Consequential loss exclusion clauses – getting them right
It is common for construction, supply, and service contracts to contain a clause excluding or limiting liability for "indirect or consequential loss". Indeed, many contractors and suppliers will not enter a contract without such a clause.
Common examples include:
“The Contractor’s liability to the Client for the Client’s indirect or consequential loss is limited to [insert amount]” (NEC ECC4)
“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, other than under [various sub-clauses]” (FIDIC Yellow Book)
“Save as otherwise stated in these General Conditions or in case of Gross Negligence there shall be no liability for either party towards the other party for loss of production, loss of profit, loss of use, loss of contracts and for any other consequential or indirect loss whatsoever, whether the loss was foreseeable or not.” (Orgalim S 2022)
“The Seller will not be liable to the Purchaser for any special, indirect or consequential loss.”
Despite the prevalence of such clauses, their legal effect in Australia remains uncertain. It can be challenging to determine with certainty whether they will exclude liability for foreseeable loss of profits or anticipated cost savings (for example, anticipated electricity savings resulting from the purchase of new, energy-efficient equipment to replace less efficient equipment).
The advice most Australian lawyers now offer is that if you wish to exclude liability for loss of profits or other specific types of loss, you should specifically describe the types of loss for which liability is excluded.
However, achieving such an outcome can be commercially unattainable if the benefit that the purchaser seeks from the contract is improved profitability or cost savings. A balance must be struck between:
protecting the legitimate interests of the purchaser, including the benefits that it is expecting to obtain from the purchase; and
protecting contract breakers from unpredictable liability.
If clauses that exclude liability for indirect, consequential, or other types of loss are not carefully drafted:
suppliers and contractors can find that they are not protected to the extent they may have thought, thus leaving themselves exposed to potentially extensive liabilities; and
purchasers may find they have left themselves with no recourse at all for certain types of losses, losses which could have drastic consequences for their businesses.
Remoteness of loss
From the middle of the 19th century, English courts recognised that requiring a contract breaker to compensate the other party for all losses arising from the breach, no matter how improbable or unpredictable, was akin to complete indemnity and could expose the contract breaker to liability that is disproportionate to the risks he or she might fairly be expected to have accepted when entering the contract.
To address the issue, the English courts developed a concept now known as remoteness of loss. The seminal case was Hadley v Baxendale. That case held that for loss resulting from a breach of contract to be recoverable by way of damages, the loss must not be too remote from the breach. The court then described when loss will or won’t be too remote. It essentially established three categories of loss: two that are recoverable by way of damages and one that is not.
The first category of loss for which a contract breaker will be liable was described as loss that arises “naturally, i.e according to the usual course of things” from the breach. In other words, it is loss of a nature and quantum that can be expected to occur in the ordinary course of events as a result of the breach, or that most people in the position of the innocent party would be expected to suffer. The courts often refer to this category of loss as “direct loss”, but let’s use more descriptive terms such as “ordinary loss” or “normal loss”.
This first category can be quite broad. It may encompass loss of profits or loss of anticipated savings if such losses would normally result from the breach, and the amount does not exceed what would typically be expected.
The second category of loss for which a contract breaker will be liable was described as loss that “may reasonably be supposed to have been in the contemplation of both parties, at the time they made the contract, as the probable result of the breach of it”. In other words, it is a loss that is reasonably foreseeable at the time the contract is entered into. Let’s refer to this second category as “foreseeable loss”.
The second category overlaps with the first, as ordinary loss is also foreseeable loss. The additional loss from the second category is loss of a nature or amount unique to the innocent party and therefore not ordinary loss, but which was nonetheless reasonably foreseeable by the contract breaker because it was communicated to the contract breaker before the contract was made and was therefore within its contemplation when the contract was formed (or ought to have been). In other words, the second category expands the losses recoverable for breach of contract to losses of a nature or amount that are reasonably foreseeable despite being unique or special to the innocent party, because they were brought to the contract breaker's attention prior to the contract’s formation.
The third category of loss encompasses everything else, or loss that is neither ordinary loss nor foreseeable loss. The contract breaker will not be liable for this loss because it is too remote from the breach. Let’s call this third category of loss “unrecoverable loss”.
The third category of loss becomes recoverable if a contract includes an indemnity, as an indemnity will cover all losses arising from the event or breach for which it is provided, including losses that are not recoverable through damages for breach due to their remoteness.
Court’s historical approach to the meaning of consequential loss in an exclusion clause
Let’s consider again the final example exclusion clause provided above:
“The Seller will not be liable to the Purchaser for any special, indirect or consequential loss.”
