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Reassessing the “Consequences” of Consequential
Damage Waivers in Acquisition Agreements
By Glenn D. West and Sara G. Duran *
Consequential damage waivers are a frequent part of merger and acquisition agreements
involving private company targets. Although these waivers are heavily negotiated, the au-
thors believe that few deal professionals understand the concept of consequential damages
and, as a result, the inclusion of such waivers may have an unexpected impact on both
buyers and sellers. The authors believe that this Article is the first attempt to define “conse-
quential damages,” as well as some of the other terms used as purported synonyms, in the
merger and acquisition context. After tracing the historical derivation of the term and its
current use by the courts, this Article considers the impact of such waivers in a hypotheti-
cal business acquisition and proposes some specific guidelines for the negotiation of these
waivers.
All deal professionals evaluating a private company acquisition transaction
should (and most do) fully appreciate the effect of contractual damage caps. In-
deed, a fundamental part of today’s private company deal market is that sellers
frequently limit the maximum damages for which they may be held liable for
breaches of their representations and warranties to a specified percentage of the
purchase price.^1 Sellers rely upon these contractual damage caps in making dis-
tributions of sales proceeds to equity holders after the closing, and buyers take
these caps into account in pricing the deal and approaching their due diligence.^2
Less understood by most deal professionals and many of their counsel, however,
is the added limitation on a buyer’s potential recovery resulting from certain “loss
exclusions” commonly set forth in the indemnification provisions of acquisition
agreements.
- Glenn D. West is a partner and Sara G. Duran is an associate in the Private Equity Group of Weil, Gotshal & Manges LLP. The authors express their appreciation to Joseph M. Nathan and Sachin Kohli, both associates in the Private Equity Group of Weil, Gotshal & Manges LLP, and Toni Anderson and Jill Meyer, former student associates at Weil, Gotshal & Manges LLP, for their research assistance with this Article.
- See MERGERS & A CQUISITIONS S UBCOMM., COMM. ON NEGOTIATED ACQUISITIONS, SECTION OF B US. LAW, AM. BAR ASS’ N, 2007 PRIVATE TARGET MERGERS & ACQUISITIONS DEAL P OINTS STUDY 68–71 (2007), available at http://www.abanet.org /abanet /common /login /securedarea.cfm?areaType=committee&role=CL 00&url=/buslaw/committees/CL560000/materials/matrends/2007_private.pdf.
- See Glenn D. West, Avoiding Extra-Contractual Fraud Claims in Portfolio Company Sales Transactions—Is “Walk-Away” Deal Certainty Achievable for the Seller? , WEIL, G OTSHAL & M ANGES LLP P RIVATE E QUITY A LERT , Mar. 2006, http://www.weil.com /news/pubdetail.aspx?pub=3368.
778 The Business Lawyer; Vol. 63, May 2008
In our experience,^3 these “loss exclusions” are thought by many to exclude
items that should not be recoverable losses in the first place. Losses that are not
actually incurred by the buyer as a result of the seller’s breach obviously are not
recoverable regardless of any specific exclusion.^4 Nevertheless, losses covered by
insurance, losses that could have been avoided or mitigated by the buyer, losses
recoverable from a third party, and losses for which there is a corresponding tax
benefi t are all examples of the kinds of losses that are expressly excluded from the
indemnification provisions of many acquisition agreements to limit recoverable
losses beyond the understood and agreed-upon cap. Each of these exclusions
can contain traps for the unwary and may unintentionally exclude out-of-pocket
losses that the buyer sustains. Exclusions relating to any of these losses, therefore,
need to be carefully and appropriately limited. But by far the most often included
and overlooked of these loss exclusions (and perhaps the one with the most sig-
nifi cant traps) is a provision excluding all “consequential” or “special” damages.
Contrary to popular belief, “consequential damages” do not compensate a buyer
for remote or speculative losses that fall into the category of items that should not
be treated as true losses at all; rather, consequential damages compensate the
buyer for real losses that the buyer has sustained as the result of the seller’s breach
of a bargained-for representation and warranty.^5 It is critical, therefore, that both
the buyer and seller understand and appreciate the effect of excluding consequen-
tial damages from recoverable losses.
THE “BOILERPLATE” CONSEQUENTIAL DAMAGE WAIVER CLAUSE
While there is truly no “standard” consequential damage waiver clause, the fol-
lowing is an example of one we frequently see in initial drafts of private company
acquisition agreements (with common variations bracketed):
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, inciden-
tal, 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.
- Our observations throughout this Article about “loss exclusions,” consequential damage waiv- ers in acquisition agreements, and the attorneys and deal professionals who draft and rely on them are based on our combined thirty-four years of experience representing clients in acquisitions and divestitures.
- See Neb. Nutrients, Inc. v. Shepherd, 626 N.W.2d 472, 481 (Neb. 2001) (“Uncertainty as to the fact of whether damages were sustained at all is fatal to recovery... .”); see also 25 C.J.S. Damages § 40 (2008) (“Where it cannot be shown with reasonable certainty that any damage resulted from the act complained of, there can be no recovery... .”); 17A A M. J UR. 2D Contracts § 707 (2008) (“[T]he mere breach of an agreement that causes no loss to the plaintiff will not sustain a suit for damages... .”).
- See infra notes 50–55 and accompanying text.
780 The Business Lawyer; Vol. 63, May 2008
to attempt to import tort-based concepts into a contractual arrangement, and sophisticated deal professionals and their counsel should welcome any provision reaffi rming that only the contract defines the parties’ relationship.^9 As a result, the
inclusion of punitive or exemplary damages in a waiver provision should cause no
particular angst to either party.
