“Excluded Losses” Provisions and the “Butterfly Effect”—the Continued Failure of Predictability Regarding Consequential Damages Waivers in M&A Agreements

The “butterfly effect” is the concept that a seemingly insignificant change in an initial cause (e.g., an initial weather condition in Brazil, with a butterfly happening to flap its wings) can have a significant effect on the result (e.g., a hurricane in Texas, rather than no, or a less severe, hurricane in Texas had the butterfly not flapped its wings in Brazil when or with the force it did), essentially making that result unduplicable and unpredictable. The butterfly effect is closely connected to “chaos theory” (remember the scene in “Jurassic Park” with the droplets of water on the back of Dr. Sattler’s hand), which basically suggests that Newton’s laws are not so reliably deterministic that you can accurately predict outcomes just by having all the supposed variables plugged into a formula. Chaos theory has so revolutionized science that in 1986, in “Proceedings Before the Royal Society of London,” entitled The recently recognized failure of predictability in Newtonian dynamics, the then president of the International Union of Applied and Theoretical Mechanics, Sir James Lighthill, issued an apology “for having misled the general educated public by spreading ideas about the determinism of systems satisfying Newton’s laws of motion that, after 1960, were to be proved incorrect.” But take heart, it turns out that chaos actually produces patterns that allow for some predictability, even if it’s not the same formulistic predictability that a reliably deterministic system would produce.

For good deal lawyers none of this should be unsettling or unfamiliar. Transactional lawyers predict outcomes based not upon formulas, but based upon a common law system that is dependent upon reasoning from prior caselaw that is, in turn, premised upon certain accepted legal principles. That system is not, and never was, formulaic or deterministic, and while at times it may appear chaotic to the uninformed, there are patterns that emerge in the caselaw that allow experienced practitioners to apply knowledge about that caselaw and those accepted principles to particular facts (which include the butterfly-wing flapping variables) to thereby predict outcomes regarding the contracts we draft and negotiate. But sometimes market forces produce terms that continue to be embraced by practitioners despite those terms having been repeatedly proven to produce unpredictable outcomes. As a result, those terms continue to be spread about (like the predictability of Newtonian dynamics) simply because they are considered “market.” One such term is the so-called “consequential damages waiver.”

What are “consequential damages” anyway? Are they the same as indirect damages? Are they the same as all lost profits? Are there lost profits that are not encompassed by the term consequential damages? Are consequential damages essentially all damages other than the difference between the value of the product or services contracted for and the value of the product or services as actually delivered (i.e., in the M&A context, all damages other than the difference between the value of the purchased company if the representations and warranties had been accurate and the value of the company as a result of one or more of the representations and warranties having proved inaccurate?) Can consequential damages be simply defined as all damages beyond the value of the promised performance in the agreement and, if so, how does that definition apply in the context of the purchase of a business rather than completion of construction project? Are consequential damages all damages beyond the reliance-based costs and expenses incurred by the non-breaching party? Or are consequential damages merely damages that are beyond the damages that would ordinarily be incurred by a non-breaching party to this type of contract, but which were in fact communicated to the breaching party at the time of contracting as being losses that the non-breaching party would actually sustain if there were a breach of this particular contract; i.e., special damages? While the historically correct answer is the last one (i.e., special damages that were communicated as likely to result from a breach at the time of contracting), one can find caselaw providing any one, or a combination of any two or more, of the above as the correct answer to the question of what are consequential damages. But a pattern emerging in the most recent cases is to differentiate between direct/general damages and consequential damages similar to how the United States District Court for the Eastern District of Pennsylvania recently did in a decision handed down on November 1, 2016:

So direct damages are the costs of a plaintiff getting what the defendant was supposed to give—the costs of replacing the defendant’s performance. Other costs that the plaintiff may not have incurred if the defendant had not breached, but that are not part of what the plaintiff was supposed to get from the defendant are consequential. Jay Jala, LLC. v. DDG Construction, Inc., C.A. No., 15-3948 (E.D. Pa. Nov. 1, 2016).

What consequential damages are not, however, are speculative or remote damages. Contrary to popular belief, consequential damages are limited by the same rules of certainty and reasonable foreseeability that govern contract damages generally? As noted in the Eastern District’s recent Jay Jala decision, “foreseeability is the limit of all contract damages, not the distinction between direct and consequential damages.” So, the idea that an actual butterfly-wing flapping default could result in a hurricane-like damages claim in the absence of a consequential damages waiver are exaggerated, particularly in the M&A context.

A pair of recent cases provides a new opportunity to again boldly suggest that practitioners cease using consequential damages waivers in M&A. Why? Because so few really know what these waivers mean in the M&A context, and even those who do cannot reliably predict how those waivers will be interpreted by any particular court across the common-law world. Both cases were decided on October 31, 2016, one by the Delaware Court of Chancery and the other by the U.S. Court of Appeals for the Tenth Circuit. One case is exceedingly rare—it directly addresses the use and impact of a consequential damages waiver in the context of an M&A transaction, while the other is a more traditional review of the meaning of that phrase in the context of a software licensing arrangement. Both are worthy of serious attention.