The separate references to “special loss”, “indirect loss” and “consequential loss” in the above clause suggest that these terms have different meanings. Why would one use different words to say the same thing? However, Australian and English courts have repeatedly ruled that consequential means the same thing as indirect when used in contract clauses like the one above. Both terms capture any loss that is not direct loss (or loss that is not “ordinary loss”, as defined above). Similarly, “special loss” when used in the above clause, is also referring to loss that is not “ordinary loss”.
This interpretation gives little utility to an exclusion of special, indirect or consequential loss, in the context of a claim for damages for breach of contract, because:
all loss in the first category will remain recoverable; and
loss in the third category would be unrecoverable in any event because it is too remote.
The exclusion has more utility if the contract includes an indemnity, as losses in the third category would be recoverable under the indemnity were it not for the exclusion.
As previously mentioned, the first category is broad and can include loss of profit, loss of anticipated savings, and loss of use, provided that the amount does not exceed what would ordinarily be expected under the circumstances.
Watch out for the use of “other” or “including”
Let’s now consider the exclusion clause from the Orgalim contract:
“Save as otherwise stated in these General Conditions or in case of Gross Negligence there shall be no liability for either party towards the other party for loss of production, loss of profit, loss of use, loss of contracts and for any other consequential or indirect loss whatsoever, whether the loss was foreseeable or not.” (emphasis added)
The use of the word “other” is potentially problematic. It leaves room to argue that loss of production, loss of profit, loss of use, and loss of contracts is:
only excluded to the extent that such loss is consequential or indirect loss; and
not excluded to the extent it falls within the first category as direct loss.
The same argument can be made in relation to clauses that exclude liability for “consequential or indirect loss, including loss of profit, loss of production …”.
Such an argument succeeded in the case of Pegler Ltd v Wang (UK) Ltd, but failed in BHP Petroleum Ltd v British Steel plc. Subtle drafting differences can dramatically affect the commercial outcome. The argument can be avoided by omitting the word “other” from the Orgalim clause.
Australia departs from the historical approach
Australian courts have shifted from the historical legal meaning given to “special, indirect, or consequential loss” in an exemption clause. However, as will be seen, they nonetheless seem to be circling back to the same commercial outcome.
A turning point for Australia came with the High Court’s 1986 decision in Darlington Futures Ltd v Delco Australia Pty Ltd. This case concerned a broker in the commodity futures market who was asked to arrange certain transactions for its client, known as tax straddles, to reduce taxable income in one year and transfer it to the following year. The transactions were not properly executed, resulting in an irrecoverable loss for the client. These transactions were undertaken without the client’s authorisation but in a manner that bound the client. The contract between the client and the broker included the following provisions:
6. ... The Client ... acknowledges that the Agent will not be responsible for any loss should the Client follow any of the Agent's trading recommendations or suggestions, nor for any loss, in the case of Discretionary Accounts, arising from trading by the Agent on behalf of the Client. The Client finally acknowledges that the Agent will not be responsible for any loss arising in any way out of any trading activity undertaken on behalf of the Client whether pursuant to this Agreement or not ...
7. ... c) Any liability on the Agent's part or on the part of its servants or agents for damages for or in respect of any claim arising out of or in connection with the relationship established by this agreement or any conduct under it or any orders or instructions given to the Agent by the Client, other than any liability which is totally excluded by paragraphs (a) and (h) hereof, shall not in any event (and whether or not such liability results from or involves negligence) exceed one hundred dollars.
The court held that the words excluding liability in clause 6 only applied to transactions undertaken with the client’s authority, and thus did not apply to the transactions in question, but that clause 7 effectively capped the broker’s liability at $100 for each unauthorised transaction because it was expressed to extend to claims arising out of or in connection with the relationship established by the agreement.
The High Court stated that:
“These decisions clearly establish that the interpretation of an exclusion clause is to be determined by construing the clause according to its natural and ordinary meaning, read in the light of the contract as a whole, thereby giving due weight to the context in which the clause appears including the nature and object of the contract, and, where appropriate, construing the clause contra proferentem in case of ambiguity.”
Building on this less hostile approach of giving the words in an exclusion or limitation clause their ordinary meaning, the term “consequential loss” was first given a broader meaning in 2008 by the Victorian Court of Appeal in Environmental Systems Pty Ltd v Peerless Holdings Pty Ltd. In this case, the owner operated a rendering plant and contracted with a contractor to replace an existing after-burner with a regenerative thermal oxidiser (RTO) of certain specifications. The contract included performance guarantees for emissions and fuel usage with pre-determined liquidated damages, in the form of a reduction to the purchase price, if the guarantees were not met.
