Case note

The Victorian Court of Appeal, in a unanimous decision delivered on 26 February 2008, rejected the approach taken in a line of English and single judge Australian authorities (describing it as ‘flawed’) that had construed the term ‘consequential loss’ when used in contracts as limited to the ‘second limb’ of Hadley v Baxendale (1854) 9 Ex 341.

Instead, the Court of Appeal held in Environmental Systems Pty Ltd v Peerless Holdings Pty Ltd that, in the context of an exclusion clause, the term ‘consequential loss’ should be given its ordinary and natural meaning and that the true distinction is between:

• normal loss, which is loss that every plaintiff in a like situation will suffer, and
• consequential loss, which is “anything beyond the normal measure, such as profits lost and expenses incurred through breach”.

This decision is a marked departure from the old approach to the interpretation of the term ‘consequential loss’. Parties should consider the losses for which they wish to exclude their liability when negotiating contracts and what their potential exposure is now likely to be under the terms of any existing contracts where the expression ‘consequential loss’ is used.

Previous position on consequential loss

Although very few decisions exist in Australia that consider the meaning of the term ‘consequential loss’, some courts have followed the English authorities that have equated consequential loss with loss falling within the second limb of Hadley v Baxendale (see Aquatec-Maxcon Pty Ltd v Barwon Region Water Authority (No 2) [2006] VSC 117; GEC Alsthom Australia Ltd v City of Sunshine, unreported, Federal Court of Australia, 20 February 1996, per Ryan J at BC9600288). That is, they found the term is restricted to losses that may reasonably be supposed to have been in contemplation of both parties, at the time they made the contract, as the probable result of its breach: Deepak Fertilisers and Petrochemical Corporation v Davy McKee (London) and ICI Chemicals & Polymers Ltd [1999] Lloyd’s Rep 387; Hotel Services Ltd v Hilton International Hotels (UK) Limited [2000] BLR 235.

These authorities held that a clause purporting to only exclude ‘consequential loss’ did not exclude loss of profits which were sufficiently proximate to the breach in question and found to flow directly and naturally from the breach.

Environmental Systems Pty Ltd v Peerless Holdings Pty Ltd - the Facts

In 1997 Peerless Holdings Pty Ltd (Peerless) contracted Environmental Systems Pty Ltd (ESPL), to design, supply and install a Regenerative Thermal Oxidiser (RTO) to replace Peerless’ existing afterburner. The RTO was required to reduce or eliminate odour emissions from Peerless’ animal rendering plant, and to achieve energy cost savings in order to comply with a licence granted by the Environmental Protection Authority . However, the RTO was never able to perform as intended. After three years of persisting odour problems, Peerless shut down the RTO and claimed damages from ESPL for breach of contract.

At first instance, Peerless sought damages for breach of contract and alternatively for damages suffered due to misleading and deceptive conduct on the grounds that if the contract had been performed, it would have obtained substantial gas savings throughout the life of the RTO, being a period of about 15 to 20 years. Further, Peerless would not have incurred additional expenses in attempting to make the RTO functional, such as the cost of Peerless’ employees involved in such attempts, and the cost of repairing the existing afterburner which was to be replaced by the RTO. Peerless succeeded on both claims but elected to take damages for misleading and deceptive conduct, which were assessed as slightly higher.

Both parties appealed. Peerless contended that it was entitled to more damages for breach of contract. ESPL claimed that Peerless was not entitled to claim additional gas costs as these were consequential losses and therefore excluded by clause 8.9.

Relevantly, the Contract contained the following clause:

8.9 LIQUIDATED DAMAGES AND /OR CONSEQUENTIAL LOSS - As a matter of policy, Environmental Systems does not accept liquidated damages or consequential loss.

The new approach

In considering the meaning of the term consequential loss in clause 8.9, the Court held that the true distinction is between ‘normal loss’, which is loss that every plaintiff in a like situation will suffer, and ‘consequential losses’, which is anything beyond the normal measure, such as profits lost and expenses incurred through breach.

However, the Court recognized that this was not the same as the distinction between the first and second limbs in Hadley v Baxendale as some consequential loss may fall within the first limb in Hadley v Baxendale as loss arising naturally from the breach of contract.

The Court had examined the line of English authorities which had found that increased production costs and loss of profit did not necessarily fall within an exclusion of liability for consequential loss. However, the Court concluded that the concept of consequential loss should now be restored to the “natural meaning of which commercial and legal usage in exclusion clauses has long since robbed it”.

Accordingly, the Court held that it was not correct to construe consequential loss as limited to the second limb in Hadley v Baxendale in accordance with the English authorities. Instead, consequential loss in the exclusion clause should have the meaning that ‘ordinary reasonable business persons would naturally conceive of’. Namely, as “everything beyond the normal measure of damages, such as profits lost or expenses incurred through breach”.

The costs of labour and the additional costs of gas claimed by Peerless were therefore excluded by clause 8.9.

What does this mean in practice?

This decision marks a sharp turnaround in the Courts’ approach to interpreting exclusion clauses. Care should be taken in negotiating and drafting clauses that exclude or limit liability for consequential loss.

It is important for parties to understand that excluding liability for ‘consequential loss’ will now likely exclude liability for all ‘loss of profits’ and ‘expense incurred through breach’ even if they are not specifically referred to or if they are within the first limb of Hadley v Baxendale and flowing naturally from the breach.

For instance, in British Sugar PLC v NEI Power Projects Ltd (1997) 87 BLR 42 the court considered the clause ‘the Seller’s liability for consequential loss is limited to the value of the contracts’ and held that loss of production and loss of profits were not limited as “consequential losses” because they arose directly and naturally from the breach. However, applying the reasoning from Environmental Systems Pty Ltd v Peerless Holdings Pty Ltd, it is likely that a court would now hold that loss of production costs and loss of profits would be considered ‘consequential loss’ and would be successfully limited by the clause.

Likewise, in Pegler Ltd v Wang (UK) Ltd [2000] BLR 218 it was held that loss of profits expressed in the contract, as a sub-set of consequential loss, were not excluded by the following exclusion clause because the relevant profits lost arose directly and naturally from the breach:

Wang shall not in any event be liable for any indirect, special or consequential loss, howsoever arising (including but not limited to loss of anticipated profits or of data) in connection with or arising out of the supply, functioning or use of the Hardware, the Software or the Services.

Again, applying the Court of Appeal’s reasoning, it is likely that loss of profits would be excluded to the extent that they are ‘beyond the normal measure of damages’.

Until such time as the House of Lords or the High Court of Australia has occasion to consider the meaning of consequential loss, it would be prudent for contracts to expressly exclude liability for certain types of loss such as loss of revenue, loss of business opportunities, loss of anticipated savings and damage to goodwill. However, these types of losses should be listed independently rather than only as examples or sub-sets of consequential loss.