Indirect and consequential loss exclusions: English law holds the line for now

A Technology and Construction Court decision last week has considered a direct attack on the traditionally narrow interpretation given by the English courts to indirect and consequential loss exclusion clauses. Although upholding the traditional interpretation in the circumstances of the case before it, the decision appears to accept the need to give such clauses their natural and ordinary interpretation in the context of the agreement as a whole and any relevant factual matrix. The case follows recent judicial commentary criticising the traditional approach and may suggest a more case-by-case approach to the interpretation of such exclusions (whether or not the same outcome is reached).

Introduction

Several decisions of the English Court of Appeal have established that contractual exclusions for “consequential and indirect losses” will be limited to losses which fall within what is known as the “second limb” of Hadley v Baxendale. Hadley v Baxendale is an old and well-known decision in English law establishing a fundamental division between two types of recoverable losses for breach of contract:

• Damages that may fairly and reasonably be considered as arising naturally, i.e. according to the usual course of things, from a breach of contract. For example, if the breach involved the destruction of a factory, both the cost of rebuilding and the loss of production suffered during rebuilding would fall within this first category. These are “direct losses”.
• Any other damages which may reasonably be supposed to have been in the contemplation of both parties at the time they made the contract. This category depends upon additional facts being known to both parties. In the example of the factory just given, it may be that loss of production during the period of rebuilding caused the loss of a particularly lucrative long-term contract. The loss of such a contract would not be recoverable unless both parties knew that the contract might be lost in the event of such a breach. These are “indirect losses”or “consequential losses” (the terms “indirect” and “consequential” loss are used interchangeably).

The traditional approach of English law has been that exclusions for “consequential” or “indirect “losses will usually exclude only those losses falling within the second category described above. In the case of the factory, therefore, such an exclusion would not affect any claim for ordinary loss of production suffered during the period the factory was unavailable. Such an interpretation has been criticised as one which the average businessman would not expect. However, the rule is very well established and in British Sugar plc v NEI Power Projects, the Court of Appeal commented that reasonable businessmen using such language must be taken to be aware of the distinction.

In more recent years judicial criticism of the traditional approach has appeared. In 2002, one member of the House of Lords stated that he wished to reserve the question as to whether the traditional approach was correct (Caledonia North Sea Limited v BT plc). In 2015, a judge of the Commercial Court who has since been appointed to the Supreme Court, indicated that the traditional approach was to be “deprecated” (Scottish Power UK Plc v BP Exploration Operating Company Ltd). In 2016, the Court of Appeal thought it was “questionable” whether the cases underpinning the traditional approach would be decided in the same way today (Transocean Drilling UK Ltd v Providence Resources Plc). Later that year, the traditional approach was departed from in Star Polaris LLC v HHIC-Phil Inc, albeit by reference to specific wording of the clause in question which suggested a different interpretation (for our Law-Now on that case, please click here).

In this most recent case, a more direct assault has been made on the traditional approach by reference to the above criticism.

2 Entertain Video Ltd v Sony DADC Europe Ltd

2 Entertain Video Ltd (“2E”) sued Sony for, among other things, loss of profit arising from a fire at Sony’s warehouse in Enfield. 2E published, marketed and sold various home entertainment media such as Blu-ray discs, DVDs and CDs. Approximately £40 million worth of stock owned by 2E was being held at Sony’s warehouse at the time of the fire, which was caused by civil disorder arising from the shooting of Mark Duggan in 2011.

One issue which arose in the proceedings was whether 2E’s claim for loss of profit was precluded by an indirect and consequential loss exclusion in the following terms:

"Neither party shall be liable under this Agreement in connection with the supply of or failure to supply the Logistics Services for any indirect or consequential loss or damage including (to the extent only that such are indirect or consequential loss or damage only) but not limited to loss of profits, loss of sales, loss of revenue, damage to reputation, loss or waste of management or staff time or interruption of business."

After the considering the recent judicial criticism of the traditional approach noted above, O’Farrell J in the Technology and Construction Court accepted the submission “that any general understanding of the meaning of ‘indirect or consequential loss’ must not override the true construction of that clause when read in context against the other provisions in the Logistics Contract and the factual matrix”. However, in evaluating the natural and ordinary meaning of the clause, the judge reached the same conclusion as the traditional approach:

“The exclusion is "for any indirect or consequential loss or damage". The direct and natural result of the fire was the destruction of the goods and the warehouse, causing lost profits and business interruption losses to the claimants. Therefore, the claims in this case do not appear to fall within the scope of the exclusion.”

Conclusion and implications

This case appears to be the first occasion on which a direct attempt to overcome the traditional approach has been made by reference to the recent judicial criticism of it (Star Polaris being a case where the rule was distinguished by reference to specific drafting). It is of note, therefore, that the court applied the traditional approach whilst accepting the need to give the words “indirect” and “consequential” their natural and ordinary meaning, in the context of the agreement as a whole and the relevant factual matrix.

It is unfortunate that the court’s reasoning in this regard is not spelt out in more detail. The central thrust of Sony’s argument was that 2E’s lost profits were a consequence of the destruction of the media held at the warehouse and were therefore “consequential” losses. The judge appears to have disagreed with this argument on the basis that the lost profits were nevertheless caused as a direct and natural result of the fire. However, there is no explanation for why the losses are said not to be “consequential”.

This judgment is likely to add to the growing debate over the proper interpretation of indirect and consequential loss exclusions under English law. In the meantime, parties negotiating contracts with such exclusions should be aware of the arguments being made for a broadening of the traditional approach. The arguments made by Sony in this case would have dramatically expanded the reach of the clause in comparison to the traditional approach which is thought not to have resulted in a single reported case where losses have been effectively excluded.

For a more detailed analysis of the traditional approach and the arguments for change please see the article by two of the present authors published in the International Construction Law Review noted below.

References:

Hadley v Baxendale (1854) 9 Ex 341

British Sugar PLC v NEI Power Products Ltd [1997] CLC 622

Caledonia North Sea Limited v British Telecommunications plc [2002] BLR 139

Scottish Power UK Plc v BP Exploration Operating Company Ltd [2015] EWHC 2658 (Comm)

Transocean Drilling UK Ltd v Providence Resources Plc [2016] EWCA Civ 372

Star Polaris LLC v HHIC-Phil Inc [2016] EWHC 2941 (Comm)

Exclusions for indirect and consequential loss: English law on the brink of change? ICLR, 2017, 34(3), pages 210-225

2 Entertain Video Ltd & Ors v Sony DADC Europe Ltd [2020] EWHC 972