Drafting Exclusion of Consequential Damages Clauses

By: Timothy Murray

ONE TIME, I WAS REVIEWING THE TERMS OF A PROPOSED contract with an executive for a client that was buying a product for a significant sum of money. The document had been drafted by the seller, and it contained the customary provision excluding the seller’s consequential damages. The executive made clear that he had no desire to discuss this clause.

“We give up consequential damages all the time,” he said abruptly.

“I see,” I said. “Do you know what ‘consequential damages’ are?”

“No,” he said, “but we give them up all the time.”

That executive is in good company. Judges and even seasoned commercial practitioners often have difficulty defining consequential damages—and for good reason. Not long ago a federal court held that a contractual provision excluding “consequential damages” is ambiguous. ¹ “The term ‘consequential damages’ is subject to multiple interpretations, and ‘no two courts or treatises define consequential damages the same way.’” ²

The implications of this ought to be alarming for contract drafters. Exclusions of consequential damages are among the most common and important provisions in a wide variety of contracts. They can significantly reduce the breaching party’s liability, sometimes by staggering amounts of money. But the difference between direct and consequential damages is often about as clear as a dense fog off the coast of Maine. When drafters include a generic exclusion of consequential damages in their contracts without bothering to define what consequential damages are, it is frequently a fact question whether the damages are direct or consequential. ³ This is tantamount to inviting a group of complete strangers of indeterminate ability—better known as jurors—to decide what the contract means, rarely a prudent drafting strategy (except where the parties cannot agree on the contract language—in that case, they might decide to take their chances on ambiguity).

Much of the practicing bar has not gotten the message. Too often, our contracts resort to generic, cookie-cutter language that excludes consequential, special, and indirect damages without further explanation. This practice is fraught with peril and demonstrates an indifference to the caselaw that exposes our clients to unnecessary risk. We need to rethink the way we approach drafting these clauses.

The Fundamentals: Hadley v. Baxendale

It is a frequently stated maxim that contract law seeks to put “the non-breaching party in the position it would have been in had the contract been performed instead of simply restoring the parties to their original positions.” ⁴ But the maxim only goes so far—there are limitations on the damages a court will award in the event of a breach, and the most important is based on foreseeability. ⁵ The foreseeability doctrine manifests itself in the distinction between direct (or general) and consequential (or special or indirect) damages. This distinction was the basis for “the most famous case in contract law, perhaps in all of Anglo-American civil law,” ⁶ Hadley v. Baxendale. ⁷

In Hadley , plaintiffs operated a grist mill that was shut down because of a broken shaft. Plaintiffs retained a carrier to transport the broken shaft to an engineering company where it would be used as a model to make a new shaft. But the carrier inexcusably delayed the shipment, causing the mill to remain closed for a longer period of time. Plaintiffs sued the carrier, and a jury awarded lost profits to plaintiffs for the delay. But the appellate court reversed because at the time the contract was made, the carrier had no reason to foresee that such damages would be a probable result of a breach. The carrier neither knew nor should have known that the mill had to close down awaiting the new shaft.

Hadley v. Baxendale quickly seeped into the DNA of our common law and is given articulation in the Uniform Commercial Code governing the sale of goods. ⁸ In a nutshell, direct damages are recoverable because they arise directly or naturally from the breach and were reasonably foreseeable to the breaching party at the time of contract formation. ⁹ But consequential damages—which are collateral to the breach—are also recoverable even though they were not reasonably foreseeable at the time of contract formation so long as they were actually foreseeable to the breaching party due to special circumstances peculiar to that transaction. ¹⁰ For example, in Hadley , if the plaintiffs had alerted the carrier at the time of contract formation that the mill would be closed due to the broken shaft, that should have been enough to make the carrier liable for consequential damages.

Here are some of the most significant problems involved in drafting exclusions of consequential damages—and some suggested ways to avoid them.

Failing to Recognize That the Lines between Direct and Consequential Damages Are Blurry

A federal court’s decision in Jay Jala, LLC v. DDG Constr., Inc. ¹¹ is a cautionary tale about how blurry the lines can be. An owner terminated a contract for the construction of a motel following a contractor’s delays. The owner finished the project on its own and sued the contractor for breach. The contractor sought partial summary judgment, claiming that certain damages were barred by the contract’s exclusion of consequential damages.

