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Michael Valo
Glaholt Bowles LLP, Toronto, Ontario
mvalo@glaholt.com

Limitations of liability clauses and setoff provisions are ubiquitous in construction contracts, yet few cases have considered how these critical clauses should properly be applied together once liability for claims and counterclaims are finally decided. Should a liability cap be applied first, before parties’ claims are set off, or should parties’ claims be set off before limits on liability are considered? The difference is not just academic, but can yield starkly different damage awards. Yet the issue has attracted little attention in Canadian jurisprudence. This article argues that, in cases with competing successful claims, liability caps should be applied first – before setoff – in accordance with the parties’ bargained-for rights.

Recently, the United Kingdom’s Technology and Construction Court had an opportunity to consider the interaction of these common provisions. In Topalsson GmbH v Rolls-Royce Motor Cars Limited,^[1] Justice O’Farrell considered whether setoff to establish the net sum due should be carried out before or after the application of the cap on liability.

The parties’ contract contained the following limitation of liability: ‘the total liability of either Party to the other under this Agreement shall be limited in aggregate for all claims no matter how arising to the amount of €5m (five million euros).’ Before applying the limit or setoff, the judge found that Rolls Royce had proved damages of €7,962,323 and the damages due to Topalsson amounted to €794,759. Since Rolls Royce’s damages exceeded the cap, the judge had to decide whether to apply the cap or setoff first.

Justice O’Farrell found that the wording of the contract required the application of setoff first, prior to considering the liability cap:^[2]

‘In contrast, under the Agreement, the cap on liability is applicable to the total liability of either party to the other in aggregate for all claims no matter how arising. The total liability of either party to the other requires the application of the above provisions to ascertain the balance of sums due or payable. On a proper construction of the express terms agreed between the parties, under the Agreement the accounting exercise to determine the net sum due to or from each party must be carried out before the cap is applied.’

While the judge’s decision turned on the very specific language of the contract, the decision sets an uncomfortable precedent for the application of setoff before the limitation of liability. The balance of this article will survey American, Australian and Canadian jurisprudence on this issue, and propose a reasoned path forward.

United States: Taylor Morrison of Colorado v Terracon Consultants, Inc^[3]

In Taylor Morrison of Colorado v Terracon Consultants, Inc, the Colorado Court of Appeal overturned a trial decision that applied a $550,000 liability cap before applying $592,500 setoff against a $9,586,056 jury award.

The claim was brought by a subdivision developer against a geotechnical engineer for construction defects based on homeowners’ complaints about drywall cracks in their new homes. At trial, the jury awarded the developer $9,586,056 in damages, but also found that the engineer’s liability was limited to $550,000. Having applied the cap, the jury deducted the $592,500 settlement from other liable contractors against the $550,000 damages to arrive at zero dollars. The developer appealed. According to the court:

‘This case requires us to address for the first time how a trial court should adjust a jury verdict awarding damages for breach of contract when there is both a setoff for the amount recovered from other liable parties and a contractual limitation on a defendant’s liability. We conclude the correct approach is to first apply the setoff against the jury verdict and then apply the contractual limitation against this reduced amount.’ (Paragraph 1)

The appeals court found that the result of applying the cap first, and then setting off ‘effectively rendered the jury’s damages finding meaningless.’^[4] The appeal court held that:

‘Had the trial court first applied the setoff against the jury verdict and then applied the contractual limitation, the court would have applied the $592,500 setoff against the $9,586,056 jury damages verdict, resulting in new total of $8,993,556. The trial court then would have capped Terracon’s liability according to the Limitation, and reached a final judgment of $550,000 for Taylor.