All of the other enumerated terms in the above “boilerplate” consequential
damage waiver provision should cause some concern, particularly to a buyer who
has otherwise agreed to bear all of its losses sustained as a result of the seller’s
breach of bargained-for representations and warranties to the extent those losses
fall below an agreed-upon deductible or exceed an overall cap on the seller’s in-
demnifi cation obligations. In the pressure to make a deal, however, deal profes-
sionals and their counsel may gloss over these provisions.
“CONSEQUENTIAL DAMAGES” IN PRIVATE COMPANY ACQUISITION
A GREEMENTS—A SHOCKINGLY AMBIGUOUS TERM
Few deal professionals or their counsel can define “consequential damages”
accurately and many misconstrue the impact a waiver of such damages may have
in the event the buyer later seeks to enforce its bargained-for representations and
warranties from the seller.^10 In fact, there is little case law construing the effect of
waivers of consequential damages in the specific context of mergers and acquisi- tions, and, as far as we have been able to determine, this is the first Article that has attempted to do so. Most of the case law regarding consequential damages arises in the context of the sale of equipment or goods, construction contracts, or agree- ments to provide transportation or other services. 11 Even in these frequently liti-
gated arenas, however, the term “consequential damages” does not appear to have
(finding that punitive damages are not available where sole claim is for breach of contact); E.I. DuPont de Nemours & Co. v. Pressman, 679 A.2d 436, 445 (Del. 1996) (holding that unless bad faith breach of contract amounts to a tort, there are no punitive damages for breach of contract); Jim Walter Homes, Inc. v. Reed, 711 S.W.2d 617, 618 (Tex. 1986) (finding that where only injury is economic loss to the subject of the contract itself, recovery lies in contract and exemplary damages are inappropriate); Kewin v. Mass. Mut. Life Ins. Co., 295 N.W.2d 50, 55 (Mich. 1980) (holding that exemplary damages are only appropriate to compensate plaintiff in cases in which defendant acts tortiously).
- For further discussion about the application of contractual principles to various aspects of the acquisition agreement, see West, supra note 2; Glenn D. West & Kim M. Shah, Debunking the Myth of the Sandbagging Buyer: When Sellers Ask Buyers to Agree to Anti-Sandbagging Clauses, Who Is Sandbagging Whom? , M&A LAW., Jan. 2007, at 3.
- It may be a sad commentary on the state of deal lawyering generally but, as suggested by one court, many of the most sophisticated and “heavily counseled” acquisition agreements contain “glar- ingly ambiguous terms that lead to avoidable litigation.” See Johnson & Johnson v. Guidant Corp., 525 F. Supp. 2d 336, 353 (S.D.N.Y. 2007). The term “material” in a material adverse change clause is a good example of an often used but frequently misunderstood term that appears in acquisition agreements without definition. See Kenneth Adams, What Does “Material” Mean? , D EAL LAW., Sept.–Oct. 2007, at 4; Glenn D. West & S. Scott Parel, Revisiting Material Adverse Change Clauses—Private Equity Buyers Should (but Mostly Can’t/Don’t) Special Order Their MACs , W EIL, GOTSHAL & M ANGES LLP PRIVATE EQUITY ALERT , July 2006, http://www.weil.com /news/pubdetail.aspx?pub=3261.
- See, e.g., infra note 13.
Reassessing the “Consequences” of Consequential Damage Waivers 781
a “clearly established meaning.”^12 Nevertheless, a consequential damage waiver
(as subsequently interpreted by a court in the context of a particular agreement)
is generally enforced against a counterparty to a contract, even if the effect is to
exclude all damages resulting from a breach of the affected agreement.^13
While sellers have legitimate concerns over their potential liability for breach
of contractual representations and warranties, there are other means of addressing
those concerns without the use of terms that have such uncertain meanings. Simi-
larly, where buyers have otherwise agreed to deductibles and caps with respect to
the aggregate recovery that they can obtain from the seller in the event the seller
breaches contractual representations and warranties, they need to consider the
burden a consequential damage waiver may add in light of their already limited
remedies. For example, if a buyer agrees to a consequential damage waiver (like
the “boilerplate” waiver above), and the seller breaches a representation that it
is in compliance with a specific customer contract on which the buyer expects
to earn an above-market profit, what damages can the buyer recover against the
seller when the customer terminates that contract based on the seller’s pre-closing
breach? Does the fact that the buyer’s losses are the profits that it could have
earned from the affected customer contract make those losses consequential dam-
ages? Would all the losses from breach of this representation be unrecoverable
pursuant to the above “boilerplate” waiver provision to the extent “lost profits”
were a stand-alone loss exclusion independent of whether the lost profits were
“consequential damages”? Even if the buyer could recover the lost profits from
that contract, what about the fact that the buyer priced its acquisition based on a
multiple of the business’s earnings? Or, what if the seller breaches a representation
as to its compliance with certain laws, and the failure of the acquired business to
comply with those laws exposes the buyer’s parent and its affiliates to debarment
or fi nes in addition to the direct negative impact on the acquired business? Are the
losses suffered by the buyer’s parent and its affiliates consequential losses arising
from the seller’s breach of the bargained-for representation or direct losses given
the known effect of a violation of those laws?
- See, e.g. , Applied Data Processing, Inc. v. Burroughs Corp., 394 F. Supp. 504, 508 (D. Conn.
- (“neither in Michigan nor elsewhere does the term ‘consequential damages’ have a clearly es- tablished meaning”). See also Caledonia N. Sea Ltd. v. London Bridge Eng’g Ltd., [2000] S.L.T. 1123, 1207 (Sess.) (noting that the meaning of indirect and consequential losses “is a question on which it is diffi cult to obtain much assistance from authority or dictionary definitions”); Gregory K. Morgan & Albert E. Phillips, Design Professional Contract Risk Allocation: The Impact of Waivers of Consequential Damages and Other Limitations of Liabilities on Traditional Owner Rights and Remedies , 33 J.C. & U.L. 1, 13 (2006) (stating that “no one knows what consequential damages are or may be, at least not with predictability or uniformity”).