Although the contract specifically mentioned certain types of consequential damages that were excluded, the court found gaps in the language, and it was unclear whether various categories of damages fell within the consequential damages exclusion. To answer this question, the court was forced to spend more than 3,000 words to figure out whether each category of damages was direct or consequential.

The court held that before the contract was terminated, the contractor charged an overhead fee, and that after the contract was terminated, the owner’s overhead costs for the time period during which it served as its own contractor “may” be direct damages. “[The contractor’s] performance under the contract was to construct the motel, but [the contractor] did not complete that performance. [The owner] is straightforwardly entitled to recover the cost of finding substitute performance . . . ” The court also held that an additional seven months of interest on the owner’s construction loan was a direct damage because the loan was “an integral cost of completing [the contractor’s] performance, which was construction of the building.” The same was true of several months of additional utility bills— they “were a direct part of [the owner] carrying out [the contractor’s] performance on its own.”

Yet, the court held that various other expenses that were directly caused by the contractor’s delay and that might have been foreseeable—extra expenses for insurance and advertising and the added costs of leasing furniture, fixtures, and equipment—were consequential damages because they were not things that the owner expected to receive from the contractor’s performance.

The opinion shows the court groping for clarity and bright lines where there weren’t any. Regardless of the correctness of the court’s conclusions, the parties could have avoided the costs and risks of litigation by addressing damages in a different way. Each category of damages was foreseeable at the time of contract formation. The parties could have specifically referenced each category and plainly stated their intentions as to them. This would have required just a few sentences—in contrast to the 3,000-plus words the court devoted to the same damages.

Of course, the task of chronicling every type of legally foreseeable loss that might occur can present daunting drafting challenges. To render all these concerns moot, contract drafters can instead agree on a damages cap for any damages that the law would allow in the event of a breach, regardless of whether they are classified as direct or consequential. There are all sorts of rational ways to arrive at such a figure, depending on the transaction and the situation of the parties.

Assuming Lost Profits Are Always Consequential Damages

Lost profits damages are often the largest component of loss from a breach of contract. It is sometimes said that “[l]ost profits are a ‘quintessential example’ of consequential damages.” ¹² But depending on the circumstances, lost profits are sometimes direct damages, and a failure to appreciate this fact is another oversight that can be costly to your client.

When a breach causes loss from a collateral, unrelated third- party business arrangement, it is typically a consequential damage. But when the contract that was breached is related to and contemplates the collateral business arrangement, the loss from the collateral arrangement may be classified as direct damages. In Stern Oil Co. v. Brown , ¹³ Stern Oil (franchisor) granted Brown (franchisee) the right to sell ExxonMobil fuel.

Brown breached the franchise agreement, and Stern Oil sued. Among the damages Stern Oil sought was lost profits for a prompt payment discount that Stern Oil would have received from ExxonMobil under its separate contractual arrangement with ExxonMobil if the Stern Oil-Brown franchise agreement had not been breached. The court held that these lost profits were direct, not consequential, damages. “Stern Oil’s relationship with ExxonMobil was an integral part of Brown’s ability to . . . purchase the ExxonMobil-branded fuel,” and it was foreseeable to Brown that Stern Oil expected to earn a profit from the fuel supplied to Brown.

Similarly, where a product manufacturer breaches a contract with a distributor that prevents the distributor from making resales of the product, the damages from the resales that the distributor was deprived of making have been held to be direct damages. Even though the resales would have been transactions separate from the breached contract between the manufacturer and the distributor, the lost profits flow directly from, and are a natural and probable result of, the breach. ¹⁴

Since lost profits can be either direct or consequential damages, if the parties to a contract intend to exclude lost profits regardless of whether they are direct or consequential, the contract must not characterize lost profits as merely consequential damages. For example, if the contract excludes “consequential damages, including lost profits,” then the only kind of lost profits that are excluded are those that happen to be consequential damages. ¹⁵ If a drafter desires to exclude lost profits of any kind, the contract should say that lost profits are excluded regardless of whether they are characterized as direct or consequential damages. Why not just say it plainly? Has anyone ever heard a judge complain that a contract is “too clear” for him or her?

