14th Mar 2018 | Articles & Newsletters
Interpreting ‘Fraud’ Exceptions to Limitation and Exclusion Clauses
It has long been common practice for commercial contracts to contain a ‘fraud’ carve-out in clauses purporting to limit or exclude liability. This exception is built in to reflect the “commercial common sense that a contracting party may be prepared to assume the risk of negligence by his counterparty, but not the risk of fraud” (as per Jacob J in Thomas Witter Limited v TBP Industries ). In this recent Court of Appeal case, Lewison LJ provided helpful guidance on the interpretation of fraud carve-outs to limitation and exclusion clauses. The essential question on appeal was whether Mr Richard Salter QC, sitting as a Deputy High Court Judge, was wrong to conclude that Interactive had no real prospect of success in bringing a counterclaim within the ‘fraud’ exception, unless it could actually plead a cause of action in fraud (which it could not do).
The Court of Appeal dismissed Interactive’s appeal, upholding Mr Salter QC’s order striking out/giving summary judgment on its counterclaim for US$55 million. Lewison LJ concluded that “the only workable criterion is whether an allegation of fraud is a necessary ingredient of the legal basis on which loss is claimed: in other words, whether an allegation of fraud is a necessary averment to a cause of action”. It followed that Interactive’s counterclaim did not fall within the words “excluding fraud” and O3B’s limitation clause was effective.
The proceedings involved a claim for unpaid fees arising from the provision by the Claimant, O3B, of satellite bandwidth to the Defendant, Interactive, for onward sale to fixed line and mobile telephone operators in Pakistan. A Master Services Agreement (“MSA”) made between the parties operated as the governing framework agreement for specific orders of bandwidth from O3B’s satellites, which were to be provided under specific Service Orders. Together, the MSA and the Service Orders required Interactive to pay monthly service fees. The obligation to pay was trigged by O3B serving a Service Commencement Notice which specified a Service Commencement Date.
In its defence, Interactive alleged that in order for the satellite system to be successfully placed into commercial operation, it must comply with certain Pakistani regulatory requirements. It was Interactive’s case that the Service Commencement Notice served on it by O3B was defective because, when the notice was served, the satellite system had not achieved regulatory approval and therefore could not have been successfully placed into commercial operation. Interactive accordingly refused to pay the service fees. As a result of the non-payment, O3B purported to terminate the MSA.
Interactive counterclaimed damages for breach of contract quantified at US$55 million. It sought to advance new allegations not against O3B directly, but against a third party known as TIS, a company subcontracted by O3B to provide its services. Interactive alleged that TIS had attempted to deceive Pakistani authorities in relation to regulatory compliance by way of a letter containing untrue statements.
The counterclaim faced a limitation clause in the MSA, which did not apply to “the liability of either party arising from fraud”. Notably, Interactive did not plead any actual cause of action in fraud against O3B, but argued that some element of dishonesty in the factual matrix of the counterclaim was sufficient to invoke the ‘fraud’ exclusion and render the limitation clause ineffective.
O3B applied for summary judgment and strike out of the counterclaim. Mr Salter QC granted O3B’s application at first instance, concluding that Interactive had no reasonable prospect of succeeding on the counterclaim (in other words, bringing it within the ‘fraud’ exception to the limitation clause) unless it could actually plead a cause of action in fraud.
The Court of Appeal noted that the main difficulty for Interactive in pursuing its counterclaim was that the nature of its case and its relationship to fraud was not entirely clear. Interactive did not allege either that it was misled by anything said or done on behalf of O3B, or that the Pakistani authorities were misled by the letter containing the untrue statements. Lewison J highlighted that Interactive “pleads no cause of action against anyone in which an allegation of dishonesty is a necessary averment”. Indeed, it was accepted by Counsel for Interactive that “an allegation of dishonesty was not a constituent part of the counterclaim”.
The Court of Appeal noted that the traditional approach to construing exclusion clauses has been one of hostility, but that since the passing of the Unfair Contract Terms Act 1977, the courts have become more accepting of such clauses. It is now recognised that, at least in commercial contracts between parties of equal bargaining power, limitation and exclusion clauses are “an integral part of pricing and risk allocation”.
Asplin LJ and Arden LJ were in agreement with Lewison LJ that the only workable criterion for determining whether a particular fraud fell within the exception to the limitation clause was “whether an allegation of fraud was a necessary averment to support a cause of action”.
This decision confirms that limitation and exclusion clauses are not to be construed narrowly (or, to put it another way, that their ‘fraud’ carve-outs ought not to be construed too broadly). The generous approach to construing such clauses in the particular context of insurance contracts had already been confirmed recently by the Supreme Court in Impact Funding Solutions Ltd v AIG Europe Insurance Ltd  UKSC 57.
It is now clear that parties wishing to rely on a ‘fraud’ exception to a limitation or exclusion clause must ensure that they plead a distinct cause of action in which dishonesty is a “necessary averment”. Examples of such causes of action include fraudulent misrepresentation or deceit, the economic torts of conspiracy and inducing a breach of contract, dishonest assistance and knowing receipt, or wrongful trading. It seems that this approach promotes certainty and is in keeping with the commercial purpose of such clauses. If ‘fraud’ in this context could simply denote a cause of action whose factual matrix includes some aspect of dishonesty, limitation and exclusion clauses would have an indeterminate scope.