The phrase “consequential loss” is very commonly used in exclusion and limitation of liability clauses. Despite its widespread use and a significant amount of case law on the topic, the legal meaning of the phrase in specific contexts is notoriously difficult to pin down. Moreover, there is a clear difference in the approaches applied by Australian and UK courts to interpreting the phrase. A recent decision of the Supreme Court of Western Australia has gone back to basics and, in doing so, has broken new ground on how to interpret the phrase.

Background

The recent decision of Regional Power Corporation v Pacific Hydro Group Two Pty Ltd [No 2] [2013] WASC 356 related to the Ord Hydro Power Station on Lake Argyle in the Kimberley region of northern Western Australia. The power station was constructed, owned and operated by Pacific Hydro under a power purchase agreement with Regional Power Corporation. The agreement was entered into in 1994. Under the agreement, Pacific Hydro was obliged to supply Regional Power Corporation with electricity. Regional Power was under a statutory duty to provide and maintain an efficient and economical supply of electricity to the region.

In 2006, the power station suffered an outage and was flooded as a result. This in turn resulted in the power station being inoperative for a 2 month period. The judgment does not go into all of the facts surrounding the outage; however, it appears that for some reason there was a loss of load which caused tripping in both of the hydro generators. The power station was equipped with an automatic back-up pumping system which sourced its power from an emergency generator. The emergency generator failed to start because “the programmable logic controller used to start the emergency generator had been incorrectly wired, such that its batteries were not adequately charged at the time of the incident.”

During the shut down period, Regional Power Corporation incurred significant expense to generate replacement electricity to meet its statutory obligations. The bulk of these expenses (approximately $4 million) related to the cost of hiring and operating diesel generators.

Regional Power Corporation sought to recover these expenses from Pacific Hydro. Regional Power claimed, amongst other things, that Pacific Hydro had breached the power purchase agreement by failing to build, operate and maintain the power station in compliance with “Good Engineering and Operating Practices“. Pacific Hydro denied any responsibility for the expenses. It pointed to the exclusion clause in the agreement:

“Neither [Pacific Hydro] nor [Regional Power Corporation] shall be liable to the other party in contract, tort, warranty, strict liability, or any other legal theory for any indirect, consequential, incidental, punitive or exemplary damages or loss of profits.”

Pacific Hydro argued that the expenses incurred by Regional Power were either “indirect” or “consequential” and therefore excluded by the clause. Regional Power argued the opposite.

The competing interpretations

It’s necessary to do a quick recap on the history of how courts have interpreted the phrase “consequential loss.”

In the UK, there is a long line of decisions which equate consequential loss with what is referred to as the “second limb” of recoverable damages, described in Hadley v Baxendale (1854) 9 Exch 341. In Hadley v Baxendale, the court stated that there are two types of damage that are recoverable for a breach of contract. Firstly, there is the damage which may fairly and reasonably be considered as “arising naturally i.e. according to the usual course of things” from the breach. Secondly, there is the damage which “may reasonably be supposed to have been in the contemplation of both parties, at the time they made the contract, as the probable result of the breach.”

There are of course difficulties with determining into which limb a particular type of damage falls. Nevertheless, if this approach was applied in this case, Regional Power would have had to show that the expenses it incurred simply arose as a natural consequence of the shut down and were therefore covered by the first limb, and therefore not “consequential loss“. On the other hand, Pacific Hydro would have had to show that the expenses did not arise naturally in the usual course of things, but were (if recoverable at all) covered by the second limb as a type of foreseeable damage arising from the special circumstances known to the parties at the time the agreement was entered into.

The UK approach was generally regarded as applying in Australia until the 2008 decision of the Supreme Court of Victoria in Environmental Systems Pty Ltd v Peerless Holdings Pty Ltd (2008) 19 VR 358. In Peerless, the court concluded that the rigid dichotomy approach applied in the UK did not accord with the natural and ordinary meaning of the phrase “consequential loss.” The court in Peerless acknowledged the decision of the Australian High Court in Darlington Futures Ltd v Delco Australia Pty Ltd (1986) 161 CLR 500, where it was held that the meaning of an exclusion clause should be determined by “construing the clause according to its natural and ordinary meaning, read in light of the contract as a whole.” In light of Delco, the court in Peerless concluded that “ordinary reasonable business persons would naturally conceive of ‘consequential loss’ in a contract as everything beyond the normal measure of damages, such as profits lost or expenses incurred through the breach.”

