Brendan Cash (Partner) and James France (Solicitor) in Dentons Kensington Swan’s Major Projects and Construction team.
A contract serves a number of functions, but two are most crucial. First, a contract helps to make the bargain between the parties clear, so that each understands its obligations to the other.
Second, a contract allows itself to be enforced by the law.
It is more than just a party’s ‘word’; it has the backing of the law. If one party breaches the contract, the law can be made to compel the breaching party to compensate the innocent party.
There are many different losses which the innocent party may suffer, but not all will justify compensation from the breaching party. Special rules of law govern this, but the parties can agree within the contract how they should be applied.
For example, the principal may not want to be liable for the contractor’s lost profits in the event of its breach. The contractor may not want to be liable for the cost of redesign that needs to be done by the principal’s consultants if it’s work creates a defect. Engaging in bargaining about what parties will be liable for is entirely legitimate; even healthy, as it serves to align expectations.
Many parties include within their contract an exclusion of ‘consequential loss’ from the losses for which they will be liable to the other party. These often look something like: Neither party will be liable to the other for any indirect or consequential loss under or in connection with this contract or otherwise at law.
You might have seen this sort of clause before. Increasingly, they are common in amendments to 3910 (usually placed in Section 7, in case you want a place to check first), but are also commonly slipped into subcontracts and supply contracts from manufacturers.
Often these clauses are included as a matter of course, and the parties have not thought about what ‘consequential loss’ actually means. It might be ‘corporate policy’ and contract managers are required to include these terms.
Their lawyers might have once told them it was important. In truth, even lawyers sometimes forget to think about consequential loss, and suggest its exclusion more for reasons of routine than utility.
In fact, exclusions of ‘consequential loss’ can be very difficult to interpret and to apply. When you think about it for a moment you can see why. Aren’t all losses consequential on something?
Maybe ‘consequential’ has a special legal meaning then? The answer is yes, but it is unfortunately more complicated than that.
The problem with ‘consequential’ loss
Traditionally, when ‘consequential loss’ appeared in a contract, that was taken to be a reference to a type of loss described in a 168 year old case called Hadley v Baxendale. That case made a distinction between what we could think of as ‘normal’ and ‘consequential’ losses (although lawyers will use a variety of terms, sometimes referring to these as limb 1 and 2).
‘Normal’ losses are those costs which always arise in similar circumstances. If a subcontractor breaks a window, the cost of replacing the window is always a loss.
‘Consequential’ losses are those which are special to the claimant in particular. Maybe the window was to an isolated, environment-controlled room, and rare art on the interior was damaged by exposure to the atmosphere. This sort of loss is specific to the claimant.
These two categories are easily blurred. What if, returning to the simple (art-less) example, the contractor needs to bring another subcontractor back in to repair the window, and this means that other teams cannot be deployed in the relevant area and delays result. Is this normal? Or was the contractor’s programme especially susceptible to perturbations?
What about lost profits? Assume the delays mean that the contractor cannot start another job for an extra two weeks, and so forgo two weeks of hypothetical profits. Is this consequential?
Many parties are under the impression that excluding ‘consequential loss’ acts as a catch all, and protects them from liability for lost profits. However in a 2022 NZ decision of the High Court, the judge observed that:
The time has long past when the law draws fine distinctions between physical and economic loss. The law reports are replete with breach of contract cases where the courts have treated an innocent party as entitled to recover loss of profits which it can prove have flowed from the breach. I am unaware of any case within the last quarter of a century in this country where such a claim has been dismissed because such losses are said to be unrecoverable because they are indirect or consequential. (Winiata v Steedman (2022) 22 NZCPR 976)
The Court is correct. Things seem to be moving away from the Hadley v Baxendale reading of ‘consequential’. But in what direction things are moving is still unclear. Increasingly in Australia there are new readings of ‘consequential’ offered up, but many are no more helpful than the traditional reading.
Arguably, many contracting parties are actually intending ‘consequential’ to include loss of profits – the loss is after all a less direct consequence of their breach, and may rely on the other party having a new profit source available, for instance. But many other parties are only intending to exclude tangential and unexpectable losses – the rare art losses.
In 2005, the confusion caused by ‘consequential loss’ in the interpretation of contracts was acknowledged by the country’s then highest court, the Court of Appeal in Rolls Royce New Zealand Ltd v Carter Holt Harvey Ltd . But the issue was left unresolved and has remained so.
At the start of this article it was suggested that (1) clarity of the bargain and (2) enforceability of compensation were the two most crucial functions of a contract.
Exclusions of consequential losses therefore risk corrupting the two most important functions. If an exclusion clause is unclear, then a party can not properly assess its risks if it breaches the contract, or trust that the other party’s assessment will correspond to its own.
A party may be more willing to engage in conduct that risks breaching the contract if it thinks it is protected by a clause excluding liability for consequential loss.
How should you deal with liability in your contract?
Exclusions of ‘consequential loss’ should therefore be avoided in favour of more precise exclusions. If you want certainty that a given liability is excluded, then it should be clearly put in the contract that X will not be liable to Y for Y’s loss of profit, or the cost of restoring Y’s rare art collection. Serious breaches can even be carved out of the exclusion, so that the exclusion won’t apply if X wilfully and deliberately causes an otherwise excluded loss.
Monetary caps can be placed on liability. Parties are entitled to as much flexibility as they can agree (and then clearly express).
Exclusion clauses will almost always have some level of uncertainty, but legal advice during the contracting process can greatly assist parties in helping to minimise it through clear drafting, particularly in respect of liabilities which are of particular concern to the party.
• Dentons Kensington Swan offers 15 minutes of free advice on construction issues to CCNZ members. This publication is not designed to provide legal or other advice and you should not take, or refrain from taking, action based on its content. Dentons Kensington Swan does not accept any liability other than to its clients, and then only in relation to specific requests for advice.