ARTICLE - Houston Law Review

ARTICLE CONSEQUENTIAL DAMAGES WAIVERS: HOW TO CONSEQUENTIALLY AND INCIDENTALLY (INCLUDING INDIRECTLY) WAIVE YOUR REMEDY Megan A. Ceder and Travis J. Distaso ABSTRACT Consequential damages waivers are often quickly absorbed as boilerplate. There is, however, increasing literature on the recognition of the potential misuse of such waivers, especially with regard to the overlap between direct and consequential damages. This article comments briefly on the above and adds insights on the interpretation of specific terms in common consequential damages waivers. TABLE OF CONTENTS I.

THE CORE OF CONTRACT ............................................................. 2

II. HARKENING BACK TO HADLEY .................................................... 4 III. THE CONSEQUENCE OF CONSEQUENTIAL .................................. 5 IV. WAIVING WORD BY WORD ........................................................... 6 A. State Interpretation ............................................................. 7 B. Incidental Damages ............................................................ 8 C. Indirect Damages ................................................................ 9  Megan A. Ceder and Travis J. Distaso are associates in the Energy Transactions and Projects Practice Group at Vinson & Elkins LLP, in Houston, Texas. They would like to thank Shay Kuperman for his help and guidance throughout the article-writing process, and Brooke Milbauer for her assistance and research.

1

2

HLRe: OFF THE RECORD

[6:1

D. Punitive Damages................................................................ 9 E. Lost Profits ........................................................................... 9 F. Diminution in Value ......................................................... 10 V. BEYOND HADLEY ........................................................................ 10 I.

THE CORE OF THE CONTRACT

In the world of business transactions, parties often desire more than the mere exchange of assets or the development of a project; they desire certainty around the effects of the transaction. In the context of an acquisition of an asset, for example, parties would have little difficulty agreeing to a bare bones purchase and sale. The basic solution would be to contract only for the delivery of legal title to the asset in exchange for monetary equivalents. In such a scenario, the parties would allow statutory and common law defaults to control any exigencies, such as the amount of damages owed if a party believed the asset was not as they expected or the determination of the party responsible for unexpected costs. More realistically, and especially in complex corporate transaction, the parties may desire to limit the unexpected effects of a transaction through the contractual allocation of liability for specific events. In so doing, the parties modify common law or statutorily prescribed remedies, to the extent allowable by law. This allocation may be accomplished in a variety of ways. Parties may decide to give warranties for certain parts of an asset to extend for a certain amount of time, such as that certain components of solar panels installed in a commercial rooftop shall be free and clear of all defects for a period of five years. They may also choose to allow for certain payments upon an event of early termination or default. More overtly, parties may contract for liquidated damages, i.e., define certain events to trigger certain payments between the parties. For example, if the parties agree to a construction schedule and the contractor fails to deliver a certain component of the project by the schedule’s deadline, the contractor may be required to pay a specified, predetermined amount of damages. Finally, parties may agree on an indemnity, i.e., an allocation of the responsibility for damages with regard to an aspect of the transaction. Regarding these contractual allocations, but especially liquidated damages and indemnities, the parties may set formal limits (often termed “limitations on liabilities”) for the

2015]

