Contracts refresher: excluding liability for loss of profits

When a technology contract goes wrong, customers will often suffer not just from a loss of systems but also from disruption to their business.

When a technology contract goes wrong, customers will often suffer not just from a loss of systems but also from disruption to their business. Disruption may lose them vital revenues and even give rise to claims from customers. It would seem intuitive that contracts should be clear cut and allow customers to claim for loss of profit. But the position is far from clear. As a result, customers and suppliers must carefully craft their contracts if they are to effectively include or exclude claims for loss of profits.

The key issue is that English law only allows losses to be claimable if they are not unlikely or reasonably foreseeable as a result of the breach at the time the contract was entered into. Exceptionally, claims may be allowed where at the time the contract was concluded the parties had special knowledge of a certain kind of loss (e.g. that one of the customer’s contracts depended on delivery by the supplier). These principles were established in Hadley v Baxendale (1854) 9 Ex Ch 341 and Heron II [1969] 1 AC 350, and  reiterated over the years.

These types of loss are often referred to in shorthand as “direct” loss to describe the “not unlikely” or foreseeable kind and “indirect loss” to cover other losses which are only claimable if special knowledge is evident. The distinction can quickly become unhelpful if the longhand definitions are forgotten as plainly a kind of loss like damage to property, on different sets of facts, could be direct or indirect under the Hadley v Baxendale test. This leads to a lot of confusion as people try to pigeonhole, say, loss of profits as necessarily being in one category or another. In reality, lawyers need to look to the case law for guidance on whether loss of profits have been determined to be claimable in similar circumstances to the ones they face, and then draft the best they can to reinforce or avoid the consequences.

The courts have therefore long recognised that loss of profits arising from a breach of contract can be a direct loss or an indirect loss, depending on the circumstances, including the nature of the contract and the nature of the breach. It is essential then that the exclusion and limitation provisions make clear whether any references to “loss of profits” are to all loss of profits (both direct and indirect), or only one or the other. Two High Court cases last year – Fujitsu v IBM, [2014] EWHC 752 (TCC) and Polypearl Limited v E.on Energy Solutions Limited [2014] EWHC 3045 (QB) – illustrate well the approach taken by the courts when interpreting exclusions of “loss of profits” in the context of direct and indirect loss and the pitfalls where the contract is unclear. Before commenting on these cases, it is helpful to delve further into the approach the courts take when interpreting exclusions clauses designed to avoid liability for loss of profits (should losses be claimable under the Hadley v Baxendale rule).

Interpreting exclusion and limitation clauses: the courts’ approach

Liability provisions in a contract typically exclude or cap a party’s liability for certain types of losses. It is important for all parties that these provisions are drafted clearly and unambiguously. A clearly drafted clause is less likely to be disputed, and if it ever fell to the courts to interpret the clause, there is less risk that the court might interpret it in a way that was not anticipated, leaving a party exposed to unexpected risks and liabilities. Good exclusion clauses do not leave it to the case law to decide what will be direct or indirect loss. They spell out the division of risk between the parties, and expressly exclude some types of loss (or cover other types through express warranties and indemnities).

In the past, the courts strained their interpretation of exclusion/limitation clauses to reach a fair or just outcome. Now, though, the courts will generally uphold and give effect to the literal meaning of a clause that has been negotiated between experienced business parties, provided the clause is clear, unambiguous and not open to more than one meaning and not drafted so widely that a party’s obligations are effectively robbed of contractual force, (i.e. so that obligations are just statements of intent).

The general approach taken by the courts when interpreting an exclusion/limitation clause is the same as for any other part of the contract, namely:

1. Ascertain what a reasonable person would have understood the parties to mean. The “reasonable person” is assumed to have all the background knowledge which would reasonably have been available to the parties in the situation in which they were at the time of the contract;[1]
2. If that approach results in two possible interpretations, then the court will generally take the interpretation that is most consistent with business common sense;[2]
3. Where the parties have used unambiguous language, the court will apply it;[3]
4. There is a presumption that a party does not intend to abandon any remedies arising by operation of law. Clear express words must be used in order to rebut this presumption.[4]
5. The court will strain against interpreting an exclusion clause in a way that renders a party’s obligation under the contract no more than a statement of intent. The court will not reach that conclusion unless no other conclusion is possible.[5]

Loss of profit; direct and indirect loss

It is good practice, when drafting an exclusion or limitation clause, to set out clearly the types of loss that the parties intend will be recoverable (subject to any agreed cap) and those that will be excluded. This gives the parties more certainty than relying on a clause that refers in broad terms to “direct” and “indirect” losses.

