Understanding Consequential Damages Waivers
What They Cover and How to Avoid Pitfalls
Consequential Damages Defined – Good Luck!
Consequential damages are typically defined as damages, losses, or injuries that result naturally, but not necessarily directly from the actions (or omissions) of the other party in a commercial engagement. Consequential damages do not necessarily have to arise from the direct wrongful action of the defendant, but result naturally from, and can be traced back to the act. They are often referred to as special damages or indirect damages. Consequential damages may include by way of example, lost revenue, lost profits, loss of business reputation, loss of goodwill, business interruption, loss of use.
In contrast, direct damages are those damages that constitute a direct, immediate, and expected loss caused by a breach or other action which compensates for that loss. Examples of direct damages may include costs to reperform inadequate work, costs of additional work, costs associated with project delays, and amounts paid for inadequate work.
In some cases, what is often considered a consequential damage may also be a direct damage if it is a direct, expected result from the breach. For example, if a party purchased a widget for mark-up and resale to its customers and the supplier breaches its obligation to provide the widget as contracted, the reseller would be precluded from selling the widget and the lost revenue could be considered a direct damage, a consequential damage, or both.
Therein lies the rub . . . what constitutes a direct damage versus a consequential damage is not always clear and very well may be interpreted differently by different courts. This is why it is critical to pay specific attention to consequential damages waivers in your contracts to ensure they actually reflect the parties’ intentions. While it is not always clear what constitutes consequential damages, courts will tend to honor the clear intent of the parties. What does that mean for drafters of these provisions? Be as clear and specific as possible.
What Do Consequential Damages Waivers Cover?
A waiver of consequential damages typically excludes liability for losses that are not the direct result of a breach but arise as a secondary consequence. These provisions are intended to limit the scope of recoverable damages and reduce the financial risks of the parties and help create certainty. However, the specific types of damages excluded often vary depending on how the contract is drafted and the subject matter of the engagement.
Common categories of damages addressed in these waivers include:
Consequential Damages: Which may include losses resulting indirectly from a breach, such as reduced future revenue caused by downtime.
Incidental Damages, which may include costs incurred to mitigate or address the effects of a breach, like extra shipping expenses or overtime labor.
Indirect or Special Damages, which may include losses that are atypical or unique to the specific circumstances of the non-breaching party, such as damages to reputation, penalties and fines, and specialized equipment costs.
Punitive Damages, which generally include damages intended to act as a deterrent to the breaching party, rather than compensate for actual monetary loss. These damages are rarely available in commercial contracts except in unique circumstances generally involving some type of willful or reckless misconduct but are still commonly disclaimed.
In addition to these categories of damages, these waivers frequently exclude specific types of losses, including by way of example:
Lost Revenues or Lost Profits
Loss of Goodwill
Loss of Data
Loss of Business or Business Opportunities
Common Pitfalls
While waivers of consequential damages can be useful, they are not one-size-fits-all and may lead to unintended consequences if poorly drafted. Common pitfalls include:
Overly Broad Language: A waiver that excludes too many types of damages may leave one party with insufficient remedies.
Ambiguity: Courts often struggle with defining "consequential damages," and unclear language very often leads to disputes over interpretation and what should or should not be excluded by the clause.
Unintentional Exclusions: Excluding "lost profits" or "loss of data" without tailoring the waiver to the specific context can inadvertently block recovery for direct damages that are essential to your business.
Conflict with Other Provisions: The waiver may conflict with indemnification, insurance, or liquidated damages clauses if not appropriately cross-referenced and contemplated in the drafting process. For example, if an indemnification provision includes indemnification for breach of contract, and the indemnification obligations are excluded from the consequential damages waiver, which they often are, a simple breach of contract, which might otherwise be limited by the limitation of liability, may now be subject to significant and possibly unlimited damages even if not intended by the parties.
Best Practices for Drafting and Negotiating
To ensure a consequential damages waiver works for your business, consider these best practices:
Define Key Terms: Be as specific as possible about the types of damages that are excluded. Avoid relying on generic terms that may lead to disputes.
Tailor the Waiver: Customize the waiver to align with your business risks, the purpose of the contract, and the specific context. For instance, if lost profits are critical to your deal, and an expected loss of non-performance, consider carving them out of the waiver. In addition, it can be helpful to specify different categories of losses separately for each of the contracting parties, as the expected losses may very well be different depending on which side of the deal you are sitting.
Coordinate with Other Clauses: Ensure the waiver is consistent with indemnity, limitation of liability, and insurance provisions.
Assess Both Sides: When negotiating, consider the risks your business is willing to accept and those you expect the other party to bear.
Consult Legal Counsel: These provisions almost always include nuances that require legal expertise and guidance, especially when negotiating transactions of particular complexity, including for example, supply chain arrangements, intellectual property licensing, certain resale arrangements, or high-dollar corporate transactions.
Consequential damages waivers are an essential risk management tool, but they can create as many problems as they solve if not carefully drafted. By understanding the types of damages they address, avoiding common pitfalls, and tailoring the language to your specific needs, you can mitigate financial risk without undermining key protections.