What are you excluding in your contract's exclusion clause?

Exclusion clauses in contracts exist to put some limits on a party's liability for damages flowing from a breach of contract. This sounds fine in theory, but they're surprisingly tricky in practice. One issue that we're seeing time and again is the difficulty of dealing with consequential losses.

The underlying rationale of damages for breach of contract is to put the innocent party in the same position as if the contract had been performed (that is, to protect the so-called "expectation principle"), but damages will not be recoverable if they're too remote from the breach.

The test for remoteness was laid down in Hadley v Baxendale (1854) 9 Exch 341 and has two limbs:

1. losses such as may fairly and reasonably be considered as arising naturally (that is, according to the usual course of things) from the breach; and

2. losses such as may reasonably be supposed to have been in the contemplation of the parties at the time when they made the contract as the probable result of the breach of it.

For a long time, parties who included a term which excluded liability for "consequential loss" thought they were excluding liability for damages under the second limb of Hadley v Baxendale.

However, this assumption has been thrown into doubt by two cases, one from Victoria and one from New South Wales. They have held that by excluding "consequential loss", the parties may actually be excluding liability for some types of damage which fall under the first limb of Hadley v Baxendale, which reduces the scope for the injured party to be compensated for the losses caused by the other party's breach of the contract.

"Normal" vs "consequential" loss: the Peerless case

In Environmental Systems Pty Ltd v Peerless Holdings Pty Ltd [2008] VSCA 26, Peerless bought an emission system supplied by Environmental Systems. The emission system failed to meet the requirements set out in the contract and Environmental Systems was held to be in breach of the contract.

Environmental Systems then pointed to the exclusion clause in the contract:

"As a matter of policy, Environmental Systems does not accept liquidated damages or consequential loss. Environmental Systems is motivated to achieving agreed milestones through respect for the client's needs and the obvious financial advantage gained from completion of projects in the shortest possible period."

As it referred to "consequential loss", the trial judge held that the clause excluded liability for loss within the second limb of the rule in Hadley v Baxendale (consistent with the traditional approach).

The Victorian Court of Appeal disagreed, saying:

• the expression, "consequential loss", in the contract's exclusion clause was intended to have its ordinary and natural meaning;
• the true distinction is between "normal loss", which is loss that every plaintiff in a like situation will suffer, and "consequential losses" which are anything beyond the normal measure, such as lost profits;
• ordinary reasonable business persons would naturally conceive of "consequential loss" in contract as everything beyond the normal measure of damages, such as profits lost or expenses incurred through breach; and
• despite the construction which has been put on consequential losses by earlier cases, it is unrealistic to suppose that the parties used "consequential loss" as if it were limited to the second limb of the rule in Hadley v Baxendale.

So what was excluded by the exclusion clause in Peerless?

In light of those principles, the Court of Appeal considered each head of loss claimed by Peerless and held that "normal losses" included the cost of:

• purchasing, installing and commissioning the system;
• attempting to make it function; and
• repairing the existing afterburner which was used to destroy odour.

The Court of Appeal did not explain why those three categories of loss were described as "normal" loss.

On the other hand, "consequential losses" included:

• the labour costs involved in attempting to make the system functional; and the
• additional energy costs incurred as a consequence of the system not being functional.

Significantly, those losses (which probably fell within the first limb of Hadley v Baxendale) were not recoverable, in light of the exclusion clause in relation to consequential loss.

Although it is not as clear, a similar approach (i.e., that consequential loss may include losses falling under the first limb of Hadley v Baxendale) appears to have been adopted subsequently by the New South Wales Court of Appeal in Allianz Australia Insurance Ltd v Waterbrook at Yowie Bay Pty Ltd [2009] NSWCA 224.

Lessons for the next contract you sign

The lesson is that you need to be specific in drafting an exclusion clause. If you want to exclude recovery for loss of profits or lost expenses (for example), the contract should state that expressly, rather than relying on expressions such as "consequential loss" or even "indirect loss".

Also worth bearing in mind is that if you suffer loss caused by another's breach of contract, the exclusion clause may not be the final word on whether you have a right to recover damages for your losses. There are numerous cases which have held that you can't contract out of liability for breach of section 52 of the Trade Practices Act (now section 18 of the Australian Consumer Law) and its analogues.

Therefore, if you're looking for a way around an exclusion clause, think about whether you have a cause of action under one of these provisions.

This is an edited version of the presentation given by Luke at our CLE Intensive for in-house counsel on 3-4 March 2011.