Clauses excluding or limiting liability for consequential losses are becoming increasingly common in construction contracts.
Case law however amply demonstrates the necessity for careful drafting. As Arch Fletcher commented in our September 2004 edition, it is easy for contractors to believe they are covered by an exclusion or limitation clause and yet be leaving themselves open to the possibility of extensive liabilities. Generally, Australian courts try to take a straightforward approach to exclusion clauses by giving them their natural and ordinary meaning in the context of the whole contract. Unfortunately, the natural and ordinary meaning given by the law to terms such as consequential loss does not always accord with what commercial parties might believe those words to mean.
This article considers Peerless Holdings Pty Ltd v Environmental Systems Pty Ltd  VSC 194, a recent decision of the Victorian Supreme Court that considered an unusual exclusion clause and the damages that would or would not be payable as a consequence.
In Peerless, the plaintiff owner operated an animal rendering business under a licence granted by the Environment Protection Authority, which required the reduction of odour emissions. The owner used an afterburner, a machine that reduces odorous emissions, for this purpose.
In 1996, the owner decided to replace its existing afterburner for several reasons, including that it was an inefficient user of energy. The owner entered into a sale agreement under which the defendant contractor agreed to supply, install and commission a REECO Regenerative Thermal Oxidiser ("RTO").
The owner claimed in the proceedings that the RTO was never able to function as intended and was not fit for purpose, and successfully sued the defendant for breach of contract. The owner claimed damages in four areas:
- the cost of purchasing, installing and commissioning the RTO, purchasing additional equipment and modifying the plant in an attempt to make the RTO functional, and repairing the existing afterburner
- the cost of the time spent by the plaintiff's employees involved in attempting to make the RTO functional
- the cost of dismantling and disposing of the RTO; and
- additional, future energy costs that would be incurred by the owner as a consequence of the RTO not being functional.
The Court held that the owner could be successful in all but the third head of damages - as the cost of dismantling and disposing of the RTO would be necessarily incurred at a later date.
Payment of these damages was subject, however, to the limitations on liability and exclusion clauses in the sale agreement. In this regard, clause 7 of the sale agreement included certain guarantees in respect of the performance of the RTO, a breach of which would entitle the owner to specified pre-determined liquidated damages. The contractor’s liability for such liquidated damages was capped at 10 percent of the value of the contract.
In addition, clause 8.9 of the sale agreement simply stated:
"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."
That simple statement was pivotal in determining the quantum of damages recoverable by the owner.
Liquidated damages for breach of performance guarantees
The performance guarantees in clause 7 were expressed to apply "only during normal operation, not during any maintenance procedures". The court held that because the RTO was unfit for its intended purpose and never attained normal operation under the sale agreement, the liquidated damages specified in clause 7 did not apply.
Exclusion of liquidated damages under clause 8.9
The apparent inconsistency between the provisions in clause 7 (providing for the payment of liquidated damages where the performance guarantees were not met) and the statement in clause 8.9 (that the contractor did not, as a matter of policy, accept liquidated damages) did not feature in the Court’s analysis.
The Court accepted the contractor’s submission that the reference to "liquidated damages" in clause 8.9 meant those damages which are "ascertained" at the time of the claim. In other words, the Court held that clause 8.9 operated to preclude recovery of costs actually incurred by the owner at the date of the claim as a result of the breach.
Consequently, no compensation was awarded under the first or second heads of damages in respect of the owner’s claim for breach of contract.
The owner was, however, successful in its claim that the contractor made false and misleading representations in contravention of section 52 of the Trade Practices Act. Accordingly the owner was able to recover these damages in full under that claim, as it is not possible to limit or exclude liability for a breach of section 52 of the Trade Practices Act. This serves as a salient reminder of the inherent limitations of clauses which purport to exclude or limit liability for breach of statutory provisions and statutory warranties, such as those found in the Trade Practices Act and Sale of Goods legislation.
Exclusion of consequential loss under clause 8.9
The next issue that clause 8.9 raised was the definition of "consequential loss", and how this would apply to the fourth (and last remaining) head of damages. Using the definition of "liquidated damages" discussed above, these damages could not be excluded as they were future unascertained costs. Unless they could be classified as a "consequential loss", they would be recoverable.
To define "consequential loss", the Court strongly affirmed that consequential losses were those falling under the second limb of the rule in Hadley v Baxendale (1854) 9 Exch 341. This rule describes the losses which a party can recover for a breach of contract as either:
- those which may fairly and reasonably be considered to arise naturally, ie. according to the usual course of things, from the breach (often referred to as direct loss); or
- those which, while not direct, 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.
Losses falling under the second limb are also often referred to as indirect loss.
The Court held that the claim for additional energy costs was not a claim for consequential loss, as the loss arose naturally and directly from the failure of the contractor to provide a RTO that could perform as intended. Accordingly, these costs were recoverable.
Commercial parties often consider "consequential loss" to mean all losses consequential upon a breach of contract, such as loss of profit, additional expenditure and the like. Peerless serves as a timely reminder that such losses will be direct losses if they arise naturally (ie. according to the usual course of things) from the breach, in which event they will fall outside any exclusion clause which only excludes liability for consequential or indirect loss.
Parties wishing to exclude liability for any loss of profit or additional expenditure arising as a result of a breach of contract need to take great care to ensure that the exclusion clause expressly excludes such losses, whether direct or consequential/indirect.
Peerless also serves as a timely reminder of the difficulties associated with excluding liability under the Trade Practices Act for misleading and deceptive conduct.
The contractor has filed an appeal against the Supreme Court’s decision.
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.