Whats so bad about … indirect loss?

I spent a good part of last week helping a client “reach a compromise solution with” their customer over whether or not the contract should exclude  responsibility for indirect loss.  Being a risk averse lawyer, I was against removing indirect loss from the list of excluded liabilities (ie risking indirect loss suffered by the customer being treated as a recoverable loss that my client, the supplier, would have to bear).  We refined the terms of the exclusion clause,  got the client’s insurer to agree to the position and the contract was signed.

But in the process, I was forced to consider what is so bad about indirect loss and whether it was actually vital to exclude it. This took me back to

College

College and I found myself re-reading a number of cases that haunted my undergraduate days.  The detail is quite involved and I have posted a more complete update note here.  For those who don’t want to get bogged down in detail, the highlights are:

Damages for loss arising from a breach of contract can be recovered if either: (1) the loss can fairly and reasonably be considered to arise naturally (“according to the usual course of things”) from the breach; or, (2) the loss can reasonably be supposed to have been in the contemplation of both parties at the time at which the contract was made.

A loss “flows naturally” if a reasonable man would have realised that the loss was a “not unlikely” consequence of the breach.  “Not unlikely” means a less than even chance but something that is not unusual and is easily foreseeable.  Indirect loss falls within the second part of this test. Contracting parties generally try to exclude it for two reasons:

First, indirect losses are too remote and too speculative to be laid at the defendant’s door.  This is often true but do not forget that before the claimant can win their claim in court, the claimant has to show that the other party is in breach, that the breach has caused the relevant loss, that the loss is not too remote and can be accurately quantified, that the loss is not the claimant’s own fault and that the claimant has taken steps to mitigate the loss suffered. Seen in that context, indirect loss is still a Bad Thing but it is not inevitable that the defendant will be responsible.  The claimant will have to work hard to prove that the other party should pay up.

Second, the loss only arises because of a set of special circumstances and these were not factored into the price of the original agreement.  So, if the defendant is held liable, the defendant is made to bear a disproportionate degree of the risk.  This is a fair point where the customer is buying a standard product or service and paying a  standard fee – a situation where the unusual has not been allowed for in the pricing.  But it is a much weaker argument where the parties are negotiating a bespoke deal and therefore have ample opportunity to allocate the risk between themselves as they see fit.

I drew several conclusions from this.

The least risky course for potential defendants must always be to exclude indirect loss, if only on the basis that the more responsibility for loss the defendant can exclude, the better their position will be.

A risky course

But, it is not the end of the world if indirect loss cannot be excluded.  If there are specific concerns then it may be appropriate to allocate the risk by adjusting the price or by consulting an insurer.  Bear in mind that any claimant has significant obstacles to overcome before their claim for indirect loss will succeed.  In that context, accepting liability for indirect loss becomes a calculated risk.

Ultimately, the best course is to comply with the terms of the contract.  If there is no breach, responsibility for indirect loss is an academic question.

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Filed under Contract drafting, General Commercial

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