Settling the terms of a construction contract and consequential loss

Considers ability of principal contractors to limit liability under construction contracts.

Everyone here will have attended a negotiation to settle the terms of a contract, or seen a contract or a clause in a contract, where one party attempts to exclude liability for what is referred to in the discussions or the contract as ‘consequential losses’ that arise from a breach of the contract.

In a construction context, it might be that a contractor purports to exclude liability for ‘consequential losses’ arising from:

  • a failure by it to construct works within the time frame required by the contract; or
  • a failure, in a design and construct contract, for the design to be fit for purpose; or
  • defects in the construction, particularly where the contract relates to the construction of an item of plant or machinery that the other party uses or needs to use to generate profits.

I intend to address the question as to what is meant by ‘consequential losses’, especially given the terms of a recent decision in the Victorian Court of Appeal about that very issue.

This paper is intended to signpost the issues that you need to be aware of when assessing, from either side, the extent of that potential exclusion.

Old rule

Before the recent Victorian Court of Appeal decision, Australian courts generally took the view that a term of the contract that purported to exclude a party’s liability for ‘consequential losses’ operated to exclude losses that fell within the second limb of the rule in Hadley v Baxendale.

The rule governing the recovery of damages for a breach of contract is accepted as having been stated in Hadley v Baxendale, and is to the following effect:

Where two parties have made a contract which one of them breaches, the damages which the other party ought to receive should be:

  • such as may fairly and reasonably arise  naturally from the breach (limb 1); or
  • such as may reasonably be supposed to have been in the contemplation of the parties at the time they made the contract as the probable result of a breach of the contract (limb 2).

This meant that Australian courts equated ‘consequential losses’ with damages falling within limb 2.

This meant that if a party managed to persuade a court that losses arose as a reasonable and natural consequence of any breach of contract (that is, they fell within limb 1) they would be entitled to recover them despite the existence of an exclusion clause for consequential loss, as the exclusion wouldn’t apply.

On that premise, many cases dealt with the question about whether a loss arose naturally from a breach of contract (a limb 1 loss) and was claimable despite the existence of the exclusion for ‘consequential loss’.

In that regard, loss of profits was generally the type of claim that was most often contested.  There were many cases where loss of profits was classed as ‘arising naturally’ (a limb 1 loss) because a plaintiff was able to show that they arose as a natural or proper consequence of the breach.  By virtue of that, loss of profits classed that way were held claimable despite the existence of an exclusion clause for ‘consequential loss’.

Equally many were held not to fall within limb 1, and the true position always depended on the relevant facts of each case.

New rule - Envrionmental Systems v Peerless Holdings Pty Ltd

The Victorian Court of Appeal, however, has held that that interpretation of ‘consequential losses’ is incorrect.

It said that the phrase ‘consequential losses’ should be given its natural and ordinary meaning as would be understood by ordinary reasonable business persons.

In ascertaining what that was, the Court of Appeal focussed on a distinction between  what it described as a ‘normal’ loss as opposed to a ‘consequential’ loss, instead of applying the distinction between  a loss falling within limb 1 of Hadley and Baxendale and a loss falling within limb 2 of Hadley v Baxendale.

It determined that a ‘normal’ loss was a loss that every plaintiff in the same situation would suffer, and that a ‘consequential’ loss is anything beyond a ‘normal’ loss. In that respect, it made specific reference to ‘consequential losses’ being lost profits or additional expenses incurred as a result of the breach.

This, of course, considerably widened the scope of what could constitute a ‘consequential  loss’ within the meaning of that phrase in any term of a contract, and by virtue of that, widened the scope of the exclusion.

Facts

To illustrate by reference to the facts, the case involved a contract for the construction and supply of an item of plant that the plaintiff intended to use as part of its larger recycling operations.

The item of plant in question was intended to upgrade the recycling operations and make it less costly to run.

The item of plant was supplied and installed but, ultimately, after much effort, would not operate in the manner intended.

The plaintiff ultimately removed the offending item and reverted to its old system.

The plaintiff claimed losses said to have arisen from the failure of the item of plant – including  the additional running costs it incurred in having to revert to the old system in addition to the costs of its attempts to make the new item of plant work as intended.

Although the Judge at first instance found that the supplier/manufacturer  of the item of plant was liable for those costs on the basis that they fell within limb 1 of Hadley v Baxendale (and were not, thereby, caught by the ‘consequential  loss’ exclusion) the Court of Appeal reversed that decision and found that those costs were ‘consequential losses’ within the meaning of that term, properly construed. As a result of that finding, the contractor/manufacturer  of the item of plant was entitled to the benefit of the exclusion clause, and was found not to be liable for those losses.

The Court of Appeal, rightly, said that those claims were not claims for ‘normal losses’.

Normal losses were simply the losses suffered in purchasing, installing and commissioning the item of plant.

Conclusion

That’s an example of how those tests can be applied on the facts of that case, but in respect of any other case, one must assess the position individually to determine what is a ‘normal loss’.

Those questions will ultimately depend on an assessment  of:

  • the particular plaintiff;
  • the nature of the breach of contract in question and the background to it; and
  • the circumstances giving rise to the losses claimed;

meaning that the scope of the new test still remains somewhat uncertain.

In that context, and from a practical perspective, when drafting these types of clauses, a contractor should specify with as much accuracy as possible the types of losses that it may wish to exclude liability for. Specific references to losses such as loss of profits, loss of revenue, loss of production, loss of use and loss of opportunity should be considered.

On the other side of the coin, a principal should be looking to do the opposite, and ensure that a provision is inserted that stated something to the effect that:

‘consequential losses do not include ….. ‘

Either way, clauses purporting to exclude liability for consequential losses need to be carefully considered.