Exclusion of “Consequential Damages” – It’s Not a “Standard” Clause, and It Should Not Be Ignored

Mar 9, 2023 | Business Law

Exclusion of “Consequential Damages" - It’s Not a “Standard” Clause, and It Should Not Be Ignored

It is common in agreements of all kinds to see a clause where a party that is providing a product or service disclaims any liability for “consequential damages.”  These clauses frequently are glossed over. They may be passed off as “standard” and part of “our normal terms and conditions.” We recommend paying attention to these clauses because they can have unexpected consequences, especially in circumstances where almost all the harm caused by a failure or breach will fall into the category of “consequential damages.”

For the party seeking to limit their exposure, depending on the circumstances, the disclaimer may not be enforceable.  A disclaimer of consequential damages may be viewed by a court as overreaching or even abusive.  As a result, these clauses may not be the most reliable way to limit exposure.

As with any operative clause in an agreement, a disclaimer of consequential damages must be examined in light of how it would be given effect in litigation or arbitration.  

What Is a Disclaimer of Consequential Damages Clause?

A clause that explicitly disclaims “consequential damages” is designed to cut off the awarding of damages for claims that are based on indirect consequences of a failure or breach. For example, if you buy a tent to cover your summer lemonade stand and make it attractive, you expect that if the tent fails you can get your money back.  It comes with express and implied warranties of fitness for purpose

However, if that tent fails and, as a consequence of that failure, you cannot sell lemonade for an extended period, the consequential damages resulting from the failed tent are lost sales, wasted lemons and other expenses incurred in anticipation of doing business. If the entire summer season is lost because there is no tent, the real damage will not be the replacement cost of the tent — it will be the loss of business and sunk costs for the season. If the tent was purchased using financing, the debt will still be due, compounding the damage. If you were negotiating a contract to buy a hundred tents from a manufacturer using borrowed money with tight repayment terms, your business might be insolvent if the tents failed and you had no ability to claim consequential damages for lost sales. Direct damages—or the replacement cost of the tents — would be cold comfort.

Manufacturers prefer to limit their damages to “direct damages” because they are narrowly defined, as compared with consequential damages, which may be the subject of interpretation.  In the above example, the “direct damage” is the cost of replacing the tent(s).   

Unintended Consequences 

While it is true that having a waiver of consequential damages in a contract may prevent the injured party from recovering lost profits, it is also the case that a court could be persuaded that the exclusion of consequential damages is unreasonable, unenforceable, or even predatory, especially where the clause appears in “terms and conditions” supplied to a purchaser at the point of delivery when it is unlikely that the terms and conditions will be read or can reasonably be negotiated..   

Sometimes Consequential Damages are the Only Damages

In some circumstances, recovery of lost revenue or profits or other business damage may be the only meaningful damages available to an injured party. 

Take the case of negotiating a non-disclosure agreement (NDA). This situation is familiar to virtually any entrepreneur or tech industry worker. If a non-disclosure covenant is breached, there may be no direct damages that can be demonstrated. The only damages may be consequential damages. For example, if a third party breaches the NDA and makes use of the “confidential” information for their own business or leaks it to competitors, the damage to the other party consists of lost business, lost sales, lost profits, reputational damage and sometimes the business itself.  These are all consequential damages. In this context, disclaiming liability for consequential damages effectively guts the purpose and intention of having the NDA in the first place.   

Business Terms vs. Clauses that Make an Agreement Binding

One way of approaching any clause in any agreement is to ask whether the clause at issue is (a) a business term or (b) a provision that makes the business deal more enforceable. As a general rule, the purpose of a commercial agreement is to specify the business terms as precisely as possible. There should be no objection to making things clear. Other provisions in an agreement, however, operate to make the agreement more legally enforceable. Where you run into a clause that actually undermines the enforceability of the agreement, objecting to that clause is always legitimate. 

A disclaimer of consequential damages in many contexts (like the NDA example above) operates to undermine the enforceability of the agreement by so severely limiting a claim for damages that the claim amount is inconsequential.  If the cost of litigation is likely to exceed the amount of the claim as limited by the agreement, then litigation is not practical.  

If a party insists on having provisions that undermine the agreement’s enforceability, you should ask why. It may be a red flag. Is the party seeking this limitation serious about adhering to the agreement in the first place? Again, take the case of an NDA. Is one of the parties entering into the NDA to obtain information and then do whatever they want with it?  Are they thinking that if they can get a disclaimer of consequential damages, enforcement of the agreement will not be viable?   

The Damage Cap—It’s a Business Term

Where we represent a party trying to limit its exposure in an agreement, we may forgo the disclaimer of consequential damages in favor of specifying a cap on damages. (Often you see both.) This approach may be a more enforceable way for a party to limit its exposure. A negotiated cap is a business term that both of the parties can understand and accept. It can be a number, as opposed to a concept.  There is no interpreting the meaning of a number. If you are negotiating a deal where you want to limit your exposure, instead of excluding consequential damages, state that in no event will you have liability exceeding (a) a specified amount or (b) the price/fee/consideration paid by the other party (ie; the value of the contract). This may limit damages in the way that both parties can live with. Of course, whether a cap makes sense or can even be economically feasible will depend on the transaction or situation. 

In some cases, such as the NDA discussed above, there should not be a cap for breach. Where a breach is “life-threatening” to a business, then a cap will not work.

Alternatively, if excluding certain damages is essential to your contract, you may not want to use the phrase “consequential damages,” which is subject to interpretation. There may be a more precise approach. For example, in an agreement with a sales agent where you are seeking to prevent the sales agent from taking your customers if he/she leaves, you might include as an exhibit the identities of the customers that cannot be solicited by the sales agent for a period of time after they leave your employment. That makes the agreement precise (more easily enforced) and goes directly to the harm you seek to prevent.

As a general rule, provisions governing limitations on damages or liability should never be glossed over.  They can have unintended consequences for both parties. A general exclusion of damages, like consequential damages, is not simply “boilerplate.”  The consequences, including alternative drafting approaches, should be thought through. 

The information provided in this blog entry does not, and is not intended to, constitute legal advice; instead, all information, content, and materials available in this blog entry is for general informational purposes only. Information in this blog entry may not constitute the most up-to-date legal or other information. Reading or using the information in this blog entry does not create an attorney-client relationship with Kavinoky Cook LLP.