‘This approach prevents double recovery because Taylor’s recovery from Terracon and the other parties did not exceed the loss actually sustained (some nine and one half million dollars). This approach also preserves Terracon’s rights to enforce the terms of the contract because Terracon would not have paid more than the Limitation agreed upon in the contract.’ (Paragraphs 31–32)

The Taylor Morrison case is not exactly analogous to the UK decision in Rolls Royce, since the setoff made was for monies received by the claimant from other defendants, not Terracon. Terracon’s liability to Taylor Morrison was capped subject to their contract, but the effect of applying the setoff first was to limit Taylor Morrison’s ability to recover under the contract, while providing Terracon an un-bargained-for benefit. In effect, Terracon received a windfall due to the payments made by other defendants. Reversing that decision and requiring setoff to be applied first did not expose Terracon to more than the limitation it had contracted for.

Australia: Global Constructions Australia Pty Ltd (in liq) v AIG Australia Limited^[5]

In Global Constructions Australia Pty Ltd (in liq) v AIG Australia Limited, the Federal Court of Australia was required to determine an insurer’s liability to pay coverage for ‘crime protection’, including for employee fraud or dishonesty, and theft or fraudulent acts. Coverage was subject to a limitation of liability and the court had to determine whether to set off from an insured’s direct financial loss before or after the application of a liability cap:^[6]

‘The insured says one finds the Direct Financial Loss from the acts, deducts the loan account and the value of the shares, and, if that sum (being A minus B) is greater than the limit of liability, the limit of liability caps the obligation of the insurer under the policy, also taking into account the retention. See Derrington D and Ashton RS, The Law of Liability Insurance (3rd ed, LexisNexis Butterworths, 2013) at 1395–1396 [8–469]. The insurer, on the other hand, says that the deduction of the loan account and the value of the shares of the malfeasor is taken off, or reduced from, the insurer’s liability having already taken into account the limit of liability. Thus here, where one has a sum of Direct Financial Loss of significantly over a million dollars, and a limit of liability of $500,000, the point at which one deducts the loan account becomes important.’

The insurer’s view that the liability is zero is because it says the loan account is $800,000 and that is to be taken off last, as it were. After one recognises that the Direct Financial Loss is more than $500,000, the liability is reduced to the limit of liability and then and thereafter the loan account is deducted.’

In the result, the Federal Court in Australia came to a similar conclusion as the Colorado Court of Appeals in Taylor Morrison:^[7]

‘If a shareholder effectively stole $20 million from the company, and had a loan account of $15 million, or a loan account of $600,000, in both cases, there would be a zero value of the liability of the insurer on the insurer’s construction. I do not think that that result would flow naturally from the structure of the policy as it appears. As I said, I read the insurer’s liability for Direct Financial Loss on the fourth line of cl 6 as referable to its liability as identified in that clause, being the Direct Financial Loss resulting from Theft or Fraudulent Acts. The contrary would see it as the insurer’s liability, including any limit of liability elsewhere provided for, and I do not think, structurally or textually, that conclusion is appropriate.

‘It follows that the insurer’s argument regarding the operation of the limit of liability is rejected. Mr Herbert’s loan account is to be set-off against the Direct Financial Loss resulting from Theft or Fraudulent Acts, prior to the application of the limit of liability and retention. It follows that the applicant is entitled to an order that leads to a judgment in at least a sum that the parties are agreed upon, using figures of the insurer with any more, if there be any more, to be ordered by reference to the findings or later agreement in the quantification debate.’

Again, the circumstances of the case are not strictly analogous to those in Rolls Royce because the payor – here the insurer – was seeking to benefit from payments or setoff from third parties (in this case, the fraudulent shareholder), to avoid its bargained-for liability to pay on the occurrence of a stipulated risk. Setoff in this case does not expose the insurer to any greater sum than its bargained-for liability cap, though the insured is able to recover more of its total losses from elsewhere.

Thus, while similar, both the American and Australian examples, above, are distinguishable from the typical construction dispute context in so far as the setoff amounts were from third parties, not the result of offsetting mutual debts between the parties. Next, we will turn to a Canadian case that is squarely on point, and was decided similarly to Rolls Royce.

