What are Consequential Damages?
Contract law recognizes a variety of damages to which a party may have a legal right. The most common, and most beneficial, of these is compensatory damages, which are designed to place the non-breaching party in the position it would have occupied had the breach not occurred. In that model, the law attempts to fix the injury caused by the breach; for example, if the defendant constructed a complex system of electrical wiring that later turned out to be faulty, resulting in a major loss of power to the plaintiff’s business, the damages may include repair costs, lost productivity, and replacement of the wires. Conversely, if the non-breaching party benefits from the breach, the damage award would accounts for that benefit while still leaving the non-breaching party in a position as close to it would have been without the breach as possible.
There are exceptions to this general theory of damages, however, and one of those are consequential damages. Consequential damages are "special circumstances which were contemplated by the contracting parties , or which the breaching party knew created a risk of damages." When an award for compensatory damages would not return the plaintiff to the place it would have been in the absence of the breach, then it may be possible to recover consequential damages. However, consequential damages demand a higher degree of specificity than compensatory damages—meaning it must be feasible to show that the defendant was aware of particular instances when the breach could cause serious harm to the plaintiff, and that the plaintiff could be reasonably expected to suffer that harm if the defendant did nothing to stop it. Both of these elements must be satisfied in order to recover consequential damages. For example, in Yost v. W.A. Brown & Son, a case before the Supreme Court of Missouri, the court held that "damages for loss of time, loss of profits, and loss of reputation being ascertained as of the time of default would be recoverable." This means that even when a contract does not list the potential damages in the event of a breach, if all of the parties understood the consequences of said breach, they could still be recoverable as long as recovery remains both necessary and reasonable.
Instances of Consequential Damages
In addition to the damages that flow directly from a breach, the cost of which are reasonably foreseeable, injured parties can sometimes recover all foreseeable consequential, or special, damages. However, to fall within this category, the damages must flow naturally from the breach and be within the reasonable contemplation of the parties at the time the contract was formed. A typical example is when the defendant’s wrongdoing results in an economic loss that the party would have earned but for that wrongdoing. However, if the defendant had to foresee not just the breach but a series of unusual events that would have led to the profit then the damages are too remote to be recovered as consequential damages.
For example, suppose a homeowner hires a contractor on a fixed-price basis to renovate a bathroom, but the contractor fails to complete the job in a timely manner. The homeowner is unable to move back into the house for an extra six months and incurs temporary housing and meal costs, which he can recover. The delay, however, does not cause the plaintiff to lose any profits, and the contract itself does not provide for such damages. The consequential damages in this case would therefore be limited to the cost of the alternative housing and meals.
However, suppose that it was not the renovation of the bathroom that caused the disruption, but the lack of heating in the house during the unseasonably cold winter. As a result, the pipes froze and burst, causing substantial damage to the plumbing system and water damage to the structure. The homeowner then lost use of not only the bathroom but also the entire house while they made repairs. In this case, they would be able to claim that they would have moved out of state to work for an extra six months minimum (Winter and Summer). So when calculating damages they would factor in their lost salary and overtime as consequential damages. These can be very significant damages. Of course, the plaintiff would have to prove that he put the defendant on clear notice of the unusual risk. If he did not or omitted to mention the extreme time and duration of his trip, then those damages are too speculative to recover as consequential damages.
Legal Requirements for Claiming Consequential Damages
Courts require that a plaintiff prove certain basic elements before they may recover consequential damages. The plaintiff must show that the parties to the contract could reasonably foresee the damages at the time of entering into the agreement. More specifically, the general rule is that consequences which are the natural result of a breach of contract may be recovered, but only if the breaching party had reason to know at the time of contract formation that the damages would occur. See Ex parte Daisy King Enter., 46 So. 3d 465, 468 (Ala. 2010); First Nat’l Bank of Mobile v. Board of Water & Sewer Comm’rs of Mobile, 363 So. 2d 1004, 1009 (Ala. Civ. App. 1978) (stating that "damages, to be recoverable for breach of contract, must be within the contemplation of the parties at the time the contract was made" and that damages "which are merely losses flowing indirectly from a breach of contract" are not recoverable); Stowers v. Lee, 607 S.W.2d 259, 261 (Ark. 1980) (stating that "the mere possibility of special damages" is too speculative for recovery). Put differently, consequential damages are recoverable only if the parties contemplated them as a "probable result of a breach of the contract at the time it was made." Ex parte Daisy King Enter., 46 So. 3d at 468. Thus, "the defendant has to have information at the time of entering into a contract which places him in possession of facts to indicate danger that special, nonquantifiable damages may arise." B. G. & S. Constr. Co. v. Hinds, 631 So. 2d 985, 987 (Ala. Civ. App. 1993); see also Management Enters., Inc. v. Century Ins. Co., 818 S.W.2d 908, 914 (Tenn. Ct. App. 1991) ("For consequential damages to be recovered, special circumstances giving rise to special damages must have been communicated to the defaulting party at the time of or before the making of the contract."); Merriman v. Smith, 132 P.2d 148, 161 (Wash. 1942) ("The special circumstances requisite to recovery of consequential damages must be communicated to the party in breach, either by express language, or because of the relationship between the parties, either expressly or by the nature of the contract, which must fairly have alerted the party in breach to the possibility of consequential damages.").