- See, e.g. , ASCH Webhosting, Inc. v. Adelphia Bus. Solutions Inv., LLC, No. 04-2593 (MLC), 2007 WL 2122044, at *5 (D.N.J. July 23, 2007); Marley Cooling Tower Co. v. Caldwell Energy & Envtl., Inc., 280 F. Supp. 2d 651, 658 & n.3 (W.D. Ky. 2003); World-Link, Inc. v. Citizens Telecomms. Co., No. 99CIV3054 GEL, 2000 WL 1877065, at *4 (S.D.N.Y. Dec. 26, 2000). However, exclusionary clauses (like consequential damage waivers) may not always work in the case of an intentional tort or other deliberate act. See, e.g. , Apache Bohai Corp. LDC v. Texaco China BV, 480 F.3d 397, 406 (5th Cir.
- (holding that in accordance with New York public policy, limitations of liability do not apply to intentional or grossly negligent acts); Kalisch-Jarcho, Inc. v. City of N.Y., 448 N.E.2d 413, 416 (N.Y. 1983) (finding that an exculpatory clause is unenforceable to excuse intentional wrongdoings).
Reassessing the “Consequences” of Consequential Damage Waivers 783
to a contract, therefore, simply involves the court “seek[ing] to approximate the agreed-upon performance.”^20 As a result, the beginning premise of the law of contract damages is that all losses sustained by a non-breaching party (whether those losses are termed conse- quential, special, general, incidental, or direct) are recoverable as damages against a breaching party to the extent necessary to place the non-breaching party in the position in which such party would have been had there been no breach of contract.^21 In the law of contract (unlike the law of torts), however, the damages
awarded for breach of contract are subject to a number of limitations that prevent
a breaching party from being responsible for every conceivable loss that can be di-
rectly traced to the breach. In fact, in both the United States and the United King-
dom, losses sustained by a non-breaching party for which damages are awarded
against the breaching party, including “consequential damages,” generally must be
“the natural, probable and reasonably foreseeable [or within the contemplation of
the parties as a] consequence of the [breach].”^22 The rationale for this rule is that
it “serves to encourage contractual relations and commercial activity by enabling
parties to estimate in advance the financial risks of their enterprise.”^23 Thus, to
defi ne “consequential damages” as those losses that are so remote that they were beyond the contemplation of the parties at the time they entered into the contract is to define consequential damages as losses for which the law does not allow recovery in contract, regardless of any provision excluding such damages. Yet, many sellers purport to require waivers of consequential damages because they believe consequential damages relate to losses beyond those that the breaching party would have ordinarily and reasonably foreseen or contemplated.^24 The rules limiting all contractual damages to those that are “natural, probable, and reasonably foreseeable” impose a judicially created “rule of reasonableness” that generally limits the extent to which any damages, including consequential damages, may be awarded for breach of contract. 25 As a result, even in the absence
of a contractual waiver of consequential damages, this standard of reasonableness
- Id. at 460.
- See, e.g. , Reynolds Metals Co. v. Westinghouse Elec. Corp., 758 F.2d 1073, 1079 (5th Cir. 1985); World Metals, Inc. v. AGA Gas, Inc., 755 N.E.2d 434, 437 (Ohio Ct. App.), appeal denied , 754 N.E.2d 262 (Ohio 2001) (unpublished table decision); Smith v. Green, [1875] 1 C.P.D. 92, 94; Robinson v. Harman, [1848] 1 Exch. 850, 855; Victoria Laundry (Windsor) Ltd. v. Newman Indus. Ltd., [1949] 2 K.B. 528, 539.
- See Enter. Oil Ltd. v. Strand Ins. Co. Ltd., [2006] EWHC (Comm) 58, [2006] 1 C.L.C. 33, 49. See also Applied Equip. Corp. , 869 P.2d at 460 (“Contract damages are generally limited to those within the contemplation of the parties when the contract was entered into or at least reasonably foreseeable by them at that time; consequential damages beyond the expectations of the parties are not recoverable.”).
- Applied Equip. Corp. , 869 P.2d at 460. For a further discussion of the rationale, see Vanderbeek v. Vernon Corp. , 50 P.3d 866, 871 (Colo. 2002) (“The Hadley rule is designed to further a fundamental principle of contract law: parties must be able to confidently allocate risks and costs during their bar- gaining without fear that unanticipated liability may arise in the future, effectively negating the parties’ efforts to build these cost considerations into the contract.”).
- Paul S. Turner, Consequential Damages: Hadley v. Baxendale Under the Uniform Commercial Code , 54 SMU L. REV. 655, 663 (2001).
- See JOSEPH M. LOOKOFSKY, CONSEQUENTIAL DAMAGES IN COMPARATIVE CONTEXT 254 (DJOF Publishing
- (1989).
784 The Business Lawyer; Vol. 63, May 2008
creates limits on the extent of the non-breaching party’s recovery for losses that the breaching party did not otherwise specifically agree to bear. This judicially created “rule of reasonableness” originated in the nineteenth century English case of Hadley v. Baxendale. 26 Law students study this case 27 and most can likely recite its facts. It has been followed by courts throughout the United States and the United Kingdom, and it remains an important touchstone around the world. 28 In our experience, Hadley is also the case most often referred to in any
discussion of “consequential damages,” although the court in Hadley never used
that term.
