15 Sep 2004

Consequential loss exclusion clauses: Issues for owners and contractors

by Arch Fletcher

Limitation or exclusion clauses which speak only of "consequential loss" or "indirect or consequential loss" ordinarily will not be effective to limit or exclude liability for direct loss of production, loss of revenue or loss of profit. If commercial reality dictates that a contract needs to include a "consequential loss" exclusion clause for the benefit of one party, the other party should carefully consider whether the clause needs to be made subject to any specific exceptions or "carve outs".

It is not uncommon for construction and procurement contracts to contain a clause excluding or limiting liability for "consequential loss". Indeed, many contractors and suppliers simply will not do business these days unless the contract contains such a clause. Typically, these clauses are intended to protect contractors and suppliers from liability for "indirect" or "consequential" losses and the clauses often mention particular types of loss such as loss of production, loss of revenue and loss of profit.

However, unless these clauses are carefully drafted:

  • contractors and suppliers may find that they are not protected to the extent they may have thought, thus leaving themselves exposed to potentially extensive liabilities;
  • alternatively, owners may find they have left themselves with no recourse at all for certain types of losses, losses which could have drastic consequences for their businesses.

Cases in both England and Australia have shown that courts tend to read loosely worded exclusion clauses quite narrowly.

English cases

English courts have tended to consider that an exclusion clause which refers merely to "consequential loss" or "indirect or consequential loss":

  • will not exclude liability for "direct" losses which fall within the first limb of the so-called rule in Hadley v Baxendale - that is, losses which arise naturally, according to the usual course of things, from the breach of contract regardless of whether the parties considered the effect of the breach at the time they entered the contract; and
  • will only exclude losses which fall within the second limb of the so-called rule in Hadley v Baxendale - that is, indirect or special losses which, at the time they made the contract, the parties contemplated as being the probable result of a breach of contract.

For example, in British Sugar Plc v NEI Power Projects Ltd a clause said "… the Seller's liability for consequential loss is limited to the value of the contracts". The consequential loss exclusion was held not to apply to increased production costs or loss of profits caused by the breakdown of defective equipment.

However, in Deepak Fertilisers & Petrochemicals Ltd v Davy McKee (London) Ltd, the clause went much further. It said, "DAVY does not assume any liability except as expressly set out in the CONTRACT and in no event shall DAVY by reason of its performance or obligation under this CONTRACT be liable in tort or for loss [of] anticipated profits, catalyst, raw materials and products or for indirect or consequential damages". The owner sought to recover the cost of rebuilding plant destroyed by an explosion.

The court took a narrow view of the consequential loss exclusion and allowed the owner to recover not only the cost of rebuilding the plant, but also wasted overheads during reconstruction. However, although lost profits were classed as a direct loss (and therefore not "indirect or consequential damage"), in this case they could not be recovered because the exclusion clause specifically and separately excluded liability for loss of anticipated profits.

In BHP Petroleum Ltd v British Steel PLC, the clause said, "Neither the Supplier nor the Purchaser shall bear any liability to the other ... for loss of production, loss of profits, loss of business or any other indirect losses or consequential damages arising during and/or as a result of the performance or non-performance of this Contract … ".

The court held that the clause did exclude liability for loss of production, loss of profit and loss of business - even if they were not examples of indirect or consequential loss within the second limb of Hadley v Baxendale - as well as excluding other claims within the second limb. The court did not think that the phrase "any other indirect losses or consequential damages" (especially the word "other" in that phrase) meant that the expressions "loss of production", "loss of profit" and "loss of business" should be read down as only applying if the relevant loss was "indirect or consequential".

In Hotel Services Limited v Hilton International Hotels (UK) Ltd, the clause said, "The Company [HSL] will not in any circumstances be liable for any indirect or consequential loss, damage or liability arising from any defect in or failure of the System or any part thereof or the performance of this Agreement or any breach hereof by the Company or its employees." The court held that the costs of removing and storing defective mini-bar chiller units and cabinets, and the loss of profits expected from their use, were direct and natural consequences of the defect and therefore still recoverable.

In Pegler Ltd v Wang (UK) Ltd, the clause said:

"Wang shall not in any event be liable for any indirect, special or consequential loss, howsoever arising (including but not limited to loss of anticipated profits or of data) in connection with or arising out of the supply, functioning or use of the Hardware, the Software or the Services … ".

