Do You Really Know What “Consequential Damages” Means?

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For seafood lovers there is nothing as delectable as fresh oysters, mussels, scallops and lobster. And many of these shellfish are harvested off the northeastern coast of the United States. For some time, however, these native shellfish have been threatened by an invasive species of sea creature called the carpet tunicate. The carpet tunicate is part of the sea squirt family. Like other invasive sea squirts, a colony of these creatures can quickly overtake an area and displace native species. Because carpet tunicate “are blob-like and yellowish-cream in color,”[1] this particular sea squirt has been referred to as “alien vomit”[2]—pretty much the opposite of “delectable seafood.”

All sea squirts begin life with a brain and a tail, like a tadpole. They use that brain to propel that tail through the water until they find a rock, dock, rope or ship’s hull to attach to; and then, unlike a tadpole, they eat their brain and spend the rest of their lives as living (but brainless) water filters, sucking water in one tube and blowing it out another. I have previously likened unconsidered boilerplate to sea squirts because, like sea squirts, most boilerplate begins its existence with the brain of a smart lawyer attempting to address a specific issue in a specific context, but over time that bespoke provision gets mindlessly copied and loses its connection to that original lawyer’s brain.[3] And that phenomenon is not problematic simply because it produces unconsidered, mindless contract language, but because that mindless contract language can actually invade your contract, like alien vomit, and overtake other bespoke provisions.[4] No contractual boilerplate better illustrates this phenomenon, or is more deserving of the moniker “alien vomit,” than the so-called consequential damages waiver. And a recent English case, 2 Entertain Video Limited v. Sony DADC Europe Limited, [2020] EWHC 972 (TCC) (24 April, 2020), provides an opportunity to revisit and once again condemn the continued use of the term “consequential damages” as part of the deal lexicon. But in order to appreciate the 2 Entertain Video decision, a little common-law history is required.

Almost one hundred seventy years ago, a crankshaft broke on the steam engine at the City Flour Mills in Gloucester, England. The proprietors, Joseph and Jonah Hadley, apparently did not have a spare part, and the mill had to remain idle while they sent the broken shaft to the manufacturer to use as a model to build a replacement that would fit that steam engine. The Hadley brothers hired Joseph Baxendale’s firm to ship the broken shaft by wagon to the manufacturer. Baxendale’s firm promised to ship the broken shaft on the second day after they took possession from the Hadley brothers. But alas, Baxendale’s firm delayed shipment for seven days after taking possession and being paid the agreed charge (the delay may have resulted from a desire to wait for additional merchandise to load with the Hadley brothers’ shaft and thereby make the trip more profitable for Baxendale’s firm, but no one knows for sure). Meanwhile, City Flour Mills was not able to operate and the Hadley brothers were losing profits daily based on the inability to meet the demand for milling (they even had to buy flour from other mills to meet their obligations to their customers). When the Hadley brothers determined that Baxendale’s firm had delayed shipment for five days longer than had been agreed, they sued Baxendale for the profits lost during the five extra days the steam engine had been shut down; and a jury awarded the Hadley brothers damages based upon those lost profits, an amount more than 20 times the fee charged by Baxendale’s firm for delivering the broken shaft to the manufacturer.

On appeal, in Hadley v. Baxendale, [1854] EWHC Exch. J70, one of the most famous cases in the common-law world, the court reversed the jury’s award because the Hadley brothers’ “special circumstances” and the losses they would sustain from the delayed shipping were not specifically made known to Baxendale so that his firm could determine whether they were actually prepared to contract with the potential for those losses in mind for the standard price that had been agreed. Had they known that the losses from a breach of their contract to ship the broken shaft on the second day after taking possession would have been so significant, perhaps they would have refused to contract, charged more for the risk being undertaken, or specifically limited available damages in the contract. In so holding, the court established the basic common-law rule for determining the proper measure of damages for breach of contract: A breaching party is not liable for any and all consequences resulting from the breach; rather, damages for breach of contract are limited to those that are reasonably foreseeable, either because (a) they “flowed naturally from a breach of this contract in the great multitude of such cases occurring under ordinary circumstances,” or (b) arose from “special circumstances” that were specifically communicated to and known by the breaching party at the time of contracting such that it “would have made it a reasonable and natural consequence of such breach of contract.” In other words, all recoverable damages flowing from a breach of contract must be reasonably foreseeable, but those that ordinarily occur from the breach of any contract similar to yours are effectively deemed foreseeable and require no special proof because they are obvious, but damages that only occur because of special circumstances unique to the non-breaching party in this particular contract require enhanced foreseeability and proof that those unique circumstances were made known to the breaching party at the time of contracting. In Hadley, the court specifically found that in the ordinary situation where a person contracts to have a part carried off to a third party by a carrier firm like Baxendale’s, the circumstances that occurred at the City Four Mills would not have occurred; i.e., they were not obvious and ordinary losses.