Canada: KBR Industrial Canada Co v Air Liquide Global E&C^[8]

The case of KBR Industrial Canada Co v Air Liquide Global E&C was an application under the Alberta Arbitration Act, for leave to appeal an arbitral award in which the tribunal, in a split decision, applied setoff of two claims before applying the liability cap to the final damages award. The key issue on appeal was the interoperation of the contractual overall limitation of liability clause and a contractual right of setoff.

Briefly, the facts were these: Air Liquide was building a hydrogenation plant and subcontracted with KBR to fabricate 77 modules to be installed in the plant. KBR struggled to comply with the delivery schedule, and Air Liquide de-scoped 20 modules from KBR and assigned them to another supplier, JV Driver Industrial Inc. KBR started an arbitration, claiming for unpaid invoices, and damages arising from the descoped work, change orders and disruption. Air Liquide counterclaimed for the cost it incurred for de-scoping the work and having JV Driver finish it. Air Liquide also claimed setoff of its damages against any amounts found to be owing to KBR.

The tribunal’s award found damages were owed to both parties: KBR was owed unpaid invoices of $18m, and Air Liquide was entitled to $22m. Under the subcontract, KBR’s liability to Air Liquide was capped at 20 per cent of the contract price, or about $8m. Two of the three panellists found that the damage awards had to be set off first, before applying the cap. After setoff, KBR was ordered to pay Air Liquide $5.2m, and the cap was found not to apply because it was greater than the amount owed.

Dissenting only on the issue of the liability cap and setoff, one arbitrator first applied the liability cap to Air Liquide’s claims, reducing KBR’s liability to the $8m cap, and then set off that amount against the unpaid invoices, directing payment by Air Liquide to KBR of $9.7m. Thus, notwithstanding their agreement on the damages initially incurred, the net difference in the arbitrator’s final award was $15m!

The Alberta Court hearing the application declined to interfere with the tribunal’s majority decision, holding that:

‘KBR has not cited any authorities in support of the proposition that this is the correct legal approach. Further, there does not appear to be anything explicit in the contract which imposes this requirement on the application of the set-off clause.’ (Paragraph 38)

‘Instead, it seems that the Panel did its best to interpret and apply the contractual clause establishing the right of set-off. Even assuming that the majority of the Panel erred in their interpretation, that again is again at most a mixed question of law and fact. There is no extricable error in law on this ground.’ (Paragraph 40)

The Air Liquide case highlights the significant swing in outcomes that can occur when the order of application of setoffs and liability caps are interchanged: in this case, parties swap from payor to payee. The larger the case, the more significant this swing can grow. Since the Alberta court declined to intervene and clarify the issue, and the tribunal’s decision holds little or no precedential weight, the issue is still very much at large in Canada.

For the reasons set out below, the author considers the majority decision in Air Liquide, like the judge’s decision in Rolls Royce, to have been in error, undermining the parties’ bargained-for limitations of liability.

What is a limitation of liability?

Limitations of liability provisions are a form of exclusion clause that are commonly found in commercial contracts, particularly in construction contracts. Such provisions may exclude types of liability (eg, many construction contracts exclude consequential damages, lost profits or lost business opportunity), or cap the amount of damages for which one party is liable to the other.

Typically, liability caps will be stipulated as a fixed amount, or may be expressed as a percentage of the overall contract price, subject to adjustments for changes or variations. Liability caps are also often subject to exclusions, including for liability due to fraud, gross negligence or wilful misconduct, and sometimes exclude amounts that are recovered through insurance proceeds or by way of third-party claims.

A limitation of liability clause can be found in most standard form construction contracts. For example, CCDC 2 Stipulate Price Contract includes the following general condition [emphasis added]:

‘13.1.2 The obligation of either party to indemnify as set forth in paragraph 13.1.1 shall be limited as follows:

.1 In respect to losses suffered by the Owner and the Contractor for which insurance is to be provided by either party pursuant to GC 11.1 – INSURANCE, the minimum liability insurance limit for one occurrence, of the applicable insurance policy, as referred to in CCDC 41 in effect at the time of bid closing.

