Exclusions and Limitation of Liability Part II

United Kingdom

Exclusions and Limitation of Liability Part II

1. Indirect and Consequential Loss ·

Remoteness of loss and “the two limbs rule” in Hadley -v- Baxendale [1854] 9 Exch 341

The courts had to develop a rule by which they could determine whether the damages claimed by the innocent party as a result of the breach of contract by the other party were allowable or whether they were in fact too remote to be properly included in the innocent party's claim. The court therefore developed the two limbs rule in Hadley v Baxendale as a method of separating that loss or damage that was recoverable and that which is not normally recoverable unless the contract breaker had the requisite knowledge when the contract was made of the special circumstances that a breach of contract might give rise to the loss claimed.

First Limb: "That loss or damage which arises naturally from the breach"
Second Limb: "That loss or damage which may reasonably be supposed to have been in the contemplation of the parties at the time the contract was made, as the probable result of the breach if it".

What is the meaning of Special, Indirect or Consequential Loss?

A line of authorities dealing with limitation clauses (the most well known of which is Croudace Construction Limited v Cawoods Concrete Products Limited (1978) 2 Lloyds 55) and recently in British Sugar v. NEI 87 Building Law Reports 42 have held that consequential loss is any loss not falling within the first limb of Hadley v Baxendale ie. loss which is not the direct and natural consequence of the breach.

Is Loss of Profits a Direct or Indirect Loss?

Depending on the circumstances, claims for loss of profits may fall into either the first or the second limb in Hadley v Baxendale as explained in Victoria Laundry (Windsor) Ltd v Newman Industries Ltd [1949] 2KB528.

There has been recent guidance on the subject of whether loss of profits is a direct or indirect loss in the case of British Sugar plc v NEI Power Projects Ltd [1998] IT CLR 125.

In the case of British Sugar, British Sugar claimed damages of £5m from NEI (the suppliers of electrical equipment installed at a sugar refinery) alleging that circuitry supplied under a contract worth £100,000 had caused repeated electrical blackouts at the plant and seriously disrupted production. The claim of £5m damages included damages for loss of profits due to production downtime. The parties had agreed a specific limitation of NEI's liability:

"In respect of the [sic]...contract, NEI's liability for consequential loss is limited to the value of the contract".

The Court of Appeal approved the previous line of authority which states the general principle that consequential loss is any loss not falling within the first limb of Hadley v Baxendale.

The loss of profits of British Sugar was an expected consequence of depriving a large and complex factory of its power supply. British Sugar's loss of profits was not consequential loss and therefore not limited by the limitation of liability clause agreed between the parties.

The lesson from the case is that if you wish to exclude liability for loss of profits, then the terms of the contract must expressly state this. This also applies to any other type of loss for example loss of data and loss of customers.

There have been two recent decisions on the exclusion of liability for consequential loss.

Pegler v. Wang (UK) Limited (unreported, 25 February 2000, Queen's Bench Division (Technology and Construction Court).

In this case Pegler took action against Wang alleging over 500 individually identified breaches of contract amounting to a failure by Wang to provide Pegler with an integrated computer hardware and software and associated services for which it had contracted to pay in excess of £1m.

A clause of the contract between the parties expressly excluded Wang's liability for

"...indirect, special or consequential loss, howsoever arising (including but not limited to loss of anticipated profits or of data)".

The court held that the clause referred to the loss under the second limb of Hadley v Baxendale (approving the Croudace Construction Limited line of cases). The reference by the words in brackets to loss of anticipated profits does not mean that the exclusion applied to all loss of profits. It is only the loss of profits which are of the character of indirect, special or consequential loss that is excluded.

Depending on the circumstances, claims for loss of profits may fall into either the first or the second limb in Hadley v Baxendale (as was explained in Victoria Laundry (Windsor) Ltd v Newman Industries Ltd [1949] 2KB528).

