UK: Excluding Consequential or Indirect Losses in Software and Outsourcing Contracts Governed by English Law

The Law Commission for England and Wales is expected to publish a long-awaited final report and draft legislation on unfair contract terms later this year. If the ideas expressed in an August 2002 consultation paper are embodied in the draft, this may have important implications for the validity of exclusions of consequential and indirect loss.

Software and outsourcing contracts usually exclude or limit liability for consequential or indirect losses; but, although the words "consequential" and "indirect" suggest the concept has great breadth, encompassing all consequences which are more than a single causal step from a breach, in practice the English courts have strictly limited the scope of such exclusions. Many losses which at first sight could be described as indirect or consequential, and might be treated as such by US judges, will be treated as direct losses by their English counterparts.

This has important implications for both customers and service providers. Because the losses which can result from software failure or defects in performance of services can far exceed their price, service providers will wish to ensure that exclusion clauses do what they want them to do, and that means understanding the English judiciary’s idea of "indirect" ("indirect" and "consequential" are often used interchangeably). Equally, customers will wish to ensure that they are adequately protected against consequences of failure and that certain losses will be recoverable. It is also necessary to have regard to the contra proferentum rule, which provides that exclusion clauses are to be strictly construed against the party which seeks to rely on them.

The legal meaning of "consequential" was first considered in a modern commercial context in Croudace Construction v Cawoods Concrete Product. Cawoods was alleged to have delivered defective concrete blocks to Croudace, and to have delivered them late, causing Croudace additional losses—including loss of productivity, inflation costs, and a claim from a sub-contractor. In respect of these additional losses, Cawoods relied upon a clause in the contract which read:

The Court of Appeal, drawing on earlier authorities, ruled that "consequential loss or damage" was that which did not result directly and naturally from the breach complained of. The court was, in effect, aligning the legal meaning of the phrase with the so-called "second limb" of the famous decision in Hadley v Baxendale. In that case Anderson B distinguished between the two kinds of recoverable damages. The first limb covered losses "arising naturally, i.e. according to the usual course of things, from such breach of contract itself", while the second limb covered those losses "such as may reasonably be supposed to have been in the contemplation of the parties at the time they made the contract as the probable result of the breach." Other kinds of damage are considered "too remote" to be recoverable.

The court in Croudace decided that the losses claimed by Croudace were a direct and natural consequence of the late supply of the concrete blocks by Cawoods, were not consequential, and were thus not caught by the exclusion clause.

This construction of the phrase "consequential loss" was confirmed by the Court of Appeal in British Sugar v NEI Power Products and Another, where it was held that increased production costs and loss of profits were not necessarily examples of consequential loss.

While the meaning of "consequential loss" may be clear in theory, the application of the concept is tricky, especially in more complex contractual situations. This was acknowledged in BHP Petroleum and Others v British Steel and Dalmine. The BHP court stated that in order to decide whether a contract clause excluding "indirect losses or consequential damages" applied, it would have to form a view about what British Steel knew about at the time of entering into the contract, although it had little in the way of evidence to assist.

In Salvage Association v CAP Financial Services the court considered a consequential loss exclusion in the context of a contract for computer software. The Salvage Association had engaged CAP to create and implement an accounting system. The project did not go according to schedule, and when the Salvage Association rejected the software it was nowhere near complete. The judge found as a matter of fact that CAP was not able to perform the contract because it lacked access to the relevant skills and experience and, consequently, that the system CAP had produced was not fit for its intended purpose.

The central legal point in the case concerned the application of the Unfair Contract Terms Act 1977 ("UCTA"), but it also provided a guide to the classification of losses under an exclusion clause differentiating between direct and indirect losses, which read as follows:

The Court held that this clause was enforceable, but the clause tumbled headlong into the elephant trap created by the English courts’ narrow definition of indirect and consequential loss. The Court held that, because the other kinds of loss referred to were said to be examples of indirect and consequential loss and not separately listed, the clause was ineffective in excluding direct economic loss.¹ The court therefore held that the following losses were direct and recoverable (in addition to the principal claim for wasted expenditure): (a) payments to a third party for use of a bureau facility; (b) wasted computer stationery; (c) payments to consultants; and (d) payments for testing.

