A recent case involving a contractual dispute between an airline and a seat manufacturer has nicely illustrated the English courts’ approach to the question of which costs and expenses incurred by an innocent party in attempting to avoid or mitigate the consequences of a contract breach can be recovered in damages from the contract-breaker.
Imagine you’re a national airline and you’re upgrading and expanding your fleet of aircraft. You order economy seats from a manufacturer, to be delivered over a period of time and fitted to six of your existing Boeing B777-300 aircraft and to fourteen new aircraft you’re buying (eight A330-300 aircraft and six huge A380-800 aircraft). The manufacturer has problems ensuring that the seats comply with safety and quality standards and fails to deliver most of them by the deadlines. As a result, you end up with five brand new A330-300 aircraft sitting in a hangar in Bordeaux that cannot be used because they have no economy seats in them; and one existing B777-300 aircraft with old, uncomfortable seats that passengers are grumbling about. A significant proportion of your fleet is therefore grounded or unable to operate to its full capacity, and you face losing large amounts of revenue and profit until the new seats are delivered – if they are ever delivered. What do you do?
Although of course the manufacturer does not admit it’s in breach of contract, you and your lawyers think you have a very strong case and a court or arbitrator will award you damages to compensate for losses that flow from the breach. But getting an award of damages could take years and of course the amount awarded might not in fact cover all the costs, expenses and loss of profits etc that you suffer.
You consider some options:
- You could terminate your contract with the seat manufacturer and try to obtain replacement seats from someone else. Your programme engineers tell you that getting equivalent replacement seats manufactured and fitted will probably take about 18 months, possibly longer; and that the price per seat will be higher than in your original contract (around US$20 million higher in total). For aircraft that you’re buying but that are still being made, you could try to get the aircraft manufacturer (Airbus) to delay delivery to give you time to agree terms with a replacement seat manufacturer. This could reduce or eliminate the amount of time you have new aircraft sitting around unable to be used.
- As a temporary measure, you could bring some old aircraft back into service to fill the gaps in your fleet and/or reinstall old economy class seats in place of the missing seats. Doing this will incur some moderate fitting and maintenance costs, but the bigger problem is that you will find it difficult to attract and retain customers when other airlines can offer them more modern and comfortable seats on the same routes.
- You could lease some modern replacement aircraft from one of the various leasing companies and try to operate them at sufficient capacity to cover the leasing costs (as well as other normal running costs). Rental payments will be substantial (around US$160 million for three years) but a current over-supply in the market means that rates are low enough that you should be able to make a profit. But how long should you lease them for? (If you go for a longer lease the price may come down, and there may be other advantages.) And would it be better to lease slightly larger and/or longer-range aircraft to give you greater flexibility with your fleet?
In broad terms, these were the circumstances faced by Thai Airlines in early 2010. They decided to pursue all three options. In relation to 2, they entered into three year leases with Jet Airways of three longer-range B777-300ER aircraft with seating capacity equivalent to the new A330-300 aircraft languishing in Bordeaux but smaller than the new A380-800 aircraft on order from Airbus. When their claim for damages against the seat manufacturer, Koito, reached the High Court in England, the judge had to decide which of the costs and expenses incurred by the airline as a result of what it decided to do should be compensated in damages. (The airline did not claim for its lost profits.) As part of this, the judge had to decide whether and to what extent damages should be reduced by savings that the airline made – e.g. because the replacement seats were lighter in weight and resulted in lower fuel costs – and benefits it received - e.g. because in the event the leased aircraft made a positive contribution to the airline’s profits after deduction of their rental and running costs.
Although the case concerned aircraft, the sort of dilemma faced by the customer (the airline) could equally be faced by customers purchasing other types of revenue-generating assets, and the principles set out by the court are of general application.
Principles of mitigation
The court found:
- The essential purpose of the mitigation rules is to identify – in the light of what the innocent party has done or not done to avoid loss resulting from the wrongdoer’s breach of contract or other legal wrong – which costs and benefits accruing to the innocent party are to be treated as consequences of the wrongdoer’s wrong and which are to be treated as caused by the innocent party’s own action or inaction. The basic test is whether the innocent party has acted reasonably in response to the wrongdoer’s wrong. Insofar as the innocent party has acted reasonably, costs and benefits accruing to the innocent party are included in the calculation of damages. Insofar as the innocent party has not acted reasonably, the innocent party’s damages are assessed as if it had acted reasonably.
- Although it is commonly said that the innocent party has a “duty” to take reasonable steps to mitigate its loss, this is potentially misleading in at least two ways:
- In the absence of a contrary agreement, an innocent party is free to act as it wishes following a breach of contract and does not owe any duty in law to the wrongdoer or anyone else to mitigate its loss. Mitigation is not a duty but an assumption; damages are calculated on the assumption that the innocent party has taken reasonable steps in mitigation, whether it has in fact done so or not.
