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Consequential loss exclusion clauses: the pitfalls

Consequential loss exclusion clauses are very common in commercial contracts, especially in those relating to construction and energy projects. They usually take a similar form to the following, which is from clause 17.6 of the FIDIC Red Book:

“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.”

The key thing to remember about consequential loss is that it doesn’t mean what you think it means.

Hadley v Baxendale

In order to sort out how English law and contractual terminology has developed on this topic, it is necessary to go right back to Hadley v Baxendale, which established the test for losses which were too remote in contract claims. In that case, the Court of Appeal said there were two kinds of losses that flowed from a breach of contract:

  • Losses of a kind which flowed directly and naturally from the breach, which were reasonably foreseeable in the ordinary course of events (limb one, often referred to as direct loss).
  • Losses of a kind which arise from a special circumstance of the case, which are only recoverable if they were in the contemplation of the parties at the time of entering the contract (limb two, often referred to as indirect loss).

The usual example given to illustrate the effect of this distinction is that from Victoria Laundry v Newman Industries. Newman was five months late delivering a boiler to the laundry. As a result, the laundry lost a lucrative contract with the government. It was held that the laundry could only recover its ordinary loss of profits, not the extra profits from the government contract because Newman didn’t know about it at the time of entering the contract with the laundry, and couldn’t reasonably be expected to know.

It will be apparent from this example that loss of profits was treated as in principle limb one or direct loss. This categorisation of a loss of profits claim has been applied in all subsequent cases (for a recent example, see McCain Foods GB Ltdv Eco-Tec (Europe) Ltd). Obviously, on the facts of a particular case, it may be that a loss of profits does not flow directly and naturally from the breach, but in almost all commercial contracts it will.

Confusion arises in the industry because in most people’s terminology, financial losses are considered indirect or consequential. Direct losses are those relating to physical damage or the cost of rectifying a defect, or the loss in market value of the thing sold or constructed. The sense of this distinction is supported in principle by the editors of McGregor on Damages (19th Edition): see the discussion at paragraphs 1-036 to 1-039.

British Sugar v NEI Power Projects

However, English law has consistently (so far) held that consequential loss means something different. The leading case is British Sugar v NEI Power Projects.

Here, the contract contained a clause limiting the seller’s consequential loss to the value of the contract. The seller contended that any reasonable businessman would understand consequential loss to mean loss of profits. However, the Court of Appeal looked at previous appellate decisions on the meaning of “consequential”  in commercial contracts, and concluded that the term had a settled meaning as a matter of law, namely that consequential loss referred to limb two Hadley v Baxendale losses only. It said that a reasonable businessman must be taken to have intended the word to have its established legal meaning.

The British Sugar approach has been followed in numerous subsequent first instance and Court of Appeal cases. Readers will appreciate that the effect of this is that an exclusion clause referring solely to consequential loss is unlikely to add anything to the protection already conferred by the remoteness rules at common law.

There are some small signs of resistance to the British Sugar approach. In Caledonian North Sea Ltd v British Telecommunications plc, the House of Lords queried whether English law had in fact taken the right direction. It is also notable that in Australia the courts have followed the McGregor construction: see for example Alstom Ltd v Yokogawa Australia Pty Ltd (No 7) [2012] SASC 49. However, as matters stand, consequential loss in English law refers to Hadley v Baxendale limb two losses only and a case will need to go to the Supreme Court before there is any change in approach.

Example types of losses

Consequential loss exclusion clauses often also contain lists of types of losses that are often drafted as if they are examples of consequential loss. Loss of profits and loss of use are two of the most frequently included. Plainly, there is something wrong here since such losses would normally be limb one losses and not examples of consequential loss at all.

The Commercial Court considered this situation in Markerstudy Insurance Co v Endsleigh Insurance Services Ltd. Here the contract included an insurance clause that read:

“Neither party shall be liable to the other for any indirect or consequential loss (including but not limited to loss of goodwill, loss of business, loss of anticipated profits or savings and all other pure economic loss) arising out of or in connection with this Agreement.”

The court held that the references to loss of profits, etc, must be taken to be examples of such losses of profits that would fall within limb two losses, and that therefore the loss of profit which had in fact occurred, which was a limb one loss, was not excluded.

However, where the contractual wording is in similar terms to the FIDIC contracts, so that the loss of profits are not characterised as an example of consequential loss but are in addition to it, or where consequential loss is formally defined as including limb one loss of profits, the courts have been able to state that the parties have successfully excluded the limb one losses that are specifically identified.

The key when drafting is carefully to consider precisely what losses are likely to flow from a breach of contract, and then specifically to identify those types of losses in the exclusion clause. In other words, rely on specific words not a general consequential loss exclusion. The key in the context of a dispute is again carefully to identify exactly what type of loss has occurred, then compare it to the listed categories of excluded loss. It is necessary to be precise in both aspects of this approach as the courts take a strict, rather than a broad, interpretation of the words.

3 thoughts on “Consequential loss exclusion clauses: the pitfalls

  1. Indirect losses under second limb of Hadley v Baxendale are recoverable if within contemplation of the parties at time contract entered into – but if recoverable under this test they are presumably still indirect losses albeit recoverable indirect losses. Therefore an exclusion of indirect loss clause will still exclude them even though they would be otherwise recoverable under second limb. Do you agree ?

  2. We can’t comment on specific clauses via this blog, but would suggest that parties always take the opportunity to draft an exclusion or limitation clause considering the contract and risks they face. Clearly, parties and their advisers also come across the unexpected, after the event. However, a clearly drafted clause, that does not rely on an understanding of (for example) Hadley v Baxendale, can sometimes avoid a costly dispute.

  3. It is common to see in b2b contracts, clauses stating that a limitations of liability and consequential loss waiver will not apply in cases of fraud or “any other liability to the extent that the same may not be limited excluded or limited as a matter of law”. I understand that this would capture those items that cannot be limited/excluded by UCTA but are there any others?

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