THE LEGACY OF H ADLEY V. BAXENDALE
For those unfamiliar with the facts of Hadley , we give a brief primer. Hadley owned and operated a flour mill.^29 The crankshaft used to operate Hadley’s mill broke and the mill had to be shut down.^30 Each day that the mill was not operat- ing resulted in lost business for Hadley. 31 Hadley needed a new crankshaft and the shaft’s manufacturer was located in a different city.^32 Hadley hired Baxendale’s common carrier firm to deliver the broken crankshaft to the manufacturer so that the crankshaft could be used as a pattern for a replacement part that would fit with the existing parts in Hadley’s mill.^33 Hadley apparently did not inform the carrier fi rm of the reason he needed the crankshaft to be delivered to the manu- facturer or the specific impact that a delivery delay would cause to Hadley’s mill. 34 Nevertheless, Baxendale’s carrier firm agreed to transport the broken shaft to the manufacturer the day after the firm received it from Hadley.^35 In breach of that agreement, Baxendale’s carrier firm did not ship the crankshaft until five days after receiving it from Hadley. 36 Hadley brought suit against Baxendale’s carrier firm and sought recovery for his lost profits resulting from the mill being shut down for the additional period beyond when the mill would have been shut down had the shaft been transported at the agreed time.^37
- (1854) 9 Ex. 341, 156 Eng. Rep. 145.
- See, e.g. , STEWART MACAULAY, JOHN KIDWELL & WILLIAM WHITFORD, CONTRACTS: LAW IN ACTION 110– (2d ed. 2003).
- See Lookofsky, supra note 25, at 12.
- Hadley , 9 Ex. at 342.
- Id.
- See id. at 344.
- Id. at 342.
- Id. at 342–43.
- There is controversy about these facts more than 150 years after the case was decided. There is some evidence that Baxendale’s clerk was in fact told that the mill was shut down due to the broken crankshaft, but he was apparently not informed that the mill would remain shut down until the old crankshaft was delivered to the manufacturer so that a new crankshaft could be made. See Eisenberg, supra note 16, at 570 n.26.
- Id. at 343.
- Id.
- See id. at 342–44.
786 The Business Lawyer; Vol. 63, May 2008
rule limiting contract damages to those that are natural, probable, and reasonably
foreseeable cease to apply to a contract breach where a broadly worded indemni-
fi cation provision is triggered by that breach?
A typical indemnification provision has an indemnifying party agreeing to “in-
demnify and hold the Buyer Indemnified Parties harmless from and against any
Losses incurred by the Buyer Indemnified Parties based upon or arising from any
breach of the representations and warranties made by the Seller in this Agreement.”
There may also be specific indemnification provisions covering the occurrence of
particular events or litigation unrelated to any breach of the agreement that sim-
ply require the seller to indemnify the buyer for all losses that the buyer incurs
as the result of any of those specific events. “Losses” are usually broadly defined
to include “all losses, liabilities, obligations, damages, actions, suits, proceedings,
claims, demands, assessments, judgments, costs, penalties, and expenses, includ-
ing reasonable attorney’s fees and disbursements,” and “Buyer Indemnified Par-
ties” are defined to include the buyer and various affiliated persons. Many times
the indemnification provisions are the sole and exclusive remedy of the buyer
under the agreement. These indemnification provisions may also set a cap on the
maximum amount that may be recoverable thereunder, contain exclusions from
recoverable losses below certain thresholds or deductibles, and provide for cer-
tain categories of losses (most notably, “consequential losses”) that are simply not
recoverable under any circumstance.
Contract damages are recoverable simply based on the fact that there was a
breach of the contract, wholly apart from the existence of an indemnification
provision and independent of whether there is any provision in the contract speci-
fying the remedy for that breach.^43 Indeed, an obligation to indemnify for losses
incurred as the result of a specified event is distinguishable from the liability that
arises from breach of the contract itself. Damages for breach of contract are de-
signed to compensate a party for non-performance of the contract; an indemni-
fi cation provision, on the other hand, obligates the indemnifying party to pay
money if certain events occur.^44 When the indemnification claim is triggered by
specific events that are unrelated to any breach of the underlying contract, this
distinction appears clear, and imposing limitations on indemnification payments
related to the probability or foreseeability of the specific events seems inappropri-
ate. As one Scottish court has noted:
In the case of an indemnity the parties are deemed to have had in contemplation that
a claim might arise, and it is immaterial how improbable it is that a claim would arise
- See Marranzano v. Riggs Nat. Bank of D.C., 184 F.2d 349, 350 (D.C. Cir. 1950) (“The right of the party to a contract to sue when damaged by the other party’s violation of it does not depend upon the grant of such right by the terms of the contract itself.”); see also 17A AM. JUR. 2 D Contracts § 709 (2008) (“Although the parties may, in their contract, specify a remedy for a breach, that specification does not exclude other legally recognized remedies.”).
- See County & Dist. Props. Ltd. v. C. Jenner & Son, [1976] 2 Lloyd’s Rep. 728, 737 (QBD) (citing Birmingham & Dist. Land Co. v. London & N. W. Ry. Co. (No. 1), (1887) L.R. 34 Ch.D. 261, 276 (CA)).
