What is indirect and consequential loss?

Last updated: 27 March 2020

Estimated reading time: 19 minutes

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Exclusion clauses are some of the most important provisions in any commercial contract and form the backbone in determining the loss suffered if in breach of contract. The success or failure of an exclusion clause can often be based on how to draft an exclusion clause to ensure that all the intended losses are excluded. Regularly, an exclusion clause includes reference to indirect or consequential loss.

In this guide we’ll consider the meaning of consequential loss and how to effectively draft an exclusion clause.  

This guide will cover:

  1. What is consequential loss in contract law?
  2. What is the difference between a direct and indirect loss?
  3. Case Law Examples of consequential loss
  4. What are examples of consequential damages?
  5. What is a consequential loss exclusion clause? And why is it important?
  6. How an exclusion clause should be drafted?
  7. How to bring a consequential loss claim if required

What is consequential loss in contract law?

Consequential or indirect loss in contract law means an unusual sort of loss that arises from a special circumstance of the case, and not in the usual course of things. This loss suffered cannot be predicted, and consequently, it is recoverable only if the party knew or should have known of the circumstance of the loss when they made the contract. This definition is known as the second limb of the rule in Hadley v Baxendale [1854] EWHC Exch J70.

The court position is that the meaning of consequential or indirect loss can only be dictated in the context of a specific contract. This is because each contract is different and as a general principle the correct interpretation of a contract term is what a reasonable person would understand by it. The courts recognise that words take their specific meaning from their context and that the same word may mean different things in different documents. Accordingly, a consequential clause will be viewed in the context of the contractual liability as a whole and will not be interpreted in isolation.

This position however leaves a great level of uncertainty as to whether a loss could have been reasonably contemplated at the time that a contract was entered in to. As a result, it is very important that a consequential clause is drafted clearly and both parties can understand specifically those losses that will be recoverable.

What is the difference between a direct and indirect loss?

To be able to assess potential losses, which may arise from a breach of contract, it is important to understand the distinction between direct and indirect or consequential loss.  

The case, which sets out the explanation of direct and consequential/indirect loss is in Hadley v Baxendale [1854] EWHC Exch J70. In this case, the Court of Appeal said that losses which flow from a breach of contract fall into two ‘limbs’:

  • Direct loss (first limb) is a loss which arises as a direct and natural result of a breach, and in the ordinary course of events.

This means that the loss is flowing naturally from the breach. For example, A buys a car from B intending to use it immediately to drive to Folkestone, Kent. The car breaks down on the way to Folkestone. The costs for the necessary repairs of the car is a direct loss and A is entitled to claim the repair cost. 

  • Indirect or consequential loss (second limb) is a loss which arises from particular and unusual circumstances that the parties knew or should have known about at the time the contract was entered in to, and do not flow naturally from the breach.

This means that damages suffered by the innocent party are limited to damages that are reasonable in the circumstances, and rule out those damages that are too remote. For example, suppose that A’s intention was to drive the car to Folkestone to get the Eurotunnel to France for a family holiday. Because the car broke, A does not reach the Eurotunnel in time before departure. Although A can claim for the car repairs, they are unable to claim for the cost of the lost holiday, because B (the seller) knew nothing of the pre-planned holiday or the consequences of the mechanical breakdown. If B was aware of the pre-planned holiday or the mechanical breakdown before or at the time of the sale contract for the car, A might have been able to claim the cost of the holiday too.  

A consequential clause is a common way of excluding risk in a contract. As such, many parties believe that excluding liability for consequential or indirect losses will not lead to financial losses. However, as demonstrated in the above examples, if the loss is direct, a clause excluding liability for consequential or indirect loss will be ineffective to exclude that liability.

