‘Consequential loss’ (or ‘indirect loss’) as opposed to ‘direct loss’, are terms frequently used in contract law, yet the law in Australia is unsettled as to the meaning of ‘consequential loss’ . If the term is not properly defined in a contract it can cause potential disputes and misunderstandings.

When negotiating high profile commercial or building contracts, it is crucial that parties understand the difference between these two types of losses, and the implications of including or excluding liability for consequential loss. It is essential that parties know what they are in for when entering into a contract, including what losses they can recover for breach of contract, and the scope of losses that they may be liable for.

Some practical examples of consequential loss include:

• Loss of income, revenue or profits;
• Loss of financial opportunity or business opportunity;
• Loss of business;
• Loss of contract;
• Loss of goodwill or reputation;
• Loss of use;
• Loss of production;
• Losses or damages  under other contracts;
• Incurring a penalty or fine at law or under contract.

In this article we aim to clarify the concept of consequential loss, its implications, and how careful contract drafting can help mitigate associated risks.

The initial legal test: Hadley v Baxendale

Traditionally, the Courts have relied on the test set out in the English case Hadley v Baxendale (1854). In this case, the Court held damages are recoverable provided the losses are not too remote from the breach itself. The Court established the following categories for losses which are recoverable for breach of contract:

1. ‘Direct Loss’: Losses that 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 contract.
2. ‘Consequential Loss’: Losses that 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 contract.

For many years following Hadley, the assumption was that any contract that excluded liability for ‘consequential loss’ was excluding liability for loss described under this second category.

In recent cases in Australia, the Courts have deviated from this approach. For example:

• In Environmental Systems Pty Ltd v Peerless Holdings Pty Ltd [2008] VSCA 26, the VIC Court of Appeal held the term “consequential loss”:
  • should not be limited to the types of losses described under the second category in Hadley;
  • should be what ordinary reasonable business persons would consider to be “beyond the normal measure of damages” arising from the breach of contract (eg, loss of profits, or expenses incurred due to the breach).
• In Regional Power Corp v Pacific Hydro Group Two Pty Ltd(No.2) [2013] WASC 356, the WA Supreme Court held that:
  • Terms such as “indirect” or “consequential” loss or damages should be given their natural and ordinary meaning;
  • Any clauses excluding “indirect” or “consequential” loss should be interpreted in the context of the whole contract.
• In Patersons Securities Ltd v Financial Ombudsman Service Ltd and Others [2015] WASC 321, the Court expanded on this to distinguish between “direct loss which flows naturally from the breach without other intervening cause, and indirect loss which does not so flow”.

It is important for the contract itself to expressly define “consequential loss” otherwise the Courts are left to interpret the term based on the specific circumstances of each case.

Best Practices for Drafting Contracts

Given the potential for disputes over consequential loss, it is advisable to adopt a proactive approach when drafting contracts. Here are some key considerations:

1. Avoid Broad Terms – Refrain from using broad terms like “indirect” or “consequential” without adequately defining them. Ambiguity can lead to disputes.

2. Specify Exclusions – Clearly list the types of losses that are not recoverable under the contract. This can prevent misunderstandings and litigation.

3. Incentivise Contractors – Consider creating incentives for contractors to promptly rectify defects. For instance, you might carve out certain losses from the consequential loss exclusion if they arise from a contractor’s failure to rectify a defect.

4. Be Cautious with Mutual Exclusions – Be wary of mutual exclusion clauses that might limit your ability to recover significant losses.

Conclusion

Understanding and properly defining consequential loss in contracts is essential for any party that wants to limit its own liability or preserve the right to recover all types of potential losses.   for both parties in a contractual agreement.

If you require assistance in drafting or reviewing a contract, and ensuring it is clear, enforceable and tailored to your specific needs, our experienced team at Keystone Lawyers is here to help.