One of the most important mechanisms in a contract for allocating risk is the ability to exclude “indirect” and “consequential” loss using exclusion clauses. It is typically on a party’s list of most important clauses that may require approvals at board level if certain requirements are not met. Notwithstanding this importance, parties are not always clear on what kind of losses the terms “indirect” and “consequential” loss capture?
The Australian case law on consequential loss has changed considerably over the past ten years and produced some surprising results. Loss of profits can be direct loss.1 Economic loss can be direct loss.2 Additional construction costs associated with a delay can be consequential loss.3
This article revisits the cases on consequential loss, considers what kinds of loss are probably now captured by the term and what is now “on market” for these kinds of exclusion clauses.
- Traditionally it was thought that indirect or consequential losses could be equated with the second limb of the test for remoteness laid down in Hadley v Baxendale (1854) 2 CLR 517. However, the Australian case law has now made it clear that this is not the case.
- Like any other clause in a contract, the Courts have indicated that these terms are to be given their natural and ordinary meaning, interpreted in the context of the contract as a whole.
- Generally, the natural and ordinary meanings of these terms distinguishes between “normal loss” which is loss that every plaintiff in a like situation would suffer, and “consequential loss” which is anything beyond the normal measure.
- As a result, it is not the case that loss of profits and economic losses will always be consequential or indirect.
- Loss of profits may constitute direct loss where the loss of profits resulting from the breach would not vary between plaintiffs.
- Given the lack of clear legal definitions, these concepts may be interpreted much more broadly or narrowly than intended. Therefore, the best approach when drafting an exclusion clause in relation to consequential and indirect losses is to clearly define the types of losses that should be excluded.
What is a party trying to exclude?
If you ask a party what loss they are intending to exclude by including a consequential loss exclusion clause the answers may vary. To some, this may mean the exclusion of claims:
- primarily, for loss of profit and/or loss of revenue;
- for losses that it was not reasonable for a party to be aware of when they entered into a contract;
- for losses that arise from the way in which the counterparty conducts its business and/or
- for losses that one party can typically insure, including through business interruption insurance.
Given the range of possibilities, each party may have a different understanding of what is meant by “consequential” or “indirect” loss and the Courts have struggled to discern the common contractual intent.
What is “consequential loss”?
At common law, damages are recoverable for breach of contract to compensate for losses caused by a breach that are not too remote.4 The test for remoteness was laid out in Hadley v Baxendale. Losses are not too remote if they:
- ordinarily or naturally flow from the breach (the first limb); or
- may reasonably be supposed to have been in the contemplation of both parties at the date of contract as a probable result of the breach (the second limb).
Traditionally, the courts took the approach that the term “consequential loss” meant those losses falling into the second limb of Hadley v Baxendale5 or losses in relation to which a party required special knowledge. While this was a test that lawyers were familiar with, it did present some challenges.
In relation to certain losses, including loss of profit and revenue, it was often difficult to characterise the loss as falling under the second limb of Hadley v Baxendale or not. This meant that if a party wanted to be sure whether this had been excluded, it needed to expressly do so.
Secondly, there was a growing recognition that this test was not really consistent with the plain and ordinary meaning of the terms “consequential’ or “indirect”. While related, the test in the second limb is focussed on the knowledge of the parties at contract execution, whereas the plain and ordinary meaning was more concerned with how close the actual causative relationship was between breach and loss, considered at the time of the breach (i.e. was a loss caused by a breach or as a consequence of something that was caused by the breach).
In Environmental Systems Pty Ltd v Peerless Holdings Pty Ltd (2008) 19 VR 358 (Peerless), the Victorian Court of Appeal held that it was not correct to equate “consequential loss” with the second limb of Hadley v Baxendale. Nettle JA stated that the term “consequential loss” should be given its natural meaning and “the true distinction is between “normal loss”, which is loss that every plaintiff in a like situation will suffer, and “consequential losses”, which are anything beyond the normal measure of damages”.
Quoting from McGregor on Damages, Nettle JA gave the example of the failure to supply services or goods in breach of a contract to do so. Generally, the direct loss would be the difference between the contract price and the market price of those goods or services. This is the “normal loss”. The consequential losses are any other losses beyond this measure that are caused by the breach and not too remote.
Twice in his judgment, Nettle JA provided “profits lost or expenses incurred through breach” as examples of “consequential loss”. These examples have caused some confusion. It was not clear from the judgment whether His Honour meant these examples would always be “consequential loss” or whether they were just examples of what constituted “consequential loss” in that particular case.
In Regional Power Corporation v Pacific Hydro Group Two Pty Ltd [No 2]  WASC 356 (Pacific Hydro), Kenneth Martin J followed the principle that the words “indirect damages” and “consequential damages” should be given their natural and ordinary meaning. However, His Honour stressed that the natural and ordinary meaning should be interpreted in the context of the contract as a whole and Nettle JA’s formulation in Peerless should not be considered generally applicable.6 Kenneth Martin J gave the example that profits lost and expenses incurred through breach will sometimes be losses within the normal measure of damages (and not consequential).