- The test of what is “reasonable” in this context is not simply one of general rationality but is governed by legal rules. Various norms of reasonable conduct have become settled: where there is an available market, the innocent party will go into the market as soon as possible and obtain a substitute for the wrongdoer’s performance. Where that does not apply, and more than one option is reasonably available, the innocent party is expected to adopt the one that is or is likely to be the least expensive. One result of these rules is that the innocent party may have acted in a way that was reasonable from the point of view of its own business interests or personal objectives and yet not have adopted what the law regards as a reasonable response to the wrongdoer’s breach of contract or other wrong for the purpose of assessing damages.
- The standard of reasonableness is, however, applied with some generosity towards the innocent party, having regard to the fact that the innocent party’s predicament has been caused by the wrongdoer’s breach of contract. The burden of proof is on the wrongdoer to show that there was a course of action which it was reasonable to expect the innocent party to adopt that would have avoided all or an identifiable part of the innocent party’s loss.
- In assessing damages for breach of contract, credit must be given for any proven monetary benefit (which either takes the form of money or which the innocent party could reasonably be expected to realise in terms of money), whether chosen by the innocent party or not, which the innocent party has received or will receive as a result of an action reasonably taken to mitigate its loss. No account is taken of “betterment” that does not confer any pecuniary advantage or is not a benefit that either takes the form of money or could be readily realised or expected to be realised in terms of money. Justice requires the sum received to be brought into action, whether its receipt was an unavoidable consequence of mitigation or not. There is generally no material difference between incurring a cost which results in the receipt of money back and simply incurring a lower cost.
Which costs and expenses could the airline recover in damages?
Although the airline’s decision to lease the three replacement aircraft for three years, rather than two, was commercially reasonable in light of various advantages that would accrue, the best evidence available to the airline at the time indicated that it would take no more than two years to get replacement seats delivered and fitted by an alternative seat manufacturer and therefore, for the purposes of mitigation, it was reasonable to assume that the leases should have been for two years only. The rental costs for the third year were therefore not recoverable.
The airline could recover the extra costs of buying replacement seats from alternative manufacturers. These amounted to around US$4 million. However, because the replacement seats were lighter in weight and Koito could demonstrate that this would reduce the airline’s fuel costs over the life of the seats by around US$1.9 million, a net amount of US$2.1 million was recoverable under this head.
Costs of storing the brand new aircraft in Bordeaux (around US$3.2 million) were also recoverable. Koito could not show that lower storage costs could or should reasonably have been incurred. But credit was given for a price reduction that the airline obtained from Airbus by agreeing that the A330-300 aircraft could be delivered late. This reduced the total amount of damages by US$9.44 million.
The most difficult issue, and the one with the highest amount at stake, was whether and to what extent damages should be reduced by monetary benefits received by the airline as a result of leasing the replacement aircraft. As the airline had acted reasonably in leasing replacement aircraft for two years, its leasing costs over that period were recoverable in damages. But if the profits earned by the airline in operating the replacement aircraft during the first two years of the leases exceeded the profits the airline would have made through operating its own aircraft over that period had the breach of contract not occurred, the “excess” profits would be a benefit that should be deducted from the leasing costs. Since it was the seat manufacturer that sought to show that the airline had so benefited and that damages should be reduced accordingly, it was up to the seat manufacturer to prove it. But attempting to estimate with any precision what the airline’s financial position would have been if the seat manufacturer had delivered all the seats on time would have been an extremely complicated task, mainly because
“the airline manages its entire fleet of aircraft in a way that is constantly adjusted to maximise efficiency. To reconstruct what would have happened if the five A330-300 aircraft which were delayed as a result of Koito's breaches of contract had been delivered on time, it would first of all be necessary to identify what routes they would have flown and to estimate the gross profits which would have been earned on those routes. If those routes were in fact flown by other aircraft, it would then be necessary to determine not only what profits were in fact earned on those routes but on what routes, if any, those other aircraft would have been deployed if the A330-300 aircraft had been available. Then a similar enquiry would need to be made for the routes which the other aircraft would have flown; and so on. Furthermore, in order to construct the relevant counterfactual scenario it would be necessary to remove from what actually happened the consequences of leasing the three B777-300ER aircraft from Jet – with all the knock-on consequences of their deployment across Thai's flight schedules.”
Unsurprisingly, given these complexities, Koito was unable to prove that the actual profits made by the airline from operating the replacement aircraft exceeded the profits it would have made absent the breach of contract. The whole amount of the leasing costs - around US$107 million - were therefore recoverable in damages.
In total, Koito was ordered to pay the airline damages of US$82,732,284, EUR19,857,165 and THB 4,640,417 (approximately US$105 million in total) plus interest and costs.
Permission to appeal and cross-appeal has been refused by the High Court, but may be granted by the Court of Appeal.