, for their validity to be upheld in court so that the defaulting party can rely upon them, they need to prove that the term is in fact reasonable and it extends so far as to cover the relevant breach.

Other similar clauses

It is important to emphasise that arbitration clauses are generally not treated as exclusion clauses since the specific rules governing the construction of exclusion clauses and to deviation do not apply to them. The same principles apply for liquidated damages.

Whilst on one hand force majeure clauses are on exclusion clauses, they may in practice have the same effect and are in most situations seem to be similarly strictly construed.