The two parts of this contract-damages-limitation regime have been referred to as Hadley’s two limbs. The first limb (a) become known as “direct” or “general” damages, and the second limb (b) became known as “special” or “consequential” damages; and this despite the fact that none of these terms appears anywhere in the decision. Although the second limb involved lost profits in the Hadley case, consequential or special damages are not limited to lost profits and not all lost profits constitute consequential or special damages; some lost profits are obvious losses that will result from a breach of a particular contract and therefore fall into the category of direct or general damages. But thus began the ubiquitous and questionable habit of including consequential damages waivers in contracts of all types notwithstanding the fact that consequential or special damages are not recoverable, even in the absence of a express waiver, unless they were within the contemplation of both parties as a natural consequence of the breach at the time of contracting. If the distinction between damages that are the natural consequence of a breach in the “great multitude of such cases” and those that only arise from special circumstances unique to the non-breaching party so that the law imposes an enhanced foreseeability requirement requiring actual rather than deemed notice seems difficult to discern, welcome to the club. In the thousands of cases considering this rule in the ensuing 166 years across the common-law world, it does not appear that anyone has really nailed this down. And it’s not even clear in all jurisdictions that the first limb/second limb distinction (to the extent that distinction is helpful in discerning the difference between direct/general and consequential/special damages) is even applicable to discerning the meaning of the term consequential or special damages in a damages limitation clause that excludes those specific damages types. But in England (some other members of the Commonwealth, and some U.S. states), at least, there appears to still be some allegiance to this distinction, however unhelpful it may actually be.

And that brings us to the 2 Entertain Video decision. 2 Entertain Video involved an alleged breach of a logistics services agreement resulting from the claimed failure by the owner of a distribution warehouse to provide security and fire protection at the warehouse for the benefit of 2 Entertain Video, a subsidiary of BBC Studios, as required under the agreement. When a fire, set by vandals, destroyed the warehouse and all of 2 Entertain Video’s stock of DVDs, CDs and other home entertainment media, 2 Entertain Video sued the warehouse owner to recover damages in excess of that covered by insurance. In particular, 2 Entertain Video sought to recover damages arising not just from the value of the destroyed stock of products, but also from the lost profits from the sales of that product. Pursuant to the logistics services agreement, the warehouse owner’s services were not limited to storing the product but specifically included actual distribution of the product including “processing orders, deliveries and returns from customers, and stock management.” When the warehouse was destroyed, so too was 2 Entertain Video’s distribution system. While there were a number of contractual clauses at issue in the decision, the warehouse owner asserted that the following clause (10.3) completely foreclosed any claim for lost profits:

Neither party shall be liable under this Agreement in connection with the supply of or failure to supply the Logistics Services for any indirect or consequential loss or damage including (to the extent only that such are indirect or consequential loss or damage only) but not limited to loss of profits, loss of sales, loss of revenue, damage to reputation, loss or waste of management or staff time or interruption of business.

