Excluded Losses Part II: An English Perspective on the Continued Failure of Predictability Regarding the Use of the Phrase “Consequential or Special Losses”

“When we meet a fact which contradicts a prevailing theory, we must accept the fact and abandon the theory, even when the theory is supported by great names and generally accepted.”  Claude Bernard

In 1897, Oliver Wendell Holmes, Jr., in an essay published in the Harvard Law Review and entitled the “Path of the Law,” described the job of a lawyer as primarily involving the art of prediction.  Lawyers study prior caselaw to predict outcomes in similar situations involving their clients’ current dealings or prior actions.  In the transactional arena, that study and predictive undertaking permits good business lawyers to determine how to properly advise their clients in ensuring enforcement, or avoiding untoward consequences arising from breach, of the contractual undertakings made or to be made by or for the benefit of their clients.  When a lawyer cannot reliably predict the meaning a particular clause will be given by a court in a future dispute regarding the contract in which that clause appears, one may well question why that clause continues to be used.

A November 7, 2016 post to Weil’s Private Equity Insights blog, entitled Excluded Losses” Provisions and the “Butterfly Effect”—the Continued Failure of Predictability Regarding Consequential Damages Waivers in M&A Agreements (“Excluded Losses Part I”), bemoaned the failure of predictability regarding one particular clause often found in contracts—the ubiquitous “consequential or special damages” waiver or exclusion provision.  Based upon a review of three cases decided in just the last two months by various U.S. courts, that post concluded that, in light of the inconsistent understanding of the meaning of the phrase “consequential or special damages” (and the consequent failure of predictability regarding outcomes arising from the use of that phrase), it was time that these terms were stricken from the U.S. deal lexicon.  A short time after that posting, the English Commercial Court, in Star Polaris LLC v. HHIC-PHIL, Inc., [2016] EWHC 2941 (Comm) (17 November, 2016), provided an English perspective on this same issue.  A review of that decision suggests that the call for striking the term “consequential or special damages” from the U.S. deal lexicon applies equally to the term “consequential or special losses” in the English deal lexicon.

To understand the Star Polaris decision, and all cases throughout the common-law world that have had occasion to consider the meaning of the terms “consequential” or “special” as modifiers of the terms “damages” or “losses,” in the context of damages limitation provisions or waivers, it is necessary to first understand the historical context in which these terms came to have some semblance of meaning before that meaning was overturned by the inconsistent manner in which those terms began to be used and understood by practitioners, deal makers, and the courts.  That historical context involves a nineteenth century English dispute between a highly successful flour mill and a carrier firm, which had been hired to deliver a package entrusted to it by that flour mill.

A Broken Shaft and a Broken Promise

In 1850, two brothers, Joseph and Jonah Hadley, decided to build a steam-powered flour mill at the entry to the port of the City of Gloucester, England.  They called their new business “City Flour Mills.”  The Hadley bothers’ business was so successful that they added additional capacity to increase their output.  One day, however, a crankshaft in one of the steam engines broke.  Unfortunately, the Hadley brothers had failed to prepare for such a possibility and did not have a spare crankshaft on hand to replace the broken one.  The manufacturer of the steam engine, W. Joyce & Co., was unable to provide a replacement part that could be guaranteed to fit the Hadleys’ steam engine unless the broken part was shipped to the manufacturer so that the broken part could be used as a pattern to build a replacement.  So, the Hadley brothers engaged the services of Pickford & Co., a carrier firm whose senior partner was a man named Joseph Baxendale, to deliver the broken crankshaft to the manufacturer.

The steam engine’s manufacturer was located in Greenwich, which is now part of London.  Pickford & Co. agreed to transport the part to the manufacturer in Greenwich the second day after they took possession from City Flour Mills, and the Hadleys paid the carrier the requested fee of £2-4s in advance.  But Pickford & Co., in breach of its contract, delayed transporting the part for five additional days (perhaps to wait for additional deliveries going to Greenwich on behalf of other customers); i.e., instead of delivering the part in two days, they delivered it in seven days.

Meanwhile, the shut-down steam engine was depriving the Hadley brothers of the profits that could have been derived from their mills operating at full capacity.  When they discovered that the delay in obtaining the replacement part was caused by the five-day delay in the delivery of the broken part to the manufacturer, they sued Pickford & Co. (and its senior partner) to recover their lost profits resulting from that delay.  And a jury awarded the Hadley brothers £50 in damages based on lost profits caused by the delayed delivery, which damages were more than 20 times the fee Pickford & Co. charged them for the transportation service.

