Understanding Consequential Damages
Consequential damages waivers are included in most contracts, and can expose a company to significant liabilities, or just as easily bar a company from recovering for significant losses. These should be considered among the “commercial” terms of a contract and negotiated to fit your circumstances.
Recovery After a Breach
To appreciate the impact of a consequential damages waiver, an understanding of what a party can legally recover under a contract is essential. Normally, when there is a breach of contract, the non-breaching party is entitled to recover damages from the breaching party as compensation for the harm suffered as a result of the breach. If not otherwise specified, these damages generally consist of all losses that would be the reasonably foreseeable consequences of the breach. They can be divided into two broad categories: “direct damages” and “consequential damages.”
A good working definition of direct damage is damage that immediately results from a breach (think of these damages as the first domino to fall as a result of the breach of contract). Consequential damages can be summed up as damages that do not flow directly and immediately from the breach.
The easiest way to see the difference between direct and consequential damages is through an example, such as a coal-fired power plant owner hiring a service provider to operate and maintain its coal yard and related equipment. If the O&M provider breaches the contract (say, due to poor maintenance), causing damages to the coal conveyors and thus forcing a shutdown of one of the boilers due to a lack of fuel, the damages to the coal conveyers would be direct and the damages (lost revenues) resulting from the shutdown of the boiler would be consequential.
A good working definition of direct damage is damage that immediately results from a breach (think of these damages as the first domino to fall as a result of the breach of contract). Consequential damages can be summed up as damages that do not flow directly and immediately from the breach.
The easiest way to see the difference between direct and consequential damages is through an example, such as a coal-fired power plant owner hiring a service provider to operate and maintain its coal yard and related equipment. If the O&M provider breaches the contract (say, due to poor maintenance), causing damages to the coal conveyors and thus forcing a shutdown of one of the boilers due to a lack of fuel, the damages to the coal conveyers would be direct and the damages (lost revenues) resulting from the shutdown of the boiler would be consequential.
Consequential Damages Waivers
A consequential damages waiver is a contractual provision that limits the liability of the breaching party by excluding, or waiving, recovery for consequential damages even if those damages are reasonably foreseeable. To return to our O&M agreement example, if the O&M agreement contained a consequential damages waiver, the power plant owner would not be able to recover lost revenues caused by the O&M provider’s breach. The consequential damages waiver would exclude any damages, other than direct damages, even if they are reasonably foreseeable because they were the second or third “dominos” to fall rather than the first.
What constitutes consequential damages, however, often depends on perspective. For instance, lost revenues or lost profits are often direct damages from a service provider’s perspective. In the example above, if the power plant owner breached the O&M agreement (instead of the O&M provider) by wrongfully terminating the agreement before the end of the agreed term, the direct result of the breach would be that the O&M provider would not realize the projected profits that it would have if the power plant owner had performed. In this case, the lost profits of the O&M provider are the first domino to fall, the direct damages. If the agreement precludes recovery of any lost profits (as many “boilerplate” consequential damages waivers do), the O&M provider could face a possible defense that it was not entitled to recover its expected profits over the rest of the term.
Consequential damages waivers also often specifically prohibit a non-breaching party from recovering what can be considered a subset of consequential damages known as “incidental damages.” Incidental damages consist of the losses and expenses incurred by the non-breaching party to address the resulting harm of the other party’s breach. In the context of the O&M agreement above, if the O&M provider failed to deliver a requested service, incidental damages may include the extra cost to identify and secure an alternative O&M provider to provide the necessary services. In a sale of goods context, incidental damages could include safeguarding or otherwise caring for defective goods until the seller makes arrangements for their removal. Such waivers are not necessarily a good idea for either party, as allowing recovery of incidental damages may actually encourage the non-breaching party to undertake mitigation efforts, thus potentially reducing the overall damages and the breaching party’s liability.
Often a party like the power plant owner will argue that it should be able to recover for consequential damages, like plant shutdowns, because this consequence was reasonably foreseeable to the O&M provider. But even if a party believes it is entitled to recover for consequential damages, other factors specific to each transaction must be considered.
