Lessons from a Consequential Case Concerning the Consequences of Consequential Damages Waivers

The variety of liability limitation provisions, both by type and scope, are legion.  And as noted in this recent decision from the U.S. Court of Appeals for the 4th Circuit, Severn Peanut Co., Inc. v. Industrial Fumigant Co., these provisions are “widely enforced,” not only because such enforcement “maximizes parties’ freedom of contract,” but also because such provisions “allow[] them to better achieve predictability in their business relationships.”  After all:

By allowing parties to bargain over the allocation of risk, freedom of contract permits individuals and businesses to allocate risks toward those most willing or able to bear them.  Parties who allocate risks away from themselves thereby cap their future expected litigation and liability costs.  Parties assuming the risks often receive benefits in the form of lower prices in exchange.

Thus, it is not uncommon to cap liability for breach of a services agreement to the amounts paid by the counterparty for that service, or to limit liability for breach of a manufacturing, supply or construction agreement to the cost of repair or replacement only.  But many agreements, including many private company acquisition agreements, approach liability limitation by excluding certain damages types, rather than specifying a specific remedy or a liability cap.  Indeed, one of the most common liability limitation provisions used throughout the world is a provision that broadly precludes “consequential” damages or losses, along with a laundry list of other damages types that some may assume (wrongly) are simply synonyms for those damages or losses that would fall within the “consequential” category of losses or damages.

As discussed in detail in a Fall, 2015, The Business Lawyer article, and as highlighted in an October 20, 2015 Weil Private Equity Insights blog posting regarding the Stanley Black & Decker case,  these types of liability limitation provisions do not actually achieve “predictability in … business relationships.”  This is particularly true in the M&A deal world.  Indeed, the meaning of many of the terms used in standard consequential damages waiver clause are “misunderstood and fraught with uncertain application in the merger and acquisition context.”  But “whether or not these terms are fully understood by the parties to the contract, an excluded losses provision ‘is generally enforced against a counterparty to a contract even if the effect is to exclude all damages resulting from a breach of the affected agreement.’”

Severn Peanut Co. did not involve an M&A deal—it involved a services contract.  Nonetheless, this case provides an opportunity to consider the potential impact of these provisions in a different context—a context that a portfolio company may face with a supply or service agreement, either as the provider or customer.  It also provides yet another opportunity to beat the drum regarding the dangers of importing these provisions into the M&A context from the services arena.

In Severn Peanut Co., a pesticide company was hired to fumigate a peanut storage dome in North Carolina.  The Pesticide Application Agreement required the pesticide company to use a specific pesticide called “phosphine” and, in doing so, to strictly comply with the “instructions” and “precautions” set forth on the products label. The products label was specific in stating that phosphine tablets should not be piled on top of one another.  The reason:  when piled on top of one another, “the tablets or pellets produce a toxic and flammable gas.”  Notwithstanding the agreement’s express terms, the label’s express requirements and warnings, and state and federal law regulating use of the product (which mandated that the product be used “only in a manner consistent with its labelling”), the pesticide company allegedly did what it should not have done and poured thousands of pellets into a single access point in the peanut dome that caused pellets to stack up on top of one another.  The result: a fire with resulting destruction of the peanut dome, the loss of millions of pounds of peanuts, lost business for the peanut storage company, as well as the cost of dealing with the fire.  The peanut storage company (and its insurer, which apparently insured many of these losses) sought to recover those damages from the pesticide company based on breach of the Pesticide Application Agreement, as well as claims of negligence.  But the Pesticide Application Agreement contained a provision that stated that the fee (which was only $8,604) that was payable for the pesticide company’s services “was ‘based solely upon the value of the services provided’ and was not ‘related to the value of [the peanut company’s] premises or the contents therein.’”  Moreover, the agreement further stated that the $8,604 fee charged for the pesticide company’s services “was not ‘sufficient to warrant [the pesticide company] assuming any risk of incidental or consequential damages’ to [the peanut company’s] ‘property, product, equipment, downtime, or loss of business.’”

Despite the fact that the peanut company had hired a service provider that was apparently certified in applying phosphine, and despite the fact that applying phosphine in a manner inconsistent with the product’s labelling not only violated the Pesticide Application Agreement, but also state and federal law, the court denied all of the claimed damages of the peanut company (and its insurer) based on the foregoing provisions.  As noted by the court, under North Carolina law:

Consequential or special damages for breach of contract are those claimed to result as a secondary consequence of the defendant’s non-performance.  They are distinguished from general damages, which are based on the value of the performance itself, not on the value of some consequence that performance may produce.

Thus, because the value of the promised performance was apparently limited to the agreed cost of $8,604, all damages in excess of that value, although directly resulting from the failure of that agreed performance, were effectively “consequential damages.”  And to the extent this seemed an unfair result, the court noted that:

[W]hile cases examining damages exclusions and liability limitations often necessarily involve bargains that look like raw deals in hindsight, defense of the liberty of contract requires that courts avoid “indulgence of paternalism” and respect individuals’ “entitle[ment] to contract on their own terms.”

The court even rejected an independent negligence claim because the alleged negligence arose from the obligations undertaken in the agreement.

In the context of a services agreement between two sophisticated parties (provided the parties actually thought through the ramification of these often-used but seldom examined or fully understood provisions), there is nothing necessarily unfair about this result.  Indeed, a waiver of consequential and lost business damages may be an appropriate means of rationalizing the price charged for the service versus the liability exposure potentially incurred in providing such a service (although the meaning of the term “consequential damages” is so uncertain that there is no guarantee that the result obtained here for the pesticide company would have necessarily been obtained in all courts—the forgoing definition of consequential damages is not followed by all courts and there are at least two other approaches to the meaning of the term).  And obviously the parties to such a contract can decide who bears the cost and risk of insurance for things going awry.

But would such a provision would ever make the same sense in an M&A context where the losses arise from a breach of representations and warranties dealing with the earning capacity of a business for which a purchase price has been negotiated and paid and where the liability limitations have been separately negotiated as caps and deductibles?  Even assuming the applicability of the North Carolina’s version of the meaning of “consequential damages,”  what is the value of the promised performance itself (i.e., the accuracy of the representations and warranties) versus the consequences arising from the failure of that performance (i.e., the inaccuracy of the representations and warranties) if the first is deemed general damages but the second is deemed consequential?  Even assuming the answer is that a waiver of consequential damages in that context (at least if limited to direct claims rather than third party claims) is that losses are limited to the difference between the value of the business as warranted and the value of the business with one or more inaccurate warranties (assuming that the waiver provision didn’t include a waiver of diminution in value damages as part of its laundry list of excluded losses), does that fully compensate the buyer for its losses when there is no measurable value differential, even though the buyer has and is suffering out of pocket losses directly attributable to the breach of the inaccurate warranties?

In the Widget Manufacturing Plant Hypothetical set forth in a May, 2008 The Business Lawyer article on this topic, the horrors of using a broad exclusion of indemnifiable losses from the otherwise exclusive remedy of a capped indemnification for breaches of the representations and warranties contained in a common private company acquisition agreement were detailed.  This hypothetical remains a useful reminder and negotiation reference.  And the recent Fall, 2015 The Business Lawyer article, which updates and supplements that 2008 article, suggests alternatives to the questionable importation of these waiver provisions from the construction, carriage and service industries into the M&A deal world.   Despite their widespread use and seeming “market” acceptance, these broad loss exclusion clauses should be avoided in the M&A deal world.