.2 In respect to losses suffered by the Owner and the Contractor for which insurance is not required to be provided by either party in accordance with GC 11.1 – INSURANCE, the greater of the Contract Price as recorded in Article A-4 – CONTRACT PRICE or $2,000,000, but in no event shall the sum be greater than $20,000,000.

.3 In respect to indemnification by a party against the other with respect to losses suffered by them, such obligation shall be restricted to direct loss and damage, and neither party shall have any liability to the other for indirect, consequential, punitive or exemplary damages.

.4 In respect to indemnification respecting claims by third parties, the obligation to indemnify is without limit.’

A similar provision can be found in the 2017 FIDIC Yellow Book [emphasis added]:

‘1.15 Limitation of Liability

Neither Party shall be liable to the other Party for loss of use of any Works, loss of profit, loss of any contract or for any indirect or consequential loss or damage which may be suffered by the other Party in connection with the Contract, other than under:

(a) Sub-Clause 8.8 [Delay Damages];

(b) sub-paragraph (c) of Sub-Clause 13.3.1 [Variation by Instruction];

(c) Sub-Clause 15.7 [Payment after Termination for Employer’s Convenience];

(d) Sub-Clause 16.4 [Payment after Termination by Contractor];

(e) Sub-Clause 17.3 [Intellectual and Industrial Property Rights];

(f) the first paragraph of Sub-Clause 17.4 [Indemnities by Contractor]; and

(g) Sub-Clause 17.5 [Indemnities by Employer].

The total liability of the Contractor to the Employer under or in connection with the Contract, other than:

(i) under Sub-Clause 2.6 [Employer-Supplied Materials and Employer’s Equipment];

(ii) under Sub-Clause 4.19 [Temporary Utilities];

(iii) under Sub-Clause 17.3 [Intellectual and Industrial Property Rights]; and

(iv) under the first paragraph of Sub-Clause 17.4 [Indemnities by Contractor],

shall not exceed the sum stated in the Contract Data or (if a sum is not so stated) the Accepted Contract Amount.

This Sub-Clause shall not limit liability in any case of fraud, gross negligence, deliberate default or reckless misconduct by the defaulting Party.’

Subject to the typical exceptions for fraud, gross negligence, or wilful or reckless misconduct, these clauses represent the maximum amount one party may owe the other in respect of any claims under the construction contract. Put another way, they set the maximum amount one party may be indebted to the other party for claims under the contract.

What is setoff?

Setoff may reasonably be thought of as a mutual cancellation of debts. In Canada, setoff is divided into legal setoff and equitable setoff. Each has three required elements.

For legal setoff, the following elements are required:^[9]

1. Liquidated debts: the claims between two parties must be for debts which are liquidated. Accordingly, non-liquidated claims (such as damages) and non-money claims (such as property claims or claims for specific performance) are not available.

2. Mutuality: the cross-claims must be between the same parties, and in the same right.

3. Connection or no connection: the cross-claims need not, aside from the requirement of mutuality, have any connection between them.

Equitable setoff is similar, but more relaxed. Debts are not required to be liquidated, so claims for damages come into play, and the mutuality requirement is relaxed. The requirements are:^[10]

1. Liquidated or unliquidated claims: including claims for damages, but not non-money claims (for example, specific performance).

2. Mutuality: this requirement is similar to the legal requirement, but arguably relaxed.

3. Connection: cross-claims must be connected in some manner.

Most construction contracts have express setoff provisions giving parties the right to set off their mutual debts: instead of parties making separate payments, the party with the larger debt may simply pay the difference between the two amounts.