Reassessing the “Consequences” of Consequential Damage Waivers 787
or that the circumstances in which the claim arises might be of an unusual nature, so
long as the claim is of a type which prima facie falls within the indemnity. 45
When the indemnification claim is triggered by a breach of the contract itself, however, the distinction between the indemnification obligation and the underlying breach of contract becomes a little less clear. If breach of contract claims are subject to the rule of reasonableness and an indemnification claim for breach of contract is brought pursuant to a specific contractual provision, why should the rule of reason- ableness not remain applicable, unless the parties clearly and unequivocally make it inapplicable? As one English court noted with respect to an indemnification provi- sion indemnifying a party for “all consequences” of the other party’s breach:
It would be odd in such circumstances if [a party] were legally liable to indemnify a loss
which was not recoverable for breach of contract, and vice versa.... [U]nder a clause
where the indemnity is triggered by a breach of contract, the indemnity is subject to
the same rules of remoteness as are damages, including the rules under Hadley v. Bax-
endale. Thus “all consequences” would mean “all consequences within the reasonable
contemplation of the parties.” If the law is prepared to select some consequences as
relevant and others not, and in contract to do so in accordance with the reasonable
contemplation of the parties, then absent clear language to the contrary I do not see
why the parties should not be viewed as intending to cover only consequences which
are reasonably foreseeable and not consequences which are wholly unforeseeable.... [
W]here the indemnity is triggered by a breach of contract, the indemnity as a matter of
construction, absent contrary provision of which “all consequences” is not to my mind
an example, only covers foreseeable consequences caused by that trigger.^46
Delaware appears to follow the same reasoning as this English case, suggesting that the analysis that governs the award of damages for breach of contract also governs claims for indemnification that are triggered by a breach of the contract
in which such indemnification provisions are contained.^47 On the other hand, an-
other English court has suggested the opposite conclusion. Noting that the court in Hadley had specifi cally recognized the right of parties to a contract to specify the damages that would be payable upon a default, the court in Patrick & Co. Ltd. v. Russo-British Grain Export Co. Ltd.^48 suggested that a contract of indemnity
was exempt from Hadley’s default rules governing damages. The rationale for this
suggestion was that a contract of indemnity specifies the damages payable in the
event of a default under the underlying contract, not a promise to perform some
obligation, the breach of which would itself give rise to damages.^49
- Caledonia N. Sea Ltd. v. London Bridge Eng’g Ltd., [2000] S.L.T. 1123, 1178 (Sess.).
- Total Transp. Corp. v. Arcadia Petroleum Ltd. (The Eurus), [1996] 2 Lloyd’s Rep. 408, 432 (QBD Comm), aff’d , [1998] 1 Lloyd’s Rep. 351 (CA Civ).
- See Cobalt Operating, LLC v. James Crystal Enters., LLC, No. Civ. A. 714-VCS, 2007 WL 2142926, at *30 (Del. Ch. July 20, 2007) (“In Delaware, damages recoverable under indemnification provisions such as the one involved here include all injurious consequences that were within the contemplation of the parties at the time the contract was made.”), aff’d , No. 491, 2007, 2008 WL 652142 (Del. Mar. 11, 2008).
- [1927] 2 K.B. 535.
- Id. at 539 (“Where a contract contains a term that the promisor, if he shall not perform some term of the contract, shall pay a sum ascertained by the contract or ascertainable under its terms, and
Reassessing the “Consequences” of Consequential Damage Waivers 789
default beyond those losses that would normally and necessarily result from such breach in the absence of the non-breaching party’s “special circumstances.” 55 Even more simplistically, “consequential” or “special” damages should be understood as encompassing all contractually recoverable damages that do not fit within the cat- egory of either “incidental” damages or “direct” damages. To understand the mean- ing of “consequential” or “special” damages, therefore, one must first understand the meaning of “incidental” and “direct” damages.
THE MEANING OF “INCIDENTAL” AND “DIRECT ” DAMAGES AS INFORMING THE MEANING OF “CONSEQUENTIAL” OR “SPECIAL” DAMAGES
The term “incidental” damages is not a synonym for “consequential” damages. Indeed, “incidental” damages are a very limited category of damages. “Incidental” damages are limited to the expenses incurred by: (i) a buyer in connection with the rejection of non-conforming goods delivered by the seller in breach of con- tract, or (ii) by a seller in connection with the wrongful rejection by a buyer of conforming goods delivered by the seller to the buyer. 56 For example, if a buyer contracted to receive a 2007 Lexus LS 460 and instead received a 2007 Lexus ES 350, the cost of returning the wrong car to the dealer would be “incidental” damages. Similarly, if a buyer ordered a new boiler for its plant and the delivered boiler was defective, the costs of attempting to fix the problem by repairing the defective parts or the costs of returning the defective boiler to the seller might also be treated as “incidental” damages. Thus, all costs and expenses incurred by the non-breaching party to avoid other direct and consequential losses caused by the breach can be considered “incidental” damages. 57 It is ill-advised, there- fore, to include “incidental” damages in a loss exclusion provision under the assumption that the term is a synonym for consequential damages. “Direct” damages (also known as “general” damages) are more difficult to de- fi ne clearly. For example, according to one New York court, “direct” or “general” damages seek to compensate the non-breaching party for “the value of the very performance promised,” while “ ‘[s]pecial’ or ‘consequential’ damages... seek to
- This understanding of “consequential damages” is described in various ways. For example, in one case decided under New York law, consequential damages were defined as “damages which arise from special circumstances that make them probable, although they would be unusual apart from such circumstances.” Nat’l Investor Servs. Corp. v. Integrated Fund Servs., Inc., 85 F. App’x 779, 781 (2d Cir. 2004) (quoting Coastal Power Int’l, Ltd. v. Transcon. Capital Corp., 10 F. Supp. 2d 345, 364 (S.D.N.Y. 1998), aff’d , 182 F.3d 163 (2d Cir. 1999)).
- See Roy Ryden Anderson, Incidental and Consequential Damages , 7 J.L. & COM. 327, 334 (1987). See also U.C.C. § 2-715 (2002) (“Incidental damages resulting from the seller’s breach include ex- penses reasonably incurred in inspection, receipt, transportation and care and custody of goods right- fully rejected, any commercially reasonable charges, expenses or commissions in connection with effecting cover and any other reasonable expense incident to the delay or other breach.”); R ESTATEMENT (SECOND) OF C ONTRACTS § 347 cmt. c (1981) (“Incidental losses include costs incurred in a reasonable effort, whether successful or not, to avoid loss, as where a party pays brokerage fees in arranging or attempting to arrange a substitute transaction.”).
- See Anderson, supra note 56, at 334.