CONSEQUENTIAL DAMAGES WAIVERS

3

amount of damages for which a party may be liable under the agreement. It is within this context of “limitations on liabilities” that consequential damages waivers come into play. That is, in addition to the above specifications and limitations, parties often choose to disclaim liability for certain types of damages, including “consequential” damages resulting indirectly from a breach of contract. A boilerplate waiver of consequential damages provision is as follows: No Consequential Damages. Notwithstanding anything to the contrary contained in this Agreement or provided for under any applicable Law, no party hereto shall be liable to any other Person, either in contract or in tort, for any consequential, incidental, indirect, special or punitive damages of such other Person, [including] [or any] loss of future revenue, [or] income or profits[, or any diminution of value or multiples of earnings damages] relating to the breach or alleged breach hereof, whether or not the possibility of such damages has been disclosed to the other party in advance or could have been reasonably foreseen by such other party.1 In theory, the intent is to disclaim liability for remote and unforeseeable damages, thereby giving certainty to the amount of damages for which a party may be liable in the future. The concern with such waivers, however (at least as it pertains to this article), is that a party may in fact be waiving any and all damages available (or a greater amount of damages than expected) as a remedy to the transaction. Take, for instance, a contract for the development of a project. An owner and a contractor agree to a transaction in which the contractor builds a unique, state-of-the-art factory on the owner’s land. Upon completion, the owner expects the factory to generate extraordinary profits due to its unique nature. The parties include in the contract a waiver of consequential damages. If the contractor completes the construction on time but fails to deliver the unique, state-of-the-art performance standard in the contract and owes resulting breach of contract damages, those damages may consist solely of extraordinary “lost profits” that the owner expected to generate from the unique facility. In such case, the 1. Glenn D. West & Sara G. Duran, Reassessing the “Consequences” of Consequential Damage Waivers in Acquisition Agreements, 63 BUS. LAW. 777, 778 (May 2008).

4


[6:1

owner may be entirely without relief due to the waiver of consequential damages in the contract. 2 II. HARKENING BACK TO HADLEY As the waiver of consequential damages stems from the desire to limit contractual damages, it is important to start at the beginning. Unsurprisingly, we are taken back to England, to the nineteenth century and to Hadley’s flour mill in need of a crankshaft.3 In Hadley v. Baxendale, the crankshaft of a mill’s steam engine broke and, after ordering a new one, Hadley contracted with Baxendale to deliver the broken shaft to a manufacturer to begin the process of creating the new one. 4 Although Baxendale agreed to transport the broken shaft the next day, Hadley informed Baxendale of neither the reason for a new crankshaft nor the effect of a delay in delivery, and Baxendale agreed to transport the broken shaft the next day.5 Baxendale, however, failed to deliver the broken shaft until five days later.6 Hadley sued Baxendale for the mill’s lost profits for the period between when the mill would have been operating without a delay on the part of Baxendale and when it actually became operational.7 The court denied Hadley’s claim for lost profits, noting that the “loss of profits here cannot reasonably be considered such a consequence of the breach of contract as could have been fairly and reasonably contemplated by both the parties when they made the contract. For such loss would neither have flowed naturally from the breach of this contract . . . nor were the special circumstances . . . communicated to or known by [Baxendale.]”8 In this holding, the modern bifurcation of damages into “direct” and “consequential” was born.9 The Hadley division of damages into two prongs continues today. First, a party may recover direct or general damages, i.e., losses that directly and naturally arise from the breach of a contract.10 Second, a party may recover special or consequential

2. Id. 3. Hadley v. Baxendale, 9 Exch. 341, 341 (1854). 4. Id. at 344. 5. Id. at 343. 6. Id. 7. See id. at 342–44. 8. Id. at 357. 9. West & Duran, supra note 1, at 778. 10. Jason L. Richey & William D. Wickard, Consequential Damages in Today’s Construction Industry, K&L GATES LLP (May 5, 2008),

2015]