Case Law Examples of consequential loss

The case law examples bellow illustrate how the courts interpreted the meaning of consequential loss and how they distinguish between direct and indirect/consequential loss. They also serve as a benchmark in understanding how critical it is when drafting a contract:  

  • To study the exact wording of the contract carefully
  • To assess what losses might occur before drafting a contract
  • To clearly define within the contract what constitutes breach  

Watford Electronics Ltd V Sanderson CLF Ltd [2001] EWCA Civ 317

A contract for the supply of bespoke integrated systems between Watford and Sanderson included a clause purporting:

  • To exclude any liability for indirect or consequential loss. The clause read as follows:

‘neither the company nor the customer shall be liable to the other for any indirect or consequential losses whether arising from negligence or otherwise. In no event shall the company’s liability under the contract exceed the price paid by the customer to the company for the equipment connected with the claim’

  • To limit liability in a general sense to the price paid under the contract

The system was faulty, and the claimant sought damages for breach of contract, for loss of profits, the increased costs of working, and reimbursement of the costs of a replacement software system.

The court discussed the question and whether it was fair and reasonable when the contract was made to include a term which sought:

  • To exclude contractual claims for indirect and consequential losses
  • To restrict loss directly and naturally resulting in the ordinary course of things, from breach of warranty to the price paid for the equipment

The decision of the court was that the clauses were fair and reasonable having being negotiated by two experienced business people who were of equal bargaining power. The court concluded that it will not interfere with contracts that both parties had substantial understanding of the agreement which they had made. The court will only interfere if is satisfied that one party, had taken advantage of the other.                                                                  

Ferryways NV v Associated British Ports [2008] EWHC 225 

The chief officer of Ferryways was killed by the negligence of an employee of subcontractors engaged by the Associated British Ports (ABP). Ferryways, sought to recover an indemnity from ABP in respect of sums paid to the chief officer’s next of kin.

Ferryways relied on an exclusion clause that stated:

‘shall have no liability to in contract, tort, negligence, breach of statutory duty or otherwise for any loss, damage, costs or expenses of any nature whatsoever incurred or suffered by Ferryways which is of an indirect or consequential nature including without limitation …. the liabilities of the Customer to any other party.’

The court examined whether the meaning of the ‘indirect and consequential loss’ had been altered by the words ‘including without limitation’. The judge decided that the additional words did not alter the meaning or extend the protection provided by the clause.

In this instance, the parties were merely identifying the type of losses which can fall within the scope of an exemption clause, so long as the losses were of an indirect or consequential nature. The words ‘including without limitation’ were not sufficiently clear to extend the liability to the losses claimed.

This case highlights the danger of misusing the words ‘indirect and consequential loss’ in an exclusion clause. It also established that clear words will be required to exclude additional types of loss.

GB Gas Holdings Limited v Accenture (UK) Limited and Others [2010] EWCA Civ. 912                      

The parties entered into a contract where Accenture agreed to design, supply, install and maintain a new IT system for GB Gas Holdings Ltd (GB Gas). The system included an automated billing system.

Under the contract, in the event of breach of warranty by Accenture, Accenture was under an obligation to make an effort to remedy the defect, depending on whether the breach was a fundamental defect or a material defect. The contract defined ‘fundamental defect’ as any fundamental breach of warranty provisions which causes severe adverse effect on GB Gas, and ‘material defect’  as a breach of warranty provision, which has or likely to have an adverse effect on GB Gas.

Accenture refused to take action after GB Gas notified them of certain alleged fundamental defects in the billing system. Under the contract, liability for the following was excluded:

  • Loss of profits or of contracts arising directly or indirectly
  • Loss of business or of revenues arising directly or indirectly
  • Loss of damages to the extent that they are indirect or consequential or punitive

 At a preliminary hearing, the Court of Appeal upheld the High Court’s finding that each items of loss (Gas distribution charges, compensation paid to customers, additional borrowing charges, cost of chasing debts and additional stationery and correspondence costs) was direct and therefore recoverable under the contract.

This case serves as a reminder that:

  • When a contract is breached, the courts will put the innocent party in the position they would have been in had the contract been performed
  • When drafting a contract it is vital to be as precise as possible about the types of loss that will and will not be recoverable
  • It is advisable to prepare a list of all foreseeable losses and agree with the other party which of those losses are recoverable if things go wrong
  • Items of potential loss, for which there is no intent to assume liability, should be excluded

What are examples of consequential damages?