The Court’s Decision

On appeal, however, the jury’s award was overturned in the now famous 1854 English decision of Hadley v. Baxendale.  In overturning the jury’s award, the appeals court established what is now viewed as the basic rule upon which all damages for breach of contract are to be determined in any jurisdiction that derives its common law from England, which includes the former members of the Commonwealth and every U.S. state other than Louisiana.  That rule, handed down by the lead judge, Baron Sir Edward Hall Alderson, is simply that a non-breaching party is entitled to recover those damages that it sustains as a result of the breach that were reasonably foreseeable, either because (a) they are the type of damages that would naturally and ordinarily be expected to arise from a breach of any similar contract, or (b) they are the type of damages that arise from special circumstances applicable to this particular non-breaching party and those special circumstances were actually brought to the attention of the breaching party at the time of contracting, so that it can be fairly said that the probability of such damages arising from such special circumstances were within the contemplation of the parties at the time of contracting.  The two means of establishing the foreseeability of damages for breach have been described as the two limbs of the common law’s contract damages limitation regime (because the effect of the rule is to place a limit on the extent of damages that may be recovered by a non-defaulting party regardless of causal connection between the breach and the non-defaulting party’s loss).  Those damages that fall within the first limb described in clause (a) above have historically been referred to as general or direct damages, while those falling within the second limb described in clause (b) above have been referred to as special or consequential damages.

Because it would not normally be expected that a failure to timely deliver a package from one location to another would result in a shut-down mill with a consequent loss of profits, the jury’s award of damages did not fall within the first limb of the contract damages limitation regime.  And because Pickford & Co. was apparently not properly made aware of the fact that the mill would remain shut down until the crankshaft was replaced (and that any delay would result in lost profits), the jury’s awarded damages also did not fall within the second limb of the contract damages limitation regime.

A 162-year-old Suggestion to Contracting Parties to Bargain for Specific Liability for Breach

The Hadley court further noted that the purpose of requiring that the non-breaching party’s special circumstances be brought to the attention of the breaching party at the time of contracting, in order to hold the breaching party liable for any damages resulting from a later breach of contract on account of those special circumstances, was to provide the parties an opportunity to specifically bargain for the allocation of responsibility for the incurrence of damages arising from those special circumstances that would not ordinarily arise from the breach of any other like contract.  Thus, the Hadley court was anticipating the negotiation of “excluded losses” provisions that in fact allocated some of the damages actually resulting from a breach of contract to the innocent party, or the possibility of a bargained-for increase in the amount being paid to the party incurring the potential additional liability as consideration for undertaking such potential additional exposure should a breach occur.  In other words, had Pickford & Co. fully understood the Hadley brothers’ special circumstances they might have bargained for an increased fee, or specifically disclaimed any liability for any delay beyond a specified rebate of a portion of the standard fee paid.  Having been deprived of that opportunity to bargain for appropriate liability, or an increased fee, based on full disclosure of the probability of that liability, Pickford & Co. was exempted from any responsibility to compensate the Hadley brothers for their loss of profits caused by Pickford & Co.’s breach of the contract to deliver the part on the second day after they received it, rather than waiting until the seventh day.  There were effectively no ordinary and normal losses flowing from the late delivery of a package.

Why Does this Matter to M&A Deal Professionals and their Counsel in the 21st Century?

So why would M&A and private equity deal professionals, or their counsel, care about this nineteenth century English tale involving an old mill that was recently converted to residential apartments in the Gloucester Docks?  Well, despite the fact that the Hadley case was decided by an English court more than 162 years ago, and approximately three score and eighteen years after the Declaration of Independence was signed, it continues to be cited with approval by courts throughout the United States, and the rest of the common-law world, as a basis for determining appropriate measures of recoverable damages for breach of contract.  And, more importantly, and unfortunately, the invitation that Baron Alderson issued to contracting parties to specifically allocate the non-breaching party’s losses that a breaching party has agreed to bear, has been met with the ubiquitous “consequential or special” losses or damages waiver or exclusion clause, with little apparent thought as to what damages for breach of contract have thereby been excluded or waived.  In other words, rather than specifically address and negotiate the appropriate party to bear losses beyond those that would ordinarily arise from a breach of any similar contract regardless of the parties’ special circumstance that have been specifically identified at the time of contracting (and which are therefore foreseeable), parties began to routinely eliminate any such damages claims arising from such special circumstances, whether known to the parties or not at the time of contracting.  And then, over the succeeding 162 years, courts, deal makers, and practitioners throughout the common-law world ceased to have any consistent understanding of the meaning of the term “special or consequential” losses or damages as used in those waiver and exclusion clauses.

The Commercial Court Refuses to Limit the Meaning of “Consequential or Special Losses” to Hadley’s Second Limb

In Star Polaris, the English Commercial Court considered the meaning of an “excluded losses” clause of a ship building contract that provided that “the BUILDER shall have no liability or responsibility whatsoever or howsoever arising for or in connection with any consequential or special losses, damages or expenses unless otherwise stated herein.”  The clause appeared in a section of the contract that detailed the responsibilities of the Builder for remedying defects in the completed ship; i.e., the only stated obligations were to make “all necessary repairs and replacements.”  Coincidentally, the defective parts at issue here included a crankshaft.  And part of the Buyer’s claimed damages included financial losses and diminution in value caused by the ship’s engine failure as a result of the defective parts.