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compensate a plaintiff for additional losses (other than the value of the promised performance) that are incurred as a result of the defendant’s breach.”^58 Linking “direct” damages to those damages that compensate a non-breaching party for the value of the contractually promised performance could lead to the conclusion that “direct” damages, in the context of a breach of a representation and warranty, are limited to “market-measured” damages, i.e., the difference between the value of assets or stock as purchased by the buyer and the value such assets or stock “would have had if they had been as warranted by the seller.”^59 Indeed, it is often assumed that the general (or direct) damages available to a buyer as the result of a seller’s breach of warranty in connection with a sale of assets are limited to “the difference between the contract price and the market or cover price,” with all other damages suffered by the buyer relegated to the realm of “special or conse- quential damages.”^60 But “[t]here is no general rule that direct damages are limited to the difference between the value of the product or service contracted for and the value of the product or service actually provided.”^61 In fact, while “direct” damages certainly include “market-measured” damages, they also include all losses “which arise ‘naturally’ or ‘ordinarily’ from a breach of contract; they are damages which, in the ordinary course of human experience, can be expected to result from a breach.”^62 Stated differently, “[d]irect damages are the necessary and usual result of the defendant’s wrongful act; they flow naturally and necessarily from the wrong.” 63 The instructions given to a jury in a Texas case are illustrative of the correct un- derstanding of “general” or “direct” damages:
“Direct damages” means those damages which naturally and necessarily flow from a
wrongful act, are so usual an accompaniment of the kind of breach alleged that the
mere allegation of the breach gives sufficient notice, and are conclusively presumed to
have been foreseen or contemplated by the party as a consequence of his breach. 64
We therefore gain the best understanding of “direct” or “general” damages by refer- ring to the first branch of Hadley’s contract damage limitation tree; i.e., “direct” or “general” damages are “those which may fairly and reasonably be considered as arising naturally from the breach” of any similar contract (“in the great multitude of such cases”) and which do not arise from any special circumstances applicable to the non-breaching party.^65
- Schonfeld v. Hilliard, 218 F.3d 164, 175–76 (2d Cir. 2000).
- See, e.g. , In re Enron Corp., 367 B.R. 384, 408 (Bankr. S.D.N.Y. 2007).
- See, e.g. , Eisenberg, supra note 16, at 565.
- Wärtsilä NSD N. Am., Inc. v. Hill Int’l, Inc., 436 F. Supp. 2d 690, 697 (D.N.J. 2006).
- Roanoke Hosp. Ass’n v. Doyle & Russell, Inc., 214 S.E.2d 155, 160 (Va. 1975).
- Wade & Sons, Inc. v. Am. Standard, Inc., 127 S.W.3d 814, 823 (Tex. App. 2003).
- Carlisle Corp. v. Med. City Dallas, Ltd., 196 S.W.3d 855, 865–66 (Tex. App. 2006), r ev’d on other grounds, No. 06-0660, 2008 WL 1145752 ( Tex. Apr. 11, 2008).
- Wärtsilä , 436 F. Supp. 2d at 697 (citing Addressograph-Multigraph Corp. v. Zink, 329 A.2d 28, 33–34 (Md. 1974)). For another definition of “general” damages, see City of Milford v. Coppola Constr. Co., 891 A.2d 31, 39 (Conn. App. Ct. 2006) (“ ‘General damages are considered to include those damages that flow naturally from a breach, that is, damages that would follow any breach of similar character in the usual course of events.’ ” (quoting 24 WILLISTON ON CONTRACTS § 64:12 (4th ed. 2006))).
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act.”^69 Thus the idea that “consequential” simply means “indirect” is potentially misleading. As articulated by one court:
The distinction between general [or direct] and special [or consequential] damages
is not that one is and the other is not the direct and proximate consequence of the
breach complained of, but that general [or direct] damages are such as naturally and
ordinarily follow the breach, whereas special [or consequential] damages are those
that ensue, not necessarily or ordinarily, but because of special circumstances. 70
In other words, consequential damages are not unbounded and unlimited losses loosely traceable to a contract breach. Rather, consequential damages are 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 circum- stances.
CONSEQUENTIAL DAMAGES ARE NOT LIMITED TO “LOST PROFITS” AND NOT ALL “LOST PROFITS” ARE CONSEQUENTIAL DAMAGES
Lost profi ts are clearly the most common form of consequential damages sought in a breach of contract case.^71 Lost profits, however, are not the only form
of consequential damages and not all lost profits constitute consequential dam-
ages. Certain lost profi ts can in fact be “direct” damages. 72 A good example is a
construction contract. If a property owner wrongfully terminates a construction contract with the contractor, the direct damages that naturally arise from that wrongful termination are the “profits necessarily inherent in the contract,” i.e., the “net profit to which the contractor would have been entitled had full performance of the contract been permitted.”^73 Similarly, if a breach foreseeably and naturally
deprives the non-breaching party of profits that would have been earned in the or-
dinary course of business and not under special circumstances, those lost profits
may also constitute direct damages rather than consequential damages.^74
- Wade & Sons, Inc. v. Am. Standard, Inc., 127 S.W.3d 814, 823 (Tex. App. 2003).
- Applied Data Processing, Inc. v. Burroughs Corp., 394 F. Supp. 504, 509 (D. Conn. 1975) (citing 5 A. C ORBIN, CORBIN ON CONTRACTS § 1011 (1974)).
- See Eisenberg, supra note 16, at 565.
- See, e.g. , Penncro Assocs., Inc. v. Sprint Spectrum, L.P., 499 F.3d 1151, 1156 (10th Cir. 2007); Computrol, Inc. v. Newtrend, L.P., 203 F.3d 1064, 1071 n.5 (8th Cir. 2000); ViaStar Energy, LLC v. Motorola, Inc., No. 1:05-cv-1095-DFH-WTL, 2006 WL 3075864, at *5 (S.D. Ind. Oct. 26, 2006); DP Serv., Inc. v. AM Int’l, 508 F. Supp. 162, 167 (N.D. Ill. 1981); Cont’l Holdings, Ltd. v. Leahy, 132 S.W.3d 471, 475 (Tex. App. 2003); Iino Shipbuilding & Eng’g Co. v. Hellenic Lines, Ltd., 175 N.Y.S.2d 750, 754 (N.Y. App. Div. 1958), aff’d , 157 N.E.2d 726 (N.Y. 1959). See also Sha-shana N.L. Crichton, Dis- tinguishing Between Direct and Consequential Damages Under New York Law in Breach of Service Contract Cases , 45 HOW. L.J. 597, 601 (2002) (“Lost profits and lost future earnings are categorized as direct damages in some instances, and consequential damages in others.”).