Under contract law when there is a breach of contract, the injured party is entitled to compensation for losses as a result of that breach. To determine an entitlement to damages arising from another party’s breach of contract, the injured party must demonstrate that the loss:

  • Was caused by the other party’s breach of contract
  • And is not too remote

In order to determine that a loss was not too remote, a party must establish that the loss was foreseeable. As discussed above, Handley v Baxendale recognises two main categories of damages in establishing whether a category of loss is foreseeable. Those are direct and indirect/consequential damages.

Direct damages are losses resulting directly from the breach and are reasonably foreseeable. Direct damages will typically include any costs associated with the actual completion or correction of the work as agreed in the contract. These are relatively easy to prove, and their purpose is to place the injured party in the same position they would have been in had the contract been performed.

Consequential damages arise when a party fails to fulfil their obligations under the contract and the other party suffers damages as a result. It is of greatest importance to understand that this goes beyond direct damages and that consequential damages expand outside the terms of the contract and arise as a result of a special circumstance of the case.

This means that:

  • The loss is within the reasonable contemplation of the parties. This principle applies even though the extent of such loss is far greater than the parties would have contemplated. For example, a herd of pigs become ill with a serious disease as a result of a faulty pig-nut silo. In the ordinary course of events only a relatively minor illness might have been expected as a result. The court held that it would not limit the liability because it was reasonable to suppose that the parties would have contemplated at the time of the contract that, in the event of the silo being defective, there was a serious possibility of illness and even death among the pigs.
  • The loss must be foreseeable not merely possible. For example, a contract for the carriage of sugar was delayed by nine days. The marked price of the sugar dropped following the late arrival of the sugar. In this instance the parties must have known that market prices fluctuate and the losses were in the reasonable contemplation of the parties as a possible result of a breach.
  • The loss must be foreseeable at the date of contracting not at the date of breach. For example, A is importing goods and resells them to B. C, is acting as an intermediary between A and B, and responsible for issuing letters of credit. By mistake C sent a letter to B demonstrating that A was gaining 19 percent mark-up on each transaction. B ends the contract with A. A suffers loss of the opportunity to make future profits from its agreement with B. As a result, A claimed four years loss of profit from C. In this instance the court decided that four years is not very remote to claim damages for the loss of future profit, since it is demonstrated that the damages arise naturally and were a reasonably predictable consequence of the actions that brought the breach of contract. 
  • Knowledge is of two kinds:

Imputed knowledge

First is the knowledge that all reasonable people are assumed to know the kind of loss which is liable to result from breach in the ordinary course of things. This is also known as imputed knowledge and includes information about the type of business that the parties run, market prices, business practices and requirements of the trade they’re involved in.

Actual knowledge

Second is the knowledge of special circumstances which may cause a greater loss, known as actual knowledge. This includes special circumstances which are not typical from one business to another. Special circumstances are those made clear to the parties and accepted in the contract with that knowledge.

For example, because of the late delivery of a boiler to your laundry business, you lose a lucrative contract with A. In such an occasion, you will be able to recover the ordinary loss of profits, but not those which would have resulted from the contract with A. Those would have only been recoverable if the boiler engineer knew, or could have reasonably expected to know, about the possibility of a contract with A at the time of entering into the contract.  

What is a consequential loss exclusion clause? And why is it important?

A consequential loss exclusion clause is a contractual clause that limits liability by seeking to protect the parties from disproportionate and unbudgeted exposure to losses if something goes wrong. Its aim is to safeguard the parties from special types of losses that have been made known to the party in breach.

When drafting a clause in a contract it is important to reduce exposure to a risk. By excluding liability for consequential loss, you protect your business from an unwelcome result.

If there are objections to the exclusion of a consequential loss, usually it is because there are concerns. The objections are an opportunity for the parties to open a dialogue to discuss and communicate their concerns at an early stage – during the negotiations stage of the contract.

This approach is not free from risks but simultaneously brings clarity. It also allows the parties the opportunity to mitigate or distribute the risk. Depending on the individual contract, it is possible that the risk can be addressed by adjusting the contract price, by obtaining insurance cover or can be easily controlled by one of the parties.

