The consequences of excluding consequential loss

Most commercial contracts contain provisions limiting liability or excluding certain categories of liability for breach of contract. More often than not, you will find one or both parties seeking to exclude liability for “consequential loss”.

Time and time again, in breach of contract cases, the courts have to decide what exactly the parties meant by that phrase. Was the loss that was suffered a consequential loss and therefore not recoverable by the innocent party?

This article is about one such case, Star Polaris LLC v HHIC-PHIL Inc [2016] EWHC 2941 (Comm). The English Commercial Court was considering an exclusion of “consequential or special losses” in a shipbuilding contract.

What was the background?

Star Polaris bought a ship from a shipbuilder. Seven months after delivery, the ship suffered serious engine failure.

The liability provisions of the contract contained the following:

• a 12-month guarantee against defects caused by specified matters, e.g. defective materials, design error, etc;
• an obligation on the shipbuilder to remedy any such defects by repair or replacement;
• an exclusion of liability for consequential or special losses, damages or expenses; and
• a statement that the guarantee replaced and excluded any other liability of the shipbuilder.

The buyer claimed damages for:

• the cost of repairing the ship;
• towage fees, survey fees and other costs that it incurred as a result of the engine failure;
• diminution in value of the ship.

What did the court decide, and why?

The buyer could claim the costs of the repair works. The remaining losses claimed fell within the consequential loss exclusion and were not recoverable. The shipbuilder’s liability did not extend beyond the obligation to remedy the physical defects.

The usual starting point in these cases is the 19th century Hadley v Baxendale. This established the principle that a party claiming damages for breach of contract can recover under two broad categories of loss:

• losses that are the direct and natural consequence of the breach; and
• indirect losses that do not arise naturally in the course of events, but the special circumstances of which were still contemplated by the parties at the time the contract was entered into.

In many previous cases, where a contract has excluded liability for “consequential loss”, the courts have interpreted this to mean losses falling within the second limb above. On this interpretation, an exclusion of liability for consequential loss does not exclude liability for loss that directly and naturally results from a breach of contract.

The buyer urged the court to adopt the same approach in this case. It argued that its losses were direct losses (i.e. within the first limb of Hadley v Baxendale) and that the shipbuilder’s exclusion of consequential losses did not cover these.

The court, however, found that the parties intended the phrase “consequential or special losses” to mean something different from the well-recognised meaning. The phrase was to be given its ordinary meaning having regard to the context and, in this case, it was being used in a “cause and effect” sense, i.e. it meant all losses caused as a result or consequence of the breach.

As a result, the language of the clause created a wider effect of excluding all financial losses over and above the cost of repair and replacement of the physical damage.

In coming to this conclusion, the court did not only look at what liability was excluded; it also took into account the liability that the shipbuilder had agreed to accept. The contract provided a “complete code” for the determination of the shipbuilder’s liability.

What can we take from this case?

It goes without saying that exclusion and limitation clauses should be drafted in as clear and unambiguous a way as possible. This is easier said than done.

This case does not set out any new principles of law, or any magic formula for drafting these kinds of clauses. It does, however, confirm that, where there are exclusion clauses in commercial contracts between sophisticated parties, the wording will be given its ordinary meaning, having regard to the context in which it is set.

If you are drafting or reviewing a commercial contract, it is not safe to assume that an exclusion clause that has been used in a previous contract will be interpreted in the same way in a different contract. It will all depend on the context.

It is worth trying to draft your contract so that it clearly sets out a complete code of damages if things go wrong. Think about what losses may arise in the event of a breach of the particular contract. Be clear about what liability is accepted and what remedies are to be provided, and exclude everything else.