Myths about fire-breathing dragons, which could emerge from a cave and fly around threatening the human inhabitants of a given locality, are both ancient and ubiquitous. Just about every culture in the world appears to have independently developed their own mythology concerning these creatures.[1] And, as a random review of a number of recently filed private company acquisition agreements reveals, it turns out that even sophisticated deal counsel are susceptible to dragon myths.

Scholars that have studied why the belief in the existence of dragons is so pervasive have developed various theories, but I prefer to believe that it began rather simply—i.e., one of our ancient forebears was holding a torch at the mouth of a cave and the flickering firelight caused the shadow of a harmless lizard to appear like a dragon on the cave wall; that sighting was then reported, everyone avoided the cave thereafter, and no one was brave enough to investigate whether there really was a dragon there at all.[2] Sometimes, transactional lawyers attempt to slay a mythical legal dragon with a bespoke provision that they believe is necessary based upon some long-ago dragon sighting that has been passed down through generations of lawyers, with no one questioning the veracity of that original sighting, or the continued existence of the creature even if its original sighting was verified.

A good example of this phenomenon, in the private company acquisition context, is the frequent inclusion of “excluded loss” provisions. An “excluded loss” provision is a clause that excludes certain losses from the benefit of the indemnification obligations of the seller in event the seller breaches any of the seller’s representations and warranties (assuming there is an indemnification obligation, rather than reliance upon R&W insurance alone). The effect of an excluded loss provision is to render all of the named damages types unrecoverable, even though the named damages types may constitute real losses actually incurred by the buyer as a direct result of inaccurate representations and warranties, are otherwise within the agreed upon Cap, and in some cases are the only losses the buyer actually sustained.

A typical indemnification provision calls for the seller to “indemnify, defend, hold harmless and reimburse [the buyer] for, from and against all Covered Losses imposed on, incurred or suffered by or asserted against [the buyer] in connection with or arising out of any breach or inaccuracy of [the seller’s representations and warranties and certain other specified obligations].” “Covered Losses” is then broadly defined similar to the following definition borrowed from a recently filed private company acquisition agreement:

Covered Losses” means any and all losses, liabilities, claims, fines, deficiencies, damages, payments (including those arising out of any settlement or Governmental Order relating to any Action), penalties and reasonable and documented out-of-pocket attorneys’ and accountants’ fees and disbursements.

There then follows a carve out to the broad definition of Covered Losses, which lists certain excluded losses that will not constitute Covered Losses, or a separate provision that specifically excludes certain damages types from recovery even if they otherwise fall within the definition of Covered Losses. A recently filed private company acquisition agreement negotiated between two sophisticated deal counsel contains a not untypical formulation of the later approach:

Consequential or Special Damages. Notwithstanding anything to the contrary contained in this Agreement, no Indemnified Party shall be entitled to be indemnified, defended, held harmless or reimbursed in respect of, and Covered Losses shall not include, any consequential, indirect, speculative or incidental damages, punitive or special damages, opportunity cost or lost prospective economic advantage or other similar damages (including damages calculated on “multiple of profits” or “multiple of cash flow” or similar valuation methodologies), except (i) any consequential or incidental damages to the extent a reasonably foreseeable consequence of breach of the applicable covenant or agreement or the matter giving rise to a claim for indemnification hereunder or (ii) to the extent awarded against an Indemnified Party in connection with a third-party claim.

The title to this provision tells the story. Like so many of its predecessors, this provision is designed to slay a mythical dragon—the hideous, fire-breathing, “consequential damages” dragon. And the numerous other words used to exclude losses (which may actually exclude far more than just consequential damages) illustrate the fears this mythical dragon evokes.

No one really knows why consequential damages waivers crossed over from the construction and supply contract context into the M&A arena, but it’s been a fixture of M&A negotiations for a long time. Note that the above exclusion does not purport to cover losses awarded to a third party as the result of a third-party claim (clause (ii) of the exception from the excluded losses); the theory is that indemnification for actual losses awarded to a third party in connection with a third-party claim are straight forward reimbursements of direct out-of-pocket damages and should be recoverable dollar for dollar from the seller (up to the Cap) if incurred as a result of a breach of the seller’s representations and warranties. In other words, the fact that the buyer or the target company was compelled by a court to pay a third party for a specific amount means that the buyer is by definition not seeking compensation for claimed damages that may somehow exceed the real, actual damages sustained. Thus, the identified excluded losses are typically only relevant in the context of direct claims by the buyer against the seller for losses arising from a breach of the representations and warranties where there is no third-party claim, or for losses sustained as a result of a third-party claim that were not part of the award in favor of the third party, but were nevertheless sustained by the buyer or the target company as a result of that claim.