Admittedly, to determine in advance what will amount to consequential loss it is not always easy.  In addition, as discussed above in the case law examples, the second limb of the Hadley v Baxendale test is open to interpretation by the court, which makes the meaning of a consequential loss exemption clause unpredictable.

However, the unpredictability of consequential loss does not mean that it will be always be recoverable by the claimant. The claimant will only succeed if they can prove breach and causation, overcome the obstacle of remoteness, and show that they have taken adequate steps to mitigate their loss. The more unexpected the loss is, the safer the defendant is likely to be.

On the other hand, if the potential loss has been discussed during the negotiations of the contract, then it might fall within the reasonable contemplation of the parties. If that’s the case then it is likely that the defendant will be liable for damages because the risk has been brought to a party’s attention.

Therefore, the most important factor of a consequential exclusion clause is that the claimant will have considerable hurdles to overcome before they can enforce a claim for consequential loss.

How an exclusion clause should be drafted?

The aim of an exclusion clause in a contract is to exclude a party’s liability for certain type of losses. For this reason, a well drafted exclusion clause is crucial in any contract, as it will provide clarity. A badly drafted exclusion clause is left to the court to interpret its meaning. As a result, a party might be left exposed to unanticipated liabilities.

It is paramount to consider the following points if you would like to reduce the opportunity for an exclusion clause to be challenged:

  • Clear and unambiguous wording is essential. If ambiguous and open to interpretation, any doubt as to its meaning may be decided against the party seeking to rely on it. Be wary of words like ‘other’ and ‘including’, which may have limiting effect on an exclusion clause. Consider using the word ‘indirect’ or ‘indirect / consequential’ rather than ‘consequential’ alone to describe loss, as commercial parties are more likely to understand the meaning of the clause if you do.
  • Bring an exclusion clause to the others party’s attention. Do not try to hide or bury an exclusion clause.  
  • Clearly identify the liability you would like to exclude. It is advisable to consider what liability you would like to exclude before you start drafting your contract. The two limbs of direct and indirect consequential loss, as explained in Hadley v Baxendale above, need to be considered carefully. As a result, you might need to consider if you want to exclude certain direct loss, such as direct loss of profit, in parallel with an exclusion of consequential loss.
  • List precisely the categories of loss you will not be responsible for (if possible). The liability in question needs to be incorporated into the contract and covered by a clause in the contract.
  • Break down the issues. Consider using separate clauses which break down the issues to be easily understood by the parties.
  • Express obligation. It’s advisable to discuss the possibility of inserting an express obligation for the parties to obtain insurance cover.
  • Statutory Controls. Contemplate if the impact of Unfair Contract Terms Act 1977 (UCTA) can be minimised or avoided altogether. UCTA imposes restrictions of liability for breach of express and implied contractual obligations. For example, Section 3 of UCTA prevents the use of an exclusion clause which excludes liability for breach of contract or claims to permit a contractual performance substantially different from what is expected or allow claims of no performance.

How to bring a consequential loss claim if required

If you decide to bring a consequential loss claim, you must follow the Civil Procedure Rules (CPR). The CPR sets forth information about the pre-action protocols, Alternative Dispute Resolution (ADR)  options and the procedures to follow if you decide to file a litigation claim. Before filling your claim and provided you established that there is a breach of contract, you should consider the following:

Dispute Resolution Clause

When dealing with a contract dispute your first action is to carefully review your contract. The contract will provide information to help you determine how serious the breach of a consequential loss is and which steps to take to resolve the dispute.

A contract will give consideration to a non-binding and binding clause, setting out the process by which the parties intend to resolve the dispute.

A non-binding clause enables the parties to enter into ADR and to reach a consensual resolution.

