Understanding consequential loss

It is apparent from the Consequential Loss Guide that in every country surveyed there are doubts about the scope of the meaning of the words ‘consequential loss’ when used in such clauses.

Examples of these widely used clauses:

1. The BP Oil International Limited General Terms & Conditions for Sales and Purchases of Crude Oil, used in global oil sales, state “...in no event, ... shall either party be liable to the other… in respect of any indirect or consequential losses or expenses …”.
2. The FIDIC Silver Book provides: “Neither Party shall be liable to the other Party for loss of use of any Works, loss of profit, loss of any contract or for any indirect or consequential loss or damage which may be suffered by the other Party in connection with the Contract, other than under…”
3. The Shipbuilders’ Association of Japan standard form shipbuilding contract states: “The BUILDER shall have no responsibility or liability for any other defects whatsoever in the VESSEL than the defects specified in Paragraph 1 of this Article. Nor the BUILDER shall in any circumstances be responsible or liable for any consequential or special losses, damages or expenses including, but not limited to, loss of time, loss of profit or earning or demurrage directly or indirectly occasioned to the BUYER by reason of the defects specified in Paragraph 1 of this Article or due to repairs or other works done to the VESSEL to remedy such defects”.

In addition, some of the international model form agreements also have ‘consequential loss’ exclusions in the arbitration clause. The AIPN Model Dispute Resolution Agreement (2017) states that: “The Parties waive their rights to claim or recover, and the [Arbitral Tribunal] [Arbitrator] shall not award, any consequential, punitive, multiple, exemplary, or moral damages…”.

The implications of such drafting might not be immediately apparent to non-aficionados of international arbitration. However, two key issues arise:

• First, if an arbitration clause requires an arbitrator “shall not” (or similar) award damages for consequential loss the issue arises as to whether the arbitrator lacks jurisdiction to do so. If an arbitrator lacks jurisdiction to award ‘consequential loss’, damages awards that are not subject to appeal on error of law might otherwise be appealable on jurisdictional grounds.  
• Second, as the arbitration agreement is severable it may be governed by a different law than the main body of the contract. If the main body of the contract and an arbitration clause each contain consequential loss exclusions, it is possible that different laws governing interpretation of those words could apply.  

Sir Kim Lewison sets out, in his seminal text The Interpretation of Contracts, “[w]here a contract excepts one party for liability for consequential loss, it will normally be interpreted as excepting him from such loss as is recoverable under the second limb of Hadley v Baxendale”.

Hadley v Baxendale (1854) 9 Exch. 341 decided that, as a matter of law, an innocent party may recover for breach of contract:

• First, losses that may fairly and reasonably be considered to arise “naturally”, i.e. according to the usual course of things from the breach of contract (the ‘first limb’ of Hadley v. Baxendale); and
• Second, 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 of it (the ‘second limb’ of Hadley v. Baxendale). 

It is not entirely clear at what point the second limb of Hadley v Baxendale became commonly referred to as ‘consequential loss’, or the context in which this arose. However, a series of English Court of Appeal decisions confirmed the approach that ‘consequential loss’ in a contractual exclusion clause would be considered, by English law, to mean the second limb of Hadley v Baxendale.

As far back as 1894, the United States Supreme Court accepted Hadley v Baxendale as “a leading case on both sides of the Atlantic” concerning the recoverability of losses.

The commentary to the Restatement (Second) of the Law of Contracts explains that: “The damages recoverable for loss that results other than in the ordinary course of events are sometimes called ‘special’ or ‘consequential’ damages. These terms are often misleading, however, and it is not necessary to distinguish between ‘general’ and ‘special’ or ‘consequential’ damages for the purpose of the rule stated in this Section.” It is evident from the Restatement (Second) of the Law of Contracts that in the law of most United States jurisdictions the second limb of recoverable damages is also “sometimes called” consequential loss.  There is a series of United States cases that follow the traditional English approach of applying this interpretation to exclusion clauses using the words ‘consequential loss’.