Okay, but what in the world are “consequential damages” and why would they be excluded from recoverable losses? The answer is that notwithstanding the facts, the term “consequential damages” has been imbued with mythic dragon-like characteristics by sellers seeking to avoid them, and buyers have many times bought into the belief that that these damages types actually possess these unfair, non-compensatory traits. Indeed, anecdotal evidence suggests that the rationale behind excluding consequential damages from recovery for breach of representations and warranties was based upon the belief that consequential damages were somehow damages beyond the actual, compensatory damages incurred by the buyer as a result of the breach, and instead somehow covered damages that were remote or speculative.

The fact, however, is that remote or speculative damages are not recoverable as damages for breach of contract as a matter of traditional common law principles. Indeed, all damages awarded for breach of contract are, in most cases, required to be reasonably certain and foreseeable. And historically, the only difference between general damages and consequential damages was the fact that general damages were deemed foreseeable because they were the normal consequence of a breach of any similar contract with any counterparty, whereas consequential damages only arose because of the special circumstances of a particular counterparty (like the fact that the counterparty entered into a contract with a third party that was dependent upon performance of the primary contract). As a result, consequential damages (also known as special damages) required enhanced foreseeability and the need to actually communicate those special circumstances to the breaching party at the time of contracting in order to hold the breaching responsible for such special or consequential damages. And note that the drafters of the above excluded damages provision gave a nod to the belief that consequential damages somehow encompassed unforeseeable losses by excepting from the exclusion of consequential damages those consequential damages that actually are foreseeable (see clause (ii) above). But make no mistake, consequential or special damages are real, actual and foreseeable damages, not some attempt to manufacture imaginary, speculative, or remote losses.

Note too that the drafters of the quoted excluded loss provision appear to couple “special damages,” not with consequential damages but with punitive damages, as if the two were related. They aren’t. “Special damages” are typically treated as a synonym for “consequential damages.” These drafters, however, appear to equate “incidental damages” with “consequential damages” in the exception to the exclusion for “reasonably foreseeable” “consequential or incidental damages.” These two concepts have nothing to do with one another. Indeed, “incidental damages” are more properly understood as constituting the costs and expenses incurred by a non-breaching in avoiding additional general or consequential damages that would be incurred by the non-breaching party in attempting to mitigate the breach. Why in the world would those damages be the proper subject of exclusion? Punitive and speculative damages are more properly coupled, as neither is typically recoverable as a matter of law for breach of contract in most jurisdictions.

Why buyers agree to a Cap on their recoverable damages and then exclude real, actually sustained losses from even counting as losses is mythic dragon slaying run amuck. And it’s worse than you may think. Despite the traditional understanding of consequential damages as those arising from special circumstances of the buyer that would not normally be suffered by any other buyer (but were actually anticipated and known by the seller to be potentially sufferable by this particular buyer’s special circumstances in the event of a seller breach), not all courts have adopted that definition. Indeed, many courts have declared the term “consequential damages” as essentially having no established meaning, even though they will undertake to give it meaning notwithstanding that the term (along with a listing of other excluded damages types) “might have been put in the Merger Agreement by lawyers who themselves were unclear on what those terms actually mean.”[3] Thus, despite some lawyers’ view that “consequential damages” is a synonym for “indirect damages,” there is no consistent caselaw that would so limit the meaning of the term to damages that have indirect causality to the breach. Waiving “consequential damages” thus exposes buyers to the risk that a court’s interpretation of that term may preclude damages that the buyer had no real intention to waive.