The Buyer took the position that consistent with numerous English cases addressing the meaning of the phrase “special or consequential losses,” the exclusion provision had to be interpreted as only excluding those losses that fell within the second limb of the Hadley contract damages limitation regime.  However, the court held that while it was true that the second limb of the Hadley damages limitation regime is the normal understanding of the meaning of the phrase “consequential or special losses,” that was not the limit of the reach of the phrase in this particular contract.  In this particular contact the phrase had to be understood as meaning all losses “following as a result or consequence” of the defective parts, other than the actual cost to repair those parts.  In other words, the waiver of all “consequential or special losses, damages or expenses unless otherwise stated herein” was read as if it eliminated the modifier “consequential or special” altogether, and instead simply said “all losses, damages or expense.”  As a result, all claimed losses, including diminution in value (i.e., the difference in value between the value of the ship as warranted and the ship after the repairs) were denied even if they would have otherwise fallen within the first, rather than the second, limb of the Hadley contract damages regime.

The Decision’s Import to Deal Makers

In the context of a provision that appeared to have been intended to delineate the exact extent of the obligations being undertaken by the Builder as part of its warranty, the decision appears sound.  Indeed, the court noted that the exclusionary clause did not impose any liability for those losses and damages that did not fall within its scope; i.e., “[i]t is not therefore a question of simply determining what liability is excluded, but of ascertaining what liability is undertaken.”  In other words, because the entire provision in which this exclusion was contained was designed to limit liability to just specific actions that the Builder was agreeing to take in the event there was a defective part, the exclusion itself had to be read more broadly as intending to cover more than what would otherwise be the case in a provision with unlimited liability except for the excluded liability.

The point remains, however, that someone thought that they really needed to put the phrase “consequential or special” in the damages exclusion clause for the benefit of the Builder and the inclusion of that phrase actually resulted in lengthy, and presumably expensive, litigation that would not have occurred if that phrase had not been included.  And, but for the placement of that clause and other language that made clear the limited undertakings of the Builder respecting the post-delivery obligations to repair and replace defective parts, it seems clear that these modifiers would have in fact limited the loss exclusion to only the second limb of Hadley.  In this case, the Commercial Court was prepared to ignore the impact of these modifiers because “[t]he obligation to repair/replace [was] exhaustive and nothing else is recoverable beyond that.”  The fact that the ship was worth less even after it was repaired than it had been before the damage done by the defective part, and that such damages claim “might well have fallen within the first limb of Hadley v. Baxendale,” was deemed irrelevant in this case because, in the context of this particular agreement, the court held that “consequential or special loss” included diminution in value, together with any other financial loss to the ship owner (for a discussion of a U.S. case stating  that diminution in value is part of Hadley’s first limb see a prior Weil Private Equity Insights blog posting, entitled Diminution in Value & Waivers of Lost Profits).  Consider how much easier this case might have been to decide if the clause had simply said: “Builder will not be liable for any of Buyer’s damages, losses or expenses in excess of the cost to repair or replace the defective part.”

For the party trying to exclude losses, the better practice is to exclude all losses of any kind, without limiting the exclusion to a specific type of losses, and then excepting from the general exclusion the specific losses that the party is actually prepared to bear (just as the Builder in the Star Polaris decision was ultimately found to have done, but would have more clearly done if it had avoided using the terms “consequential or special losses” in the first place).  For the party expecting recovery in the event of breach, these terms can bite harder than just potentially limiting the exclusion to the second limb of Hadley—because, despite the historical efforts to define “consequential or special losses,” there is simply no commercial certainly as to which limb of the Hadley damages limitation regime a particular loss might fall when it is incurred as a direct result of a counterparty’s breach.  This phrase really does need to be stricken from the deal lexicon.

A Phrase in Constant Search of Meaning

This is not the first time there has been a call to eliminate the phrase “consequential or special” damages or losses from the deal lexicon (see e.g., this 2008 article and this 2015 article from The Business Lawyer).  The fact is that the phrase has no clearly established and immutable meaning in any particular contract.  And its literal dictionary meaning appears largely divorced from its intended meaning.  “Special” is generally defined as “unique” or “different from what is usual,” which does seem fairly consistent with the second limb of Hadley (except that Hadley only permits recovery of such special damages if they were in fact made known to the breaching party as probable to occur upon a breach at the time of contracting).  In other words, special losses not recognized as probable at the time of contracting are not recoverable for breach of contract even in the absence of a waiver. The term “consequential,” on the other hand, is generally defined as “following as a result or effect” or “important; significant.”  And despite their different dictionary definitions, courts have generally treated the terms “special” and “consequential” as synonyms.