The equipment supplied by the contractor did not meet the emission guarantees. Despite considerable efforts to make the RTO function as intended, it was unable to manage the odour satisfactorily, leading the owner to shut down the RTO and revert to using an afterburner.
The owner sought to recover the costs it incurred in purchasing, installing, and commissioning the RTO. It also aimed to recover the expenses incurred from having its employees attempt to make the RTO functional, along with the additional gas costs resulting from operating the old after-burner until it could be replaced with a more efficient one.
The contract included the following clause:
“As a matter of policy, Environmental Systems does not accept liquidated damages or consequential loss. Environmental Systems is motivated to achieving agreed milestones through respect for the client's needs and the obvious financial advantage gained from completion of projects in the shortest possible period.”
The court considered the reference to liquidated damages in this clause to be an error, given the contract’s provisions prescribing liquidated damages for failing to meet the performance guarantees.
Most relevantly, the court held that “consequential loss” should not be limited to losses that are recoverable under the second limb of Hadley v Baxendale, and that these words should instead have their ordinary or normal meaning. The court said that “the true distinction was between ‘normal loss’, which is loss that every [claimant] in a like situation will suffer, and ‘consequential losses’, which are everything beyond the normal measure, such as profits lost or expenses incurred through breach.” (my emphasis)
The court held that the claimed employee costs and additional gas costs fell within this broader interpretation of consequential loss and were therefore excluded by the contract.
The reference to “such as profits lost or expenses incurred through breach” in the court’s definition of consequential loss was unfortunate because it suggests that profits lost or expenses incurred through breach will always be categorised as consequential loss.
However, subsequent decisions in Regional Power Corporation v Pacific Hydro Group Two Pty Ltd [No 2] and Paterson Securities Ltd v Financial Ombudsman Service Ltd have clarified that this was not the court’s intention and that loss of profits or expenses incurred through breach can be ‘normal loss’ in particular circumstances.
In Regional Power Corporation v Pacific Hydro Group Two Pty Ltd [No 2], a project company that supplied electricity to a statutory authority was held liable for costs incurred by the statutory authority in procuring diesel generators and diesel fuel to provide replacement electricity for a two-month period during which the project company was unable to fulfil its contractual obligation to provide electricity due to an unexpected shutdown of its hydroelectric power station, despite the following a clause in their contract:
Neither [party] shall be liable to the other party in contract, tort, warranty, strict liability, or any other legal theory for any indirect, consequential, incidental, punitive or exemplary damages or loss of profits.
The court determined that the costs incurred by the statutory authority in procuring replacement electricity represented direct or normal loss and, therefore, were not excluded by the above clause.
The 2015 decision in Paterson Securities Ltd v Financial Ombudsman Service Ltd involved provisions that provided:
“FOS may decide that the Financial Services Provider compensate the Applicant for direct financial loss or damage”; and that
“FOS may decide that the Financial Services Provider compensate the Applicant for consequential financial loss or damage up to a maximum amount of $3,000 per claim made in the Dispute.” (emphasis added)
These provisions draw a distinction between:
“direct” financial loss or damage, for which liability is unlimited; and
“consequential” financial loss or damage, for which liability is capped at $3000 per claim.
The court held that, although loss of profits will not be a normal loss in many cases because it varies between claimants and so will not be a loss that every claimant in a similar situation will suffer, there may be situations where this is not the case. In other words, loss of profit can be a direct loss (or normal loss or ordinary loss) if it flows naturally from the breach, and the amount does not exceed what would ordinarily be expected.
This suggests that the enduring impact of the Peerless decision is not as radical as was initially thought. When an exclusion of consequential loss is construed to exclude loss beyond normal loss (or ordinary loss or direct loss) then loss of profit, loss of use, and loss of anticipated savings will remain recoverable to the extent that they constitute normal loss, i.e., loss that ordinarily flows from the breach and does not exceed the quantum that would ordinarily be expected.
The final case I want to mention is the 2012 decision in Alstom Ltd v Yokogawa Australia Pty Ltd (No 7). This case involved a subcontract for providing electrical, control, and instrumentation works at a new power station that included an overriding special condition stated as follows:
Notwithstanding any other Article of this Electrical and C&I Contract the Subcontractor shall not be liable for any indirect, economic or consequential loss whatsoever.
The subcontract separately required the subcontractor to pay liquidated damages if it failed to achieve provisional acceptance by the required date, and to pay ‘performance guarantee payments’ if it failed to achieve specified performance guarantees.
Unlike the previously discussed clauses, this clause expressly excludes liability for any “economic loss” and does not attempt to differentiate the composite phrase “indirect, economic or consequential loss” from direct loss.