Until recently, the foregoing traditional approach appeared to be settled law in most common law jurisdictions. In addition to being the law in England and most United States jurisdictions, the traditional approach appears to have been adopted at some point in most other common law jurisdictions. For example:

1. Singapore still follows the traditional English law approach.
2. India still follows the traditional English law approach.
3. Scotland’s law has largely evolved in concert with that of England.
4. Hong Kong generally follows the traditional English law approach.
5. Australia used to follow the traditional English law approach until recently.

The foregoing traditional approach to equating ‘consequential loss’ in an exclusion clause to the second limb of Hadley v Baxendale was questioned, but not resolved, by Lord Hoffmann in Caledonia North Sea Ltd v British Telecommunications [2002] UKHL 4 where he reserved his position on the question as to whether “the construction adopted by the Court of Appeal was correct”.

The traditional approach was overturned by the Victorian Supreme Court (Court of Appeal) in Environmental Systems Pty Ltd v Peerless Holdings Pty Ltd [2008] VSCA 26.  In Regional Power Corporation v Pacific Hydro Group Two Pty Ltd [2013] WASC 356 the Western Australian Supreme Court went on to state that the “natural and ordinary meaning of the words [consequential loss] begins with these words themselves, assessed in their place within the context of the [contract] as a whole”.

The English courts have not yet followed Australia. There is obiter dicta to suggest at least some judges are sympathetic to the Australian approach. Two recent cases that questioned the traditional approach in England are Transocean Drilling UK Ltd v Providence Resources plc [2016] EWCA Civ 372 and the Star Polaris [2016] EWHC 2941 (Comm). However, in 2 Entertain Video Ltd & Ors v Sony DADC Europe Ltd [2020] EWHC 972 the High Court subsequently applied the traditional approach in the context of a ‘consequential loss’ exclusion clause.  

As a general rule, the analysis above in relation to common law jurisdictions’ approach to ‘consequential loss’ in exclusion clauses does not readily transpose to civil law jurisdictions.

According to Article 1231-4 of the French Civil Code, damages for contractual breach are limited to damages that are the immediate and direct consequence of the breach. Under French contract law, establishing whether the loss is direct or indirect is a matter of causal link.

Notwithstanding the above, ‘consequential loss’ clauses are used in contracts governed by French law. For example, the FIDIC contract wording literally translates ‘indirect or consequential loss or damage’, as “la perte ou le dommage indirect ou consequent”.

French law doctrine has tried to propose definitions of consequential damage in order to conceptualise and clarify its various uses under French law. Two main meanings have been identified:

• First, a purely legal definition of consequential damage refers to ‘second degree’ damage, i.e. which is directly even though not immediately connected to the causal event, as opposed to indirect (or remote) damage. As such ‘consequential loss’ would be loss that is recoverable according to Article 1231-4 of the French Civil Code that the parties may elect to exclude. 
• Second, the concept of consequential loss refers to economic losses. As such, consequential loss is a specific kind of intangible damage (including for instance the lucrum cessans under Article 1231-2 of the French Civil Code). In these circumstances, whether causation is direct or indirect is irrelevant.

As such, a case-by-case analysis is necessary, applying the above rules of interpretation, to establish the proper meaning of ‘consequential loss’ when used in a French law contract. Therefore, the use of the words in the context of a French law contract remain problematic.

German law does not explicitly recognise the terms ‘consequential loss’, ‘direct loss’ or ‘indirect loss’. Notwithstanding the above, contractual exclusions of liability clauses using German law regularly seek to exclude ‘consequential loss’ without defining what is meant. Court decisions on the interpretation of the meaning of consequential losses are very limited in number and not always coherent.

The federal supreme court (Bundesgerichtshof) and a higher regional court (Oberlandesgericht) ruled in the 1990s that, in a contract which is subject to German law but written in English, terms such as ‘consequential loss’, which have a specific meaning in English law, will generally be construed according to English law principles.

