A Commercial Court decision earlier this month has upheld a broad interpretation of a consequential loss exclusion in favour of the traditionally narrow interpretation given by the English courts to such clauses. The decision follows recent judicial commentary criticising the traditional rule and may encourage parties to argue for a more case-by-case approach to the interpretation of such exclusions.

Introduction

Several decisions of the English Court of Appeal have established that contractual exclusions for “consequential and indirect losses” will be limited to losses which fall within what is known as the “second limb” of Hadley v Baxendale. Hadley v Baxendale is an old and well known decision in English law establishing a fundamental division between two types of recoverable losses for breach of contract:

  • Damages that may fairly and reasonably be considered as arising naturally, i.e. according to the usual course of things, from a breach of contract. For example, if the breach involved the destruction of a factory, both the cost of rebuilding and the loss of production suffered during rebuilding would fall within this first category. These are “direct losses”.
  • Any other damages which may reasonably be supposed to have been in the contemplation of both parties at the time they made the contract. This category depends upon additional facts being known to both parties. In the example of the factory just given, it may be that loss of production during the period of rebuilding caused the loss of a particularly lucrative long term contract. The loss of such a contract would not be recoverable unless both parties knew that the contract might be lost in the event of such a breach. These are “indirect losses”.

Exclusions for “consequential and indirect losses” will usually exclude only those losses falling within the second category described above. In the case of the factory, therefore, such an exclusion would not affect any claim for ordinary loss of production suffered during the period the factory was unavailable. Such an interpretation has been criticised as one which the average businessman would not expect. However, the rule is very well established and in British Sugar plc v NEI Power Projects, the Court of Appeal commented that reasonable businessmen using such language must be taken to be aware of the distinction. As the present case shows, however, the specific circumstances of a given case may show that something different was intended.

Star Polaris LLC v HHIC-Phil Inc

Star Polaris entered into a contract with HHIC-Phil Inc (the “Yard”) for the construction of a cargo ship. Approximately 8 months after delivery, the vessel suffered a serious engine failure. The Yard denied liability for the failure and a dispute arose between the parties as to liability for the costs of repair and financial losses arising from the failure.

Among other things, the Yard relied on an exclusion in the contract for “consequential or special losses, damages or expenses”. This exclusion was contained in a clause setting out detailed provisions as to liability for and the repair of defects discovered in the vessel. The clause was expressed to replace all other obligations and liabilities of the Yard under the contract or at common law. In this context, the Yard contended that the word “consequential” was used in a cause-and-effect sense as excluding any losses caused as a knock-on effect of the engine failure.

The case was decided first by arbitration and then by an appeal to the Commercial Court, and on both occasions the Yard’s interpretation of the word “consequential” was upheld. The court and arbitral tribunal found that the defects clause as a whole made it sufficiently clear that the consequential loss exclusion was intended to exclude liability for losses over and above those specifically accepted by the Yard in the clause (which was limited to repair of defects and any physical damage caused thereby). The parties were not therefore held to have intended the usual interpretation of “consequential loss”, limited to second limb losses under the rule in Hadley v Baxendale.

Conclusion and implications

The traditional “second limb” interpretation of consequential and indirect loss exclusions has come under renewed criticism recently. Last year, one judge in the Commercial Court commented that “this unnatural interpretation of the term ‘consequential loss’ is to be deprecated” (Scottish Power UK v BP). Earlier this year, in referring to the traditional interpretation of such exclusions, the Court of Appeal commented that (Transocean Drilling v Providence Resources):

“It is questionable whether some of those cases would be decided in the same way today, when courts are more willing to recognise that words take their meaning from their particular context and that the same word or phrase may mean different things in different documents.”

These comments may suggest judicial appetite for a change in the traditional rule. The present case may also be seen to give support to arguments in favour of a more flexible interpretation of such exclusions depending on the context of the clause in question, rather than the application of a fixed, judicially determined interpretation in all but exceptional cases. The traditional rule is however supported by a number of decisions at Court of Appeal level and it remains to be seen whether any real case for change can be made.