Excluding Consequential Damages is a Bad Idea.

by Ken Adams (originally posted February 15, 2010 in Adams on Contract Drafting)

[For a follow-up to this post, see this March 2, 2010 blog post.]

I have in front of me a contract—it’s for the sale of goods—that contains the following provision excluding certain kinds of damages:

Neither party will be responsible or held liable for any consequential, special, or incidental losses or damages.

You can rely on sellers asking for this kind of provision, and buyers routinely accept it. But I suspect that many lawyers and their clients have an uncertain grasp of what such provisions are meant to accomplish. A rationale you’ll hear is that they prevent a party from seeking damages that are remote, in other words damages that the parties couldn’t have contemplated while they were doing the deal.

But you may be surprised if you take a closer look at these provisions. That’s what I did, with an article that I mentioned in this July 2008 blog post as my trusty guide: “Reassessing the ‘Consequences’ of Consequential Damage Waivers in Acquisition Agreements,” 63 Business Lawyer 777 (2008). It’s by Glenn D. West, a Weil Gotshal partner whose name has cropped up on this blog a few times, and Sara G. Duran, but in the interest of brevity I’ll be referring to it as “Glenn’s article.” It focuses on waivers of consequential damages in the context of M&A, but the analysis applies more broadly.

Let’s start by considering what damages a party is entitled to in the absence of any limitation. For a nonbreaching party to be awarded damages for losses caused by breach of a contract, generally those losses must be a reasonably foreseeable consequence of the breach. So even in the absence of any limitation, contract damages don’t compensate parties for losses that are remote.

So that’s the baseline. To understand the implications of excluding from that baseline certain kinds of damages, you have to understand the doctrinal jargon used. Each term is, to varying degrees, difficult to define clearly, given that it expresses a vague standard and given the inconsistent guidance provided by the wealth of related litigation in different jurisdictions. Here’s my boiled-down version of the analysis in Glenn’s article:

Direct damages: These are best understood as damages that one would reasonably expect to arise from the breach in question, without taking into account any special circumstances of the nonbreaching party; also referred to as “general” damages.

Incidental damages: These are expenses incurred by a buyer in connection with rejection of nonconforming goods delivered by the seller in breach of contract, or by a seller in connection with wrongful rejection by a buyer of conforming goods delivered by the seller to the buyer.

Consequential damages: These are best understood as including all losses sustained by the nonbreaching party that are attributable to any special circumstances of the nonbreaching party that the parties were aware of when they entered into the contract; in other words, consequential damages encompass all contractually recoverable damages that aren’t either direct or incidental damages; also known as “special” damages.

It’s clear what “consequential damages” don’t do: they don’t compensate a buyer for remote or speculative losses, which shouldn’t even constitute losses. But many people are unaware of that. Here’s what Glenn’s article says on that subject:

[T]o define “consequential damages” as those losses that are so remote that they were beyond the contemplation of the parties at the time they entered into the contract is to define consequential damages as losses for which the law does not allow recovery in contract, regardless of any provision excluding such damages. Yet, many sellers purport to require waivers of consequential damages because they believe consequential damages relate to losses beyond those that the breaching party would have ordinarily and reasonably foreseen or contemplated. The rules limiting all contractual damages to those that are “natural, probably, and reasonably foreseeable” impose a judicially created “rule of reasonableness” that generally limits the extent to which any damages, including consequential damages, may be awarded for breach of contract. As a result, even in the absence of a contractual waiver of consequential damages, this standard of reasonableness creates limits on the extent of the non-breaching party’s recovery for losses that the breaching party did not otherwise specifically agree to bear.

Given that background, here are my problems with excluding certain kinds of damages:

Many of those asking that certain kinds of damages be excluded assume incorrectly that otherwise the nonbreaching party would be entitled to recover remote damages.The jargon used in such exclusion language doesn’t have a clearly established meaning, so is conducive to dispute.It seems arbitrary to exclude certain kinds of contractually recoverable damages but not others.

But for me, here’s the clincher, as stated in Glenn’s article: “While sellers have legitimate concerns over their potential liability for breach … , there are other means of addressing those concerns without the use of terms that have such uncertain meanings.”

Consider the contract I mentioned at the top of this post. In addition to excluding certain kinds of damages, it limits the buyer’s recovery in any claim to what the buyer paid for those goods. That by itself rules out the prospect of the buyer’s being awarded damages that far outstrip the purchase price. Why does the seller also need to engage in the messy business of excluding certain kinds of liability? Any buyer would be advised to resist vigorously that sort of overkill.

So here’s what I suggest: I’m proposing to buy some widgets, and it’s likely that the seller will want to limit damages. I’m the one drafting the contract; I could elect to omit from my draft any mention of excluded liabilities, but it would be more constructive to try to head off any debate by attempting to address the seller’s concern using my own language, narrowly tailored to avoid the excesses of the traditional exclusion language. It would just says what the law is [language revised Feb. 16 9:00 a.m. EST in response to comment by Mark Anderson]:

Neither party will be liable for breach-of-contract damages that the breaching party could not reasonably have foreseen on entry into this agreement.

Glenn’s article in effect endorses this approach: “Instead of waiving ‘consequential’ damages, buyers should seek waivers of ‘remote’ or ‘speculative’ damages.” If that doesn’t satisfy the seller—it wants to exclude some recoverable damages—I’d propose that we instead put an absolute cap on damages rather than engage in the arbitrary and uncertain exercise of excluding certain kinds of damages.

And even if my draft contains an absolute cap from the start, it would be harmless to exclude remote damages, and there might be some benefit to doing so: it could cut short any discussion I might otherwise be forced to have if the seller is one of the many who don’t understand that a buyer is entitled to only those damages that are foreseeable.

Of course, if the seller wants to double dip—wants both an absolute cap and to exclude consequential damages—we’d have to have a different, and more vigorous, discussion.

***

In closing, some stray thoughts:

This is just one example of an accepted bit of boilerplate that doesn’t make much sense. In this September 2006 blog post I wrote about another favorite waste o’ time, the “successors and assigns” provision.

Just as Glenn’s article considers U.S. and English law, I suspect that my conclusions in this post would apply in any common-law jurisdiction.This post confirms my aversion to using doctrinal terms of art in a contract.

That’s something I considered in this recent post in connection with use of the terms fraud and intentional misrepresentation.

Ken Adams is president of Adams Contracts Consulting LLC, author of A Manual of Style for Contract Drafting, and an advisor to LegalSifter.