Whether the above rulings of the German courts would still apply today is unclear, as the underlying assumptions have been criticised by prominent scholars. An alternative approach would be to equate ‘consequential loss’ with the concept of Folgeschäden (literal translation “consequential damage”) or mittelbare Schäden that has developed in German law. It is generally agreed that costs to repair (or replace) damaged property or to heal an injured person are direct losses and not Folgeschäden or mittelbare Schäden and therefore not excluded as consequential loss.

Portugal, Brazil and Angola do not have the concept of ‘consequential loss’ embedded within their legal framework. However, the concept remains widely used in exclusion clauses.

Under Articles 562 and 564 of the Portuguese Civil Code (“PCC”), a party causing loss or damage to another has the obligation to compensate the injured party for damage suffered (danos emergentes) and loss of profits (lucros cessantes) that the non-defaulting party probably would not have suffered if the breach of contract had not occurred. The position is substantially the same in Articles 562, 563 and 564 of the Angolan Civil Code (“ACC”) and Article 402 of the Brazilian Civil Code (“BCC”).

The terms ‘indirect’ and ‘consequential’ are generally used interchangeably. This, perhaps, is a result of a common law drafting tradition. Although indirect loss is not defined by the PCC, ACC or BCC, it is widely understood to mean loss that is indirectly caused by the breach as a matter of causation.  As there is only an obligation to pay damages for ‘direct loss’, it is arguable that such an exclusion adds nothing to the position at law. Although many in the industry associate the term with lucro cessante (loss of profit) there is no obvious jurisprudence to support this approach.  

The words ‘consequential loss’ have no given or recognised meaning in Peruvian, Colombian, Chilean or Mexican law. Article 1558 of the Chilean Civil Code; Article 2110 of the Mexican Federal Civil Code, Article 1321 of the Peruvian Civil Code and Article 1613 and 1616 of the Colombian Civil Code state that only ‘direct damages’ resulting from a breach of contract may be claimed.

As a consequence, there is uncertainty as to how an exclusion of ‘consequential loss’ should be treated in meaning or effect. In the Colombian energy sector ‘consequential loss’ is often associated with lucro cesante (loss of profit). However, it should not be assumed that it will be given that meaning as there is no clear jurisprudence on the issue. In Chile and Peru, it seems likely that ‘consequential loss’ will most likely be associated with ‘indirect damage’, which is not recoverable in law in any event. However, again, there is no clear jurisprudence on the issue. 

On the basis of the above analysis, it might be assumed that civil law jurisdictions in the Asia Pacific region follow civil code jurisdictions elsewhere. However, the issue is more complex.

Article 416 of the Japanese Civil Code allows a party to seek “damages which arise from any special circumstances if the party should have foreseen such circumstances”. This wording has its origin in the second limb of Hadley v Baxendale. It is not clear from jurisprudence whether ‘consequential loss’ in an exclusion clause would be equated to such special circumstances (or damages).

In turn, the South Korean Civil Act is modelled on the Japanese Civil Code. As such, the conceptual approach of Hadley v Baxendale has also made its way into South Korean law through the concept of ‘special loss’.  Absent clear jurisprudence, Korean law will be faced with the same conundrum as Japanese law as to whether ‘consequential loss’ should mean the second limb of Hadley v Baxendale or something else. 

China takes an entirely different approach. As with many other civil law jurisdictions, the words ‘consequential loss’ in China have no attributed legal meaning. Whilst its use should be avoided, it is possible that it would be given a wide interpretation to include loss of profits in all material types. 

In addition to the above, the Consequential Loss Guide also covers a variety of associated issues such as the relationship between the words ‘consequential loss’ and the scope of other heads of loss also excluded by the clause. The Consequential Loss Guide is available at: https://cms.law/en/int/expert-guides/cms-guide-to-consequential-loss-clauses-in-the-energy-sector

The Consequential Loss Guide demonstrates that the governing law will have an important impact on the construction and interpretation of a consequential loss exclusion clause, so careful thought should be given to using model form clauses in jurisdictions where the concept does not readily translate.

The authors would like to thank the numerous lawyers at CMS that contributed to the Consequential Loss Guide.