- Imaging Sys. Int’l, Inc. v. Magnetic Resonance Plus, Inc., 490 S.E.2d 124, 126 (Ga. Ct. App. 1997) (quoting Franklin v. Demico, Inc., 347 S.E.2d 718, 721 (Ga. Ct. App. 1986), and Williams v. Kerns, 265 S.E.2d 605, 609 (Ga. Ct. App. 1980)), aff’d , 543 S.E.2d 32 (Ga. 2001).
- See, e.g. , supra note 72. In the classic English case of Victoria Laundry (Windsor) Ltd. v. New- man Industries Ltd. , [1949] 2 K.B. 528, the court apparently deemed ordinary lost profits natural and foreseeable under the first branch of Hadley and did not require special notice, but the extraordinary
Reassessing the “Consequences” of Consequential Damage Waivers 793
In the context of a business acquisition priced at a multiple of revenue, lost profits may be the only true basis upon which to determine market-measured direct damages for breach of a representation affecting that revenue. 75 Specifi- cally excluding “lost profits” in addition to “consequential damages,” therefore, may result in the exclusion from recoverable losses of “direct” damages and the only actual losses that the non-breaching party has sustained. Nevertheless, it is a com- mon fixture of consequential damage exclusions to exclude “lost profits” as re-
coverable losses, in addition to consequential damages, regardless of whether the
lost profits constitute consequential damages or are in fact direct damages.^76 As
previously noted, many deal professionals and their counsel do this because they believe, wrongly, that the term “lost profits” (like the term “indirect damages” or “incidental damages”) is simply a synonym for “consequential damages.”^77
SO WHAT HAVE WE LEARNED?
“Consequential damages” are simply those losses suffered as a result of a breach that would not have occurred in the absence of some special circumstance appli- cable to the non-breaching party that would not normally have been applicable to most other parties to a similar contract. If the buyer would have suffered losses “in the great multitude” of situations involving buyers of similar businesses, the court should properly view the losses as “direct” rather than “consequential” damages. Assuming the damages sought by the buyer do in fact qualify as “con- sequential damages,” the buyer has to establish that its consequential damages are recoverable pursuant to Hadley’s rule of reasonableness, which is applicable to all contract damage claims, including claims for “direct damages.” Under Hadley’s rule of reasonableness, all damages the buyer seeks from the seller (both direct
profi ts that would have been obtainable from an available and highly lucrative government contract were not recoverable under that branch because there was no notice. See id. at 542. See also Transfield Shipping Inc of Panama v. Mercator Shipping Inc of Monrovia (The “Achilleas”), [2007] 2 Lloyd’s Rep. 555 (CA Civ) (holding that loss of profits from loss of new ship charter contract because of ship’s late return by current charterer are losses arising under first, not second, branch of Hadley ).
- See, e.g. , Cobalt Operating, LLC v. James Crystal Enters., LLC, No. Civ. A. 714-VCS, 2007 WL 2142926, at *30 (Del. Ch. July 20, 2007), aff’d , No. 491, 2007, 2008 WL 652142 (Del. Mar. 11, 2008).
- In the “boilerplate” consequential damage waiver, this distinction is not made unless “[includ- ing]” is eliminated, “[or any]” is included, and the terms “lost profits” and “lost revenues” are thereby treated as standalone damage exclusions.
- Courts tend to do this as well. See, e.g. , Topp, Inc. v. Uniden Am. Corp., No. 05-21698-CIV, 2007 WL 3256849, at *3 (S.D. Fla. Aug. 23, 2007); Aurora Health Care, Inc. v. CodoniX, Inc., No. 03-C-612, 2006 WL 1589629, at *7 (E.D. Wis. June 2, 2006); Roneker v. Kenworth Truck Co., 977 F. Supp. 237, 240 (W.D.N.Y. 1997); Scott v. Palermo, 649 N.Y.S.2d 289, 289 (N.Y. App. Div. 1996). So, deal counsel can perhaps be excused for this common misconception. Notwithstanding the com- mon linking between all lost profits and consequential damages, the distinction between a clause that lists lost profits as a subset of consequential damages and a clause that lists lost profits as a separate category of excluded losses can, in fact, be a critical one. See, e.g. , Penncro Assocs., Inc. , 499 F.3d at 1155–62; Spinal Concepts, Inc. v. Curasan, No. 3:06-CV-0448-P, 2006 WL 2577820, at *5–6 (N.D. Tex. Sept. 7, 2006); Sing. Telecomms. Ltd. v. Starhub Cable Vision Ltd., [2006] 2 S.L.R. 195, 218 (Sing. Ct. App.); Ease Faith Ltd. v. Leonis Marine Mgmt. Ltd., [2006] EWHC (Comm) 232, [2006] 1 Lloyd’s Rep. 673, ¶¶ 139–50.
Reassessing the “Consequences” of Consequential Damage Waivers 795
companies in merger and acquisition transactions. While our first hypothetical involves the purchase of a bull, and not a business, the legal principles applicable to one apply equally to the other.