Assuming an Exclusion of Consequential Damages Will Exclude Tort Damages

Many disputes between contracting parties involve not only contractual but extra-contractual claims. Yet, too often we draft exclusions as if only contractual claims will be asserted. This can be costly to our clients. The standards for excluding damages arising from a party’s tort liability are typically more stringent than the standards for excluding consequential damages arising from a garden-variety breach of contract. For example, states typically look with some measure of disfavor on contracts that excuse a party of liability for his or her own negligence. Such provisions should be explicit, making clear that the exclusion extends to negligence.

In Abercrombie & Fitch Stores, Inc. v. Penn Square Mall Ltd. P’ship , ¹⁶ mall tenant Abercrombie sued landlord Penn Square for damages to its premises and merchandise caused by an overhead pipe leak. In the ensuing litigation, the jury awarded Abercrombie damages for Penn Square’s negligence, but not for breach of contract. On appeal, Penn Square argued that the damages were in the nature of consequential damages, which were excluded by the parties’ contract. The court disagreed, holding that although it is possible to contractually restrict and even avoid tort recovery, any such exculpatory language in the contract must clearly and unambiguously evince the parties’ intent to restrict or avoid tort damages.

The lesson: contract drafters need to consider whether an exclusion of damages might apply to any potential extra- contractual claims—and draft accordingly.

The Presumption of Cumulative Remedies

If a drafter wants to avoid consequential damages, he or she might spell out a remedy in the contract with the intention that it will be the exclusive remedy in the event of a breach. But merely listing a specific remedy will not be sufficient to prevent the non-breaching party from obtaining other remedies.

There is “a presumption that clauses prescribing remedies are cumulative rather than exclusive. If the parties intend the term to describe the sole remedy under the contract, this must be clearly expressed.” ¹⁷ The party seeking to limit damages needs to spell out that the prescribed remedy is the sole and exclusive remedy. Failure to do so means that when a breach occurs, the court will treat the remedy expressed in the contract as non-exclusive and allow the non-breaching party to recover the entire panoply of remedies allowed by law, including consequential damages. ¹⁸

Where It Is Unjust to Exclude Consequential Damages

“[I]t is of the very essence of a sales contract that at least minimum adequate remedies be available.” ¹⁹ Sometimes, an exclusive contractual limited remedy (for example, an exclusive remedy that limits the buyer’s recovery to the purchase price of the product) does not allow the aggrieved party sufficient damages to be made whole. In that case, courts sometimes allow the aggrieved party to recover consequential damages despite the exclusion of consequential damages.

This scenario is rare, but it occurs when “a product with a latent defect [is] incorporated into something else that cost much more to fix than merely the purchase price of the defective item.” ²⁰ In one case, a contract limited the seller’s damages to the purchase price of the product, but it was foreseeable to the seller that “the purchase price amounted to only a small fraction of the overall repair cost when the product failed . . . .” ²¹

Where a limited contractual remedy would not make the aggrieved party whole and, in fact, would leave him or her with substantial loss, the seller might want to reconsider limiting its damages to purchase price. Otherwise, in the event of a breach, a court might impose consequential damages, which could be even more substantial.

If a Remedy Fails of Its Essential Purpose, It Might Eliminate the Exclusion of Consequential Damages

When a contract contains an exclusive limited remedy for a buyer’s damages in the nature of “repair or replace,” if that remedy fails of its essential purpose (that is, if the product fails, and the seller does not repair or replace), the buyer is entitled to remedies otherwise allowed by law. ²² Some courts hold that in this scenario, even if the contract contains an exclusion of consequential damages, the buyer nevertheless is entitled to consequential damages. ²³

To anticipate this problem, the seller should include language in the contract to this effect: “The parties agree that, regardless of the failure of the sole and exclusive remedy, seller will not be liable for any consequential damages of whatsoever kind or nature.”

Timothy Murray , a partner in the Pittsburgh, PA, law firm Murray, Hogue & Lannis, writes the biannual supplements to Corbin on Contracts, is author of volume 1, Corbin on Contracts (rev. ed. 2018), and is co-author of the Corbin on Contracts Desk Edition (2017).