According to the court, this clause was “unhappily drafted” because the supposed examples of damages intended to be excluded by the phrase “indirect or consequential loss or damage” were qualified by the parenthetical to only be excluded if they in fact constituted indirect or consequential loss or damage to begin with. Thus, they were of no help in determining the meaning of the phrase “indirect or consequential loss or damage.” So, the court reverted to cases that had used the two Hadley limbs to distinguish between direct and consequential loss. And like those prior cases, the court concluded that any exclusion of consequential loss did not exclude damages covered by the first limb of Hadley. Thus if the damages occurred directly and naturally from the breach in the great multitude of cases, they were included in the first limb and were not excluded. While the fire destroyed the product, and the direct and natural damages from that may have been limited to the value of that lost product (after all what a non-breaching party intends to do with a stored product is ordinarily the non-breaching party’s special circumstances), the fire also destroyed the warehouse and the ability of warehouse owner to provide the logistics support that was the basis for 2 Entertain Video’s distribution system (and those losses were obviously a part of the contract, not independent special circumstances). According to the court, “[t]he direct and natural result of the fire was the destruction of the goods and the warehouse, causing lost profits and business interruption losses to the claimants.” Had the clause in question avoided the use of the term consequential damages and simply limited all damages for all breaches to a specified amount, or just listed all the examples directly rather than only as a subset of consequential damages, the result here would presumably have been different.[5]

But alas, folks just like using the term “consequential damages” in loss exclusion clauses and it can clog up the works and cause confusion; it’s “alien vomit.” And this can occur on either side of the Atlantic. As one U.S. court noted, “[d]espite the vast number of cases purporting to define ‘consequential damages’ by repeating time honored but general definitions and distinctions between consequential and direct damages, the meaning remains elusive.”[6] Indeed, it is probable that many deal professionals and their counsel do not even consider Hadley’s two limbs (if they have even heard of them—although the Hadley case is studied in virtually every law school) when negotiating provisions purporting to exclude consequential damages. Instead, some deal professionals and their counsel tend to equate consequential damages with speculative or remote losses; and that is just plain wrong because speculative and remote damages are not recoverable under either Hadley limb. Other deal professionals and their counsel tend to think of consequential damages as being damages that are not “actual” damages when consequential damages are very much “actual” damages. Still other deal professional and their counsel tend to make one of the following assumptions: (a) consequential damages are those damages that are not directly caused by the breach; i.e., they are the same as “indirect damages;” (b) consequential damages are the equivalent of lost profits; (c) consequential damages are those damages beyond the difference between the value of what was promised in the agreement and what was actually delivered, (d) consequential damages are any losses incurred by the non-breaching party beyond the costs of replacing the breaching party’s performance, (e) consequential damages result from a collateral arrangement entered into by the non-breaching party that was impacted by the breach, or (f) some other variant of the foregoing that is equally unhelpful. And the truth is you can find caselaw supporting all these approaches. While some courts do equate consequential damages with the term indirect, the rule has also been stated as follows:

The distinction between general [or direct] and special [or consequential] damages is not that one is and the other is not the direct and proximate consequence of the breach complained of, but that general [or direct] damages are such as naturally and ordinarily follow the breach, whereas special [or consequential] damages are those that ensue, not necessarily or ordinarily, but because of special circumstances.[7]

And as has already been noted, while some courts have done so, consequential damages are not generally equatable to lost profits; some lost profits constitute direct or general damages, while some lost profits fall into the category of consequential or special damages. This point was brought home famously in a 2014 New York case that appeared to take some New York lawyers by surprise.[8] All the other approaches are equally uncertain in application to a specific case.[9]

Commentators and courts across the common-law world have struggled to interpret the intent of parties using the term “consequential damages” in a damages limitation or exclusion clause. Do the parties really intend to refer to the second limb of a 166 year-old case? Or do they have something else in mind? After all, the dictionary definition of “consequential” includes “important” and “following … as an (immediate or eventual) effect.” Well, that is pretty much what all damages are. Would you really want to waive all the important damages or those that followed as an immediate or eventual effect of a breach? Probably not. And as one commentator noted, the most common way parties learn what consequential damages actually means is the same way “road bugs learn about MACK trucks.”[10] But parties keep on using terms like “consequential or special damages,” and it can be a problem both for the party who believes the terms mean more than they do, as well as for the party who believes the terms mean less than they do. Parties using these terms are inviting a court to interpret them even though these terms “might have been put in the … [a]greement by lawyers who themselves were unclear on what those terms actually mean.”[11] Hence, it’s alien vomit. And we haven’t even discussed the other terms that get spewed into damage exclusion clauses as purported synonyms for consequential damages, like incidental damages, diminution in value damages, business interruption losses, damages based upon multiples of earnings, and the like. These terms are not synonyms. Instead, these undefined terms with unpredictable meanings can potentially eliminate all damages arising from a breach of contract; or fail to eliminate the very damages you want to eliminate because you qualified all of those other damages types as an effective subset of “consequential damages” (and you don’t have to use a parenthetical like that used in 2 Entertain Video to accomplish that limitation either).[12]

