Republished with permission from Carswell, a division of Thomson Reuters Canada Limited.
This article carries on the general theme of exclusions picked up by Kerry Short and Donald Lucky in their earlier papers, however in this case in the context of the standard exclusion of "consequential damages" in most standard form contracts. As the author notes in her opening paragraphs, it is common to assume that "consequential damages" are economic damages incurred beyond mere physical loss, but as her analysis shows this is not the prevailing legal interpretation of the phrase.
After surveying the development of the common law in this area in helpful chart format, the author identifies eight areas of direct damage that are not excluded by consequential damages exclusions: loss of profits; delay damages such as stand-by charges and inflationary factors; increased replacement cost; increased production costs; increased energy costs; overheads; cost to remediate defective equipment; and in some cases mental distress.
The author seeks a more pragmatic and situational analysis of the meaning of "consequential damages" on the facts of each case, and not a rule of law approach, which leads, the author argues, to commercial uncertainty.
How often have you seen a bald exclusion of "consequential damages" in a contract? Exclusions of "consequential damages" are widespread and, amongst business people and lawyers alike, there appears to be an ordinary and natural meaning commonly associated with that phrase which encompasses "everything beyond the normal measure of damages, such as profits lost or expenses incurred through breach".1 In other words, "consequential damages" are commonly understood to be those damages that are economic in nature and that are beyond the damages associated with physical loss. This is not, however, the prevailing legal interpretation of the phrase.
How is it possible that business people have a common understanding of the phrase "consequential damages" that is not aligned with the legal interpretation? Have the courts taken an approach that does not reflect business as it is negotiated?
In 1854, the Court of Exchequer issued its decision in Hadley v. Baxendale,2 likely unaware of the legacy it would leave.3 Now we are entering a new era where the old rules, often applied though not always consistently, are under scrutiny as courts assess them to determine whether they are applicable to modern commercial transactions. This article looks at the origins of the Hadley v. Baxendale rules, considers how those rules have been applied over the years and assesses the new cases that are taking a different view of the interpretation of the phrase "consequential damages".
2. ORIGINS OF THE RULE
The facts that gave rise to Hadley v. Baxendale related to a contract to transport parts for a flour mill. The crank-shaft of the steam engine broke and the mill could not be operated. The plaintiff owners ordered a new crank-shaft to be made, which required sending the broken shaft to the repair facility for sizing. The owners alleged that the defendant courier promised to deliver the broken shaft to the repair facility the second day after the owners dropped it off but that the courier took seven days to deliver the broken shaft. As a result of the delay, the completion of the new shaft was delayed for five days, which translated into lost profits for those days and the payment of wages paid during the shut-down period. The courier paid for the cost of the wages for the workers, but resisted the claim for lost profits.
The courier defended the claim on the basis that the damage was too remote. When the Court heard the matter on appeal, it set out two rules for the recovery of damages. Losses had to fall into one of the rules to be recoverable:
- those losses that arise naturally, according to the usual course of things, from the breach of contract itself; or
- if special circumstances were communicated by the plaintiff to the defendant, those losses that may have been reasonably supposed to have been in the contemplation of both parties, at the time they made the contract, as the probable result of the breach.
Alderson J. declined to award damages to the owners because the only particulars communicated by the owners to the courier at the time the contract was made was that the courier was to deliver the broken shaft and that the owners were the owners of a mill.4
It is the second rule in the Hadley v. Baxendale that gives rise to the issue of whether or not "consequential damages" are recoverable as they are only available where special circumstances have been contemplated by the parties. This was explained by Alderson B.:5
If special circumstances under which the contract was actually made were communicated by the plaintiffs to the defendants, and thus known to both parties, the damages resulting from the breach of such a contract which they would reasonably contemplate would be the amount of injury which would ordinarily follow from a breach of contract under the special circumstances so known and communicated. But, on the other hand, if these special circumstances were wholly unknown to the party breaking the contract, he, at the most, could only be supposed to have had in his contemplation the amount of injury which would arise generally, and in the great multitude of cases not affected by any special circumstances, from such a breach of contract. For, had the special circumstances been known, the parties might have specially provided for the breach of contract by special terms as to the damages in that case; and of this advantage it would be very unjust to deprive them.
The Hadley v. Baxendale rules were modified by the English Court of Appeal in Victoria Laundry (Windsor) Ltd. v. Newman Industries Ltd. (Coulson & Co., Ltd. [third party])6 by imposing a reasonable foreseeability test and by applying the rules to all types of damages arising in contract.