Brace Industrial Contracting, Inc. v. Peterson Enterprises, Inc., C.A. No. 11189-VCG (Del. Ch. Oct. 31, 2016), involved a dispute over a Stock Purchase Agreement governing the purchase and sale of a scaffolding business. The buyer of the business complained that the seller had represented and warranted a detailed list of scaffolding equipment that would be available to the purchased company following closing. This was apparently equipment that was needed to properly operate the business post closing. The court found that the seller had in fact inaccurately represented the amount of scaffolding equipment that was in fact available to the company and that the buyer had suffered damages as a result. The court awarded damages to the buyer in an amount equal to the replacement cost of the shortfall in the represented amount of equipment. But the buyer also sought to recover rental costs associated with renting additional equipment to make up for that shortfall in order to complete pending jobs until the replacement equipment could be acquired. The court, however, denied the buyer’s claim for rental costs because “consequential damages” had been specifically waived as recoverable losses under the indemnification provisions that had capped the buyer’s total indemnification claims to no more than 10% of the purchase price. According to the court, an award of the replacement cost of the missing equipment made the buyer “whole for the shortfall between what the Defendants promised and the Plaintiffs received,” and the extra rental costs fell into the category of “consequential damages.”

Not a terrible result here to be sure, but what if replacement equipment had been unavailable for purchase and, unless the equipment was rented, the company would have defaulted on its promised jobs that would have produced the EBITDA for which the buyer had paid a multiple? Those losses would have presumably fallen into the category of consequential damages too. And keep in mind that the seller’s damages were already capped at 10% of the purchase price and the breach of the representation was the direct cause of the losses. Was that really what the buyer had in mind when it capped its claims at 10% of the purchase price and then further excluded a broad category of foreseeable contract-based damages that happen to have the moniker “consequential damages?” What if the breached representation had been the existence of all permits necessary to complete pending jobs and the replacement cost for one of the missing permits was just $10? Would a buyer be happy to learn that the consequential damages waiver limited his claim to only $10 after the company defaults on those jobs because city officials shut the work down pending the completion and review of that missing permit?

Solidfx, LLC v. Jeppesen Sanderson, Inc., Nos. 15-1079 and 15-1097 (10th Cir. Oct. 31, 2016) involved a dispute over a License and Cooperation Agreement between a software development company and a company that makes the charts that pilots use to navigate and land at specific airports. The idea behind the agreement was for the software company to develop an easier to use electronic version of the charts rather than the traditional paper versions. Soon after the licensing agreement was signed the first version of iPad was announced and the navigation chart company decided to create its own iPad app rather than work with the software company on the development of their iPad app. Worse still, the navigation chart company provided its iPad app free of charge to its customers. The software company’s means of making money from the creation of its iPad app had been to license that app to the navigation chart company’s customers.

There does not seem to have been much dispute about the fact that the navigation chart company breached its contract with the software developer. The only dispute was the damages to which the software company was entitled. And you guessed it, there was a consequential damages waiver in the License and Cooperation Agreement. The twist on this consequential damages waiver was that it purported to waive all claims for lost profits, not just those that would have otherwise fallen into the category of “consequential damages.” Because the only damages sustained by the software developer, other than the startup costs associated with their development activities, was the lost profits from future sales to the navigation chart company’s customers, the scope of the waiver was outcome determinative regarding whether there was any meaningful remedy at all for the navigation chart company’s breach.

The loss exclusion provision in the License and Cooperation Agreement clearly waived any “loss of use, revenue or profit,” as well as any “consequential damages.” In other words, unlike some provisions that list lost profits as a subset of consequential damages, which have been interpreted as only waiving lost profits to the extent they constitute consequential damages, this provision waived all lost profits whether they were general damages or consequential damages. But not satisfied with that holding, the court went on to opine that even had the waiver been limited just to consequential damages, the lost profits sought by the software company would have nonetheless constituted consequential damages despite the fact that their loss was the direct result of the breach. Why? Because all lost profits derived from anticipated contracts with third parties are considered consequential damages, while only lost profits derived from existing nonparty agreements contemplated by the contract with the breaching party or directly arising from that primary contract itself are considered direct or general damages. As a result, there may have been a breach, but the software company had no real remedy because it had been waived no matter how the exclusion clause was interpreted. According to the court, “[e]ven if the relevant contract provision ‘may severely if not completely restrict [a party’s] ability to recover for [the relevant] breach of contract, parties are free to agree to such provisions.’” So there you have it, these loss exclusion clauses will be enforced as written, even if the result is to deny any real remedy for the breach.

It is one thing to agree to these provisions in supply, construction and development agreements, it is quite another to import them into an M&A indemnification framework where there are already bargained-for deductibles and caps on the available remedies for breach of the limited representations and warranties made by the seller. And the use of the term “consequential damages” is just the tip of the iceberg in these loss exclusion provisions. Many of these provisions waive much more than just the already unknowable scope of consequential damages by including other terms such as “loss of earnings,” “diminution in value,” “business interruption,” and “multiples of earnings.” Could including some of these terms in a “laundry list of precluded damages” impact even the most basic determination of the difference between what was promised and what was in fact delivered based upon the price that was paid? In earlier postings to Weil’s private equity Insights blog (available here and here) some of the risks of including these terms in loss exclusion clauses were previously reviewed.

Buyers should resist these provisions in M&A transactions, and sellers, in limiting their liability, should rely instead on the negotiated deductibles and caps, and upon the overall limits of certainty and reasonable foreseeability that is built into the common-law contract damages regime (and which already excludes remote or speculative damages). Otherwise we are asking courts, as was observed by then Chancellor Strine in Pharm. Prod. Dev., Inc. v. TVM Life Sci. Ventures VI, L.P., Civ. A. No. 5688-VCS, 2011 WL 549163, at *7 (Del. Ch. Feb. 16, 2011), to enforce agreements containing a “laundry list of precluded damages [that] might have been put in the Merger Agreement by lawyers who themselves were unclear on what those terms actually mean.” It’s time that we all acknowledged the “recognized failure of predictability” in that approach and finally struck these terms out of the deal lexicon.