Pacific Hydro concerned a contract for the supply of electricity by the Defendant to the Plaintiff. The Plaintiff relied on this contract to meet its statutory obligations to supply its customers with electricity. The Defendant failed to supply electricity in breach of its contract with the Plaintiff, and the Plaintiff incurred economic expenses to source alternative power for its customers. Kenneth Martin J found that those expenses were, in the circumstances, direct. It was relevant that the Plaintiff had firm obligations to arrange an alternative source of power for its customers and the Defendant would have been aware of this at the time of making the contract.
Kenneth Martin J’s formulation of “direct loss” was consistent with the example of a breach of a goods or services contract given by Nettle JA in Peerless. The “direct loss” was the difference between the contract price and the market price of procuring an alternative. An economic loss was held to constitute “direct loss” in this context.
Patersons Securities Ltd v Financial Ombudsman Service Ltd and Others (2015) 108 ACSR 483 (Petersons) is an example of how a Court after Peerless applied the new approach in relation to consequential loss in relation to loss of profits.
This case concerned the investment of client monies by Patersons Securities in a manner that breached its contracts with two of its clients. The Financial Ombudsman awarded damages to the clients which reflected the difference between the value of their portfolios and the value that they would have held had the money been invested properly in accordance with the contracts. Mitchell J held that, despite constituting lost profits, those losses were direct (and therefore not “consequential losses”).
His Honour agreed with Kenneth Martin J in Pacific Hydro that “Nettle JA did not, in Peerless, intend to set down a fixed and inflexible rule, to be applied in all circumstances and all contractual contexts, that loss of profits can only be consequential or indirect loss. The critical concept employed by Nettle JA was “normal loss”, which is loss that every plaintiff in a like situation will suffer. Consequential losses were anything beyond the normal measure.”
In interpreting “indirect” and “consequential” loss, Mitchell J considered that, in general terms, their ordinary and natural meaning distinguishes between “direct loss which flows naturally from the breach without other intervening cause and indirect loss which does not so flow.“7
Prior to Peerless there was significant risk that the term “consequential loss” would not exclude loss of profit.
After Peerless, there were many who thought that the term “consequential loss” would always capture loss of profit and economic loss. However, the subsequent cases made it clear that this is not the case. Kenneth Martin J in Pacific Hydro and Mitchell J in Patersons both held that Nettle JA’s examples only applied to the facts in Peerless and did not constitute a general rule.
The position on loss of profit was summarised helpfully by Mitchell J in Patersons:
“In many cases, a loss of profits will not be a normal loss, because generally the profits which a plaintiff may make will depend on the particular plaintiff’s revenue or cost streams. For many contracts, the loss of profit resulting from breach will vary between plaintiffs, and so will not be a loss that every plaintiff in a like situation will suffer. As a general statement, it is not doubt correct to say that loss of profits will not be “normal loss” in that sense. However, there may be particular cases where that is not so. For example, if the relevant contractual obligation is to secure a minimum net rental return then the failure to deliver that return will produce “normal loss” which any plaintiff having the benefit of that contractual promise would suffer.”
This means that after Peerless parties can have more confidence that losses such as profit and loss of revenue are covered by the term “consequential loss”. However, this may not always be the case. Due to this uncertainty and that this area of law is still evolving, it is still prudent for parties to be express about what they are trying to exclude.
What is the “on market” approach to “consequential loss”?
Best practice, for contractors and principals alike, is to ensure that the clause is clear and does not rely on undefined concepts of “consequential loss” to capture the particular losses that should be excluded.
Commonly, the following kinds of loss are expressly excluded:
- Loss of profit
- Loss of use of any plant or facility
- Loss of opportunity
- Loss of goodwill
- Special or punitive damages
- Loss of contract
Care should be taken if including loss of contract in an exclusion clause to preserve the proper operation of a termination for convenience clause. In MacMahon Mining Services v Cobar Management  NSWSC 731, it was determined that loss of contract included the loss of the particular contract between the parties, with the result that damages for a wrongful termination did not include an amount for the loss of profits that the contractor would have earned under the contract had it been performed. This was the case even though the contractor would have been compensated for those amounts had the contract been terminated for convenience under the relevant clause in the contract.
It is clear from the Australian case law that concepts of “direct”, “indirect” and “consequential” loss do not have fixed and settled legal meanings. These terms are to be given their natural and ordinary meaning, interpreted in the context of the contract as a whole. This leaves a fair amount of uncertainty as to what will be captured by an exclusion clause that uses these terms. It may be interpreted much broader or much narrower than intended. Therefore, the best approach when drafting an exclusion clause is to clearly define the types of losses that should be excluded.