And just ponder for a moment what the word consequential means in ordinary English. The word “consequential” in the term “consequential damages” is an adjective modifying “damages.” What is the ordinary definition of “consequential”—isn’t it “following as a result or effect?” Do you want to exclude all damages that follow as a result or effect of the breach? I don’t think so. And remember the secondary definition of the word consequential is “important or significant.” Do you want to exclude all damages that are important or significant? What does that leave you with; only damages that are unimportant or insignificant? No thanks; the de minimis exclusion probably already eliminates those. Not saying that is how it would be interpreted, just noting that its ordinary meaning is susceptible to that interpretation—and the various meanings that have been ascribed to the term by the courts are no less frightening in limiting recovery of actual, real losses.[4]

And what are we to make of some of the other terms included within this excluded loss provision that is titled “Consequential or Special Damages?” What is included in the phrase “opportunity cost or lost prospective economic advantage or other similar damages (including damages calculated on ‘multiple of profits’ or ‘multiple of cash flow’ or similar valuation methodologies)?” The most common approach to general damages for breach of warranty is to compare the value of the company as warranted to the value of the company as actually delivered with one or more of the warranties having been determined to have been inaccurate. How exactly would this common damage formulation be determined if one of the more common methods of valuing the company have been excluded as a basis for determining value? Indeed, some excluded loss provisions are more explicit in waiving “diminution of value” as a complete category of damages.

Furthermore, what is excluded by excluding “opportunity cost or lost prospective economic advantage.” Of course some excluded loss provisions explicitly waive all “lost profits.” But could that quoted phrase nonetheless preclude any recovery for losses sustained by virtue of a breach of a representation regarding the continued effectiveness, without default by the target, of a favorable, long-term, above market customer contract? Would those losses constitute “lost prospective economic advantage?” Are you sure of the answer? If not, why use terms as to which you are unsure of their meaning?

The questions raised by the various terms used in the quoted excluded loss provision do not end there. Imagine the buyer entered into an acquisition agreement containing the above quoted excluded loss provision. Imagine further than the buyer discovers that the seller misrepresented the target company’s compliance with applicable law and its possession of valid permits to operate its manufacturing plant. It turns out that one of the required permits expired six months before the purchase agreement was entered into. The buyer discovered this expired permit as a result of a routine inspection conducted by the regulatory authority that issued the permit. As a result of this discovery, the buyer is forced to close the plant while the necessary process is followed to obtain the required renewal of the expired permit. This process requires a full inspection, that in turn necessitates some required repairs. And while this is going on the plant is required to shut down. In order to avoid defaulting on a number of customer contracts, the buyer buys product for its customers from competitors. The cost of the product exceeds the contract price being paid by the customer (which would have produced a profit for the buyer had the plant been operational and the product was being produced by the buyer). The buyer timely provides notice of the breach and expects to be indemnified for all these losses up to the contractual Cap, less the deductible.

The response from the seller, however, is that except for the filing fee required for the non-renewed permit, and the repairs necessary to obtain that permit, all other losses are excluded by the above quoted excluded loss provision (and the seller initially took the position that the repair costs would not count either because they were excluded “incidental damages,” but the seller later conceded that the repair costs were nonetheless foreseeable and therefore carved back in to Covered Losses). Is the seller right? If so, is that what the parties intended, or is this an unintended consequence of an attempted slaying of a mythical dragon?

Attempting to slay a mythical dragon (through a bespoke provision in a contract) may seem harmless; after all, dragons don’t exist, so how can efforts to kill one cause harm? But when a weapon is fired at a non-existent creature (in the form of a bespoke legal provision), real creatures (i.e., actual benefits of one’s bargain) can become collateral damage. And, to paraphrase Oliver Wendell Holmes, Jr. in his famous essay, The Path of the Law, even if it turns out there is some kind of dragon in that cave, you still need to go in and drag it out into the sunlight so you can count its teeth and measure its claws to determine its true danger; only then can you properly determine whether to kill it, tame it, or ignore it.[5]

And in transactional lawyering that means you either have to do some regular case reading or have someone on your team who does. One means of doing this, of course, is by joining the Business Law Section of the American Bar Association’s M&A Jurisprudence Subcommittee of the M&A Committee. There you can find a group of lawyers who are regularly dragging purported dragons out of caves, and counting their teeth and measuring their claws, to determine whether changes in deal practice may be necessitated by developments in the caselaw. Regularly reading Weil’s Private Equity Blog posts can’t hurt either.