Setoff and liability caps

Parties can only set off amounts that they owe to each other. They may not set off against notional amounts that they do not owe. Even in the context of equitable setoff of damages claims, such setoff can only be effected once the amounts are determined by a court or arbitrator.

Now consider the following example:

‘A contractor enters into a FIDIC Yellow Book agreement with an owner to deliver a new power plant, with an agreed to liability cap of $10 million. Issues arise on the project, including significant delay, which both parties accuse the other of causing. Ultimately, the contractor is terminated and brings a claim for delay damages, termination damages, and unpaid invoices. The owner counterclaims for delay damages, including lost profit.

The tribunal finds the contractor liable to the owner for delay damages of $17m, including $1m in lost profit, but as profits are excluded, total damages are reduced to $16m. On the other side, the owner is found to be liable for unpaid invoices in the amount of $5m.’

Now the question arises which to apply first: the setoff or the liability cap. Applying setoff first, the owner is owed $11m, and the cap brings it down to $10m. If, however, the cap is applied first, the owner’s $16m award is reduced to $10m, and after setoff the owner would be owed $5m. It is submitted that only the latter approach is fair and consistent with the parties’ bargain.

There is little question that the $1m in profit is not owed to the owner because of the contractual exclusion: its deduction, in the first instance, is not particularly controversial. Most observers would agree that it would be unfair for an owner to prove $1m in lost profit and use that to set off against a debt to the contractor, where lost profit is expressly excluded. If the contractor could never be liable to the owner for lost profit, it would be wrong to reduce the contractor’s award by any amount of profit.

Why then should losses in excess of an express cap be treated differently? The parties agreed that the contractor’s liability to the owner would not (or could not) exceed $10m. Whether or not damages are proved at some greater amount is immaterial since the contractor is not liable for damages above the cap. In other words, the excess is not part of the contractor’s debt to the owner, just as the owner’s damages resulting from lost profit are not the contractor’s liability.

When setoff is applied first, the benefit of the bargained for cap on liability is undermined. Consider a different example. The contractor’s liability is capped at $10m. A contractor proves damages for unpaid invoices of $20m, and the owner proves delay damages of $15m. Two scenarios are possible: if setoff is applied first, the contractor will be awarded $5m. In other words, the contractor will have forgone $15m to the owner, when it had bargained for a maximum liability to the owner of $10m. That the money was not ‘paid’ is irrelevant; the lost revenue is just as real to the contractor, and is just as valuable as cash.

Moreover, in the above example, the owner benefits from withholding payment of the invoices. Had it paid the contractor as it should have, at the end of the same arbitration, the contractor would have been owed zero, and the owner’s $15m award would have been reduced to $10m. Instead, because it had accrued a debt to the contractor by failing to pay invoices worth $20m, it has improved its position by $5m. This outcome perverts incentives and is contrary to the parties’ bargain. Setting off damages amounts before the application of a liability cap creates the real risk that parties will be liable for more than the maximum amount of their potential indebtedness.

That the outcome would have been different if the damage awards were mutually paid instead of setoff should be sufficient to prove the necessity of applying a liability cap before setoff. In the previous example, had the parties exchanged two cheques, there could be no dispute that the contractor’s net outcome would be plus $10m. There is no legal or equitable reason for that outcome to be different – ie, $5m less – because the parties elect to set off their mutual debts rather than make separate cash payments.

Conclusion

Setoff and liability caps are a common feature of construction contracts, yet their interoperability in the claim context is not well considered. Given the lack of clarity coming from courts, parties should consider clear, express language in their contracts to establish exactly when liability caps should be applied in circumstances of mutual debts under the contract. As argued above, allowing setoff of damages before caps are applied risks unfairly exposing one party (or both) to an amount of liability that is in excess of their contractual limits, even if actual payment of monies may not exceed the capped figure.

Michael Valo is a partner at Glaholt Bowles LLP in Toronto. He can be contacted on mvalo@glaholt.com.