In The Heron II. Koufos v. C. Czarnikow, Ltd.,7 the House of Lords reiterated that Hadley v. Baxendale set out one rule for damages with two different parts, that it was a universal rule applicable to all contracts and that it allowed for recovery of what is reasonably foreseeable.8 Lord Diplock considered that the Court had the opportunity to reconsider the old principles of law and provided the following summary of the principles related to consequential loss:
. . . in the added light of the clear and comprehensive statement of the modern principles governing the measure of damages for breach of contract concircumstances tained in Victoria Laundry. . . . This judgement, of ASQUITH, L.J., . . . made it clear:
(i) that there are not two rules formulated in Hadley v. Baxendale but two different instances of the application of a single rule;
(ii) that the rule as to the measure of damages for breach of contract applies to all kinds of breaches of all kinds of contracts;
(iii) that the aggrieved party is entitled to recover such part of the loss actually resulting to him as was at the time of the contract reasonably foreseeable by the party who broke it as liable to result from the breach.9
[Emphasis in original.]
Lord Diplock further explained the prevailing thought that the right to recover consequential damages can be determined by looking at the intent of the parties when entering into the contract and, where that intent is not expressed, damages can be determined by assessing what can be reasonably assumed that the party breaching the contract would know it is liable for.
The non-performer may, of course, have expressly stipulated what monetary reparation he will make (by a liquidated damage clause) or excluded his liability to make reparation (by an exemption clause) for breach of a particular primary obligation; but if he has not, his conduct in entering into the contract is in itself sufficient to induce the other party to believe that he, the non-performer, undertakes, in the event of non-performance of that primary obligation, a secondary obligation to make monetary reparation for any loss sustained by the other party of a kind which the non-performer has reasonable grounds for assuming that the non-performer knows is liable to result from the breach. The other party is entitled to assume that the nonperformer knows of the kinds of loss which are liable to result from the breach in the usual course of things, for instance that in the case of nondelivery of goods he will have lost the value of the goods at the date at which they should have been delivered; but he is not entitled to assume, unless at the time of the contract he has communicated the information to the non-performer, that the non-performer knows of an exceptional kind of loss which is only liable to result because of the existence of special circumstances peculiar to the other party which are outside the usual course of things.10
In other circumstances Hadley v. Baxendale is seen as a test for remoteness in relation to a claim for contractual damages.11
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1 Environmental Systems Pty Ltd v. Peerless Holdings Pty Ltd,  VSCA 26, ¶93.
2 Hadley v. Baxendale (1854), [1843–60] All E.R. Rep. 461 (Ex. Div.).
3 For a discussion of why the Hadley v. Baxendale case should not be followed in modern contract law see M.A. Eisenberg, "The Principle of Hadley v. Baxendale" (1992) 80 Cal. L. Rev. 563.
4 Note that at the trial there was evidence that an employee of the owner attended at the courier's office the day before the shaft was dropped off and made enquiries. During this exchange, the courier's clerk was advised that "the mill was stopped and the shaft must be sent immediately" and that in reply to this comment the courier's clerk said that if the broken shaft was dropped off before noon, it would be delivered the following day. This brings into focus that part of the second rule, which states the special
concircumstances must be in the parties' contemplation at the time they made the contract. See Hadley v. Baxendale, supra note 2, at p. 464H This point is taken up in Victoria Laundry (Windsor) Ltd. v. Newman Industries Ltd.,  2 K.B. 528 (C.A.), where Asquith L.J. states, "If the Court of Exchequer had accepted these facts as established, the court must, one would suppose, have decided the case the other way round—must, that is, have held the damage claimed was recoverable under the second rule, but it is reasonably plain from the judgement of Alderson, B., that the Court rejected this evidence . . .". See Victoria Laundry, supra at p. 1001F.
5 Hadley v. Baxendale, supra note 2, at p. 465F.
6 Supra note 4.
7  3 All E.R. 686 (H.L.).
8 For a discussion of the foreseeability concepts as they relate to the test and Hadley v. Baxendale see Andrew Tettenborn, "Hadley v. Baxendale Foreseeability: a Principle Beyond Its Sell-by Date?" (2007) 23 Journal of Contract Law.
9 The Heron II. Koufos v. C. Czarnikow, Ltd., supra note 7, at p. 604D (footnotes omitted).
10 Ibid., at p. 605B (footnotes omitted).
11 For a discussion of the remoteness test as set out in The Heron II. Koufos v. C. Czarnikow, Ltd., see Andrew Robertson, "The basis of the remoteness rule in contract" (2008) 28:2 Legal Studies 172 to 196.
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