Consequential Loss and IT Lawyers

August 31, 1998

As well as dealing with abstruse areas of intellectual property and telecommunications regulation, computer lawyers need to deploy some basic contract law. Contractual issues are hot topics in the IT world for a number of reasons, including the following:

  • the IT business is particularly sophisticated and most commercial arrangements are committed to print in exhaustive detail by talented and creative clients and lawyers
  • the transactions are of relatively high value and the potential economic losses arising out of defective performance are equally high
  • as we are constantly made aware, the imminent millennial date changes may catch certain systems and processors by surprise and cause immense problems for the unprepared, the unprotected or the uninsured.

If only by reason of the millennium factor, there is no hotter topic than the effect of exclusion clauses.

Excluding Liability

` …The Supplier shall not be liable for any indirect or consequential loss however caused …’

Even as merely the starting point for negotiations, the above words are well known to lawyers and used on a regular basis. The first question is: what do they mean? The second question is: are they dangerous?

The aim of this article is, in the light of the recent Court of Appeal decision of British Sugar plc v NEI Power Projects Limited and Another [1998] ITCLR 118, to suggest to those involved in drafting and negotiating IT contracts that the undefined use of the word ‘consequential’ in the context of exclusion clauses should cease.

Even if it does not (for obvious pragmatic reasons) achieve that ambition, it may assist greater understanding of a commonly used legal phrase and how potential dangers can be averted.

Types of Loss

We bandy around the following phrases and distinctions and sometimes confuse ourselves.

  • Reliance loss/Expectation loss
  • Direct/Indirect loss
  • Direct loss/Consequential loss
  • General damage/Special damage
  • First limb Hadley v Baxendale loss / Second limb Hadley v Baxendale loss

Sometimes the distinctions need clarifying and sometimes they are unhelpful.

The Context

We may as well start with a brief look at some of the facts from the most recent and celebrated (reported) IT failure litigation, St Albans City and District Council v International Computers Limited [1995] FSR 686 (Scott-Baker J.); [1997] FSR 251 (CA; Nourse, Hirst LJJ, Sir Iain Glidewell).

As a result of a mistake in rate collection software, the district authority had a shortfall in its income for 1990-1 of £484,000 (receipts shortfall). It had to pay its local county council, by way of precept, an additional £1,795,000 which with various adjustments came to £685,000 (unfunded payments). With interest of £145,886 for two years (and a slight arithmetical error), the total awarded by Scott Baker J came to £1,314,846. Scott Baker J made no allowance for the fact that the receipts shortfall was recouped the next year. The Court of Appeal decided that such allowance should have been made and only awarded the unfunded payments, although interest on the receipts shortfall for one year was allowed. So the Council’s damages were reduced to £758,509.

The type of loss recoverable in this case was not categorised under any particular type or any particular heading. Given the nature of the tender documentation, ICL were found to have known all about the council’s financial requirements and the entire loss, subject to the recoupment argument, was held to be recoverable. No distinction along Hadley v Baxendale (HvB) lines was made, in fact HvB was not mentioned.

The exclusion clause in question disclaimed all liability for ‘any indirect or consequential loss or loss of business, or loss of profits sustained by the customer’ and restricted loss not within these categories to the sum of £100,000. The clause was found to be part of ICL’s written standard terms of business and to fail the reasonableness test thereby made applicable by the Unfair Contract Terms Act 1977.

What was the nature of the St Albans loss?

You might argue that this loss was recoverable under the second limb of HvB (HvB2): it is clear that the tender documents gave ICL every indication of why St Albans DC needed the system and what the consequences would be if it failed. The loss did not arise from the failure itself: such loss would involve the additional cost of a replacement system or any necessary remedial costs. However, it might also be powerfully suggested that loss of profits or anticipated savings on a computer system are first limb (HvB1) matters given the ubiquity of IT and the general awareness of its capabilities and risks.

It certainly appears to me that Scott Baker J treated the loss as direct loss rather than ‘consequential loss’ because he looked very closely at thereasonableness of the £100,000 limit in all the circumstances, and did not feel the need to look at the total exclusion of consequential loss.

The point is not easy and that is why it is unhelpful to define ‘consequential loss’ in terms of one limb rather than another. But this is how British Sugar may regrettably and dangerously be applied.

What British Sugar decided

In British Sugar, the Court of Appeal confirmed the meaning attributed to ‘consequential loss’ in Croudace Construction Ltd v Cawood’s Concrete Products Limited [1978] 2 Lloyd’s Rep 55 which is summarised in Chitty on Contracts as follows: ‘The exclusion of liability for ‘`consequential loss or damage’‘ will not cover loss which directly and naturally results in the ordinary course of events…, but only loss which is less direct and more remote’. It seems to have disapproved a passage in McGregor on Damages equating ‘consequential loss’ with indirect loss or rather loss beyond ‘damage to the thing contracted for’.

