05 Mar 2008

What does it mean to exclude or cap liability for consequential loss?

Contractors often seek amendments to Government procurement contracts to exclude or cap any liability which they may have under the contract for consequential loss, but does either party really understand the implications of doing this?

What is consequential loss?

Where a contractor breaches its obligations under a contract and Government suffers loss as a result of that breach, the loss suffered can be categorised as either direct loss or consequential loss.

  • Direct losses are those losses which arise naturally, that is according to the usual course of things, from the breach. At law, Government is entitled to recover all direct losses which it suffers. For example, where a contractor fails to supply an asset or a service in accordance with the terms of the contract, the loss suffered by Government from not being able to use the asset or service will often be a direct loss and recoverable at law.
  • Consequential loss (also known as "indirect loss") is all loss suffered by Government which is not a direct loss. It is only recoverable by Government at law where it is reasonable to assume that the loss would have been in the contemplation of the parties at the time they made the contract as a probable result of a breach of it. This involves asking what reasonable business persons (who are taken to understand the ordinary practices of the other's trade or business) would be taken to have contemplated as the natural or probable result of a breach of the contract.

While the definitions of the different categories of loss are simply enough stated, in practice, it can be very difficult to determine whether loss is categorised as direct or consequential loss and, if it is consequential loss, whether it is recoverable by Government at law. How the loss is characterised and whether it is recoverable will depend on the circumstances of each particular contract, so it can be difficult for Government to readily assess the impact of any exclusion or cap.

Generally, you can assess the impact of an exclusion or cap by:

  • identifying the contractor's key obligations under the contract (e.g. an obligation to design and manufacture an asset by a specified date);
  • identifying the losses which Government may suffer if the contractor fails to comply with each of the key obligations (e.g. loss of use of the relevant asset);
  • characterising the losses identified as either direct loss or consequential loss in accordance with the tests outlined above; and
  • in relation to the consequential losses, identifying which ones the Government can probably recover at law by applying the tests outlined above. Any exclusion or cap will affect those consequential losses which are recoverable.

Additionally, a contractor might provide an indemnity for losses arising from certain events which could allow Government to recover all direct loss and consequential loss suffered. Any exclusion of consequential loss which applies to loss recoverable under an indemnity will have a greater potential impact on Government.

Loss of profit, revenue and business

Some contractors seek to exclude or cap liability for consequential loss on the basis that this will be sufficient to exclude or cap liability for loss of profit, revenue or business. There are many examples of contracts where such loss is a direct loss and recoverable regardless of whether there is an exclusion of consequential loss. For example, loss of profit, revenue or business will often be a direct loss in the case of a contractor's failure to supply under construction or supply contracts for revenue producing assets such as factories or shops. Accordingly, excluding liability for consequential loss may not be sufficient to exclude liability for loss of profit, revenue or business.

Contractors should also be aware that it will be less common for Government to suffer loss which is capable of being characterised as loss of profit, revenue or business as it is not often that Government's activities in relation to a particular contract will be capable of giving rise to such loss.

Commonwealth Government procurement policy

The Commonwealth Government has specific policies which regulate when the Commonwealth Government can agree to exclude or cap a contractor's liability under a contract. Of particular note, the policies require:

  • risks should be borne by the party best able to manage them. Government should not accept risks which the contractor is better placed to manage;
  • the potential losses which are being excluded or capped should be investigated and identified;
  • Government should implement a risk management process, including conducting a risk assessment as part of the planning process prior to entering into a contract, and preparing a risk management plan where necessary. This includes an assessment of the likelihood of the particular loss arising;
  • any potential costs arising from the exclusion or cap of liability for consequential loss should be taken into account when assessing value for money;
  • any exclusion or cap of liability should be of limited scope and relate to an explicitly identified risk rather than being of general application. Accordingly, Government should avoid agreeing to a general exclusion of, or cap on, consequential loss; and
  • Government should consider all other options available, for example, whether the contractor can obtain insurance to cover the risk.

In considering the scope and effect of any exclusion or cap on any loss, Government must also ensure that the maximum amount that may become payable under a spending proposal for the purposes of regulation 10 of the Financial Management and Accountability Regulations 1997 includes the potential cost of any contingent liability contained in the spending proposal - these contingent liabilities include any liabilities that the Government may potentially owe to a third party as a result of excluding or capping the contractor's liability.

Common carve outs

Where Government does agree to exclude or cap the contractor's liability for consequential loss, it is usual (and may be required to comply with Government policy) to provide that the exclusion or cap will not apply to any consequential loss arising from liabilities:

  • for which the contractor is otherwise covered e.g. liabilities covered under an insurance policy or liabilities which the contractor can recover from third parties (such as subcontractors);
  • under indemnities for third party claims for damage to property or personal injury arising out of the contractor's activities or infringement of intellectual property rights by the contractor;
  • for fraud, criminal conduct, wilful misconduct or gross negligence;
  • to pay liquidated damages under the contract; and
  • arising from the contractor's abandonment of the contract.

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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.