Recent court decisions in Australia serve as a warning that the use of broad and undefined terms in exclusion clauses in commercial contracts can have unintended consequences.

Contractual exclusion clauses act to protect parties from the extreme effects of a breach of contract. Often these clauses attempt to exclude liability for broad and undefined categories of loss, such as “consequential loss”. The courts on a regular basis are asked to decide what is meant by “consequential loss” and whether an exclusion clause applies.

It is settled law in England that contractual damages fall into two categories. Within the first category are damages which “arise naturally from the breach of contract”. The second category is limited to damages which both parties actually knew may arise in the event of a breach. Under English law, consequential losses fall within the second category, although loss of profits is considered a direct loss and is not a consequential loss.

The Australian courts in recent years have interpreted “consequential loss” differently and in doing so have caused uncertainty.

In Environmental Systems v Peerless Holdings1, the Victorian Court of Appeal refused to apply the English approach. In that case, Peerless claimed additional labour and energy costs incurred trying to make a regenerative thermal oxidiser supplied by Environmental Systems work satisfactorily.

The court held these costs were “consequential” and excluded by the contract. Interestingly, the court decided the claim on the basis of what a business person would consider consequential loss to mean. The court said:

“... ordinary reasonable business persons would naturally conceive of ‘consequential loss’ in contract as everything beyond the normal measure of damages, such as profits lost or expenses incurred through breach.”

Note that the court distinguished between “normal loss” and “consequential loss”. Normal loss was held to be loss that every plaintiff in a like situation would suffer. The court also expressly stated that loss of profits was “consequential loss”.

Peerless was applied by the courts in a number of subsequent cases. However, in 2013, the Supreme Court of Western Australia in Regional Power Corp v Pacific Hydro (No 2)2, moved away from the Peerless approach. In that case, Pacific Hydro negligently constructed a hydro power station for Regional Power, resulting in a two-month outage. Regional Power sued Pacific Hydro, claiming damages for its expenses incurred in arranging an alternative power supply during the outage. Pacific Hydro argued that these were “consequential losses” and excluded under the contract.

The court stated that it did not consider that the court in Peerless was attempting to establish “a rigid new construction principle for limitation clauses beyond the present circumstances of that case”. The court held that the correct approach was to examine the natural and ordinary meaning of the relevant clause in the context of the agreement as a whole and against the commercial context of the contract. The commercial sophistication of the parties, and their understanding that Regional Power had statutory obligations to provide a continuous electricity supply, was also important. The court decided that Regional Power’s losses were “direct” in the context of the contract and were not excluded.

The debate as to the meaning of the term “consequential loss” in Australia has reached another fork in the road. Whether the courts will continue to follow Peerless, which is a decision of a higher court, or move towards the Pacific Hydro approach, remains to be seen.

However the lessons for international commerce are clear. First, contracting parties should not assume that the term “consequential loss” will have the same meaning across different jurisdictions and commercial contexts. Secondly, contracting parties should be specific when drafting exclusion clauses and should not rely on broad undefined exclusions.