Energy Sector: 'Loss of Profits' and 'Consequential Loss'

A recent decision by the New York Court of Appeals in Biotronik A.G. v Conor Medsystems Ireland, Ltd has caused a stir among legal practitioners in New York. The court held that the lost profits arising from a collateral contract with a third party constituted general (direct) damages and was not exempted by a ‘consequential damage’ exclusion clause. Previously, it was widely thought that all loss of profits would be covered by consequential loss exclusions.

In English law, ‘loss of profit’ has in many circumstances been decided by the courts to be ‘direct loss’. However, Biotronik remains of wider interest as it highlights cross-jurisdictional differences in contractual interpretation and the importance of carefully drafting ‘consequential loss’ exclusion clauses.

Although Biotronik is not an energy industry case, the issues addressed by the New York courts will be of interest to the energy industry where ‘consequential loss’ exclusions are commonplace and lawyers involved in transactions come from differing legal traditions.

‘Consequential loss’ in English law

The general rule under English law for the recovery of damages following breach of contract was set down in Hadley v Baxendale: recoverable damages are those either (i) arising naturally or directly from the breach of contract (‘direct loss’), or (ii) within the contemplation of the parties at the time they made the contract (‘indirect’ or ‘consequential loss’). Other losses are irrecoverable as remote.

The second limb of loss in Hadley v Baxendale covers situations where there is ‘knowledge of special circumstances’ at the time of the contract and a party has therefore been put on notice of a type of ‘exceptional loss’, which would not arise in the usual course of things, that by reason of that notice it has effectively undertaken to bear in the event of a breach.

Exclusion of ‘consequential loss’ in English law

In English law, where a contract exempts liability for ‘consequential loss’, it will normally be interpreted (absent contractual definition) as excepting a party only from such loss as is recoverable under the second limb of the ‘rule’ in Hadley v Baxendale i.e. ‘exceptional loss’ relating to ‘knowledge of special circumstances’.

The English courts have repeatedly made it clear that an exclusion of ‘indirect or consequential loss’ does not exclude ‘loss of profit’ that arises directly and naturally from the breach i.e. loss of profits that a reasonable business man would expect to flow from such a breach in the usual course of events. This will often include losses of profit from collateral arrangements with third parties.

However, it is, of course, open for the parties to agree a wider definition of ‘consequential loss’ if they so elect. For those in the oil and gas industry, this is common practice (see for example: Oil & Gas UK Model Form JOA, AIPN Model Operating Agreement, Crine/LOGIC standard contracts).

Biotronik

The background to the Biotronik dispute concerned a distribution agreement between the parties, under which Biotronik was an exclusive distributor for certain areas of a specialised stent. The dispute arose when Conor Medsystems ceased worldwide distribution causing Biotronik to believe it was entitled to damages for lost profits, despite the contract’s provisions excluding ‘any indirect, special consequential, incidental or punitive damage’.

It seems that New York case law was understood by many practitioners to have previously decided that ‘lost profits’ were ‘consequential damages’ when, as result of the breach, loss is suffered on collateral business relationships. However, in Biotronik the New York Court of Appeals reached a different conclusion.

The agreement in Biotronik contemplated the re-sale of the stents and the contractual price was benchmarked against the re-sale price. On this basis, the contemplation of collateral relationships was found to be the very essence of the contract. The court held that this meant that lost profits were the ‘direct and probable result of a breach and thus constitute general damage’. As general damage, the losses could be claimed by Biotronik because they were not excluded by the exemption clause.

Comment

Unlike in New York law, there has been no tendency under English law to label ‘lost profits’ arising from the existence of relationships with third parties as consequential or indirect damages.

In many cases, in English law, loss of profits under collateral or on-sale arrangements will be naturally flowing from the breach and likely to be direct loss. It will only be where the loss is ‘exceptional’, arising from special circumstances, that the loss is likely to be defined as ‘consequential loss’.

However, the law on this subject remains in transition. Before placing reliance on the ‘rule’ in Hadley v Baxendale to define the meaning of ‘consequential loss’ or on the common law rules on remoteness of damages to limit recoverability, parties should keep in mind the advice of the retired Law Lord, Lord Hoffmann, that: ‘For my own part I think that, although an excellent attempt was made in Hadley v Baxendale to lay down a rule on the subject [i.e. recoverable damages], it will be found that the rule is not capable of meeting all cases; and when the matter comes to be further considered, it will probably turn out that there is no such thing as a rule, as to the legal measure of damages applicable in all cases’.

It therefore remains important, in sophisticated contractual relationships, that the parties should clearly express their intention as to the scope of recoverable loss and exclusions of liability in the contract.