Hotel Services Limited v Hilton International Hotels (UK) Limited 2000

In this case the defendants sold a kind of hotel minibar to Hilton which were installed in a number of hotels under long term rental contracts. The minibars did not work properly and had to be removed and Hilton claimed damages for repudiatory breach of the implied term of merchantable quality. The damages which were awarded were under the following heads:

(i) rental over-payments;

(ii)costs of removal and storage of the chiller units; and

(iii) loss of profits. The defendant appealed on the basis that loss of profits was not recoverable because of the exclusion clause in the Contract. The court found that the exclusion clause stating that the defendants would not be liable for “…any indirect or consequential loss, damage or liability arising from the direct failure of the System or any part thereof or the performance of this Agreement or any breach hereof by the Company or its employees” did not exclude the loss of any profits which Hilton would have otherwise have been earning and which were direct or natural consequences of the dangerous unserviceability of the equipment.


Clear words must be used if you wish to exclude certain heads of liability i.e. for loss of profits that arise in the other party's normal course of business. Furthermore, you should not qualify the term "loss of profits" by drafting an exclusion clause which provides an exclusion of liability from "indirect or consequential loss including loss of profits".

2. Severance

The “blue pencil test”?

Severance means the rejection from a contract of objectionable promises or the objectionable elements of a particular promise, and the retention of those promises or of those parts of a particular promise that are valid.

The doctrine of severance may be applied by the courts whether or not there is an express severability provision (see Living Design (Home Improvements) Limited v Davidson [1994] IRLR 67). However, it appears in practice that some judges prefer to see an express severance provisions in a contract before being prepared to exercise their discretion to use the court’s residual powers to sever and it is therefore advisable to include one if required.

The doctrine of severance can be used to serve two purposes: (a) it may be invoked to cut out altogether an objectionable promise from a contract leaving the rest of the contract valid and enforceable, and in such a case the offending promise is eliminated from the contract; and (b) it may operate to cut down an objectionable promise in extent, but not to cut it out of the contract altogether as, for example, where an agreement in restraint of trade which is void as being unreasonably wide is converted into a valid promise by the elimination of its unreasonable features. In such a case, the promise remains in the contract minus the “offending parts” and so reduced in extent.

The “blue pencil rule” is the predominant principle that the court will not rewrite the promise as expressed by the parties. The court will not add or alter words and thus frame a promise that the promisor might well have made but did not make. One test which can be applied to the clause to see if severance is available is whether it is possible to run a “blue” pencil through all the provisions except for the provisions you wish to retain without altering the “main purport and substance” of what the parties had written? If so, the rump clause or agreement will remain enforceable (see Attwood v Lamont [1920] 3KB 571).

ford Electronics Limited v Sanderson CFL Limited [2001]

The Courts are not inclined to sever the unreasonable parts of an exclusion clause from the reasonable parts leaving the latter in force. However, to some extent this rule may have been undermined by the recent case of Watford Electronics Limited v Sanderson CFL Limited [2001]. In this case the Court of Appeal overruled the first instance judge on an interpretation of the clause. The Court of Appeal distinguished the two separate sentences within the exclusion clause - one dealing with exclusion of “indirect or consequential losses” the other setting a cap on the liability to the contract price. The first instance judge indicated this clause was one exclusion, although the Court of Appeal overturned the decision deciding it was two separate exclusions or limitations within one clause. This is a relative novel approach for the Court of Appeal to adopt and the safest course of action must still be to split up the clause into the various heads of loss that are being excluded in the hope that if the court finds one of them unreasonable the other areas will still be effective.

Example Clause

Set out below is an example of part of an exclusion clause setting out the various heads of liability to be specifically excluded.

2.1 Subject to Clause 2.2, Supplier shall not be liable to Buyer for:

2.1.1 loss of profits;

2.1.2 loss of sales or turnover;

2.1.3 loss of or damage to reputation;

2.1.4 loss of production;

2.1.5 loss of anticipated savings;

2.1.6 loss of goodwill or business opportunities;

2.1.7 loss of customers;

2.1.8 loss of, or loss of use of, any software or data;

2.1.9 loss under or in relation to any other contract; or

2.1.10 any special, consequential or indirect loss or damage, costs, expenses or other claims for consequential compensation;

whatsoever (howsoever caused) which arise out of or in connection with this Agreement or the [Products/Services].

