In an article in the first of the March 2014 editions of Constructive Notes, consideration was given to the operation of exclusory or limiting provisions directed to economic, indirect or consequential loss. We have all seen simple clauses in contracts to the effect of 'neither party is liable to the other for any consequential or indirect loss'. The presumption of most is that this will exclude damages that are too distant or unknown, but what if anything, does it really exclude?
As a basic premise, when one party breaches a contract, the other party is entitled to damages that flow from that breach. Over time this principle has narrowed to what is commonly referred to as the 'two limb approach'.1The two limbs outline what types of damages can be claimed, all others being considered too remote. The first limb is those damages that arise naturally from a breach of contract (obvious and direct). The second limb is those damages that are non-direct but that would be within the reasonable contemplation of the parties at the time of contracting. Understandably, this second limb, which is where consequential type losses would potentially sit, has been the subject of considerable dispute over the last 150 years.
In Australia, the High Court decision in Darlington v Delco 2 confirms that at the time of contracting, parties can include clauses excluding certain damages, however these clauses must be construed according to their natural and ordinary meaning.
However it is not a simple just excluding 'consequential loss'.
Unfortunately, there is still no consensus in Australia as to what the natural meaning of consequential loss actually is. There are conflicting decisions in three jurisdictions: Victoria, South Australia and Western Australia, none of which are strictly binding on Queensland or New South Wales.
In Victoria,3 the test is what an ordinary reasonable business person would consider consequential loss i.e. everything beyond the normal measure of damages such as lost profit.
In South Australia,4 a very broad approach has been taken using a literal interpretation of the word 'consequential' so that consequential loss means any loss that was consequent or following, immediate or eventual, flowing from a breach of contract. This could exclude even direct or first limb losses.
In Western Australia,5 the position is different again. Here, the Court rejected the Victorian position (beyond the normal measure) and also excluded strict reliance on the second limb test. Instead, it reinforced the original view in Darlington v Delco that consequential loss exclusion clauses should be construed on a case by case basis according to their natural and ordinary meaning as determined in the context of the relevant contract when read as a whole.
In summary, there is still an obligation to give clauses their natural meaning but there is no consensus on what this meaning is for consequential loss. The solution is comparatively simple though. Whenever you want to deal with consequential losses, then define that term in the contract so that the meaning is clear.
There are some simple steps to consider every time this process is undertaken.
- Decide what specific types of indirect or consequential loss you want to exclude and then list them in the definition e.g. loss of profit, loss of future contracts, losses from business interruption, loss of business opportunity and so on. If included, then the meaning will be clear. If you do not include a specific loss then the meaning will be open to dispute later. For example simply broadly stating that 'Consequential Loss means any and all indirect or consequential losses' is of next to no real assistance.
- Consider if there are any specific exclusions from the general classes of consequential loss that you list. The most common is delay liquidated damages. When liquidated damages are calculated, they will take into account a variety of factors, some of which could fall within your definition of consequential loss, such as business interruption. To avoid ambiguity, simply make it clear that the exclusion of consequential loss does not apply to liquidated damages. Liquidated damages will then be a separate head of loss that is a genuine pre-estimate of losses associated with delay that does not fall within the consequential loss exclusion.
- Consider insurance implications. There is no sense in requiring the other party to have a policy that names you and has coverage of $20 million if you then exclude their liability for a large part of what the policy covers. Rather than having an argument with an insurer over whether it is only required to indemnify parties for their contractual liability, which excludes consequential loss, consider whether it is necessary or appropriate to carve out insurance coverage from the consequential loss exclusion. In that way the other party will reduce its direct personal liability but you will both still have the protection of the insurance policy. As most consequential loss clauses are mutual, excluding liability of both parties, you should also always check with your own insurance broker before doing so to ensure that this does not diminish coverage under your own policies.
- Consider how the consequential loss exclusion impacts or interacts with other clauses of the contract, in particular indemnities or warranties. Be aware that a specific exclusion of consequential loss may reduce a more general right of indemnity or ability to enforce a warranty. For example, it is common to carve out from the consequential loss exclusion, the indemnities relating to personal injury and death, so that these remain in force, irrespective of whether elements of the indemnity would usually be considered as consequential losses.
In short, think about what obligations you want to limit and what rights you want to protect and then draft a specific consequential loss definition and an exclusion clause that meets those requirements. When doing so also consider how this works in the context of the whole contract. If you do not do this, then you run the risk of dispute and then leaving it to the Court to make a decision on how the definition of consequential loss and the relevant clause is meant to be interpreted. As we can see above, there is currently no certainty as to how courts in Queensland or New South Wales will do so.
1Hadley v Baxendale (1854) 9 Exch 341.
2Darlington Futures Ltd v Delco Australia Pty Ltd (1986) 161 CLR 500.
3Environmental Systems Pty Ltd v Peerless Holdings Pty Ltd  VSCA 26.
4Alstom Ltd v Yokogawa Australia Pty Ltd & Anor (No 7)  SASC 49.
5Regional Power v Pacific Hydro [No 2]  WASC 356.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.