The concept of unlimited liability refers to circumstances in which a party will have no limits on their liability in the event something goes wrong. In contrast, limited liability occurs when there is a ceiling of some amount beyond which the party with limited liability cannot be sued.
When you’re running your business, you will often want to limit your liability as much as you possibly can. In contrast, if you’re dealing with other businesses you may want them to have unlimited liability so they can be responsible when things do go wrong. The circumstances and context will vary on whether or not you will lean towards limited or unlimited liability.
There are two key ways a business and its owners can limit its liability. The first is through setting up a limited liability business structure and the second is through limiting its liability in contracts. This article will explore each of those two areas.
Limited Liability Vs Unlimited Liability Business Structures
Whether or not your business structure has limited liability depends on which structure you operate under. Let’s go through the main business structures and explore what kind of liability each business structure has.
A company is a business structure that is popular for its ‘separate legal entity’ doctrine. This just means that the company is treated as its own person, meaning the company can enter into contracts and be responsible for legal obligations as a natural person would.
Under this business structure, the business owners generally will have limited liability and will not be liable for any wrongdoings of the company. The total potential liability of the business will be limited to the company and the company’s assets.
So why doesn’t every business use a company structure, given that it has this limited liability protection? Well, a key consideration is that a Company Structure is a little more complex (and costly) to set up. It also has ongoing compliance costs, including requiring the business to file separate tax returns and maintain independent books and records from its owners.
It’s also important to note that are two common exceptions to the limited liability rules for companies:
- If the owners have signed a personal guarantee such as a bank loan
- When a owner who is a director breaches one of their director’s duties
In either one of these instances, the business owners may be subject to unlimited liability should something go wrong.
Partnership Or Sole Trader
A sole trader, on the other hand, is not as secure as a company structure. While it’s cheaper and relatively easier to set up, it has unlimited liability which puts you at risk as the business owner. So, if the business runs into any financial trouble, you could be personally liable.
You’ve started selling home-grown produce from your backyard. Since you’re a smaller business and aren’t really willing to drop extra cash this early in your business journey setting up a company, you opt for a Sole Trader structure in the hopes this will relieve that additional stress.
One of your customers makes a complaint that they have fallen sick after eating one of the fruits they bought from you. They tell you that they are entitled to a refund, and will be reporting it to the ACCC.
As a business with unlimited liability, you’re personally liable for troubles like this. Assuming the case is taken to the ACCC, any relevant costs or compensation will be paid by you.
If the situation was a bit more serious and required a larger payment of compensation, there is a risk of your personal assets (like your car or house) being involved so that compensation can be made successfully.
Some sole traders attempt to compensate for the fact that they may have unlimited liability by taking out business insurance, so they are covered in the event that things go wrong in the business. This is certainly helpful in protecting against unlimited liability, however insurance policies often have limits, exceptions and loopholes – and so there is always a risk that you may end up being personally liable for a business issue, even if you’re an insured sole trader.
A Partnership Structure generally also does not have limited liability – and therefore partners in a partnership will have unlimited, personal liability if things go wrong. Counterparties will be able to sue them for an infinite amount. The one exception is a limited liability partnership. Limited liability partnerships only hold the partners accountable for their own actions. So, under a limited liability partnership, one partner cannot be responsible for the negligence of the other partner.
Like sole traders, partnerships are generally inexpensive to set up and some of the liability risk in running a partnership business can be reduced by taking out business insurance. But it is not as secure as a company structure in protecting business owners from liability.
If you want to set up a partnership structure, our expert lawyers can draft a Partnership Agreement that is tailored to your specific needs.
How Can My Contracts Limit My Liability?
In addition to utilising limited liability business structures and taking out business insurance, contracts are another mechanism businesses can use to reduce liability. By inserting certain clauses in your key contracts (e.g your customer agreements and your supplier agreements), you can significant limit the liability of your business.
So, which clauses would you want to include?
Limitation Of Liability Clauses
The most common clause used by businesses to limit liability in contracts is the Limitation Of Liability Clause.
A Limitation Of Liability Clause will place a cap on the amount you can be liable for under the relevant contract. It can also limit the ways or the time frame within which you could be responsible for something your business does. The advantage is that a customer will only be able to sue you for the maximum amount set out in the clause.
A typical limitation of liability clause looks like this (taken from a web design contract):
To the maximum extent permitted by applicable law, the maximum aggregate liability of the Web Designer to the Client in respect of loss or damage sustained by the Client under or in connection with this agreement is limited to the total Fees paid to the Web Designer by the Client.
Let’s say a web designer builds a website for a client under this contract, and afterwards the client’s website crashes due to the negligence of the web designer.
Usually, the client would be able to sue the web designer all losses the client suffered as a result of the web designer’s negligence. This might include compensation for flow on losses or damages suffered as a result of the website outage – e.g. the costs of fixing the website, and lost revenue or sales as a result of the outage. If the client runs a big online business, these losses could be significant, and could be enough to put the web designer out of business!
However, because there is a limitation of liability clause in the web design contract, the client would only be able to sue the web design for a refund of fees paid from the web designer and no more. This way, the web designer is protected from a potential business-ending risk!
It is common for limitation of liability to have reasonable exclusion clauses, which are basically certain circumstances where the limitation will not apply. For example, if fraud occurs or if there is criminal activity then these may be excluded from the limitation of liability.
It’s very important to understand the scope and meaning of any exclusion clauses present in your agreements because these are the circumstances in which you or the business will have unlimited liability.
Let’s take the above web designer example again. Let’s say the clause included the following exclusion clause:
The limitation of liability in this agreement will not apply where the Web Designer infringes the intellectual property of a third party causing loss or damage to the Client.
Now let’s say the web designer copies parts of the website it builds for the client off a website operated by a competitor of the client. The competitor finds out and decides to sue the client for damages on the grounds that the client is infringing their copyright.
In this circumstance, the client may be able to sue the web designer. Because of the exclusion clause, the web designer would not be able to rely on the limitation of liability and may have unlimited liability to the end client.
What Is The Contra Proferentem Rule?
Exclusion clauses can be complicated and it can sometimes be difficult to work out whether they apply in particular circumstances. Given how important they are, drafting airtight exclusion clauses and limitation of liability clauses are critical in any agreement. This is particularly so because, if there is a dispute regarding an exclusion clause, then the contra proferentem rule will apply. Essentially, this means that if there is any ambiguity, doubt or room for interpretation that makes the clause difficult to enforce, the Court will resolve this by going against the favour of the party looking to rely on the clause.
In other words, you’re siding with the party who will be disadvantaged by the clause. This has been justified by the fact that exclusion clauses can be misinterpreted in many situations.
As a result, if you have a limitation of liability clause or exclusion clause in your contract, it’s critical that you have a lawyer look over it and ensure it is effective in protecting your business from liability.
Liability is a rather intricate matter – getting it right could save you and your business a lot of money. Contracts, business insurance and your underlying business structure each play a role in the types of liability your business is exposed to.
It’s always important to seek the help of an expert to ensure you have a watertight business structure and to craft well-drafted liability clauses which could ultimately save your business from significant losses in the future.
If you would like a consultation on any of the issues raised in this article, you can reach our team of legal consultants at 1800 730 617 or firstname.lastname@example.org for a free, no-obligations chat.
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