5

damages, i.e., losses arising from special circumstances surrounding the breach to the extent that the breaching party knew of the circumstances at the time the contract was made. 11 In line with Hadley, most jurisdictions, by default, allow parties to recover damages only to the extent they were reasonably foreseeable to the breaching party.12 As this analysis pertains to Hadley, the court found that the lost profits were not reasonably foreseeable from the late delivery of a crankshaft. 13 As such, Hadley would only be able to recover for such lost profits if Hadley had made Baxendale aware of this special circumstance.14 III. THE CONSEQUENCE OF CONSEQUENTIAL The second type of damages in Hadley, i.e., special or consequential damages, is a more vaguely defined concept.15 While some commentators debate whether such damages should be classified as merely “indirect” damages (as opposed to “direct” damages in prong one of Hadley), a good definition for special or consequential damages seems to be: “losses directly attributable to and caused by a contract breach as a result of the special circumstances of the non-breaching party that would not have occurred in the ordinary case of a breach of a similar contract not involving such special circumstances.” 16 This leads to a critical problem observed by commentators, namely, the potential overlap between direct damages and consequential damages. A good example is in the context of a corporate asset acquisition. On the one hand, the parties may agree in the representations and warranties that an asset has certain specifications that the buyer is relying on to generate increased profits, and, in turn, value in the future. Meanwhile, the parties may also include a provision containing a waiver of consequential damages.17 If the representations and warranties prove false, and the asset fails to perform up to the buyer’s expectations, the buyer

http://www.klgates.com/files/Publication/d2f0d5fa-7ebb-4c2c-9d96-94577868f2d7/Presenta tion/PublicationAttachment/35e1a2c8-ef0c-466d-aea0-9cd6af9dd6ca/constructioneer_articl e_richey.pdf. 11. West & Duran, supra note 1, at 791–92. 12. Id. 13. Hadley, 9 Exch. at 355–57. 14. Id. 15. West & Duran, supra note 1, at 791–92. 16. Id. 17. Id.

6


[6:1

may sue for breach of contract.18 While, under the Hadley default, the buyer would likely recover because the representation of the company’s special circumstances makes such damages reasonably foreseeable, due to the waiver of consequential damages, the buyer may in effect have no recourse as all damages would be in the form of lost profits or otherwise consequential damages, both of which were waived in our example provision.19 The easiest way to see this is by way of the four basic scenarios in which it may occur: Likely to Recover Lost Profits? Inform of Special Circumstances

Do Not Inform of Special Circumstances

Waive Consequential Damages

Depends*

No

Do Not Waive Consequential Damages

Yes

No

*A waiver of consequential damages that specifically excludes damages arising from special circumstances may exclude consequential damages, even if such damages are the only possible damages recoverable.20 Such a waiver may occur, for example, if the waiver includes “notwithstanding anything else in the Agreement,” and if damages provisions are not carved out or upstaged by state law. IV. WAIVING WORD BY WORD There is a further complexity with regard to consequential damages waivers in that they waive many individual words and phrases. Looking again at the boilerplate provision from before:

18. 19. 20.

Id. Id. West & Duran, supra note 1, at 778.

2015]


7

No Consequential Damages. Notwithstanding anything to the contrary contained in this Agreement or provided for under any applicable Law, no party hereto shall be liable to any other Person, either in contract or in tort, for any consequential, incidental, indirect, special or punitive damages of such other Person, [including] [or any] loss of future revenue, [or] income or profits[, or any diminution of value or multiples of earnings damages] relating to the breach or alleged breach hereof, whether or not the possibility of such damages has been disclosed to the other party in advance or could have been reasonably foreseen by such other party.21