2.2 Nothing in this Agreement shall be taken to exclude or limit Supplier's Liability:

2.2.1 for death or personal injury caused by Supplier's negligence;

2.2.2 Supplier's Liability for fraud or fraudulent misrepresentation;

2.2.3 any breach of the conditions implied by Section 12 Sale of Goods Act 1979 or Section 2 Supply of Goods and Services Act 1982; or

2.2.4 any Liability which cannot be excluded or limited by Law.

The distinction between “direct” and “indirect” loss will be difficult to apply to any given set of facts and it may be better for both parties if they set out the types of loss that the Customer would wish to recover or the Supplier would wish to exclude in the event of a breach (for example, monies paid under the Agreement, the additional cost of locating and implementing alternative solutions from a third party, the cost of reconstituting lost data, the costs of management time etc).

3. Wilful Misconduct and Gross Negligence

It is not unusual for exclusion clause to state that it will not apply to certain forms of loss. Typically, the exclusion clause may be amended by the party not attempting to rely on it to state that the exclusion clause does not apply to loss or damages resulting from acts or omissions which were the result of “gross negligence” or constituted “wilful misconduct”. On the other hand there is no rule of English law which prevents a party from excluding liability for gross negligence or wilful misconduct – if they can!

Gross Negligence

the exclusion clause is amended to state that it will not apply to “gross negligence” the question arises as to what this actually means in practice. Most English law lawyers have a “healthy disrespect” of the distinction between “gross negligence” and “mere negligence” (see Armitage v Nourse [1997] 2 All ER 705, 713).

ss negligence has been described as being simply an extreme degree of ordinary negligence. (see Grill v General Iron Screw Collier Co [1866] 35 LJCP 321, 330). A more detailed consideration of what constitutes the meaning of “gross negligence” was given in Red Sea Tankers Ltd v Paparhristidis (The Hellespont Ardent) [997] 2 Lloyd’s Rep 547, 580-588. In this case the court stated that “gross” negligence is:

”clearly intended to represent something more fundamental than failure to exercise proper skill and/or care constituting negligence.”

refore, a clause which provides only for an exclusion or carve out of “gross negligence” from the limitation of exclusion of liability clause may run the real risk that mere negligence is not included within the exclusion. It is not however all that clear on the face of it what is gained by the inclusion of the words “gross negligence” as a carve out from the liability clause without any further explanation of what this means in the contract.

Wilful Misconduct or Default

In relation to “wilful misconduct” the classic definition of this terms was provided in the case of Forder v Great Western Railway Co [1905] 2 KB 532, 535-536 in the following terms:

“Wilful misconduct…means misconduct to which the will is party as contradistinguished from accident, and is far beyond any negligence, even gross or culpable negligence, and involves that a person wilfully misconducts himself who knows and appreciates that it is wrong conduct on his part in the existing circumstances to do so, or to fail or omit to do (as the case may be), a particular thing and yet intentionally does or fails or omits to do it, or persists in the act failure or omission, regardless of the consequences or acts with reckless carelessness, not caring what the results of his carelessness may be.”

We are able to state with greater certainty than with “gross negligence” what is meant this term, however, if the exclusion clause already excludes or limits liability for negligence and a breach of the contract there does not seem much merit in trying to include in the same clause an exclusions for gross negligence and wilful default as it is likely that these terms will be judged as being part of the actions constituting the negligence and breach of contract which is already excluded.

Entire Agreement Clauses
An entire agreement clause is commonly used as a way of consolidating all of the obligations of the parties to an agreement together into the one document in order to attempt to avoid the possibility of including oral and written representations within the contract.