Care is needed when drafting to make clear whether references to “loss of profits” are to both the direct and indirect kind, or only one or the other. Two High Court cases last year illustrate well the approach taken by the courts when interpreting exclusions of “loss of profits” and the pitfalls where the contract is unclear.

Fujitsu v IBM

In Fujitsu v IBM, the court had to decide whether an exclusion clause in a sub-contract between IBM and Fujitsu effectively excluded IBM’s liability for all loss of profits (i.e. direct and indirect), or for only “indirect” loss of profits.  IBM was the principal contractor under a contract for the provision of IT and business process change services and Fujitsu was its subcontractor. Fujitsu alleged that IBM had breached the subcontract by failing to allocate to Fujitsu the performance of services that, under the terms of the sub-contract, should have been performed by Fujitsu. As a preliminary issue, the High Court had to consider the exclusion clause in the sub-contract, which read:

“20.7 Neither Party shall be liable to the other under this Sub-Contract for loss of profits, revenue, business, goodwill, indirect or consequential loss or damage…”

Were the types of loss listed in the clause (loss of profits, revenue etc.) intended to be examples of indirect or consequential loss? The court ruled that the clause excluded liability for all loss of profit, not just the “indirect” kind. If the intention was to exclude indirect loss of profit only, the court said that it would have expected the parties to make this clear.   The references to “loss of revenue, business or goodwill” were not necessarily indicative of indirect loss. As it stood, the clause did not make “loss of profit” a sub-set of “indirect or consequential loss”. There was nothing in the context or surrounding clauses that pointed to a different interpretation than to simply apply the words of the clause.

Polypearl Limited v E.on Energy Solutions Limited

The same issue arose in a more recent case – Polypearl Limited v E.on Energy Solutions Limited.  Polypearl claimed that E.On Energy Solutions was in breach of a minimum spend commitment under an agreement for the sale/purchase of cavity wall insulation products. Polypearl claimed loss of profits of £2.1m on the shortfall and, as a preliminary issue, the court had to consider whether the following clause excluded liability for all loss of profit or for indirect loss of profit only:

“(10.1) Neither party will be liable to the other for any indirect or consequential loss, (both of which include, without limitation, pure economic loss, loss of profit, loss of business, depletion of goodwill and like loss) howsoever caused (including as a result of negligence) under this Agreement, except in so far as it relates to personal injury or death caused by negligence.”

Polypearl argued that its lost profits on the shortfall were a direct loss, and the judge agreed. The judge noted that the words in parenthesis made the meaning of the clause ambiguous. Did these words mean that Clause 10.1 applied only to indirect or consequential loss of profit? The court ruled that the clause excluded liability for indirect/consequential loss of profits, and not direct loss of profits:

1. The most likely (and often the only) damage that Polypearl would suffer from E.on’s failure to meet the minimum spend commitment would be a loss of profits. It was unlikely that a business person would wish to exclude this direct loss;
2. It was more in accordance with business common sense to interpret the words in parenthesis as an explanation of the phrase “indirect or consequential loss” rather than an attempt to place all loss of profits in the “indirect” category;
3. The clause did not clearly indicate that the parties intended to abandon a claim for direct loss of profits. The clause did not go far enough to rebut the presumption that the parties to a contract do not intend to abandon any remedies for a breach of contract arising by operation of law.

 Drafting tip      

It seems from these cases (and others)[6] that ambiguity around whether a particular type of loss is excluded or not commonly arises where references to specific types of loss (e.g. loss of profit, revenue, goodwill etc.) are bundled in with a reference to “indirect” loss. If the intention is to exclude liability for a certain type of loss in all cases, whether the loss is direct or indirect, then one way of avoiding this ambiguity is to separate out the exclusion of liability for indirect loss and the exclusion of liability for that specific type of loss.

[1] Rainy Sky v Kookmin [2011] UKSC 50, at 14

[2] Rainy Sky v Kookmin [2011] UKSC 50, at 21

[3] Rainy Sky v Kookmin [2011] UKSC 50, at 23

[4]Modern Engineering (Bristol) Ltd v Gilbert-Ash (Northern) Ltd [1974] AC 689 at 717

[5]Astrazeneca v Albermarle [2011] EWHC 1574, at 313

[6] See for example Proton Energy Group SA v Orlen Lietuva [2013] EWHC 2872 (Comm)