October 30, 2013 Articles

PCAOB Proposes New Auditing Standards to Expand Reporting Obligations

The board proposed new standards that, if adopted, would expand the nature and scope of disclosures in the auditor?s report on financial statements.

By Joshua D. Maggard

Courts in most states will enforce limitation-of-liability provisions under the theory that parties should have the freedom to contract. The bad news is that most courts are skeptical of these provisions and will invalidate anything they decide is “unconscionable.” Nor is it an exaggeration to say that the stakes are potentially staggering. In 2011, one actuarial firm was held liable for $73 million in damages for “lost” pension contributions and investment earnings, in a suit brought by its client of 22 years. The firm did not have a limitation-of-liability provision in its contract, severely undercutting its argument that it never contemplated such exposure for its professional services, even in light of the modest annual fees it received.

Limitation-of-liability provisions are important but are helpful only to the extent they are enforceable. Fortunately, courts generally consider the factors discussed below when deciding whether to uphold such provisions. Carefully reviewing and implementing the five tips outlined here may help avoid that next $100 million malpractice suit altogether.

The Placement: Is the Provision Conspicuous, Concise, and Clear?
The first major factor that courts consider is whether the provision is conspicuous and understandable, or is instead buried in the contract, either by physical placement or extensive legalese. The rationale behind this factor is to confirm that both parties were aware of and in agreement with the limitation provision, and courts generally consider this question using a “reasonable person” standard. If a reasonable person would not notice the provision or understand its significance when reading through the contract, there is a good chance that a court will invalidate it.

Practice tip: To make sure the provision is conspicuous, firms should place the limitation of liability in a separately numbered provision, under a bold heading entitled “Limitation of Liability.” The provision should be short and clear, and may be further emphasized by using different fonts, font sizes, or color. Interestingly, however, the use of all capital letters actually reduces emphasis, presumably for the same reason we tune out people yelling on talk radio stations, and should be avoided. This first factor is very important, because courts may strike down an otherwise reasonable limitation amount if the provision containing it is inconspicuous or unclear.

The Formation: Did the Parties Negotiate the Provision?
Under the second factor, courts review the particulars of how the parties reached agreement concerning the provision. While the first factor considers whether a “reasonable person” would consider the provision conspicuous, courts may still strike down a provision where there is evidence the provision was not the product of good-faith negotiation between both parties. This concern is particularly compelling where the provision is included in a contract of adhesion, or where a contract is found to involve public interests or services. As a result, firms must take steps to demonstrate that the provision was willingly and knowingly entered into by both parties.

Practice tip: The primary strategy is to draw specific attention to the provision within the contract itself, which can be done in a number of ways, including having both parties initial next to the provision, referencing the provision in correspondence sent to the client, referencing and incorporating the provision in connection with fee negotiations, and placing a statement immediately above the signature block that “this contract contains a limitation-of-liability provision that has been read and consented to by both parties.” In fact, firms should consider taking all of these steps and should retain any drafts and modifications of the provision negotiated between the parties. The main concern under this third factor is whether both parties understood and consented to the limitation. The more opportunities that the firm has to establish these facts, the likelier it is that the provision will be enforced.

The Amount: Is the Liability Limit Unreasonably Low?
The third factor is driven by the bottom line—is the limitation amount reasonable, or is it unconscionably low? Unsurprisingly, this determination varies wildly based on the jurisdiction. While some courts have enforced low limitations even in the face of high potential exposure, finding that this result is precisely what the parties contemplated, other courts have invalidated provisions on the grounds that the amount is unconscionably low. Although not always clearly articulated, the policy rationale is that low liability amounts “remove the incentive to perform with due care.” The key to getting the provision enforced is convincing the court that the limitation is not unreasonably low. One effective strategy for accomplishing this is demonstrating that anything over the limitation of liability would be unreasonably high. Courts frequently look to the amount of the fees as a proxy for the amount of risk assumed by the contracting party, and explicitly tying the limitation of liability to the fees that the parties agreed were reasonable for the services is an effective approach.

Practice tip: Firms should consider setting a limit of some multiple of the actual fees received and also including language in the contract that these fees “do not contemplate the Firm becoming involved in legal proceedings that would expose the Firm to open-ended liability.” The parties also can make clear in the contract itself that the compensation for professional services reflects the allocation of risk agreed to by the parties, which courts have found to be a compelling reason for enforcing a limitation of liability tied to those fees. This third factor is a crucial one, and significant time should be spent to ensure that a court will not invalidate the parties’ agreement to cap liability as a result of an amount that is too low.

The Content: What Liability Is Limited?
Even if the first three factors are satisfied and the provision would be generally enforceable in most situations, a court may still decide that the provision does not apply to the particular case before it. Several courts have closely parsed language and refused to enforce a provision that did not specify that it applied, for example, to both tort and contract actions.

Practice tip: Firms should clearly state that the limitation of liability applies to any legal or equitable claim brought by the plaintiff, whether brought under tort, contract, malpractice, fiduciary duty, statutory, or any other legal theory. Firms also can include language specifying that regardless of the legal theory pursued, neither party is liable for loss of profit, consequential, punitive, or similar damages, and that multiple claims arising out of the same services shall be considered as a single loss for limitation purposes. Finally, many states prohibit limitations of liability for certain types of conduct, including gross negligence or willful and wanton conduct, and firms should review their ability to enter into agreements regarding this type of conduct in each jurisdiction. By avoiding overbreadth in the scope of the covered conduct, firms can avoid invalidation of otherwise valid provisions. It would be cold comfort to realize that an invalidated provision would have applied in 99 percent of situations had its reach not been overbroad.

The Scope: Whom Does the Provision Cover?
Finally, an otherwise airtight provision may still be invalidated if it is not clear that the respective parties are covered by the limitation provision. As a result, both parties should decide whom will be covered by the provision: only the firm, its officers and directors, all employees, or some subset. Courts have carefully parsed these agreements and have sometimes excluded certain types of employees from the agreement—or even all non-signatories entirely. In cases where the provision is construed to benefit only the firm, plaintiffs may be able to sue the professional directly to circumvent the limitation of liability.

Practice tip: Firms should address this issue by specifically defining all entities that are covered under the provision, whether or not they are actual signatories to the contract. If it appears likely that personal liability could be an issue, parties also may include an agreement not to personally name employees, directors, or officers in any future lawsuit.

While the most important and least controllable factor is the proclivities of the individual judge who will control the actual litigation, there is a much better chance of enforcing a provision that is the product of careful consideration and drafting of limitation-of-liabilities provisions. Parties should confirm that existing provisions (1) set a reasonable limit, (2) are conspicuously placed in the contract, (3) are the product of documented negotiation, (4) clearly set out the liability to which they apply, and (5) cover everyone the parties intend to be covered. You may never be able to entirely escape liability in litigation, but with careful drafting, and the right judge, you should be able to limit it.

Keywords: professional liability litigation, limitation of liability, malpractice, fee negotiations

Joshua D. Maggard is a partner with Quarles & Brady LLP in Milwaukee, Wisconsin.