REUTERS | Peter Cziborra

Indirect and consequential loss exclusions – is it time for change?

Parties to construction contracts often include clauses in their contracts seeking to exclude claims for indirect and consequential losses, believing that such clauses are likely to prevent claims for financial losses such as lost profits and business interruption. Contracting parties may consider such financial losses to be beyond the ordinarily recoverable losses flowing from a breach (as compared to the actual cost of repairing defects, for example). However, it is unlikely that such exclusion clauses will bar a claim for this type of financial loss.

But is a change forthcoming? The TCC’s recent decision in 2 Entertain Video Ltd v Sony DADC Europe Ltd suggests judicial appetite for a change to the traditional and narrow interpretation of indirect and consequential loss exclusion clauses. Although the court’s decision accorded with the traditional interpretation, O’Farrell J considered that indirect and consequential loss exclusion clauses should be given their natural and ordinary interpretation while considering the contract as a whole and any relevant factual matrix.

Background to the traditional approach

There is a line of cases that establish that a contractual exclusion for consequential and indirect losses is limited to losses which fall within what is known as the second limb of Hadley v Baxendale. Hadley v Baxendale is an old and well-known case that established the remoteness test for recoverability of damages for breach of contract. The two limbs are:

Limb 1: damages that arise naturally from the breach, in the ordinary course of things (direct losses).

Limb 2: damages that may reasonably be supposed to have been in the contemplation of both parties, at the time they made the contract, arising as the probable result of the breach (indirect or consequential losses).

Loss of profit will not inherently be categorised as an “indirect or consequential loss” such that it may be caught by an exclusion clause for such losses. Financial losses, including loss of profit, which one would normally expect to flow from the breach, are likely to be classified as direct loss.

By way of example, in Croudace Construction Ltd v Cawoods Concrete Products Ltd, the judge at first instance (whose decision and reasoning was upheld by the Court of Appeal), held that the word “consequential” did not cover any loss that directly and naturally resulted in the ordinary course of events from late delivery of masonry blocks for a construction project. The contract provided that the suppliers of the masonry blocks were:

Not under any circumstances to be liable for any consequential loss or damage caused or arising by reason of late supply ….”

The judge held that losses that began to “clock up at once” (such as the wasted cost of the workforce, plant and equipment) were to be regarded as direct and not consequential loss. The loss was considered a direct and natural consequence of the breach and was recoverable notwithstanding an exclusion clause precluding recovery of consequential loss. Therefore, commercial parties should be wary when drafting their exclusion of loss clauses.

Moving away from the traditional approach?

Notwithstanding this, a combination of developments in the general principles of contractual interpretation, together with the courts taking a more flexible approach indicate that courts may now be moving away from the traditional approach.

In Transocean Drilling UK Ltd v Providence Resources plc, the Court of Appeal stated in respect of consequential loss:

“It is questionable whether some of … [the past] cases [such as Croudace Construction v Cawoods] would be decided in the same way today, when courts are more willing to recognise that words take their meaning from their particular context and that the same word or phrase may mean different things in different documents.”

In Transocean, “consequential losses” were defined in the contract as:

“(i) any indirect or consequential loss or damages under English law, and/or

(ii) to the extent not covered by (i) above, loss or deferment of production, loss of product, loss of use … loss of business and business interruption, loss of revenue … loss of profit or anticipated profit …”

The Court of Appeal did not consider it necessary to categorise the losses as ones that fell within one or other of the limbs of Hadley v Baxendale. Instead the court’s starting point was the language of the clause itself and the natural meaning of the words:

“…the court’s task is not to re-shape the contract but to ascertain the parties’ intention, giving the words they have used their ordinary and natural meaning.

Similarly, in Star Polaris LLC v HHIC-Phil Inc, the court concluded that although the meaning of “consequential loss” in an exemption clause usually meant the exclusion of losses falling within the second limb of Hadley v Baxendale, in the absence of judicial consideration of the particular clause in question, it should be construed on its own wording in the context of the particular agreement as a whole and its particular factual background.

In Star Polaris, the shipbuilder had expressly agreed to repair or pay for physical damage and some identified consequent expenses. It was common ground that the liability provisions of the contract provided a complete code for damages. The court held that, by excluding liability for “consequential or special losses, damages or expenses”, the parties intended to exclude all financial losses, consequent on physical damage, that had not expressly been accepted.

The facts of 2 Entertain Video Ltd v Sony DADC Europe Ltd

2 Entertain Video Ltd (2E) issued proceedings claiming, among other things, loss of profit and other business interruption losses against Sony arising from a fire which destroyed Sony’s warehouse following the civil disorder and riots in London in 2011.

At the time of the fire, Sony provided logistic services and warehouse storage facilities to 2E who stored stock valued at approximately £40 million. The parties’ contract included the following exclusion clause (clause 10.3):

Neither party shall be liable under this Agreement in connection with the supply of or failure to supply the Logistics Services for any indirect or consequential loss or damage including (to the extent only that such are indirect or consequential loss or damage only) but not limited to loss of profits, loss of sales, loss of revenue, damage to reputation, loss or waste of management or staff time or interruption of business.”

The decision

The court looked first at the ordinary and natural meaning of the “unhappily drafted” provision. It considered that the second part of the clause was not helpful even though it sought to provide an indication of categories of loss that the parties sought to exclude because “loss of profits” and the other stated categories of loss were losses that may or may not fall within the exclusion.

Sony argued that the combination of clause 10.1, which provided that Sony’s liability for any loss of or damage to 2E’s materials or goods “shall not exceed their manufacturing replacement cost” and clause 10.3, the consequential loss exclusion, constituted the complete contractual scheme of risk and liability allocation:

  • Clause 10.1 identified the particular loss for which Sony would be liable and defined the limit of such liability.
  • Clause 10.3 excluded the lost profits and business interruption losses claimed by 2E as these were consequential on the loss of the goods.

It relied on Transocean and Star Polaris in support of this interpretation.

The court disagreed noting that:

  • Unlike the provisions in Star Polaris, clause 10.1 did not attempt to define the extent of Sony’s liability for all breaches under the contract. It was simply concerned with compensation for the loss of, or damage to, the goods. It did not preclude a claim for lost profits and other business interruption losses and did “not assist in ascertaining the true meaning of clause 10.3”.
  • There was no definition of indirect or consequential loss in the contract as there was in Transocean that would suggest a wider meaning than the second limb of Hadley v Baxendale.

The court agreed with Sony’s submission:

“…that any general understanding of the meaning of ‘indirect or consequential loss’ must not override the true construction of that clause when read in context against the other provisions in the [contract] and the factual matrix.”

However, it concluded that clauses 10.1 and 10.3 could not be interpreted in the way suggested by Sony to exclude the loss of profits and business interruption costs claimed by 2E. These losses flowed directly and naturally from the fire and from Sony’s breach in failing to provide the logistics services.

Going forward

Although the court thought the way in which the exclusion clause had been drafted in this case was unhelpful, it considered the words in the contract and the surrounding facts, giving the words “indirect and consequential loss” their natural and ordinary meaning.

Parties should consider carefully the drafting of any exclusion clauses and the types of losses they are trying to exclude. Financial losses, such as lost profits and business interruption costs (as in this case), may not necessarily constitute indirect or consequential loss or damage and, as a result, may not be captured by a generic description of categories of loss.

To what extent will the courts continue to uphold the traditional interpretation? Given that judicial commentary in a number of cases over recent years has suggested a change in approach, it will be interesting to see whether the courts will adopt a case-by-case approach when interpreting such exclusion clauses going forwards.

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