What damages are recoverable for breach of contract? There are few more fundamental contract questions than this. And thanks to a 150 year old case (Hadley v Baxendale) and some heavyweight judgments where the rule in Hadley v Baxendale has been elucidated, English law has provided an answer – the so-called ‘remoteness test’ – which is relatively well-settled, and well-understood.

Until now. In the summer 2008 decision of Transfield Shipping v Mercator Shipping, the House of Lords has raised questions about the remoteness test, and proposed another approach to the question of remoteness based on an ‘assumption of responsibility’. The end result, according to most commentators (including a QC involved with the case), is to have made the law less clear and less predictable than it was before. It is a very open question, furthermore, whether this decision will make a difference in practice.

The rule in Hadley v Baxendale states (in rather anachronistic language) that a claimant may recover damages for breach of contract where the damage is: (1) such as may fairly and reasonably be considered either as arising naturally i.e. according to the usual course of things from the breach of contract; or (2) such as may reasonably be supposed to have been in the contemplation of both parties at the time they made the contract as the probable result of the breach.

The stages of the dispute

The dispute concerned the late return of a ship by its charterer (Transfield) to the shipowner (Mercator), and the amount of losses which Mercator could recover as a result. The dispute was very fact-specific, and arose in circumstances of great price volatility in the shipping market. We don’t need to present the specific facts here. What is important is that whereas an arbitrator, the High Court and the Court of Appeal all concluded that the recoverable damages should be assessed on the traditional Hadley v Baxendale basis (as summarised above), and concluded in favour of Mercator’s damages claim, namely for its full loss of profits arising out of late delivery, the House of Lords reversed the decision, arguing that an “oversimplistic” interpretation of Hadley had been taken. That in itself is quite a statement, given the substantial commercial experience of the judges involved at the lower stages.

The decision

The House of Lords proposed that the question to be asked was whether a given type of claimed loss is one for which a party has assumed responsibility. This involves the interpretation of the contract as a whole against its commercial background. Lord Hoffmann and Lord Hope, expressing the view of the majority, concluded on the facts that Transfield could not reasonably be regarded as having 'assumed the risk' of Mercator’s loss of profit on the subsequent charter, especially in view of the fact that nothing was known at the time about the terms on which any subsequent charter might be entered into. The Law Lords slashed the size of Mercator's damages, and instead supported Transfield’s view that all that was recoverable was the difference between the market rate and the charter rate over the short period during which Mercator could not use the ship because of its late delivery.

Key messages

The compensation that Mercator received is actually in line with standard practice in the shipping industry. However, it is the novel reasoning of the House of Lords in reaching this result that makes this case challenging. The House of Lords has arguably made the remoteness test for contractual damages unclear by suggesting an 'assumption of responsibility' dimension to the traditional Hadley v Baxendale test. This new approach involves taking wider factors into account such as generally accepted practices within a particular market or sector. Ironically, this approach depends to some degree on the parties’ knowledge, and therefore overlaps with the Hadley v Baxendale test anyway! Furthermore, it is important to note that only two of the Lords adopted the assumption of responsibility test explicitly, and the facts of the case were very specific. It will be interesting to see how courts interpret and apply this decision.

The assumption of responsibility test (if it does take root) could reduce damages awarded in the event of breach since it opens up the scope for defendants facing large claims to argue that they could not reasonably be assumed to take responsibility for particular losses taking account the usual practice in a particular market. One idea that has been suggested is that a contracting party should bring any particular potential losses to the attention of the other contracting party at the time of entering into an agreement (and document this) in order to increase the likelihood of recovering such losses in the event of breach.

Source: Transfield Shipping Inc v Mercator Shipping Inc [2008] UKHL 48, [2008]4 All ER 159 - House of Lords, 9 July 2008