The court held that the clause only covered losses falling under the second limb of Hadley v Baxendale. The claimed losses - which in this case included loss of sales, loss of opportunity to increase margins, loss of opportunity to make staff cost savings and wasted management time resulting from breaches of the computer hardware and software contract - were held to fall under the first limb of Hadley v Baxendale and therefore to still be recoverable.

The court said that the reference to "loss of anticipated profits" did not mean that the exclusion applied to all loss of profits. Rather, it was plain from the context that the exclusion only applied to "loss of profits" which was of the character of indirect, special or consequential loss. This aspect of the case makes for an interesting contrast with the decision in the BHP Petroleum Ltd case where the court held that the references in that case to "loss of production", "loss of profit" and "loss of business" were not to be read down as only applying if the relevant loss was "indirect or consequential". Obviously, subtle drafting differences can result in very different outcomes.

The Australian context

There are surprisingly few Australian cases on point. As a general rule, Australian courts will interpret an exclusion clause according to its natural and ordinary meaning read in light of the contract as a whole (thereby giving weight to the context in which the clause appears, and the nature and object of the contract).

In GEC Alsthom Australia Ltd v City of Sunshine, the relevant clause was an indemnity provision which said:

"The Council shall indemnify GECAA on demand against any direct loss (excluding consequential loss) ... which GECAA sustains or incurs as a consequence of any failure by the Council to observe or perform any of its obligations under the Construction Agreement, the Premises Lease or the Gas Supply Agreement."

The court held that the clause entitled GECAA to an indemnity in respect of damage directly flowing from a breach of contractual obligations and was wide enough to cover lost revenue, which the court did not consider to be excluded "consequential loss".

Some possible carve outs

Where a consequential loss exclusion is to be included in a contract for the benefit of one party, the other party - often the owner - needs to consider whether any "carve outs" (exceptions) need to be introduced with a view to ensuring that the first party will remain liable for certain types of loss (although there may well be another limitation clause which then caps that liability at a particular amount).

Examples of specific carve outs which warrant consideration include:

  • Liability to pay liquidated damages. Liquidated damages will often represent a pre-estimation of the types of loss which might well be caught by a "consequential loss" exclusion (eg. loss of production or loss of revenue).
  • Liability for unliquidated damages in lieu of unenforceable liquidated damages. Where liquidated damages are specified, it is not uncommon for the contract to also provide that the owner is still entitled to recover general (or common law) damages if the liquidated damages provision is held to be unenforceable (eg. if the liquidated damages are found to be a penalty). Without a carve out for this entitlement, the entitlement could be negated or substantially eroded by a "consequential loss" exclusion.
  • Liability under indemnities regarding claims by third parties. It is common for contracts to include indemnities in favour of the owner for claims made against the owner by third parties for:
    • personal injury, death, property damage or nuisance arising out of the performance of the work by the contractor; and 
    • infringement of intellectual property rights by the contractor. 

    Because claims by third parties may include claims for indirect losses, and because the owner's liability to third parties is usually uncapped, it is important that the value of the indemnities not be watered down by a "consequential loss" exclusion.

  • Liability for fraud or criminal conduct.
  • Liability for wilful misconduct and gross negligence. The concepts here are those of intentional misconduct which has substantially harmful consequences and results from a conscious indifference to the rights or welfare of those who may be affected; and the concept of gross carelessness or gross dereliction of duty.
  • Insured liabilities. The idea here is to exempt from the exclusion clause, any liabilities to the extent the defaulting party is indemnified under any insurance policy effected under the contract. There will often be debate between the parties as to whether this carve out should apply to the extent of the entitlement to indemnity or only to the extent of any proceeds actually recovered from the insurer.
  • Liability for losses to the extent they are recoverable by the defaulting party from others (such as subcontractors).
  • Liability to pay interest or other amounts which the contract expressly treats as recoverable "debts".
  • Liability which, by law, the parties are not allowed to limit or exclude. Parties also need to be aware that there are legal difficulties with effectively limiting or excluding some statutory liabilities (eg. liability for breach of certain provisions of the trade practices legislation).

The above list is not necessarily exhaustive. Some parties may have other particular losses for which they do not want to give the other party any relief from liability (eg. liability under special provisions dealing with confidentiality or trade secrets).

As with all limitation and exclusion clauses, the particular circumstances of each case need to be taken into account and careful drafting is required. It must also be acknowledged that not every contracting party will agree to all of the listed carve outs. These exceptions are often the subject of negotiation.

Owners who have to accede to a limitation or exclusion clause should consider whether insurance is available to take up any of the capped or excluded risk.

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.