Liability clauses – can't live with them, can't live without them. But as time, and practice, goes on, they become more and more complex. So, it is becoming increasingly important to explain the likely interpretations of the phrases used.

Loss of profits is a key example. What exactly is loss of profits? Is it a direct or indirect loss?

The shipping case of Transfield Shipping Inc v Mercator Shipping Inc [2008] UKHL 48 goes back to some key questions in relation to what losses can be recovered under the head of loss of profit. While it is specific in many ways to its industry, the approaches taken by the House of Lords and the Court of Appeal before it give a useful insight into the interpretation of liability clauses.

Like ships in the night

The facts of the case were that when a ship was not returned on time from its charter, a follow-on charter, agreed after the initial charter had set sail, could not be fulfilled.

Because of the rates available in the market at the time when the follow-on charter was concluded, it was at a much higher rate than the initial charter. However, by the time it became clear that the ship would not be returned in time, the rates had fallen again, and the owners had to agree to a reduction in the rate. Could the ship owners claim the lost profit from having to reduce the fees on this follow-on charter?

A little background is required here into the world of shipping law. Evidence was given to the initial arbitrators that 'the general understanding in the shipping market was that liability was restricted to the difference between the market rate and the charter rate for the overrun period and "any departure from this rule [is] likely to give rise to a real risk of serious commercial uncertainty which the industry as a whole would regard as undesirable."'

A body of case law had built up around this principle. While everyone agreed that this was indeed the accepted position, the particular claim made in this case had never been made before. The arbitrators held that the principle was irrelevant in the case. They also held that the types of losses claimed – the loss of profit arising from missing dates for a new fixture – were a "not unlikely" result of late delivery, and so they were not so remote as to be unrecoverable.

Decisions, decisions

The Court of Appeal agreed – the ship owners were entitled to claim this loss. As the type of loss was expected, it did not matter whether the level of loss could be anticipated.

To hold otherwise would be to relieve the charterer from the primary liability resulting from their breach, which could not be right.

The House of Lords however was more measured in its approach. Starting from the standpoint that all contractual liability is assumed voluntarily, the Lords assessed the intention of the parties – had the charterer's accepted the liability for this exceptional lost profit?

Commercial uncertainty = no liability 

The Lords held that to construe that the parties had entered into this charter intending that the charterer would take responsibility for any such losses arising from the late delivery of the ship would lead to too much commercial uncertainty. The charterer would not know whether a new charter had been entered into, for how long, on what terms, what the effect of late commencement would be, and what the charter rate would be. It was not enough for the charterer to know that in principle the owners would lose a follow-on charter. They must have some information which would enable them to assess the extent of liability.

Hadley v Baxendale re-interpreted

The judgement of this case is a great review of the authorities on remoteness of damages, from Hadley v Baxendale (1854) onwards. 

In deciding that the charterers could not have intended to assume the liability for the loss of profits, the Lords did not discount the rules as set out in this important case. However, it did make clear that the rules were not as inflexible as may have been thought. The rules are there primarily to "give effect to the presumed intentions of the parties and not to contradict them".

In particular, the Lords drew an analogy with the case of Victoria Laundry (Windsor) Ltd v Newman Industries Ltd [1949], where loss of profits from standard contracts were considered to flow "naturally from the breach" and were recoverable under the first limb in Hadley v Baxendale. However, losses from a particularly lucrative dyeing contract were a different type of loss. Therefore, the parties had to have sufficient knowledge of them before they could be held to have assumed liability for them. They constituted a "different and higher form of risk".

The moral of the story

This case confirms the position understood by shipping lawyers that the damages recoverable for late return of a charter are the difference between the market rate and the charter rate.

However, for general contract drafters, the case holds a different lesson. Many of us without specific knowledge of this industry would think it logical that this type of loss may arise if a ship was returned late, and therefore the losses would be recoverable. The House of Lords has encouraged us to investigate further into the intentions of the parties when considering what liabilities have been assumed. If a particular liability is of concern, the parties should ensure that it is specifically dealt with in the contract, and not assume that simply because it has not been excluded it is fair game.