Two important elements of any commercial contract are the warranty and the exclusion of consequential losses. In the context of the sale of goods, warranty provisions will typically cover defective products and the seller’s liability will be limited to the replacement or repair of the goods and may not cover so-called "consequential" damages. However, when a warranty fails of its essential purpose, contractual limitations on recovery of consequential losses can be compromised.
"Failure of essential purpose" of a warranty is a legal term that describes the situation where a warranty provides insufficient remedies to a purchaser. In a con-struction setting, the most typical example of this is the purchase of a piece of commercial equipment that is in some way defective. When the defect is discovered, the purchaser contacts the seller and requests that the seller fulfill its warranty obligations by fixing the equipment. Courts have held that a "limited repair or replace" warranty fails of its essential purpose when the seller is not able to fix the equipment in a reasonable amount of time, even if numerous attempts at repair are undertaken.
A warranty can also fail of its essential purpose when a volume purchaser discovers a "serial defect"- i.e., a defect present within a large number of similar units. Even if the seller replaces the products under warranty, the warranty may still fail of its essential purpose if the purchaser is required to absorb the cost of uninstalling the products and shipping them back to the seller (as well as absorbing the resulting loss in produc-tion or cooling or other output). The theory behind this doctrine is that mere replacement of the defective prod-ucts does not sufficiently compensate the purchaser – in legalese, the purchaser is deprived of the "benefit of the bargain."
When a warranty has failed of its essential purpose, the purchaser may be allowed to recover consequential losses despite a contractual exclusion of the same. The Uniform Commercial Code ("UCC"), which governs the sale of goods and is adopted in some form by every state, specifically addresses failure of a warranty and consequential losses. Section 719 of the UCC expresses the following rules: first, if a warranty fails of its essen-tial purpose, all "normal" remedies (including recovery of consequential losses) become available to the pur-chaser; second, if a consequential loss exclusion is un-conscionable, it is not valid. The interplay between these provisions begs the question: if a warranty fails of its essential purpose, thereby allowing the purchaser the full range of remedies available for breach of contract, does a consequential loss exclusion remain valid if it is not unconscionable? In other words, is a contractual conse-quential loss exclusion automatically extinguished when a warranty fails of its purpose?
The majority of states hold that the two UCC provi-sions are dependent – that a consequential loss limitation is automatically extinguished when a warranty fails of its purpose and the purchaser is allowed to recover con-sequential losses despite the contrary limitation in the parties’ contract. The logic of this position is that the balance of risk inherent in a contract between two parties is materially altered when a warranty fails to serve its purpose. The majority states include Alabama, Dela-ware, Idaho, Illinois, Massachusetts, Michigan, Ohio, South Dakota, and Wisconsin. The minority of states hold that the two UCC provisions are independent – that a contractual limitation on recovery of consequential losses remains valid even when a warranty fails of its purpose. The logic of this position is that the balance of risks was negotiated between the parties and it should not be disturbed. Minority states include some behe-moths in commercial contracting: California, New Jer-sey, New York, North Carolina and Tennessee. Some states, such as Mississippi, have not explicitly addressed this issue.
In order to better protect against liability for conse-quential losses, manufacturers and sellers of equipment and materials should consider including a contractual provision explicitly stating that the consequential loss exclusion functions independently from the terms of the limited warranty. The provisions should state that the parties agree the consequential loss exclusion will re-main in place even if the warranty fails of its essential purpose. Even in the majority rule states, this type of contractual clause has a good chance of holding up in a court of law because the UCC can be modified or over-written by a contractual agreement. The following are two sample clauses, which can be added to consequen-tial loss exclusions:
"This disclaimer and exclusion shall apply even if the express warranty set forth above fails of its essential purpose."
"Customer acknowledges and agrees that Seller has set its prices and entered into the Agreement in reliance upon the disclaimers of warranty and the limitations of liability set forth herein, that the same reflect an allocation of risk between the parties (including the risk that a contract remedy may fail of its essential purpose and cause consequential loss), and that the same form an essential basis of the bargain between the parties."
Of course, the purchaser, whether contractor or owner, faced with this effort by the equipment supplier, should be diligent in attempting to negotiate more favorable terms.