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18 June, 2020

Do you know what losses you are able to recover from the other side if they are in breach of contract?

Do you know what losses you will be liable for if you are in breach of contract?

Now more than ever you need to evaluate your existing contracts to see how exposed you are in terms of the likely risk of having to pay damages to any other party to the agreement if a breach of contract arises and conversely what losses you are likely to have to pay out for.

You need to know if your exclusion or limitation clauses will stand up to scrutiny - excluding the losses that you intended to exclude or leaving open the door to recovery.

Understanding where the risk lies in the contract is so important, but often overlooked when agreeing to standard terms; normally on the assumption that no dispute will arise. The drafting is crucial for either maximising or minimising recovery depending whether you are the party in breach or the person seeking to recover your losses.

The well-established position

Direct losses such as the costs of rectification and remedial costs will likely be recoverable from the party in breach even where the contract attempts to exclude such losses. That is because, if the losses are not recoverable such that there is no remedy for a breach, the party not in breach will be deprived of all remedy meaning that the terms of the contract cannot be enforced.

The key consideration is whether you will be liable for any other losses.

The Case of Hadley v Baxendale is well-established case law which outlines two considerations as to whether the losses are too remote to be recoverable. If the loss fits into either limb then it is not too remote.

  • Limb One - Are the losses arising naturally from the breach, or in the usual course of things (Direct Losses); or
  • Limb Two - Are the losses such that may reasonably be supposed to have been in the contemplation of both parties, at the time they made the contract, arising as the probable result of the breach (Indirect or Consequential Losses).

As you can see the case gave us a definition of "indirect or consequential losses".

Exclusion or limitation clauses often attempt to exclude indirect or consequential losses - by this the parties often mean financial losses such as loss of profit, loss of opportunity or loss of management time. However, the meaning of "indirect or consequential losses" is open to interpretation by the Courts and the parties - in some cases, loss of profit could be regarded as a direct loss.

The traditional approach adopted by the Courts is to consider whether the loss falls within either limb of Hadley v Baxendale (as outlined above) and to use the definition of "indirect and consequential losses" when considering whether the exclusion is valid. This interpretation does not offer much protection in terms of excluding financial losses such as loss of profit or business interruption as, where they are foreseeable and flow naturally from the breach, these are likely to be considered direct losses.

Adopting a new interpretation of Indirect and Consequential Losses

Judicial commentary has been indicating a need for a change in interpretation for some time, so that the interpretation of "indirect or consequential losses" is more closely aligned with the parties' intention to exclude financial losses aside from rectification costs.

Examples of comments include:

"…the court's task is not to re-shape the contract but to ascertain the parties' intention, giving the words they have used their ordinary and natural meaning."
Transocean Drilling UK Ltd v Providence Resources plc

"The [exemption clause] should be construed on its own wording in the context of the particular agreement as a whole and its particular factual background."

A recent Technology and Construction Court Decision in the matter of 2 Entertain Video Ltd v Sony DADC Europe Ltd has further highlighted a need for change in approach, albeit the losses were held to be recoverable and not excluded. The required change is that:

"…any general understanding of the meaning of 'indirect or consequential loss' must not override the true construction of that clause when read in context against the other provisions in the [contract] and the factual matrix."

The Courts are open to a broader interpretation of exclusion and limitation clauses and have shown a willingness to consider the facts on the matter when determining what is meant by "indirect and consequential" losses and not to stick to the traditional interpretation.

Our Advice

Clear, unambiguous drafting of exclusion and limitation clauses is fundamental to ensuring that the risk allocation you intended is upheld in the event of a dispute. Financial losses, such as lost profits and business interruption costs may not be captured by a generic description of categories of loss. It may be appealing to attempt to exclude broad categories of loss, but the more specific you are, the more likely it is that your intention will be understood by the Courts.

The Courts have indicated a willingness to move away from the narrow traditional interpretation, but this doesn't mean that the loss will be successfully excluded.

Be clear about what liability is accepted and what remedies are to be provided.

For more information contact Lucy Bailey in our Dispute Resolution department via email or phone on 0333 207 0677. Alternatively send any question through to Forbes Solicitors via our online Contact Form.

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