In addition to waiving “consequential” and “special” damages, the provision waives damages that are “incidental,” “indirect,” or “punitive” and damages that are or derive from a “loss of revenue,” “loss of income,” “loss of profits,” “diminution of value,” or “diminution of multiples of earnings.” While these terms are commonly waived together as a string of boilerplate synonyms, many of these terms are subject to unique interpretations. A. State Interpretation Importantly, one should be aware that state law varies in the interpretation of these words. In Texas, for example, a court may classify damages as direct if they are implicitly or explicitly classified as such in the contract, even if they would otherwise be considered consequential.22 In Tennessee Gas Pipeline Co. v. Technip USA Corp., Tennessee Gas Pipeline (“TGP”) hired Technip USA to construct a pipeline upgrade.23 The contract obligated TGP to provide services at the site, including permit and water services, as well as providing operations personnel.24 The upgrade took longer than anticipated due to delays involving components, technology, labor shortages, and weather.25 TGP sued for increased 21. Id. at 778 (emphasis added). 22. McKinney & Moore, Inc. v. City of Longview, No. 14-08-00628-CV, 2009 Tex. App. LEXIS 9299, at *5 (Tex. App.—Houston [14th Dist.] Dec. 8, 2009, pet. denied) (“[B]y definition, if particular damages are specifically accounted for in the contract, they are direct, not consequential in nature.”). It is also worth mentioning that state categorization of damages affects whether a party’s pleadings are sufficiently pled. For example, in Texas, direct damages do not require a special pleading, whereas consequential damages must be specifically pleaded. TEX. R. CIV. P. 56. 23. Tenn. Gas Pipeline Co. v. Technip USA Corp., No. 01-06-00535-CV, 2008 Tex. App. LEXIS 6419, at *2 (Tex. App.—Houston [1st Dist.] Aug. 21, 2008, pet. denied). 24. Id. at *8. 25. Id. at *3.

8


[6:1

costs it accrued due to the delay.26 Technip claimed that the expenses were barred under the contract’s waiver of consequential damages.27 The court of appeals held that, because the contract “clearly contemplated” that TGP would be responsible for the services, the expenses related to those services were direct damages.28 However, the expenses incurred to rent a generator were consequential because such expenses did not necessarily result from the breach.29 Thus, the contract language controlled the court’s determination of direct versus consequential damages. B. Incidental Damages Incidental damages may be defined to “include costs incurred in a reasonable effort, whether successful or not, to avoid loss” related to the breach. 30 Examples of incidental damages include a party paying brokerage fees to arrange a substitute transaction and costs to return or reject defective goods or equipment. 31 Waivers of incidental damages could prevent a party from recovering the reasonable costs to attempt to avoid a loss or to remedy a breach, and these types of waivers should “almost always” be resisted. 32 For example, under a contract without a waiver of incidental damages, a seller of nuclear fuel was able to recover $293 million for a large incidental storage bill when the buyer failed to perform under the contract. 33 If the parties had instead included in the contract a waiver of incidental damages, the seller may not have been able to recover damages for the large foreseeable storage bill. 34 It bears mentioning that incidental damages appear to be the least similar to the other damages in the above example

26. Id. 27. Id. 28. Tenn. Gas Pipeline Co., 2008 Tex. App. LEXIS 6419, at *8. 29. Id. 30. RESTATEMENT (SECOND) OF CONTRACTS § 347 cmt. c (1981). 31. Brian L. Hager, The Unintended Consequences of Consequential Damages Waivers, HUNTON & WILLIAMS (Mar. 2013), http://www.richmondbar.org/wpcontent/uploads/2013/07/business_law_tip_March_2013.pdf. 32. Avoiding Unintended Consequences of Damage Waiver Provisions in M&A Agreements, GIBSON DUNN (July 10, 2012), http://www.gibsondunn.com/publications/ pages/AvoidingUnintendedConsequences-DamageWaiverProvisionsMAAgreements.aspx. 33. Commonwealth Edison Co. v. Allied Chem. Nuclear Prods., Inc., 684 F. Supp. 1429 (N.D. Ill. 1988). 34. Id.

2015]


9

waiver of consequential damages (even though they are commonly included under the same section heading: “Waiver of Consequential Damages”). As such, parties should be wary of grouping this type of damages together with consequential damages. If parties nevertheless do so, language should be provided in the document stating that headings are for convenience purposes only. C.