APPLYING WHAT WE HAVE L EARNED TO A CONSEQUENTIAL DAMAGE
H YPOTHETICAL—THE I NFECTIOUS INFERTILITY SYNDROME^83
Imagine a situation in which a breeder of prize bulls sells one of her bulls to a cattle rancher. The cattle rancher plans to use the purchased bull (together with bulls she already owns) to impregnate her substantial herd of heifers and reap the profits from the sale of the resulting calves the following spring, as well as to improve the quality of her herd through the retention of some of the calves for future use. In the bill of sale, the buyer specifically demands (and the selling breeder, having no actual knowledge to the contrary, provides) a written warranty that the purchased bull is disease free and fertile. It turns out that the purchased bull has a contagious disease that not only renders the bull infertile but infects and renders infertile all of the rancher’s other bulls. As a result, there are no calves born the next spring. In addition, the rancher contracted with a neighboring rancher to loan the neighbor for a fee several of her existing bulls to impregnate the neighbor’s herd. The contract with the neighboring rancher contained a war- ranty respecting the loaned bulls similar to the warranty provided by the breeder respecting the purchased bull. Because of the unknown infertility of our rancher’s bulls (caused by the infection spread from the purchased bull), the neighbor has now suffered losses similar to the losses suffered by our rancher, and the neighbor is looking to our rancher for recovery. Worse still, our rancher, in reliance upon the anticipated profits from her calf crop and the breeding fees from the neigh- boring rancher, mortgaged her ranch to buy adjoining land to accommodate her growing herd. As a result of her lost profits, she was unable to pay her mortgage and the bank foreclosed on her ranch.^84 Assuming our rancher can prove that the purchased bull caused the barrenness of her herd of heifers, the infertility of her other bulls, and the infertility of her neighbor’s heifers, what are our rancher’s damages? How much of those damages are legally recoverable from the selling breeder? Would the answer be different if
- Any discussion of consequential damages invariably involves the use of a hypothetical. Typi- cally a hypothetical in this area is a situation in which wild and ruinous losses are incurred by a contracting party and “caused” by a given breach for which no one would willingly make him- or herself liable. Properly understood, most of the wild and ruinous losses imagined in any such hypo- thetical are actually non-recoverable “remote” damages (i.e., damages that are not natural, probable, and reasonably foreseeable), not recoverable “consequential” damages arising from the buyer’s special circumstances contemplated by the parties at the time they entered into the contract. But we hope our own hypotheticals illustrate the difference between non-recoverable “remote” damages and recover- able “consequential” damages and between “direct” damages and “consequential” damages.
- This hypothetical fact pattern is loosely based on the English case of Smith v. Green , [1875] 1 C.P.D. 92, 94, the Scottish case of Waddington v. Buchan Poultry Products, Ltd. , [1963] S.L.T. 168 (Sess.), and the U.S. case of Baden v. Curtiss Breeding Service , 380 F. Supp. 243 (D. Mont. 1974). For other hypotheticals with some similar facts, see Lookofsky, supra note 25, at 64, 253 ( Contagious Abortion hy- pothetical and Bull Semen hypothetical), and Treitel, supra note 18, at 167 (Pothier cow hypothetical).
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the breeder had specifically indemnified our rancher for “all losses” that she sus- tained as a result of any breach of the breeder’s written warranty? What would the impact be on our rancher’s damages if the infertility disease were curable and the bull (together with the other infected bulls) could, after an inexpensive treatment, be returned to full health notwithstanding the loss of an entire calving season? How would any of these answers differ if our rancher had waived any claim for “consequential damages” in connection with the breeder providing the warranty or agreeing to an indemnity? We assume in our hypothetical that our rancher has no ground for asserting a claim of fraud against the breeder. As a result, our rancher’s remedies are limited to the damages available for breach of contract (as opposed to tort-based remedies).^85
APPLYING CONTRACT’S RULE OF REASONABLENESS
TO THE RANCHER’S LOSSES
There is no question that our rancher has suffered substantial losses as a result of the breeder’s breach of warranty. The promised performance was the delivery of a disease-free and fertile bull. That did not occur. Based on the general damages rule for breach of contract,^86 our rancher should be entitled to whatever amounts would compensate her fairly for all losses she has sustained as a result of the breeder’s failure to deliver the bull in its warranted condition. But Hadley’s rule of reasonableness generally limits the recovery of damages to those losses (whether direct or consequential) that are natural, probable, and reasonably foreseeable at the time the contract was made.^87 Despite the loss of her ranch, it is very unlikely that any court would allow the rancher to recover damages for that loss in the absence of some specific in- demnifi cation agreement by the breeder. The losses are not natural, probable, or reasonably foreseeable. Thus, absent a clear indemnification provision, this loss is a remote loss and is unrecoverable even in the absence of a consequential damage waiver. On the other hand, the cost of replacing the defective bull with one that is fertile and disease free is natural, probable, and reasonably foreseeable, as is the cost of restoring the bull to the disease-free and fertile condition that was war- ranted.^88 These are the market-measured direct damages available for any breach
- For a discussion of extra-contractual claims of fraud in the context of contractual limitations on available remedies, see West, supra note 2.
- See supra note 21.
- See supra note 22. The two branches of Hadley’ s rule of reasonableness are actually two different means of establishing foreseeability. Damages from the first branch (i.e., direct damages) are dam- ages foreseeable because they occur in the “great multitude of such cases.” Damages from the second branch require evidence of actual knowledge by the breaching party of the non-breaching party’s “special circumstances” to hold the breaching party responsible for such damages. “[T]here are not so much two rules, as two means by which a defendant may possess the knowledge necessary to make his liability a fair one. That knowledge may either arise from the ‘usual course of things’, [sic] or from the communication of special circumstances... .” See Transfield Shipping, 2 Lloyd’s Rep. at 567, 570.
- Note, however, that the cost of repair or restoration must be reasonable and is generally limited by the diminution in value attributable to the breach. See Jacob & Youngs, Inc. v. Kent, 129 N.E. 889, 891 (N.Y. 1921). In a case for breach of a construction contract, Judge Benjamin Cardozo set forth
