Energy commodity contracts can be of significant monetary value, and their breach may expose the defaulting counterparty to significant liabilities for contractual damages. In considering potential liabilities, contracting parties need to be aware that under English law they are not only liable for damages that arise in the ordinary course of business but also damages arising as a result of special circumstances that have been communicated to their counterparty at the time of contracting — the latter being known as indirect damages or consequential loss. However, the concept of consequential loss is easier to state in general terms than to apply to specific situations. For the purpose of this article, we briefly consider, as a matter of English law principles, the meaning of consequential loss, its recoverability as damages and the exclusion of consequential loss. We also address the implications in each case for offtake contracts for energy commodities.
Remoteness of Damages – Direct and Indirect Damages
Under English law, damages may only be recovered for breach of contract if they are not considered to be too remote — this has come to be known as the principle of “remoteness of damage”. Generally speaking, there are two types of damages that will satisfy the test for remoteness, namely:
- losses that arise naturally or according to the usual course of things (i.e., direct damages). These losses are supposed to have been in the contemplation of the parties at the time they made the contract, and are the probable result of the breach; and
- losses which do not arise naturally or in the usual course of things (i.e., indirect damages), but where the circumstances giving rise to such damages have been communicated to the defendant at the time of contracting.
For either type of damages, the underlying principle expressed is whether the defendant, or breaching party, had the knowledge (whether actual or imputed) at the time of contracting that the damage in question would be a “not unlikely” consequence of the breach. Following the case of The Achilleas, an additional hurdle may exist for claimants to satisfy the remoteness test, namely, the defendant must also have assumed responsibility for the losses of the particular kind suffered. It is not entirely clear whether the “assumption of responsibility” principle is a separate test or part of the remoteness test. In any case, it appears from the judgment of The Achilleas itself and subsequent cases that the assumption of responsibility principle has limited application. This article will focus on the usual foreseeability test in which an assumption of responsibility is satisfied.
Claims for Consequential Loss
What then is the importance of distinguishing between direct damages on one hand and indirect damages or consequential loss on the other? First, while consequential losses are recoverable as damages for breach of contract, such recovery will depend on proof of the communication of special circumstances to the defendant. Furthermore, the question of what amounts to consequential or indirect loss is important in determining the effective scope of an exclusion clause that seeks to exclude liability for consequential or indirect loss. The following damages illustrate examples of direct losses or consequential losses under an energy commodity offtake contract:
- Loss of Profits – One common misconception is that loss of profits always constitutes a consequential loss. On a number of occasions, the English courts have recognized that the loss of profits, if the usual and natural result of a breach, will amount to direct damages. For instance, if a buyer (being a coal trading company) purchases a spot coal cargo, but the supplier fails to supply such cargo, the buyer’s loss of profits under its re-sale contract with a third party (that is entered into on ordinary commercial terms) is likely to be treated as a direct loss. Arguably, the buyer should not have to prove communication of special circumstances and that it was within the supplier’s contemplation that the buyer (being a coal trading company) would resell the cargo in the normal course of its business. However, if the buyer were to also claim the loss of potential profits due to its third party offtaker not awarding to it a tender for future cargoes as a result of the supplier’s failure to supply the spot cargo in question, then such a claim for loss of profits may arguably be treated as a claim for consequential loss instead.
- Replacement Costs – If a seller fails to make available the agreed supply of the energy commodity, then one potential loss suffered by the buyer would be higher prices incurred (if any) of purchasing a replacement supply. In the context of an LNG sale and purchase agreement (SPA), if a seller fails to supply LNG, the buyer may have to purchase replacement fuel to replace the missed LNG cargo. If the costs of purchasing replacement fuel are higher than would be incurred for the missed cargo, such additional amount paid for the replacement costs can, in principle, constitute direct damages — for instance, where the buyer is the owner of a power plant and it is within the parties’ contemplation that the buyer would need to purchase replacement fuel in place of the missed cargo. However, if the replacement fuel is a different commodity, then there may be a question of whether the additional replacement costs should be treated as a consequential loss. The answer will depend on the extent to which the seller was aware or could reasonably have been aware that a different commodity could potentially be used as a replacement fuel — see the discussion below on the extent of loss.
- Additional costs and liabilities to third parties – In the event of a breach of contract, the non-defaulting party may not necessarily claim loss of profits or revenue, but it could instead claim for additional costs incurred as a result of the breach. For instance, a failure of the buyer to offload an oil cargo in accordance with an ex-ship contract could result in the seller being exposed to demurrage charges under its vessel charter. Given that demurrage clauses are commonplace in vessel charters, such demurrages charges should arguably be treated as direct rather than consequential losses.
