A party seeking to recover damages for breach of contract can recover under two broad categories of loss:
- losses that are the direct and natural consequence of the breach; and
- indirect losses that do not arise naturally in the course of events, but were still contemplated by the parties at the time the contract was entered into
(Hadley v Baxendale ).
Parties to commercial contracts often seek to exclude or limit liabilities for certain types of loss caused by breach. Doing so effectively can be a challenge, however, especially when the phrases “direct” and “indirect” loss are used and the contract seeks to explain what is meant by each.
Excluding and limiting liability for loss of profit seems to cause particular difficulties. This is partly because a loss of profit can be a direct or an indirect loss depending on the circumstances.
A recent English High Court case illustrates the pitfalls.
P entered into a contract to supply products to E. The contract stated:
“Neither party will be liable to the other for any indirect or consequential loss, (both of which include, without limitation, … loss of profit).”
The contract capped liability for any direct loss at £1 million.
P alleged that E had breached the contract by buying fewer of the products than it was obliged to buy. P claimed for loss of profits of just over £2 million.
E argued that the exclusion clause should be read as if all claims for loss of profits were indirect losses and therefore excluded.
The court held that the most likely damage that P would suffer from E’s failure to buy the products was a loss of profits. In other words, it was a direct loss under Hadley v Baxendale principles.
The court held that the exclusion clause did not exclude liability for a direct loss of profits. However, the cap of £1 million for direct loss would apply.
The court reasoned that the words “loss of profits” in the exclusion clause were subordinate to the preceding words “indirect or consequential loss”. The words “loss of profits” acted as an explanation of what could be an indirect or consequential loss. It was not an attempt to place a direct loss in the indirect category.
If the parties had intended to abandon a claim for direct loss of profits, clear language should have been used in the contract. If all loss of profits claims were to be deemed indirect, the parties could have easily included this term.
This interpretation was more consistent with business common sense, said the court, as it was unlikely that the parties had intended to abandon a claim for direct loss of profits. If E were correct, the effect would be to exclude all possible claims for indirect or direct loss of profit. That in turn would reduce the contract to a non-binding statement of intent.
The lesson is clear. As a loss of profit can be an indirect or direct loss, if parties want to exclude all loss of profit claims, the clause must be clearly drafted to say so – bearing in mind the risk that the contract may then be reduced to a non-binding statement of intent.
On January 21, 2015