Exclusion clauses are also subject to the terms of UCTAand the Misrepresentation Act 1967, and these statutes may also affect the enforceability of exclusions of consequential loss.

In accordance with UCTA, it is standard practice to carve-out from the scope of exclusion clauses both liability for personal injury and death resulting from negligence and losses arising from fraud. However it may be necessary to go further. UCTAprovides that "In the case of other loss or damage, a person cannot so exclude or restrict his liability for negligence except in so far as the term or notice satisfies the requirement of reasonableness." (Negligence is defined as the breach "of any obligation, arising from the express or implied terms of the contract, to take reasonable care or exercise reasonable skill in the performance of the contract" or "of any common law duty to take reasonable care or exercise reasonable skill (but not any stricter duty)" or certain duties relating to occupiers liability.)

An even stricter provision applies in the case of written standard terms of business. In such a case the party on whose terms the agreement is signed may not exclude or restrict any liability with respect to any breach of contract, unless the contract term in question satisfies the requirement of reasonableness. In this regard, the courts take a wide view of what constitutes "standard terms of business."

Section 3 of the Misrepresentation Act 1967 is also applicable. This provides that terms excluding or restricting liability or remedies in respect of misrepresentations will also be subject to the (same) reasonableness test.

"Reasonableness" is described in the Act as the requirement that the relevant contract term be "a fair and reasonable one to be included having regard to the circumstances which were, or ought reasonably to have been, known to or in the contemplation of the parties at the time when the contract was entered into." Thus the best assessors of reasonableness are usually the parties themselves.

In Salvage Association v CAP Financial Services the judge accepted that in considering reasonableness it was sensible to look at the matters set out in Schedule 2 of UCTA (which the Act says should be used to interpret reasonableness in another context). Schedule 2 lists bargaining power, special inducements, knowledge of the term, conditionality, and whether the goods in question were bespoke. This was applied in St Albans v ICL, where the court found that a clause limiting ICL’s liability to £100,000 was unreasonable. The court made reference to the relative ability of the parties to meet the losses, the level of ICL’s insurance cover, and the strong bargaining position of ICL.

In Watford v Sanderson the court gave consideration to whether a standard term which excluded indirect and consequential loss, and which limited liability in respect of other losses to the contract price, was reasonable. It held that it was. The court referred to the fact that the contract price had been adjusted to take account of the risk allocation, and noted that the other party’s own standard terms contained a similar exclusion.

The lesson to be drawn from the case law on consequential loss can be simply stated: If you want to exclude a particular type of loss, say so. Do not rely upon a reference to consequential or indirect losses as a "sweeping-up" provision. It follows that before contracts are agreed, the parties ought to consider carefully all the kinds of loss which could arise in relation to the contract. Only then is it possible to properly apportion risk between the parties by the use of an exclusion clause. Suppliers should beware of clauses excluding and limiting liability drafted to describe "loss of profits" as an example of "consequential loss" as loss of profits can, in appropriate circumstances, be direct losses and recoverable unless specifically excluded. On the other hand, customers may wish to include express provisions that certain types of losses, such as amounts paid to third parties and/or internal expenses incurred in correcting errors or obtaining replacement software or services, should be considered as direct losses and not excluded.

Watford v Sanderson provides those relying on clauses excluding consequential loss with some comfort. However, this judgment does not mean that all clauses excluding consequential loss will be reasonable. Reasonableness depends upon the particular circumstances of the contract.

The law relating to unfair contractual terms may soon be changed, and this could affect the law relating to the enforceability of exclusions and limitations of liability for consequential loss. The Law Commission’s consultation paper on the subject published in August 2002 envisaged a consolidation of the law and, as regards business to business contracts, an exemption from control for terms which are individually negotiated on the one hand, and a generally applicable test of fairness and reasonableness to apply to non-negotiated terms on the other. It remains to be seen whether this idea will be embodied in the final report and accompanying draft legislation which the Commission is expected to publish in the early part of this year.

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