- Extent of Loss – In general, the extent of the loss itself should not affect the characterisation of the loss as a direct loss or consequential loss. However, for the purposes of financial or economic loss at least, the magnitude or extent of the loss may impact a court’s characterisation of the loss as a direct or consequential loss, especially where the loss can be tied to a particular contract. Hence, if:
- the seller fails to deliver under a coal offtake contract and the re-sale contract is of an unusually profitable type (i.e., the mark-up is significantly above market practice);
- the type of replacement fuel is not contemplated by the seller at the time of contracting (for instance the contract was for the sale of an LNG cargo and it was not contemplated that power plant buyer could use diesel fuel in place of gas as a replacement fuel) and such replacement fuel costs are considerably higher than what was anticipated; or
- the demurrage costs to a seller a result of buyer’s failure to offload a cargo is pegged to a demurrage rate significantly higher than the prevailing market rate.
In these situations an argument might exist that such additional loss or cost constitutes a different type of loss altogether (and they do not merely affect a question of the extent of loss) and that such loss or cost is at most consequential loss that requires proof of communication of special circumstances before the defendant can be held liable for it. In any case, it is worth noting that under the assumption of liability principle, the greater the extent of the loss, the more unlikely that a court will find that the defendant has accepted liability for such loss in question. Hence, even if the extent of loss does not ultimately affect the characterization of such loss as a direct or consequential loss, it may affect the finding of whether the assumption of responsibility principle has been satisfied on the particular facts.
Exclusion of Consequential Loss
Under English law, contracting parties can agree to exclude the recovery of certain types of loss (including consequential loss) as a result of a breach of contract. It is important to remember, however, that the loss of profits under English law may amount to either direct or indirect loss. Accordingly, an exclusion of “consequential loss” or “indirect loss” will not necessarily exclude loss of all profits if there are losses of profits which are deemed to flow naturally and directly as a result of the breach (i.e., direct losses).Hence, if the intent is to exclude all claims for loss of profit, then liability for loss of profits should be specifically excluded by clear contractual wording. Care should be taken to clearly state that such exclusion applies to both direct and indirect loss of profit. Note that where an exclusion of the loss of profits is expressed as part of the exclusion of consequential loss, this will be read by the courts as only excluding the consequential loss of profits — for instance, in one English case, a clause that excluded liability for “indirect, special or consequential loss, howsoever arising (including but not limited to loss of anticipated profits or data)” was interpreted as only excluding the loss of profit to the extent that it was a consequential loss.
Even if the exclusion clause expressly and separately excludes the recovery of loss of profit, whether consequential or otherwise, courts or arbitrators may be reluctant to exclude loss of profit if this is the only loss likely to be suffered by the innocent party. For instance, in a case concerning the sale of a crude oil cargo, the court considered the meaning of an exclusion clause providing that “in no event shall the seller have any liability for any…loss of profit…or any type of special indirect consequential loss.” Bearing in mind that there was no market price for the cargo blend (as it was a tailored rather than standard product), the court rejected the seller’s argument this clause would exclude liability for loss of profit as a result of supplying an off-specification cargo. Instead, the court held that this clause should be read as only excluding liability for loss of profit where it is a “special indirect or consequential loss” and not where it is “ordinary and entirely foreseeable consequence of supplying a different specification of refinery feedstock.”
However, one should not draw the conclusion that the approach described above would necessarily be applied to other offtake contracts with exclusions of liability for loss of profit. In the first place, if there is a market price for the commodity in question, then the innocent party may frame its compensation claim as one for the contract price/market price differential (instead of as a claim for loss of profits), and hence there may not arise at all an issue of whether the claim falls under the exclusion of loss of profits — more specifically and for instance, in the case of the buyer’s failure to take delivery, the seller may claim for the positive difference between (i) the contract price and (ii) the market price when the goods ought to have been accepted by the buyer. In this respect, it has been held by an English court in a case involving the sale of crude oil that the contract price/market price differential is not the same as a computation of loss of profit. In any case, energy commodity contracts often stipulate specific contractual remedies in the case of failure by either one of the parties to deliver or take delivery of the commodity or product in question. Parties may stipulate for the payment of liquidated damages in the event of a failure to deliver by the seller or failure to accept delivery by buyer, or a take or pay liability regime (e.g. under a long term LNG SPA) where the buyer will pay for cargoes not taken subject to a subsequent make-up right. Hence, in the context of an energy commodity contract, it would not be easy to succeed on the argument that a clause expressly excluding liability for loss of profits would deprive the innocent party of any remedy and hence should be interpreted to apply only to an indirect loss of profits.
Given the high value of energy commodity contracts, it is important to understand and bear in mind the scope of consequential loss, its potential implications for recovery of damages and the issues relating to its exclusion by way of contract. In particular, while the principles applicable to the dichotomy between direct loss and consequential/indirect loss are fairly well-established under English law, the application of these principles can, in practice, be very difficult. Determining whether a loss is a direct or a consequential loss will often require a fact-sensitive consideration and analysis of the surrounding circumstances relating to the contract in question.