An entire agreement clause may have three main effects in the Contract:

Exclude liability for breach

An entire agreement clause may be used by a party to state that they are not actually in breach of the contract. It is essentially an assertion that the written contract includes the only terms of the contract and therefore the contract has not been breached unless the “innocent party” can point to the specific term that is being or has been breached. The entire agreement clause in the Watford v Sanderson case was as follows:

“The parties agree that these terms and conditions (together with any other terms and conditions expressly incorporated in the Contract) represent the entire agreement between the parties relating to the sale and purchase of the Equipment and that no statement or representations made by either party have been relied upon by the other in agreeing to enter into the Contract”

Clearly the first part of this clause covers the point that a party could not try to bring a claim against the other party for breach of a term which is not expressly in the written contract. However, it should be noted that this would not be effective to exclude liability for a term which cannot be excluded at law, for instance the implied terms under Section 6 of the sale of Goods Act.

Exclusion of Other Promises and Representations – The Thomas Witter Case

In the entire agreement clause in the case of Thomas Witter Ltd v TBP Industries Ltd [1996] 2 All ER 573 the entire agreement clause was as follows:

“This agreement sets forth the entire agreement and understanding between the parties or any of them in connection with the Business and the sale and purchase described herein. In particular, but without prejudice to the generality of the foregoing, the Purchaser acknowledges that it has not been induced to enter into this Agreement by any representation or warranty other than the statements contained or referred to in [the warranty schedule.”

The court held in this case that the first part of this clause was not effective to exclude remedies for contractual misrepresentations as it does not specifically state that it does. This is an example of the Courts taking a strict interpretation view of the clause. The court then went on to say that as a pre-contractual representation was in the same terms as one of the representations in the warranty schedule the purchaser could bring a claim under this pre-contractual representation. Therefore, if you are looking to exclude liability for one or more particular representations it is best to specify these clearly and have the other party agreeing to waive any rights or remedies it might have had in relation to them.

Section 3 of the Misrepresentation Act 1967 (as amended by Section 8 of UCTA)

Section 8 of UCTA inserted a new Section 3 into the Misrepresentation Act 1968 which subjects any contract term which would exclude or restrict liability for any pre-contractual misrepresentation or any remedy for such misrepresentation to a test of reasonableness. This section is relevant to all types of contract and is not therefore limited to consumer contracts or where a party deals on their standard terms. The courts have not taken a consistent approach when considering if an entire agreement clause would fall foul of Section 3 of the Misrepresentation Act. The Law Commission has suggested that the entire agreement clause simply gives rise to a presumption that there is no other term of the contract but leaves it open to the parties to adduce evidence that they did intend some additional term to have effect. The courts have decided in previous cases that where a clause does not expressly exclude liability for a pre-contractual misrepresentation it will not have this effect as the courts have insisted on the need for clear words to be used. However, the courts have more recently established in relation to these clauses that they may be effective to prevent the person to whom the representation was made from asserting he relied upon it. In other words the person is essentially estopped from being able to claim that they relied on the pre-contractual representation. It should be noted though that this rule is not without its problems because, as acknowledged in the Watford Electronics case, “it may be impossible for a party who has made representations which he intended should be relied upon to satisfy the court that he entered into the contract in the belief that a statement by the other party that he had not relied on those representations was true”.

The Future

The Law Commission Consultation Paper on Unfair Terms in Contracts has looked into the existing legislation in this area and has come up with some key recommendations which can be summarised as follows:

Replacing the Unfair Contract Terms Act (UCTA) 1977 and the Unfair Terms in Consumer Contracts Regulations (UTCCR) 1999 with a single piece of legislation, which will provide the protection required by European legislation and would include the additional protection given to consumers by UCTA;

Rationalising the controls over non-negotiated terms in business-to-business contracts, so that these apply not only to clauses that exclude or limit liability but also to other unfair terms that have not been negotiated between the parties;

Re-writing the legislation in a way that is clearer and more accessible to consumer and business advisers; and

Requiring terms of a contract should be “transparent” in terms of being expressed in plain language; and

That the new legislation should apply to terms in cross border-contracts for the supply of goods to consumers.

The Commission is asking for any comments on its proposals and opinions by 8 November 2002. For a copy of the consultation document, you can use the following link: http://www.lawcom.gov.uk/library/lccp166/cp166.pdf or contact TSO, tel 0870 600 5522.