We’ve often seen provisions in contracts that purport to limit damages, usually including a reference to lost profits. Here’s a sample of that kind of wording:

Limitation on Damages. Notwithstanding anything to the contrary contained herein, neither party shall be liable to the other for any consequential damages, including damages for lost profits or loss of opportunity, suffered by the other party.

If you’ve encountered such language in a contract, you may have wondered what it’s for and whether it’s effective. The purpose of such a provision is to explicitly exclude the parties to the contract from claiming certain kinds of damages for breach.

Suppose that I had a store and a windstorm damaged the roof so severely that I couldn’t open for business until it was repaired. And suppose that I hired a roofer to put on a new roof and the contract called for the work to be completed by a certain date. And, for the sake of the story, suppose that the deadline was the day before Thanksgiving because I wanted to be open the day after Thanksgiving, which is a very big day for holiday sales. But my roofer is late starting and finishing, so my store isn’t open on the Friday after Thanksgiving. Can I sue and collect for lost profits?

It is a general principle of contract law that damages for breach of contract should put the innocent party in the same economic position that he would have been in if the other party had fulfilled the contract. An example would be that if B doesn’t deliver the widgets he contracted to sell to A, then A buys the same quantity of widgets from another supplier and if A has to pay more for the widgets, then B is liable to A for the difference paid by A. Likewise, if my roofer failed to perform, I could hire another and if I had to pay more, sue the first roofer for the difference. But because of my roofer’s breach of contract, my store wasn’t open the day after Thanksgiving and I have lost profits. Shouldn’t I be able to recover those, too?

Maybe. The law makes a distinction between “general damages” and “consequential damages.” Lost profits are treated as consequential damages when, as a result of the breach of contract, the innocent party has a loss on other business arrangements. But when the innocent party is seeking to recover money that the breaching party agreed to pay under the contract, any lost profits involved will be general damages.

The classic case on this issue is Hadley v. Baxendale, an English case decided in 1854. Hadley ran a grain mill. The crankshaft on the steam engine that turned the mill broke, and he ordered a replacement from a supplier who required that the broken shaft be provided in order to make sure the replacement would be fabricated to the correct dimensions. Baxendale was hired to deliver the old shaft to the supplier by a certain date but was late with delivery. Accordingly, Hadley was delayed in receiving the replacement shaft, and during that time he couldn’t operate and he lost business. He sued Baxendale for the lost profits. The court ruled against Hadley, saying that the lost profits were not a reasonably foreseeable result of Baxendale’s failure to perform.

So when would lost profits be recoverable? A more recent case discussing this issue is Tractebel v. AEP Power, from the U.S. Court of Appeals, Second Circuit, decided in 2007. The facts were that AEP had contracted to build a co-generation plant, where steam would be produced and first used to generate electric power which would then be sold to a customer for use in industrial production. Tractebel had agreed to purchase the electric power output of the plant for twenty years. The power purchase contract was signed in late 2000, just before construction began. During construction, open market power prices dropped, so that Tractebel could purchase a similar amount of power from other sources at lower prices. So Tractebel repudiated the contract. The parties wound up in court, where it was held that Tractebel’s repudiation was wrongful (i.e., Tractebel was in breach of the contract).

AEP sought damages for the breach, which included lost profits. Tractebel objected, arguing that such damages were consequential and speculative due to the number of assumptions that would be necessary to establish them—assumptions about the price of electricity over the twenty-year contract period, as well as assumptions for the life of the contract about costs of operating the plant, possible changes in regulatory climate, demand for power, and advances in technology.

The court acknowledged that when lost profits are characterized as consequential damages, the plaintiff has a higher burden of proof. He has to demonstrate that the existence of damage is reasonably certain and that the damages were foreseeable and within the contemplation of both parties, and he must prove the amount thereof with reasonable certainty. But, said the court, when the lost profits are general damages, the injured party only has to show a reasonable basis for estimating the loss. Here, the court held, the lost profits damages sought by AEP were a claim for general damages, not consequential damages:

The profits are precisely what the nonbreaching party bargained for, and only an award of damages equal to lost profits will put the non-breaching party in the same position he would have occupied had the contract been performed. … AEP seeks only what it bargained for—the amount it would have profited on the payments TEMI [Tractebel] promised to make for the remaining years of the contract. This is most certainly a claim for general damages.

The court went on to state that when lost profits are general damages, the burden of uncertainty as to the amount of the lost profits is on the party in breach: “A person violating his contract should not be permitted entirely to escape liability because the amount of the damage which he has caused is uncertain” and when the fact of general damages is certain and the only uncertainty is as to the amount, the innocent party only has to provide a “stable foundation for a reasonable estimate of damages.”

As a result, the court did not agree with Tractebel that the number of variables involved in assessing AEP’s claim made any measure of lost profits inherently speculative or provided a sufficient reason to deny relief. Instead, the court said:

The variables identified … exist in every longterm contract. It is not the case that all such contracts may be breached with impunity because of the difficulty of accurately calculating damages.

Accordingly, the court said reasonable assumptions about the open issues could be made, taking into account any evidence introduced and an estimate of the lost profits made based on those assumptions. The risk that the future might show such assumptions to be mistaken, said the court, is appropriately borne by Tractebel as the breaching party.

Turning back to the question posed at the beginning of this article—“Can I recover lost profits because my store wasn’t open due to the roofer’s breach?”—it seems likely that the answer is no; I bargained for a roof, not sales to customers so such lost profits would be considered consequential damages. Therefore, I could recover such lost profits only if the contract actually provided for them.