Consequential loss - what does this exclude?

The courts continue to look at the meaning of “consequential loss” in limitation of liability clauses and at whether the traditional legal meaning or the ordinary language meaning should apply.

What’s the issue?

Exclusion clauses in a contract aim to exclude a party’s liability for certain types of losses. It is essential that these clauses are drafted clearly and without ambiguity if they are to be effective. Well drafted exclusion clauses are important in any contract, but we often see issues relating to these clauses in disputes arising from IT contracts. If an IT project fails, there is inevitably a dispute between the customer and supplier as to the nature of losses recoverable under the contract. These are likely to include both direct losses (e.g. the loss of the failed software system itself) and indirect losses (e.g. caused by business disruption although loss of profits can be both direct and indirect loss depending on the circumstances).

The risk of a badly drafted exclusion clause is that it is left to the courts to interpret its meaning, which can often result in a decision which leaves one party exposed to unanticipated liabilities.

What’s the development?

Once again the interpretation of exclusion clauses limiting liability for “consequential losses” has come before the courts. The High Court’s decision in Star Polaris LLC v HHIC-PHIL INC is an interesting reminder of the debate surrounding exclusion clauses and the interpretation of “consequential loss”.

As with all cases on limitation of liability, this decision revolves around the exact wording of the clause but the Judge accepted that when read as a whole, it could be seen that the clause had the wider meaning of financial losses caused by guaranteed defects, above and beyond the cost of replacement and repair of physical damage. The relevant clause was intended to operate as a complete code under which all liability for losses over and above those specifically accepted by the defendant shipbuilder were excluded.

What does this mean for you?

The courts have, in the past, construed the phrase “consequential losses” narrowly, using the traditional interpretation set out in Hadley v Baxendale, often in an attempt to achieve what was perceived as a fair outcome. Now, the trend, reflected in the Star Polaris decision, is for the courts to give the words used their natural and ordinary meaning. This is particularly true for commercial contracts negotiated between sophisticated parties.

This case serves as further guidance on the courts’ approach to interpreting the phrase “consequential losses” in an exclusion clause and develops the debate around whether the term should be given its traditional legal definition or interpreted using the ‘natural language’ definition. It is a helpful reminder of the need to draft such clauses carefully in a clear and unambiguous way which accurately reflects the intentions of the parties as to which types of losses are excluded.

It is important when drafting the contract to consider (a) what type of losses may occur from the possible breaches of that specific contract, (b) whether they are intended to be included or excluded and © whether the use of language such as “consequential” or “indirect” loss reflects the intention of the parties as to what should be recoverable and what should not. Careful drafting at this stage can substantially diminish the risk of disputes on exclusion clauses if an IT project goes wrong.

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Case law has established the traditional interpretation of the meaning of “consequential loss” in exclusion clauses. The principles under contract law are described under two limbs.

• The first limb relates to direct losses - “losses arising in the ordinary course of things” those claimable losses which arise naturally as a result of the breach.
• In more exceptional circumstances, and under the second limb, are “indirect” losses or “consequential losses” - “losses likely to arise from special circumstances of the case”. These are particular losses recoverable only if the other parties know of those circumstances and if it was in the reasonable contemplation of the parties at the time the contract was made as being a probable result of the breach.

In Star Polaris, the vessel built by the defendant shipyard suffered a serious engine failure. The ship owner claimed compensation against the shipbuilder for repair costs and expenses caused by the engine failure (such as towage fees). The ship owner also claimed the loss of value in the vessel following the incident. On the question of breach, the tribunal found that while the shipbuilder was responsible for certain causative defects (breach of warranty of quality because there were weld spatters in the pipework at delivery), the chief engineer was negligent in failing to react to alarms which would have slowed the engine down. This meant not all of the losses could be recovered. The shipping contract excluded losses for “consequential … losses, damages or expenses” and this included a claim for diminution in value.

The ship owner appealed the arbitral award to the High Court. The judge confirmed that although exclusion clauses are no longer read narrowly, the words must be given their ordinary meaning. The phrase “consequential or special losses, damages or expenses” did not mean those losses coming within the second limb (arising from special circumstances known at the time the contract was entered into). Rather the clause had a wider meaning of financial losses caused by guaranteed defects above and beyond the replacement and repair of physical damage. A claim for diminution of value was therefore excluded as a consequential loss.

The shipbuilder’s liability was limited to the repair of defects (due to defective materials, design error, construction miscalculation and/or poor workmanship) and to physical damage caused by them - financial loss as a consequence of the physical damage was excluded. It was said that under the contract the exclusion clause was intended to operate as a complete code under which all liability for losses over and above those specifically accepted by the defendant shipbuilder in were excluded. The appeal failed.