Whilst the Peerless formulation sounds simpler, it can in practice be equally as difficult to apply because the court in Peerless gave very little guidance as to how to assess the “normal measure of damages” in any particular circumstance. In many ways, the Peerless decision replaced the dichotomy of the first and second limb approach with an alternate approach which can be equally as rigid. Moreover, the decision in Peerless does not explain why “profits lost or expenses incurred through the breach” must invariably fall outside the scope of the “normal measure of damages.”

Both Pacific Hydro and Regional Power accepted that the first and second limb dichotomy is no longer the correct constructional approach in Australia. Did this mean that the court had to apply the new interpretation approach set out inPeerless? If it did, the expenses incurred by Regional Power were likely to be regarded as consequential loss, particularly since “expenses incurred through breach” are expressly mentioned in Peerless as a type of consequential loss.

What did the court say?

The court went back to basics. It simply applied the High Court’s approach in Delco of construing the exclusion clause according to its natural and ordinary meaning, read in light of the contract as a whole. In doing so, the court did not follow the decision in Peerless. In fact, the court doubted whether the court in Peerless actually intended to create a rigid general rule as to how “consequential loss” should be interpreted.

The court summed it up as follows:

“To reject the rigid construction approach towards the term “consequential loss” predicated upon a conceptual inappropriateness of invoking the Hadley v Baxendale dichotomy as to remoteness of loss, only to then replace that approach by a rigid touchstone of the “normal measure of damages” and which always automatically eliminates profits lost and expenses incurred, would pose equivalent conceptual difficulties. Accordingly, I doubt whether the observations in [Peerless] were intended to carry any general applicability towards establishing a rigid new construction principle for limitation clauses going much beyond the presenting circumstances of that case.”

The court then proceeded to consider the agreement as a whole. In particular, the court noted how clause 16.3 of the agreement recognised that Regional Power “may need to generate its own electricity to make up a shortfall or obtain the shortfall from any other source.” The agreement also recognised Regional Power’s statutory supply obligations to the Kimberley region and expressly acknowledged that Regional Power may have to “maintain a reliable supply of electricity to its customers during the period that Reliable Operation is lost.”

Overall, the court concluded that the expenses incurred by Regional Power were “fully direct damages or losses“; they were not indirect or consequential.

Points to Take Away

  • The decision is a clear departure from the approach advocated in Peerless. The status of Peerless as the leading Australian case on consequential loss must now be questioned.
  • The decision in Peerless made it clear that lost profits and expenses incurred through a breach were consequential. There is now less certainty as to whether these types of losses and expenses will be characterised as consequential loss. Instead, this will need to be determined on a case by case basis having regard to the terms of the relevant contract as a whole, rather than by applying any general rule as to the meaning of consequential loss.
  • Rather than just rely upon general phrases like indirect or consequential loss, the prudent approach is to be more explicit about the particular types of loss and damage that are to be excluded. The exclusion clause in this case expressly excluded loss of profits. In hindsight, if Pacific Hydro intended to exclude liability for Regional Power’s expenses in generating replacement electricity, it should have done so expressly.
  • The decision indicates that third party claims (such as supply interruption claims made against Regional Power by its customers) will likely be regarded as consequential or indirect. However, this cannot be regarded as a general rule.
  • In light of this decision and the move away from Peerless, contracting parties who previously obtained advice on their rights in relation to exclusion clauses, should now revisit their positions.
  • As at the date of this article, no appeal has been filed by Pacific Hydro. The last date for filing an appeal is 17 October.

Getting the limitation and exclusion clauses right is absolutely critical to any contract. At Rockwell Olivier, we have wide-ranging experience in helping businesses achieve the best possible outcome. Our recent experience and extensive network of contacts cover a range of industries including FMCG, building products, facilities management, retail, transport and manufacturing and financial services.

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