August 2001

Closing the ‘Expectation Gap’: Pros and Cons of Limiting Liability Language in Engagement Letters

Engagement letters are superb tools for managing client expectations. The process of clearly defining and coming to mutual agreement about the scope of a job is one of the essential benefits. Such efforts help close the “expectation gap” concerning what constitutes the successful completion of a job.

But engagement letters can do more than that. On those unfortunate occasions when something goes seriously wrong, engagement letters can also close the expectation gap concerning who is responsible and who will pay what amounts in liability settlements. In short, by using effective language to limit liability in an engagement letter, accountants can improve their negotiating position in the settlement process.

At Camico Mutual Insurance Company, we are increasingly recommending the use of limiting liability language in engagements where the risk-versus-reward scale is not appropriately balanced. Limiting liability language is best used on jobs in which the risk is high compared to the reward. For instance, Y2K consulting clearly was a situation that called for the use of such language. Similar engagements appear more frequently today as accountants take on more assignments like high tech and investment advising, in which the risks are harder to predict than in more traditional services.

One Camico member recently agreed to evaluate a client’s entire accounting system, whereby he would purchase, install, and test new accounting software. He was concerned about the potential for liability problems if the new system developed major glitches, so he included the following limiting liability language in the engagement letter:

As we discussed, our essential fees in this engagement are very small compared to the amount of business that will be processed by your new accounting system. Accordingly, our liability to you in the event of any defects in the system will be limited to the lesser of our fees for this engagement, or the cost to repair any defects in the accounting system that we may have caused.

This language illustrates a number of key characteristics of effective limiting liability language. First, it is brief and unintimidating enough to not arouse a client’s suspicions about lengthy or “tricky” legalese. Second, it clearly spells out the area of concern (in this case the new accounting software system). Third, it provides a specific description of the accountant’s liability if there are major problems with the system. Finally, it acknowledges that problems could be caused by the accounting firm. Such language is more likely to win the respect of a court than verbiage that attempts to avoid responsibility in areas where the accountant is genuinely negligent.

In spite of its value, there are downsides to the use of limiting liability language. It does not limit liability to any third parties in a lawsuit, nor is it enforceable in every court. Furthermore, as with any risk containment effort, some clients might be offended, which may lead to loss of business. Nevertheless, Camico believes that, especially in high risk–lower reward jobs, the benefits of limiting liability language far outweigh the potential negatives.

Benefits begin during the assessment stage, by encouraging the accountant to evaluate risks versus rewards, an inherently valuable exercise. In addition, discussions and negotiations with the client contribute to a climate of open communication from the onset. The communication process can also help detect prospective clients that are totally inflexible in sharing liability risks—clients one may be better off without. Most significantly, limiting liability language can be a valuable reference point in settlement discussions.

As to whether such language will stand up in court, this will vary from state to state and court to court. At present, such decisions are being made on a case-by-case basis. However, the mere act of communicating with the prospective client and coming to a mutual agreement that is formally documented is a positive step toward limiting liability. In short, a few brief, clearly written sentences that spell out the risk, define the appropriate liability, and accept responsibility for potential negligence may significantly reduce settlement fees. For more information on Camico services call (800) 652-1772.