Indirect Damages

Indirect damages are “consequential damages” according to some commentators, while others disagree. 35 One court noted that the meaning of “indirect damages” is “a question on which it is difficult to obtain much assistance from authority or dictionary definitions.” 36 Even so, it would be beneficial for a buyer to do as follows: [I]nstead of waiving “consequential” damages, buyers should seek waivers of “remote” or “speculative” damages. Even the term “indirect” damages is preferable to the term “consequential” damages for a buyer. In the alternative, buyers should suggest limiting the seller’s indemnification obligation to losses “directly” arising from the breach, particularly if the seller says it is concerned with “indirect” consequences arising from intervening causes.37 D. Punitive Damages Punitive damages are tort based and awarded as a punishment for over-the-top behavior.38 Courts generally do not award punitive damages in breach of contract cases and it makes little to no difference if the parties waive this type of damages.39 E. Lost Profits Loss of future revenue, income or profits is the “most common form of consequential damages[;] however, not all lost 35. See West & Duran, supra note 1, at 792. 36. Caledonia N. Sea Ltd. v. London Bridge Eng’g Ltd., [2000] S.L.T. 1123, 1207 (Sess.), available at http://www.scotcourts.gov.uk/opinions/cou1308.doc. 37. West & Duran, supra note 1, at 806. 38. Lawrence Hsieh, Drafting Waiver of Consequential Damages, N.Y. L.J., Mar. 8, 2012, available at http://www.newyorklawjournal.com/id=1202544728589/DraftingWaiver-of-Consequential-Damages?slreturn=20150230011315 (requires a subscription to access); see Punitive Damages Definition, LEGAL INFO. INST., https://www.law.cornell.edu/ wex/punitive_damages (last visited May 23, 2015). 39. Kingsley v. Baker/Beech-Nut Corp., 546 F.2d 1136, 1142 (5th Cir. 1977).

10


[6:1

profits are consequential damages.”40 In fact, it may be costly to waive lost profits as a subset of consequential damages. For example, lost profits could be direct (as opposed to consequential) damages upon a wrongful termination of the contract itself. The non-breaching party could claim as direct damages the expected profits from the contract had the breaching party fully performed.41 However, if the breach of the same contract causes termination of other contracts, then the lost profits may be consequential damages.42 Therefore, buyers may want to avoid language that waives lost profits as a separate category from consequential damages. In fact, one court held that the following provision waived recovery of lost profits, both consequential and direct, because it treated lost profits as a separate category of damages: “Neither party shall be liable for incidental, punitive, exemplary, indirect or consequential damages, or lost profits arising under or relating to this Agreement.”43 F. Diminution in Value Diminution of value or multiples of earnings “is a measure of value equal to the difference in the market value of what was warranted or promised under the contract and what was actually received.” 44 A claim for diminution of value could be categorized as either a claim for direct or consequential damages.45 Therefore, if a buyer agrees to the example waiver above, it may waive forms of both direct and indirect damages, hindering any ability to recover the appropriate damages under the contract. V. BEYOND HADLEY Parties should recognize that the example consequential damages waiver that often appears in the boilerplate of a contract may heavily impact the amount of damages recoverable. If special attention is not paid to the seemingly synonymous string of words, there may be various unintentional consequences

40. Hager, supra note 31, at 2. 41. Id. 42. Id. 43. Thomas H. Warren, W. Jason Allman & Andrew Morris, Top Ten Consequential Damage Waiver Language Provisions to Consider, ASS’N OF CORPORATE COUNSEL (July 1, 2012), http://www.acc.com/legalresources/publications/topten/ttcdwlptc.cfm. 44. Id. 45. See id. (stating diminution in value damages can be indirect or direct damages).

2015]


11

and an unanticipated allocation of risk. The following tips may be followed in nearly every transaction:   

Consider the type of damages that a party would need to recover to be made whole under the contract and draft accordingly; In the event of doubt, attempt to negotiate a damages cap on a whole, rather than a waiver of specific types of damages; and Do not waive the ability to recover incidental damages, lost profits or, if applicable, diminution in value.

While the lesson from Hadley v. Baxendale is often to inform the other party of special circumstances, an overly aggressive consequential damages waiver may nevertheless waive that remedy dearly bargained for.