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1.Team Contrs., L.L.C. v. Waypoint NOLA, L.L.C., 2017 U.S. Dist. LEXIS 160763 (E.D. La. Sept. 29, 2017). 2.Id. at *10 (citation omitted). 3. “In general, the precise demarcation between direct and consequential damages is a question of fact, and the commercial context in which a contract is made is of substantial importance in determining whether particular items of damages will fall into one category or the other.” Amer. Elec. Power Co. v. Westinghouse Elec. Corp., 418 F. Supp. 435, 459 (S.D. N.Y. 1976). See alsoTeam Contrs., L.L.C., 2017 U.S. Dist. LEXIS 160763; Civic Ctr. Drive Apts. Ltd. P’ship. v. S.W. Bell Video Servs., 295 F. Supp. 2d 1091 (N.D. Calif. 2003). 4. Wells Fargo Bus. Credit v. Hindman, 734 F.3d 657, 673 (7th Cir. 2013). 5. Other limitations are that damages must be proven with reasonable certainty, and they must be the proximate consequence of the wrong. 6. Robert M. Lloyd, The Reasonable Certainty Requirement in Lost Profits Litigation: What It Really Means, 12 Transactions 11 (2010). 7. Hadley v. Baxendale, 9 Ex. 341, 156 Eng. Rep. 145 (1854). 8. U.C.C. § 2-715(2)(a). 9. 11 Corbin on Contracts § 56.6 (2018). 10.Id. E. Materials Corp. v. Mitsubishi Plastics Composites Am., Inc., 307 F. Supp. 3d 52 (E.D. N.Y. 2018). Again, there are a wide variety of definitions of consequential damages. Both direct and consequential damages require some kind of foreseeability to be recoverable, but “out of the thousands of cases where plaintiffs have found their damages limited by references to a doctrine of foreseeability . . . virtually all have involved claims for consequential losses in some form or another.” Andres Tettenborn, Consequential Damages in Contract—the Poor Relation?, 42 Loy. L.A. L. Rev. 177, 182-183 (2008). 11. 2016 U.S. Dist. LEXIS 150969 (E.D. Pa. Nov. 1, 2016). 12. Diversified Mgmt. Solutions v. Control Sys. Research, 2016 U.S. Dist. LEXIS 189771, at *12 (S.D. Fla. May 13, 2016). 13. 908 N.W.2d 144 (S.D. 2018). 14.See Elorac, Inc. v. Sanofi-Aventis Can., Inc., 2018 U.S. Dist. LEXIS 162384 (N.D. Ill. Sept. 24, 2018) and the cases cited. 15.Id. 16. 425 P.3d 757 (Okla. Ct App. 2018). 17. U.C.C. § 2-719 cmt. 2. This is not just a U.C.C. concept. Courts also apply this principle to contracts governed by common law principles. M.G.A., Inc. v. Amelia Station, Ltd., 2002 Ohio App. LEXIS 5177 (Sept. 27, 2002); Creighton Univ. v. GE, 2009 U.S. Dist. LEXIS 22166 (D. Neb. Mar. 18, 2009). 18. Advanced BodyCare Sols., LLC v. Thione Int’l, Inc.,615 F.3d 1352 (11th Cir. 2010); Consolidation Coal Co. v. Marion Docks, Inc., 2010 U.S. Dist. LEXIS 32524 (W.D. Pa. Feb. 22, 2010); Philip Morris USA, Inc. v. Appalachian Fuels, LLC, 2009 U.S. Dist. LEXIS 31765 (E.D. Va. Apr. 15, 2009); Lowe v. Smith, 2016 Tenn. App. LEXIS 689 (Sept. 19, 2016); Canterbury Apartment Homes LLC v. La. Pac. Corp., 2014 Wash. App. LEXIS 1804 (July 22, 2014). 19. U.C.C. § 2-719 cmt. 1. 20. Luckey v. Alside, Inc., 245 F. Supp. 3d 1080, 1091, n. 18 (D. Minn. 2017). 21. Marvin Lumber & Cedar Co. v. Sapa Extrusions, Inc., 964 F. Supp. 2d 993, 1003 (D. Minn. 2013). 22. U.C.C. § 2-719(2); Barrack v. Kolea, 651 A.2d 149 (Pa. Super. 1994) (non-U.C.C. contract). 23.See, e.g., Steer Am., Inc. v. Niche Polymer, LLC, 2018 U.S. Dist. LEXIS 141799 (N.D. Ohio Aug. 21, 2018).