Broken contracts typically lead to financial compensation: damages. Damages can be sub-divided into direct and indirect losses. Many contracts will seek to exclude liability for some losses especially indirect (or consequential) loss. A case decided by the High Court at the end of last year reminded us that such exclusion clauses are fact specific and cannot slavishly follow legal orthodoxy – on the facts of any given case an exclusion of consequential loss may or may not cover particular types of loss – it all depends on the facts.
The orthodox position is that direct and indirect losses follow the two limbs of the rule in Hadley v Baxendale (1854). That rule provides that:
“Where two parties have made a contract which one of them has broken, the damages which the other party ought to receive in respect of such a breach of contract should be such as may fairly and reasonably be considered either arising naturally, i.e. according to the usual course of things, from the breach of contract itself, or such as may reasonably be supposed to have been in the contemplation of both parties, at the time they made the contract, as the probable result of the breach of it.”
In BHP Petroleum v British Steel plc  the judge held that: “…authority dictates that the line between direct and indirect or consequential losses is drawn along the boundary between the first and second limbs of Hadley v Baxendale.”
This was generally approved by the Court of Appeal in my favourite direct / indirect case: Hotel Services v Hilton . The Court commented that the division had the “virtue of practicality” but did not, of itself, give the answer: “one has to be continuously alive to differences of surrounding fact.”
The case concerned hotel mini-bars. The Hilton group installed these mini-bars in their hotels. Unfortunately, the chillers leaked ammonia, which not only corroded the equipment but also created a risk of injury, or even fatality, to the guests. Unsurprisingly, Hilton removed the mini-bars and claimed:
- Rentals paid
- Cost of removal
- Loss of profit
The contract excluded liability for indirect or consequential loss. The Court of Appeal held all 3 heads of loss to be direct and hence outside the scope of the exclusion. Hilton had rented the machines to sell drinks at a profit and, preferably, an improved profit. The Court saw nothing wrong with the simple conclusion that getting and keeping the equipment out of the hotel bedrooms and the loss of profit were a direct loss and, hence, unaffected by the contractual exclusion. No special knowledge was required to establish that remedial costs and loss of profit are the obvious consequence of unusable, and possibly dangerous, equipment.
However, as the Court noted, “one has to go back to the language of the clause in its documentary and factual context and try to see what it means.”
In Transocean Drilling UK v Providence Resources  the Court of Appeal picked up this theme. The case concerned a drilling of an appraisal well. The judge found the rig not to have been in good working order and the owner of the rig to be liable accordingly. The contract had detailed provisions excluding consequential loss including that each would indemnify and hold the other harmless from its own consequential loss. This was held to be part of a “sophisticated allocation of losses” and was not a simple exclusion clause.
The Court questioned whether some of the historic cases on exclusion clauses would be decided in the same way today when the courts “are more willing to recognise that words take their meaning from their particular context and that the same word or phrase might mean different things in different documents.”
These invitations were picked up by arbitrators and affirmed by the Court in Star Polaris v HHIC-Phil . The case concerned the liability for defects arising under a shipbuilding contract. The contract provided for the exclusion that the shipbuilder would have “no liability or responsibility whatsoever or howsoever arising for or in connection with any consequential or special losses, damages or expenses”. It also provided for a guarantee against defects for 12-months and a positive duty to repair and remedy defects. The guarantee was expressed to “replace or exclude any other liability … implied by statute, common law, custom or otherwise.” Within a few months the vessel suffered a serious engine failure. The buyer claimed the cost of repairs, towage fees, survey fees, off hire and off hire bunkers. The tribunal found that the only obligation on the shipbuilders was to repair and replace defective items: in context the exclusion of consequential losses had a wider meaning than the Hadley v Baxendale meaning.
The issue for the Court was whether there was this wider meaning and whether diminution in value of the vessel was a consequential loss. The Court rejected a challenge to the arbitrators’ award. On a proper reading of the entire contract liability had been comprehensively excluded and a limited guarantee of fitness had been provided. The overall effect was to exclude liability for anything beyond the express obligations undertaken by the shipbuilder. The buyer could not point to any express provision that gave rise to a claim for the losses claimed. Therefore, consequential losses did not have the Hadley v Baxendale meaning but a wider meaning of financial loss caused by the guaranteed defects above and beyond the cost of the repair and replacement of defective items that had been guaranteed.
In those circumstances, diminution in value was another example of consequential loss and hence liability for it had been excluded even though it might have fallen within the first limb of Hadley v Baxendale. The obligation to repair and replace was exhaustive and nothing beyond that was recoverable.
The case shows that exclusion or limitation clauses should not be viewed in isolation: context is everything. The proposition that consequential losses are those falling within the second limb of Hadley v Baxendale can no longer be accepted as necessarily a truism. It might be and might not be. It follows that it is dangerous to lift a clause that has been found to have a particular meaning from one contract to another, as the context might be quite different. The Courts will also uphold sophisticated allocation of risk and exclusion provisions especially those in bespoke contracts that have been specifically negotiated. If that involves departing from the orthodoxy that the line between direct and indirect losses is the same line as the separate limbs of Hadley v Baxendale, the Courts will do so.