Consequential loss is a loss that is not a direct or foreseeable result of the harm suffered. Generally, the law does not permit the recovery of consequential loss, which distinguishes it from direct and foreseeable loss. However, there are some important exceptions including where parties to a contract separately define what indirect loss means.
In this article, we explain what indirect loss is and how it is different from other kinds of loss.
When a party breaches a contract, one or all of the parties may suffer loss because they have incurred some kind of cost or expense or lost some benefit as a result of the breach.
The loss that may be suffered by a party could be either:
- direct loss;
- consequential (or indirect) loss; or
- a combination of both direct and consequential losses
Farrah Motley wrote this article. Farrah holds a bachelor’s degree in Law and Business (majoring in accounting) from the Queensland University of Technology. Farrah was admitted to the Supreme Court of Queensland in 2014 and is an experienced contract lawyer.
Why is consequential loss important?
The term “consequential loss” is often used in the context of commercial contracts. To a lesser extent, it is also used in business-to-consumer contracts. Consequential loss is considered to be an important part of managing contractual liability. It also changes the allocation of risk between parties to a contract.
Consequential loss exclusion clauses often go hand-in-hand with liability, indemnity and limitation of liability clauses. If one party wants to ensure they are not responsible for consequential loss, the other party may take on that responsibility. Parties often heavily negotiate consequential loss exclusion clauses.
Another reason why consequential loss is important is that if something goes wrong:
- a potential claim for damages can significantly grow. For instance, the direct loss may only be $100 but the consequential loss could be $1,000
- an insurance policy may not cover consequential loss. Therefore, the party in breach may have to pay for the damage out of their own pocket
What is the difference between direct and consequential loss?
There is a difference between:
- how the law distinguishes between direct and consequential loss; and
- how the parties to a contract agree to distinguish between direct and consequential loss.
How the law distinguishes between direct and consequential loss
There are several important cases that outline the legal position relating to consequential loss.
Hadley v Baxendale  EWHC J70
Under the Common Law (judge-made law), damages are recoverable for breach of contract in relation to a loss that is not too remote. Hadley v Baxendale set out the rules to determine whether the loss was too remote.
The Court stated that loss will not be too remote provided that it:
- ordinarily or naturally flows from the breach; or
- may reasonably be supposed to have been the probable result of a breach in the contemplation of both parties at the date of the contract
Initially, the approach taken was that “consequential loss” was a loss that fell into the 2nd category. But then came the case of Peerless…
Environmental Systems Pty Ltd v Peerless Holdings Pty Ltd (2008) 19 VR 358
In Peerless, the Court chose not to take the approach in Hadley v Baxendale. Instead, the Court found that the definition of “consequential loss” should be given its natural and ordinary meaning. The difference between direct and consequential loss was that:
- direct loss is a loss that every plaintiff in similar circumstances would suffer
- consequential loss is a loss that goes beyond the normal measure of damages
And then came Pacific Hydro…
The Court in Pacific Hydro used the terms “indirect damages” and “consequential damages” interchangeably. The Court said it should interpret them in their usual way like it did in the Peerless case.
However, the Court went a step further. It emphasised that the natural and ordinary meaning should be interpreted in the context of the contract as a whole.
Loss of profits and expenses incurred by a party due to a breach may (depending on the circumstances) be considered direct loss. However, different circumstances may consider it to be indirect loss.
How the parties to a contract agree to distinguish between direct and consequential loss
If a contract includes an indemnity clause, the usual elements for a breach of contract cause of action do not apply. If an event happens that the indemnity covers, the indemnity will be triggered. Depending on the wording of an indemnity clause, the clause may call for compensation for certain types of loss. The definition of loss is therefore important in the context of an indemnity.
If the indemnity requires compensation for certain types of loss which may be considered consequential loss at law, the party in breach may nevertheless be liable to pay the amount of consequential loss.
This can be problematic because the parties are (through the contract) changing the legal definition of direct and consequential loss. For the innocent party seeking to enforce the indemnity, it’s good news.
Under a claim for breach of contract, that loss may not be recoverable against the defaulting party. However, by claiming under the indemnity and expanding on the potential types of loss, the innocent party may be entitled to a greater amount of compensation.
How can consequential loss impact an insurance policy?
Generally, policies of insurance respond to legal liability, not contractual liability. This is not always the case. For instance, a policy of insurance may include an extension to cover liability assumed under a contract.
However, by and large, insurance policies will not cover an insured for indirect loss. This is because (at law) it is considered to be “consequential loss”. This becomes problematic when an insured has assumed liability under a contract for consequential loss.
If that loss would not otherwise be recoverable under the usual legal rules, the loss may not be covered by the insurance policy. This may mean that the insured is left out-of-pocket and the innocent party is compensated more. Contract lawyers often pay close attention to consequential loss clauses.
Real-life examples of consequential loss
Patersons Securities Ltd v Financial Ombudsman Service Ltd and Others (2015) 108 ACSR 483
In this case, Patersons Securities invested client money in a way that breached its contracts with two of its clients. The Financial Ombudsman awarded damages to the clients. The damages were the difference between the value of their portfolio investments and the value that they would have held if Patersons Securities had correctly invested their money under the contracts.
Mitchell J held that, despite constituting lost profits, those losses were direct (and therefore not “consequential losses”).
The critical concept applied was that ‘normal loss’ is a loss that every plaintiff in similar circumstances would suffer. Consequential losses were anything beyond that normal measure.
The ordinary and natural meaning of consequential loss distinguishes between:
- direct loss which flows naturally from the breach (without another cause) and
- indirect loss which does not flow naturally
Examples of consequential loss exclusion clauses
Here are some examples of consequential loss exclusion clauses. When negotiating contracts, I will consider the types of indirect loss that the parties may suffer. I make sure to tailor the clause to the deal being struck.
Example One – broad indirect loss
The example below is a broad exclusion of consequential loss:
Neither party is liable to the other for any indirect or consequential loss, including loss of profit, loss of revenue, loss of opportunity, loss of contract, loss of production or loss of goodwill, howsoever arising.
Example Two – using the Common Law definition of indirect loss
The example below simply reflects the legal definition of consequential loss (and it may not make any difference whether the exclusion was included or not):
Neither party is liable to the other for any loss which does not arise as the ordinary result of the breach by that party.
Is loss of profit considered “consequential loss”?
Before Peerless, there was a risk that the term ‘consequential loss’ always included a loss of profit.
After Peerless, many thought that the term ‘consequential loss’ would apply to economic loss and loss of profit. However, Pacific Hydro clearly stated that the examples given in Peerless were particular to that case and were not considered to apply as a general rule.
According to Pacific Hydro, whether the term ‘consequential loss’ covers loss of profit and loss of revenue will depend upon the circumstances of the matter.
When you make a contract, it should clearly state the specific types of losses you want to exclude. This applies to all the parties entering into a contract.
How can Prosper Law help?
We help Australian businesses with legal matters. We can review, negotiate and draft commercial agreements and consequential loss clauses. Contact us today if you need to talk to experienced contract lawyers.
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