Distinction between Consequential and Direct Damages
Consequential damages, also known as special damages, are those that are not the direct and immediate result of a wrongful act, but only a consequence of it. Instead, they flow from the injured party’s special circumstance or situation. For example, if the non-breaching party has suffered lost inventory due to a defendant’s breach of contract, the lost inventory may constitute consequential damages. These damages required the initial act that was the cause of the breach, i.e., a failure to deliver the correct amount of inventory for the plaintiff to have lost anything from it.
Another aspect of consequential damages under the common law analysis is that they must be foreseeable. If a party reasonably contemplates the damages at the time of contract formation or if it is clear that the wrongdoer should have contemplated the damages , and thus bears the risk of them, then the plaintiff may recover those "consequential" damages. In the previous example of lost inventory, a defendant who is a supplier of raw materials to a manufacturer of widgets would have the loss incurred by the manufacturer in this scenario as an entirely foreseeably outcome of its breach. Of course, whether a defendant can reasonably foresee damages as a result of its breach is often fact-specific and thus subject to debate.
Direct damages, on the other hand, are the exact, immediate loss of any sort actually caused by a breach. An example of a direct result of breach of the same contract discussed above would be a cessation in the manufacturing of widgets due to those inventory losses, and losses likely to be attributed entirely to the breach.
Contractual Limitations and Exclusions
It is not unusual for a contracting party to include a prohibition against claims for consequential damages in the contract. In addition to limiting or excluding consequential damages, a party may attempt to shorten the statute of limitations or remove other types of damages from the risk of loss clause. Two examples of such clauses are: The indemnitor shall have no liability for any indirect, incidental or consequential damages. In no event shall either party be liable to the other for special, indirect, consequential, punitive, exemplary or incidental damages or losses of profits, business, revenue, goodwill, work stoppage or anticipated savings as a result of any breach of agreement by the indemnitor, notwithstanding any notice of the possibility of such damages. The reason that a party may attempt to include such clauses is in order to try and limit its liability. There is no such thing as a memorandum of understanding, letter of intent, letter of understanding or request for proposal that has not contained some form of a limitation of liability terms and conditions. Even with these terms and conditions, disputes arise after the transaction or relationship has been consummated. Lest the reader believe that there is some trick in the art of drafting, most of these provisions are unenforceable. The underlying principles involve the UCC and the UCOA or an adhesion theory and public policy. Certain limitations of liability clauses may be legally permissible, such as the limitation of liability to a specific dollar amount or exclusion to a particular type of loss. Still there are certain limitations of liability that courts have routinely found unenforceable. One such common example is the limitation of liability to reasonable or net profits.
Case Law on Consequential Damages
One of the seminal cases in the recognition of the concept of consequential damages is Hadley v. Baxendale, where an employee, Hadley, took a broken crankshaft from the mill operated by the employer, Baxendale, to a foundry to have a replacement made. The delivery of the crankshaft to the foundry was delayed, and, in consequence, the mill was idle for an extended period of time. The court ruled that it was not liable for these consequential damages, because Hadley did not convey to the employee Baxendale that such a delay would result from not delivering the crankshaft on time. Thus, the damages were not foreseeable. As a consequence of this case, the law has evolved to the understanding that, as stated succinctly in a case decided by the Delaware Supreme Court, "Hadley … stands for the proposition that a party should not be liable for unforeseeable consequential damages."
In NYM Holding Corp. v. Domestic Bank, a bank had entered into several written loan agreements with a company, with provisions that any default would result in the automatic acceleration of the debt. The agreements also provided for automatic acceleration if the debtor became insolvent. Approximately one year after the loan documents were signed, the debtor’s accounts began to show insufficient funds to cover its liabilities. The bank allowed a grace period for the debtor to make up its deficiencies, which it failed to do. After twelve months went by, the bank accelerated the debt and brought a foreclosure action on its mortgage , resulting in the foreclosure of assets pledged to it.
The trial court awarded the bank the face value of the secured notes, but denied the bank’s claim to alleged consequential damages, which included lost profits. The bank argued that Hadley is not applicable because the contractual provision accelerated upon insolvency of the debtor, and that the lost profits were, therefore, foreseeable. The Superior Court agreed with the trial court.
The Superior Court explained why the lost profits were not foreseeable. "At the time the note [was] executed, the parties could not have foreseen with any degree of certainty that [the debtor] would enter foreclosure proceedings and that [the bank] would suffer damage. [At the time the loan documents were executed], it was uncertain whether [the debtor] would even experience a downturn in its fortunes. It was also uncertain whether [the bank] would find it necessary to exercise its right to accelerate the debt." Therefore, the loss of profits was too remote to be foreseeable. The bottom line: it is not enough for a party to assert that a contemplated course of conduct will provide that the damages are foreseeable when the subject agreement is reached, but rather, the damages must be foreseeable at the time of default. Thus, notwithstanding the acceleration clause, the damages for losses resulting from the default were not foreseeable, because the default was not foreseeable. Acceleration does not ensure the foreseeability of consequential damages.