The decision itself is, regrettably, an inadequately edited and reported transcript of an ex tempore Court of Appeal judgment and does not provide any particularly helpful review of the relevant principles. It may also go beyond the authorities on which it relied. In summary, it is a case which should be noted and skirted around by well-informed lawyers.

It appears that NEI supplied faulty equipment to British Sugar for a price of around £100k. As a result of breakdowns in the power supply, increased production costs and loss of profits due to breakdowns led to a damages claim of over £5m. The applicable contractual exclusion clause was construed as follows:

`The seller will be liable for any loss… arising from the supply… save that the Seller’s liability for consequential loss is limited to the value of the contracts.’

On a preliminary issue, Lord Justice Waller held:

`On a proper reading of that clause, an obligation was being placed on the defendants to pay such damages as flowed naturally and directly from any supply by the defendants of faulty goods or materials, with the limitation being imposed in relation to some other type of loss which did not flow so directly, for example, damages which might flow from special circumstances and come within the second limb of Hadley v Baxendale.’

However, the effect and consequences of this decision are nevertheless not clear from the report.

The point is that loss of profits is not necessarily always or ever anHvB2 matter. As seen above, HvB was not mentioned in St Albansat all. Had the British Sugar clause been present in St Albans,and had it been found to be free of UCTA problems, the full loss might stillhave been recoverable as ‘direct’ loss. St Albans District Council wouldhave won their full damages and the clause would not have protected the softwarehouse. It can be strongly argued that certain types of financial loss, includingloss of expected profits, flow ‘naturally’ and ‘directly’ from faultysoftware.

The reference to HvB2 in British Sugar is misleading andpotentially dangerous. In the cases which led up to British Sugar and on whichthe Court of Appeal relied, principally Croudace, HvB was not referredto as a defining factor, simply a source of examples of what mightamount to consequential loss. One definition tracked through appears to be thesubmission of Mr Garland QC, as he then was, accepted by Parker J at firstinstance in Croudace:

`… all loss and damage survives save only such damage as, in the absence ofthe clause, would only have been recoverable on proof of special circumstances.Put another way, it is submitted that nothing is within the word‘`consequential’‘ if it directly and naturally results in the ordinarycourse of events…’

This, as I have suggested above, is the case with much financial loss causedby shortcomings in computer systems. Financial loss and loss of profits is justas ‘direct’ and ‘natural’ as having to replace or repair a piece ofdestroyed hardware.

The Danger for the Unwary

knowledge, specialised in selling to numerous local authorities then itis arguable that the loss would have been ‘direct’, arising naturally underHvB1. Thus, if British Sugar is followed too literally, it is notexcludable by the classic clause.

British Sugar and the cases preceding it have made life verydifficult for suppliers and defendants attempting to rely on an exclusion ofconsequential loss. That is because whether something is direct, natural orconsequential will vary with the facts and the circumstances and an additionalcomplication arises if you try to fit it into HvB categories whichshould really be limited to the remoteness issue.

The Lessons to be Learnt

Depending on the facts, the parties and the type of business involved, thesame loss can be either ‘direct’ or ‘consequential’. And your standardreliance on the classic clause excluding consequential loss (and limiting onlydirect loss) may not work as you want it to work, even though you havenegotiated it and it is completely reasonable according to all the establishedtests.

The distinctions between direct, indirect, and consequential loss are now sounhelpful that they should be avoided. Loss is recoverable or it isn’t. Thereare three main steps in analysing a situation:

  • identify and distinguish reliance loss and expectation loss in respect of which there is a choice to be made (see Anglia Television v Reed [1972] 1 QB )
  • look at remoteness issues based on foreseeability which is where HvB comes in but where, more importantly, a test of the commercial background and the particular type of business involved will be necessary
  • consider how the risk has been allocated – this will involve looking at the validity of any exclusion clauses.

This is one of those areas where an analysis of the detailed facts and theparties’ knowledge and expectations is as important as any statement of legalprinciple.

How to Draft an Exclusion Clause

This is an exercise which is imperative in the light of the uncertaintiescaused by the almost universal awareness that the advent of the years 1999 and2000 will cause disputes over responsibility for various kinds of loss. Forgetthe words ‘consequential loss’, ‘indirect loss’ or any such confusingterms of art. Look at the transaction as a whole. Identify the risks involvedand any special circumstances concerning the intentions of the person who willuse the system or solution and the claims made for it by the provider. Definethose risks in your own terms and allocate the risk by reference to the usualfactors: contractual price, bargaining position and availability of insurance.Then exclude and limit by reference to those definitions, making sure that it isclearly a negotiated document, with trade-offs offered and given in return fordifferent levels of exclusion.

And if you must use the term ‘consequential loss’, make sure yourdefinition is an umbrella of the specific forms of loss which concern you. Butone resolution, for the years 1999, 2000 and the ensuing millennium, might be toditch it completely.