You don’t know what you’re missing

(a). Introduction

Many contracts contain an exclusion clause barring the recovery of “consequential damages” in the event of a breach. This term of art has become so ubiquitous that we might not stop to think about what it means. If you do stop and think about it, you may find the meaning is not easy to nail down.

When dealing with the risks of contract interpretation in litigation, such ambiguity and uncertainty spell trouble. In this article, we take a look at the most commonly adopted definitions of “consequential damages” and consider how to minimize confusion and mitigate risk when contract drafting.

(b). Consequential damages mean what exactly?

For dealmakers and businesspeople, “normal” damages are often thought of as the difference between the market value of the goods or services that ought to have been provided under the contract and the value of those which were in fact provided. For example, if Seller contracted to provide 100 widgets but delivered only 80, Buyer would “normally” be entitled to the value of 20 widgets. Consequential damages are understood to be any loss – typically, any economic loss – beyond this “normal” value, such as lost profits or incurred expenses.¹

The Alberta Court of Appeal adopted a similar approach in Dow Chemical Canada ULC v NOVA Chemicals Corp, a case about the breach of an ethylene production contract. The court held that in a contract for the delivery of a product, the loss of the value of the product is the direct damage, while anything above that value is prima facie consequential damages. The court then examined the specific contract as a whole, in light of its purpose and commercial context, to confirm that Dow Chemical’s downstream profits in fact constituted consequential damages.²

The court accordingly found the defendant liable for the value of the ethylene which, in breach of the contract, the defendant failed to provide. On the basis of a clause excluding liability for consequential losses, however, the defendant avoided liability for lost profits for the sale of polyethylene, which was the end-product for which the ethylene was being provided.

Most Canadian courts, however, have hewed closely to the venerable tradition of Hadley v. Baxendale. That case, familiar to law students across the country for the last 150 years, arose out of Baxendale’s failure to deliver Hadley’s broken steam engine crankshaft to a repairman with sufficient haste. Without the crankshaft, Hadley’s mill ground to a halt (pun intended) and he sued to recover the profits that he had lost due to the delay.

In ruling on Hadley’s claim, the 1854 Courts of Exchequer declared that the recoverability of damages for breach of contract is governed by the principle of foreseeability. In short, under the common law, only foreseeable damages are recoverable. Consider this principle against the purpose of an exclusion clause, which is to contract around this common law rule by limiting a party’s potential recovery even further.

Hadley set forth two types of foreseeable damages:

• The first type is “the amount of injury which would arise generally” in similar cases. These damages are commonly known today as “direct” or “general” damages. They are always foreseeable.
• The second type is any “injury which would ordinarily follow from a breach of contract” only due to the special circumstances in which the parties found themselves. This category is often known as “indirect” or “special” damages. Such damages will be deemed foreseeable only if the special circumstances that caused the loss were previously communicated to the other party.³

Until Dow Chemical, most Canadian courts have taken the view that “consequential damages” are synonymous with these “special circumstances” damages in Hadley. To determine whether a particular loss constitutes “consequential damages”, a court following this approach will examine the facts to see if the loss arose from special circumstances, as opposed to the “usual course of things.”⁴

But not all Canadian courts have agreed with this reasoning. A minority of cases have interpreted “consequential damages” in terms of causation instead of foreseeability. Under this framework, consequential damages are deemed to be those losses that are causally removed from the original breach – typically because they result from the direct damages of the breach rather than from the breach itself.⁵

(c). Where we go from here

The different approaches to consequential damages in the courts create significant uncertainty for deal lawyers and their clients about how a given court would likely interpret a “consequential damages” term, should a dispute later arise over the application of the exclusion provision.

Careful contract drafting can help mitigate the risk of unexpected judicial interpretations. A strong solution is to provide a clear definition of “consequential damages” in the contract itself. Any definition should precisely delineate the types of loss that fall within the scope of the term. Alternatively, the parties could omit the term from the contract altogether and replace it with plain language describing the types of specific damages that fall within the scope of the exclusion clause. Either way, it is preferable to take a proactive approach and signal the parties’ intended meaning so that litigators and courts are not struggling to piece together what the parties meant by the words of their contract.

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Jason Annibale is a partner and Emily Hush is a legal consultant with McMillan.