Using terms that have no “clearly established meaning”[13] is a bad idea. It is particularly problematic in the M&A context where recoverable losses (if any) have already been capped at a low percentage of the purchase price.[14] For example, if a seller breaches a representation regarding compliance with law and it turns out there is a missing permit and the authorities shut your plant down for the three weeks required to apply for that missing permit, does an exclusion of consequential damages preclude the buyer from claiming indemnification for the revenues lost during that three-week shut down, and limit indemnifiable losses to the costs of acquiring the missing permit (subject to the cap of course)? If you are not sure, stop spewing alien vomit in your agreements—it’s gross and it’s dangerous.

Endnotes

  1. New York State Department of Environmental Conservation, available here.
  2. Stephan Bullard, Robert Whitlatch, Sandra E. Shumway & Richard W. Osman, Scientists Crying “Foul”: Sea Squirts are Invading Long Island Sound, Wrack Lines 17 (2006), available here.
  3. See Glenn West, Avoiding the Mindless Use of the Brainless MAC Clause,Weil Insights, Weil’s Global Private Equity Watch, August 7, 2017, available here.
  4. See, e.g., Glenn West, “Standard” Versus “Bespoke” Boilerplate—A Distinction That Can Make a Big Difference, Weil Insights, Weil’s Global Private Equity Watch, July 9, 2019, available here.
  5. See Glenn West, Excluded Losses Part II: An English Perspective on the Continued Failure of Predictability Regarding the Use of the Phrase “Consequential or Special Losses”, Weil Insights, Weil’s Global Private Equity Watch, December 12, 2016, available here.
  6. DaimlerChrysler Motors Co. v. Manuel, 362 S.W.3d 160, 181 n.20 (Tex. App. 2012).
  7. Applied Data Processing, Inc. v. Burroughs Corp., 394 F. Supp. 504, 509 (D. Conn. 1975) (citing 5 A. CORBIN, CORBIN ON CONTRACTS § 1011 (1974)).
  8. Biotronic AG v. Conor Medsystems Ireland Ltd., 11 N.E.3d 676 (N.Y. 2014).
  9. See Glenn West, “Excluded Losses” Provisions and the “Butterfly Effect”—the Continued Failure of Predictability Regarding Consequential Damages Waivers in M&A Agreements, Weil Insights, Weil’s Global Private Equity Watch, November 7, 2016, available here.
  10. Roy Ryden Anderson, Incidental and Consequential Damages, 7 J.L. & Com. 327, 353 (1987).
  11. Pharm. Prod. Dev., Inc. v. TVM Life Sci. Ventures VI, LP, No. 5688-VCS, 2011 WL 549163, at *7 (Del. Ch. Feb. 16, 2011).
  12. See e.g., Two Oil Services, L.L.C. v. Simons Petroleum, L.L.C., No. 2:14–cv–3433, 2015 WL 3622659 (W.D. La. June 8, 2015); Westlake Fin. Grp., Inc. v. CDH-Delanor Health Sys., 25 N.E.3d 1166, 1175-78 (Ill. App. Ct. 2015); see also Medfusion, Inc. v. Allscripts Healthcare Solutions, Inc., No. 14 CVS 5192, 2015 WL 1455680 (N.C. Super. Ct. Mar. 31, 2015).
  13. Applied Data Processing, Inc. v. Burroughs Corp., 394 F. Supp. 504, 508 (D. Conn. 1975).
  14. For a deep dive into the problematic use of terms like “consequential damages” in the M&A context see Glenn D. West, Consequential Damages Redux: An Updated Study of the Ubiquitous and Problematic “Excluded Losses” Provision in Private Company Acquisition Agreements, 70 Bus. Law. 971 (2015); Glenn D. West & Sara G. Duran, Reassessing the “Consequences” of Consequential Damage Waivers in Acquisition Agreements, 63 Bus. Law. 777 (2008).

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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