Imagine you have entered into a carefully negotiated contract to purchase a business, with a specific set of bargained-for representations and warranties from the seller, with a specified percentage of the purchase price as an agreed cap on the aggregate damages you can recover for a breach of any of those representations and warranties.  Would you knowingly agree to waive any right to pursue actual damages you incurred as a direct result of a breach of those representations and warranties simply because they happened to be “important,” “significant,” or, worse still, simply “follow[ed] as a result or effect” of that breach?  And even if the damages were unique or different than usual, so what?  Are you really prepared to cap your damages claims at an agreed percentage of the purchase price and then have claims for damages that directly resulted from the breach excluded, even when they are below the agreed cap, simply because they are unique to your situation (but known to be a likely occurrence at the time of contracting in the event of a breach)?  Remember, the Hadley distinction, when properly applied, is not a causality distinction.  In other words, consequential damages are not necessary those that are “indirect,” even though damages that do not fall within the second limb, but instead fall within the first limb, of Hadley are often called “direct” damages.

The courts’ efforts to define these terms, either by reference to Hadley’s second limb or through interpretive discernment of the intent of the parties who actually used the terms in a particular contract, but that may not have actually given the terms any real thought, has led to a confusing and largely indecipherable body of caselaw.  As was noted by a Texas court, DaimlerChrysler Motors Co. v. Manuel, 362 S.W.3d 160, 181 n.20 (Tex. App. 2012), “[d]espite the vast number of cases purporting to define ‘consequential damages’ by repeating the same time-honored but general definitions and distinctions between consequential and direct damages, the meaning remains elusive.”  And Australia has a number of recent cases that have clearly moved away from the Hadley first and second limb distinction in defining what is and is not consequential damages or losses.  Even England appears poised for a more dramatic shift from the Hadley distinction, as being a sacrosanct means of determining what are direct versus consequential losses, than that suggested by the Star Polaris decision.  Indeed, discussing the line of English cases that have considered the meaning of “consequential loss” and largely limited that meaning to the second limb of Hadley, Lord Moore-Bick noted recently, in Transocean Drilling UK Limited v Providence Resources Plc, [2016] EWCA Civ. 372, at [15] (13 April. 2016), that “[i]t is questionable whether some of those cases would be decided in the same way today, when courts are more willing to recognise that words take their meaning from their particular context and that the same word or phrase may mean different things in different documents.”

Yet Another Call to Stop the Madness

Despite the facts of Hadley, consequential damages are not to be equated with or limited to “lost profits.”  Indeed, not all lost profits even constitute consequential damages—some lost profits constitute direct damages.  Consequential damages are not those damages that would not have been foreseeable to the parties at the time of contracting—consequential damages must be foreseeable just the same as direct damages.  Consequential damages are not remote or speculative damages—certainty and foreseeability are required for all damages recoverable for breach of contract.  Similarly, consequential damages are not necessarily indirect damages—some courts suggest this is true, but others do not.  Consequential damages are not necessarily all damages other than the difference between the value of the product or service promised and the value of the product or service delivered—even though there are some cases that would suggest this.  But some recent U.S. cases do seem to suggest that the proper approach to differentiating between direct and consequential damages is that direct damages are limited to the costs of replacing the promised performance from the breaching party, while consequential damages are all consequences of the breach other than the cost of replacing the defaulted performance.

If this is all confusing to you, it is to almost everyone—lawyers, deal makers, and the courts.  And it’s particularly difficult to apply these concepts in the context of an M&A transaction.  And that leads to a “failure of predictability” that impacts the ability of business lawyers to actually do the job Holmes suggests is the main reason clients hire us.  And, as noted in the Excluded Losses Part I post, none of this takes into account the proliferation of excluded losses provisions on both sides of the Atlantic that expressly exclude all “lost profits” in addition to consequential damages, as well as additional exclusions such as “loss of use,” “loss of opportunity,” “loss of revenue,” “loss of business,” and even, “diminution in value.”  The fact that some of these terms would clearly fall within the first limb of Hadley is irrelevant if they are included in such a way that they are not limited by a modifier tied back to the term “consequential or special loss.”  And with the inclusion of such additional terms, it may not be clear that there are any remaining recoverable damages for breach at all.

The fact that the Hadley brothers’ mill has been recently converted into residential apartments is probably as good a reason as any to end the madness of continuing to include “consequential or special losses” as a phrase in any contract.  The only thing that can be predicted with any certainty about the continued use of that phrase is that no one can in fact predict, with any degree of certainty, the meaning that it will be given by a court on either side of the Atlantic.