As business litigators we commonly see the phrase ‘consequential damages’ in our clients’ contracts with others. However, when questioning our clients—”What do you understand the consequential damages to include here?”—we learned that many of our clients do not quite understand what the phrase ‘consequential damages’ really means and what those damages include and do not include. Our clients do know that excluding consequential damages from any contract serves to minimize exposure to contingent contract liabilities which are oftentimes claimed in an alleged breach of contract. But a natural and probable consequence of failing to understand and consider: 1) what qualifies as a consequential damage, including those that may be unique to a specific business or industry, and 2) corresponding contract language to exclude those consequential damages, could result in overinflated and infinite damages claims that far exceed the value of the underlying contract. We aim here to provide some guidance on this category of potential damages in breach of contract claims and give some insights on how the category of consequential damages may be defined.
The concept of ‘consequential damages’ assumes that one party breached an agreement and the non-breaching party has sustained some damage that they are seeking recompense from the breaching party. Absent contractual exclusions, there are three general categories of damages for which a non-breaching party may claim entitlement under a breach of contract theory. The first category is ‘general’ or ‘expectation damages,’ which are caused by one party’s alleged failure to perform its express obligations under a contract. For example, if a commercial contract calls for one company to inspect and maintain equipment (whether it be copiers, airplanes, elevators or escalators) then general damages for a failure to adequately perform specified contract obligations would be either: 1) the cost or value of correct performance under the contract, 2) the cost to correct deficient performance. The second category are called ‘special damages.’ These must be specifically pled against the breaching party or are otherwise forfeited. Special damages include damages that are particular to one party’s business that the other contracting party was made aware of. For example, a company who purchases goods and resells them for profit could claim special damages resulting from lost resale opportunities on account of defectively delivered goods. The third category is ‘consequential damages’ which are understood to include damages that a party claims to have incurred outside of the terms of the contract. That is, consequential damages are inherently dependent on the relationship and costs incurred by a contracting party and a third-party. Traditionally, consequential damages have been defined to include purely financial damages (loss of use, lost profits, reputational losses, investment losses) bearing only an indirect relationship with the subject matter of an underlying contract.
It is because consequential damages may only indirectly relate to the subject matter and the value of the underlying contract—meaning, true consequential damages could in some cases greatly exceed the value of the underlying contract—virtually all sophisticated commercial contracts contain exclusions or waivers of consequential damages. At the same time, however, most commercial contracts lack a formal definition on what is meant by the term “consequential damages” and how that exclusionary term should be construed in light of the subject matter and performance obligations under a contract. As a result, disputes frequently arise between contracting parties about what should be categorized as recoverable general damages, i.e., damages directly and necessarily flowing from a breach of contract, and excludable consequential damages. In breach of contract litigation, third-party expenses that are sometimes interpreted to be general damages ultimately permit one party to recover costs that it would not otherwise be entitled to had the contract been fully performed. For example, litigation involving continuing service contracts in industries such as pharmaceuticals, professional consulting services, fleet management, vertical transportation equipment, commercial machinery, security systems and IT are susceptible to a laundry list of claimed damages that include elective damages incurred in hiring third-party consultants, correlative damages for repairs and replacement of defectively maintained equipment, differences in contracting prices for a new continuing service contract, and delay damages for delayed response times. For parties in a fixed-price continuing service contract, such damages claim could easily exceed the value of the contract. On many occasions, a non-breaching party will argue that delay damages constitute a recoverable general damage rather than an excluded consequential damage since the delay reflects a measure of actual damage sustained by a failure of performance obligations.
In Keystone Airpark Authority v. Pipeline Contractors, Inc., 266 So. 3d 1219 (Fla. 1st DCA 2019), Florida’s First District Court of Appeal expanded the definition of consequential damages by taking a causation-based approach to determine whether claimed damages necessarily flow from a failure to perform the affirmative obligations of a contract. The analysis in Keystone is instructive so discussing the facts and issue in dispute is helpful to understand the Court’s methodology and conclusion. In Keystone, an airport sued an engineering firm and a contractor for breach of contract. The engineering firm was contracted to inspect, observe and monitor the construction of airplane hangars and taxiways at an airport to ensure a contractor’s compliance with the plans and to ascertain the need for correction or rejection of the construction work. The contract also required the engineering firm to determine the suitability of materials used by the contractor. As it turned out, the contractor used substandard materials which caused premature deterioration in the hangars and taxiways, and the airport sued the engineering firm and the contractor in a breach of contract action to remove, repair and replace the airport hangars and taxiways.
The engineering firm moved for summary judgment on the breach of contract claim and argued that the repair costs were not the direct or necessary consequence of its alleged failure to inspect, detect and report problems with materials used in the construction work. In other words, the engineering firm argued repair costs were consequential damages that are excluded from its contract with the owner. To determine whether cost of repairs constituted a consequential or general damage for the engineering firm, the First District Court of Appeals applied a causation-based inquiry: did the engineering firm’s failure to inspect or report on the adequacy of construction materials used necessarily cause the need for repair? The First District Court of Appeals answered this question in the negative. While the engineering firm admitted that it failed to report on the suitability of materials used by the contractor, in this context, the need for repairs was not a necessary consequence that flows from the engineering firm’s breach of contract. This is because the construction itself prompted necessary repairs, to wit: the failure to use suitable materials in constructing air hangars and taxiways. Said another way, had the contractor used suitable materials from the outset, no repairs would have been necessary, regardless of whether or not the engineering firm complied with the terms of its contract.
The strict causation test applied in Keystone is useful in evaluating consequential damage clauses at the drafting stage and equally for evaluating those clauses in litigation involving breach of contract claims. Understanding and applying the distinction between damages that necessary result from a failure to perform affirmative contractual obligations with those damages that may result from a failure of performance obligations is key to defining what items of damage should constitute consequential (and therefore, excluded) damages in litigation. Consequential damages should be strictly defined to include all categories of damages that do not necessarily result from a failure to perform express obligations under a contract. For instance, if a contract calls for the maintenance of elevators and escalators and that maintenance is not adequately performed ultimately resulting in the claimed need to replace the equipment, a subsequent breach of contract action to recover the cost to repair or replace elevators and escalators should be categorized as seeking an excluded consequential damage. In other words, claimed damages to repair and replace vertical transportation equipment on account of deficient maintenance may be appropriately categorized a consequence, rather than necessary and logical result of a breach of a maintenance obligations under a contract. The same would hold true of any rents and reputational losses alleged to result from elevators or escalators that suffer unnecessarily prolonged outages as a result of the maintenance provider’s omissions; store owners and operators cancelling their leases would be considered consequential damages relative to the issue of inadequate or poorly performed elevator and escalator maintenance. General damages in this case could be construed to mean the value of the maintenance contract itself—the service provider would be on the hook for return of money paid for maintenance services not performed and/or the cost of the owner to purchase substitute maintenance service.
Characterization of consequential damages using a strict causation test should be applied to reduce recoverable damages to an amount that does not greatly exceed the total price of a contract for a given term. Under this strict causation approach, what is often categorized as delay damages in maintenance contracts may be more appropriately characterized as consequential (and excluded) loss of use damages, since the only harm incurred in this context is the loss of use for the time that equipment was waiting to be serviced.
Used strategically, appropriately defining excluded “consequential damages” at the contracting stage or, alternatively, employing a strict causation test to pending claims seeking consequential damages are effective ways to narrow or prevent further disputes over what constitutes consequential damages to begin with. Because even the definition of consequential damages could greatly increase or decrease exposure in a breach of contract claim, consulting with experienced counsel on these issues is certainly warranted.