One key consideration is the amount of money paid under the contract relative to the goods or services provided. Undoubtedly, the power plant owner would prefer the ability to recover for plant shutdowns. An O&M provider, however, is often reluctant to bear this risk because the service fees (and profit margins) it receives are usually small compared to the damages that would likely result from a shutdown of the power plant. One way parties may manage these risks in comprehensive power plant O&M agreements is for the O&M provider to warrant minimum availability over specified periods, with financial consequences of failing to meet the minimums—but O&M providers almost never accept liability for consequential damages.
Another key consideration is whether a consequential damages waiver is appropriate given the type of transaction. A consequential damages waiver may be entirely appropriate for a services agreement or an energy trading agreement. But in a trading agreement, parties should take care not to exclude damages for failure to deliver or receive the product or for early termination, even if such damages might arguably be considered “consequential.” In the context of a company purchasing an operating power plant or a company that owns one or more power plants, consequential damage waivers are often not included or are heavily negotiated, because some of the types of damages a buyer is most concerned about may be considered consequential.
Two final considerations that always come into play are a company’s own risk tolerance and the bargaining position of the parties.
What constitutes consequential damages, however, often depends on perspective. For instance, lost revenues or lost profits are often direct damages from a service provider’s perspective. In the example above, if the power plant owner breached the O&M agreement (instead of the O&M provider) by wrongfully terminating the agreement before the end of the agreed term, the direct result of the breach would be that the O&M provider would not realize the projected profits that it would have if the power plant owner had performed. In this case, the lost profits of the O&M provider are the first domino to fall, the direct damages. If the agreement precludes recovery of any lost profits (as many “boilerplate” consequential damages waivers do), the O&M provider could face a possible defense that it was not entitled to recover its expected profits over the rest of the term.
Consequential damages waivers also often specifically prohibit a non-breaching party from recovering what can be considered a subset of consequential damages known as “incidental damages.” Incidental damages consist of the losses and expenses incurred by the non-breaching party to address the resulting harm of the other party’s breach. In the context of the O&M agreement above, if the O&M provider failed to deliver a requested service, incidental damages may include the extra cost to identify and secure an alternative O&M provider to provide the necessary services. In a sale of goods context, incidental damages could include safeguarding or otherwise caring for defective goods until the seller makes arrangements for their removal. Such waivers are not necessarily a good idea for either party, as allowing recovery of incidental damages may actually encourage the non-breaching party to undertake mitigation efforts, thus potentially reducing the overall damages and the breaching party’s liability.
Often a party like the power plant owner will argue that it should be able to recover for consequential damages, like plant shutdowns, because this consequence was reasonably foreseeable to the O&M provider. But even if a party believes it is entitled to recover for consequential damages, other factors specific to each transaction must be considered.
One key consideration is the amount of money paid under the contract relative to the goods or services provided. Undoubtedly, the power plant owner would prefer the ability to recover for plant shutdowns. An O&M provider, however, is often reluctant to bear this risk because the service fees (and profit margins) it receives are usually small compared to the damages that would likely result from a shutdown of the power plant. One way parties may manage these risks in comprehensive power plant O&M agreements is for the O&M provider to warrant minimum availability over specified periods, with financial consequences of failing to meet the minimums—but O&M providers almost never accept liability for consequential damages.
Another key consideration is whether a consequential damages waiver is appropriate given the type of transaction. A consequential damages waiver may be entirely appropriate for a services agreement or an energy trading agreement. But in a trading agreement, parties should take care not to exclude damages for failure to deliver or receive the product or for early termination, even if such damages might arguably be considered “consequential.” In the context of a company purchasing an operating power plant or a company that owns one or more power plants, consequential damage waivers are often not included or are heavily negotiated, because some of the types of damages a buyer is most concerned about may be considered consequential.
Two final considerations that always come into play are a company’s own risk tolerance and the bargaining position of the parties.
Conclusion
While it is tempting for business and operational personnel to ignore the “boilerplate” legal provisions in a contract, it is important to understand the scope and effects of the consequential damages waiver. If the consequential damages waiver is not carefully considered when the deal is struck, it can result in a very unpleasant surprise if a breach does occur.
—Thomas H. Warren is a member of the Energy and Environmental Practice Group and chair of the Energy Projects Team at the law firm of Sutherland Asbill & Brennan LLP (Sutherland Asbill & Brennan LLP), and associate W. Jason Allman is also a member of that practice group.