The main forms of non-binding ADR are:

  • Negotiation is an attempt by the parties’ representatives to resolve the dispute and to preserve an ongoing commercial relationship  
  • Mediation is the process of using a neutral mediator to resolve the dispute  
  • Early neutral evaluation (ENE) is the evaluation of the likely outcome of the dispute by a neutral third-party

A binding clause enables the parties to submit their dispute to a third neutral party to determine the dispute. The main forms of a binding decision, aside from litigation are:

  • Arbitration is when an Arbitration Agreement between the parties dictates that the dispute is resolved by an arbitrator
  • Expert Determination is the process where the dispute between the parties is submitted to a neutral expert to decide on the matter referring to them
  • Adjudication is specific to construction and professional negligence contracts

Some contracts will also consider an escalation clause, also known as tiered or stepped dispute resolution clause. An escalation clause, is where the parties agreed that any dispute between them shall be resolved on staged basis. Usually, the first step is to use internal dispute management (negotiation), followed by an ADR stage (mediation or ENE) and concludes with formal dispute resolution (litigation or arbitration/adjudication).

Limitation Periods

A limitation period is a time limit within which a party can bring a claim. For a contract dispute, there is a statutory limitation period provided by the Limitation Act 1980 or agreed in the contract by the parties. Once this time limit is expired, the right to bring a claim is lost.

The time limit under the Limitation Act 1980 is within 6 years for a breach of contract and 12 years if the contract is executed as a deed.

The Pre-Action Protocols (discussed below) have their own procedural time limits. If there is not enough time to comply with the time limit of the relevant protocol before the statutory limitation period expires then a claim form should be served and simultaneously file a request of ‘stay of proceedings’ until completion of the pre-action protocol. 

Time periods in a contract could be longer or shorter than the statutory limitation period. A limitation period specified in the contract must be reasonable to be effective. The Unfair Contract Terms Act 1977 sets out the reasonableness test. 

Pre-Action Protocols

Prior to commencing proceedings there is an expectation by the courts for the parties to consider Pre-Action Protocols. Failure to consider the Protocols will result in cost penalties at a later stage of the proceedings. 

The rules governing the pre-action protocols can be found in the:

  • Pre-action protocols. Currently there are 13 official pre-action protocols. These deal with disputes related, but not limited to construction and engineering, professional negligence and possession claims. Each protocol outlines specific procedures to be followed before issuing proceedings.
  • Practice Direction on pre-action conduct and protocols (PDPACP). If the dispute falls outside the protocols, PDPACP is the only source in regards to the pre-action conduct that should be adopted. Parties are expected to exchange proportionate information to allow them to understand each other’s position and make informed decisions about settlement and how to proceed.

Litigation

Litigation is governed by the CPR, and involves each party trying to prove their case on the balance of probabilities, before a judge.

A claimant will commence proceedings by issuing a Claim Form at the relevant court. The relevant court is determined by the value of the claim. As a general rule, claims below £100,000 will be issued in the County Court and claims above £100,000 in the High Court.

Contractual disputes claims above £100,000, including breach of contract, are undertaken by the Queen’s Bench Division (QBD), which is a Division of the High Court. The QBD has its own guide, the Queen’s Bench Guide (QBD Guide), and must be read with the CPR.  

Both the CPR and the QBD Guide set out detailed guidance governing the litigation process and the time-frames for each procedural step. The main litigation stages are:

  • Issuing the claim and exchanging statements of case. Commonly, the Claim Form is accompanied by Particulars of Claim. Particulars of Claim set out the claimants’ case and states the nature of the remedy claimed. Once the court issues the claim form, it is served to the defendant. The defendant has 14 days to file an Acknowledgement of Service and further 14 days to file a Defence.
  • Exchange of evidence. If the claim is allocated to the QBD then a case management conference will take place where directions will be provided. At this stage the parties will be required to carry out disclosure, exchange witness statement and expert witness statements (if any). The court will set the time-frames for when exchange of evidence will take place.
  • Trial. The court will provide a date and the length of time for the trial to be heard. During the trial the court will hear legal submissions, witness and expert evidences. Judgment will be given at a later date and during a short hearing at court.
  • Post-trial. If the judgment is in your favour the other party will be ordered to pay damages within a set period of time.
  • Appeal. If the judgment is against you then you can appeal this decision. The right of appeal is usually 14 days from the date of the decision.
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