The court considered the words “indirect … or consequential loss” separately from “economic loss” and held that the former should be given their ordinary and natural meaning. It ruled that they excluded liability for “any loss consequential or following, immediate or eventual, flowing from a breach of contract” in circumstances other than those that give rise to the payment of liquidated damages or performance guarantee payments. The court construed “economic loss” to have the meaning given by tort law to “pure economic loss”, being financial loss that is not consequent upon loss of or damage to property of the claimant or personal injury to the claimant.
This interpretation of “indirect … or consequential loss” is considerably broader than that given in earlier cases, where consequential loss was interpreted as interchangeable with “indirect loss” and therefore did not capture “direct loss.”
With respect, most businesspeople do not intend to give up their right to recover all losses arising from a breach of contract when they agree to exclude liability for “consequential loss”. The fact that the parties had agreed to a liquidated damages regime for late provisional acceptance and breaches of specified performance guarantees was no doubt a factor that led the court to adopt this unusually broad interpretation of “consequential loss” in the context of an exclusion clause. The court in Pacific Hydro noted that this broad interpretation “is not a sensible meaning to be attributed to the word ‘consequential’ when used within [the limitation clause] … in an overall context.” I don’t expect this broad interpretation to find support going forward.
Balancing commercial interests
Given the uncertainty surrounding court decisions on the exclusion of consequential loss, the advice many Australian lawyers now provide is that if you wish to exclude liability for loss of profits or other specific types of loss, you should explicitly describe the types of loss for which liability is excluded. A typical approach is to exclude liability for Consequential Loss and then define Consequential Loss along the following lines:
Consequential Loss means loss of income, profit or revenue, loss of bargain, loss of business opportunity, loss of goodwill or reputation, loss of use or benefit of use, loss of production or failure to realise anticipated savings.
As mentioned earlier, this approach is problematic because it excludes all liability for the described types of loss, even if the fundamental reason why the other party entered into the contract was to obtain a benefit of that nature. Most businesses enter into contracts to generate or increase their profits. Alternatively, a business might purchase new, more efficient equipment to lower its operating costs. If businesses cannot recover the profit or cost savings they expected to generate from a contract when the other party fails to perform as promised, the value of the contract can be completely eroded.
It surprises me how many businesses accept exclusions of liability of this nature. I suspect it is often because they haven’t fully grasped the commercial consequences of such exclusions.
So, where does the solution reside?
Typically, for the supplier or service provider, the potential quantum of loss is a greater concern than the type of loss. Accepting potential liability for a quantum of loss that is out of all proportion to the potential rewards available from the contract doesn’t make commercial sense.
If the amount of loss for which the supplier or service provider will be liable due to a particular breach, such as delayed or defective performance, is capped at an appropriate amount, then the risk can become commercially acceptable.
Those companies that insist on excluding liability for Consequential Loss as defined above will often accept liability to pay liquidated damages intended to compensate the purchaser for loss of profits or anticipated savings due to delayed delivery or breach of specific performance guarantees, provided there is an appropriate cap on the total liquidated damages that may become payable. Consequently, liquidated damages regimes can offer the customer a right to compensation that sufficiently protects its financial interests while also shielding the contract breaker from unpredictable liability.
Carve-outs
Finally, you may wish to consider some carve-outs from the exclusion or limitation clause. Common carve-outs include liability arising from fraud, gross negligence, deliberate default or reckless misconduct by the defaulting party.
Others worthy of consideration can include:
Insured liabilities. The idea here is to carve out any liabilities to the extent the defaulting party is indemnified under any insurance policy effected under the contract. There will often be debate between the parties as to whether this carve-out should apply to the extent of the entitlement to indemnity or only to the extent of any proceeds actually recovered from the insurer.
Liability for losses to the extent they are recoverable by the defaulting party from others (such as subcontractors). Again, there will often be debate as to whether the carve-out should apply to the extent such amounts are recoverable or only to the extent actually recovered.
Liability under indemnities regarding claims by third parties. Contracts commonly include an indemnity in favour of the purchaser for claims made against it by third parties for:
property damage, personal injury, nuisance or pure economic loss arising out of the supplier’s performance of the contract activities; or
infringement of intellectual property rights by the supplier.
Because claims by third parties may include claims for indirect losses, and because the purchaser's liability to third parties is usually uncapped, it is important that a "consequential loss" exclusion does not erode the value of the indemnity to the purchaser.
The above list is not exhaustive. Some parties may have other particular losses for which they do not want to give the other party any relief from liability (eg liability under special provisions dealing with confidentiality or trade secrets).
As with all exclusion and limitation clauses, the particular circumstances of the contractual relationship must be considered when drafting and negotiating the exclusion or limitation and the carve-outs.
