Consequential Damage Disclaimers in Supply Agreements
What is a consequential damage?
This is the million (sometimes multimillion) dollar question. According to Black’s Law Dictionary, consequential damages are “losses that do not flow directly and immediately from an injurious act but that result indirectly from the act.”1
Let’s take a straightforward example: if you get hit by a car, your hospital and physical therapy bills are clearly a direct damage. On the other hand, if you are out of work for six months recovering from the injuries, your lost wages during that time are consequential damages. Note that, although the damages are consequential, in terms of the financial impact on you, they are no less real than the direct damages. The same is true in a commercial scenario.
Examples of Consequential Damages.
Below is a list of common examples of consequential damages in a commercial context:
- Loss of anticipated profits;
- Loss of business;
- Cost of unsuccessful attempts to repair defective goods;
- Loss of goodwill;
- Losses resulting from interruption of buyer’s production process;
- Loss of reputation; and
- Loss of sales contracts because of delayed products.
Disclaimers of Consequential Damages.
In theory, the definition of consequential damages is not that complicated, but in application, the results become muddled. Commercial contracts typically include a consequential damage disclaimer, but one reason to resist such a disclaimer may simply be to avoid contentious and expensive litigation to determine whether a party’s damages were direct or consequential in nature.
Generally speaking, if you are the buyer under a supply agreement, you will want to resist a disclaimer (even a mutual disclaimer) of consequential damages, because it is much more likely to benefit the seller of the product than it is to benefit you as the buyer. Typically, the buyer’s primary or only obligation under a supply agreement is payment for the product, the failure to do which does not carry with it as much risk of consequential damages as the sale of a product creates for the seller.
Further, Article 2 of the Uniform Commercial Code (which governs the sale of goods and has been adopted in all states except Louisiana) provides that personal injury or property damage proximately resulting from any breach of warranty is a consequential damage.2 As such, as a buyer under a supply agreement, if the contract includes a consequential damage disclaimer, your warranty remedies will not help you in the case where the product the seller has sold you is defective and injures someone (it should be noted that a warranty remedy provision may also provide for sole and exclusive remedies of repair/replace/refund, in such case your warranty remedies will not protect you for such personal injury/property damage claims, even in the absence of a consequential damage disclaimer).
On the other hand, as the manufacturer/seller of a product, the seller could be subject to a host of consequential damages in the event it fails to timely deliver the products or delivers defective products and as such the seller will want to push for a consequential damage disclaimer.
Carve outs from the Consequential Damage Disclaimer.
In most arm’s-length commercial agreements between sophisticated parties, the parties will agree to include a consequential damage disclaimer that is subject to certain carve-outs that permit a party, in certain situations, to recover consequential damages from the other party. The most common carve-outs from a consequential damage disclaimer are as follows:
- Third party indemnification claims. Claims brought by third parties for which a party is entitled to be indemnified should be carved out from consequential damage disclaimers. If an indemnifying party commits an act for which it has provided an indemnity under the agreement (for example, a common indemnity is for claims arising from a party’s negligent acts or omissions) and that act injures a third party who then sues the indemnified party, the indemnified party will expect to be held harmless for that suit. However, a claim by a third party (and the defense of such claim) is likely to be classified as a consequential damage as to the indemnified party. As such, an indemnity can be overridden by a consequential damage disclaimer that does not properly carve out third party claims.
- First party negligence and misconduct. In addition to third party indemnification claims (which may, depending on the indemnity provision, include third party claims resulting from a party’s negligence or willful misconduct), where bargaining power permits, the buyer should push for a separate carve-out from the consequential damage disclaimer for “first party” negligence or willful misconduct. That is, if a party is negligent or acts with willful misconduct, and the other contractual party is injured by it, the injured party should be entitled to recover all damages resulting from such negligence or willful misconduct, regardless of whether those damages are direct or consequential. As discussed above, a consequential damage is still a real damage that a party must prove it has suffered. There is no reason a party should be excused from liability for such damages arising from that party’s negligence or willful misconduct simply because the damages are consequential. It should be noted that, in states that have adopted the Economic Loss Rule, this carve-out will not be sufficient to preserve a claim for economic losses resulting from a negligence/willful misconduct claim. If you want the right to recover those types of losses in such states, you will need to include an indemnity for first party negligence and willful misconduct or carve such losses out from the sole and exclusive remedy provisions of the warranty.
- First party intellectual property infringement. Where intellectual property is involved, the indemnity should include an indemnification by the seller for infringement of the intellectual property rights of a third party. If so included as an indemnity, these third party claims will already be carved out from the consequential damage disclaimer by virtue of the first carve-out listed above. However, where buyer’s intellectual property is involved, a buyer should also insist on a carve-out for damages incurred by the buyer as a result of an infringement by the seller of the buyer’s (rather than a third party’s) intellectual property rights. The damages resulting from a violation of intellectual property rights are often going to be consequential (for example, lost profits or loss of market share). As such, for a buyer to have an adequate remedy for a violation by the seller of the buyer’s intellectual property rights, first party intellectual property infringement must be carved out from the consequential damage disclaimer.
- Product Recall. If a buyer needs to conduct a product recall or other field corrective actions, the buyer may incur expenses that far exceed the cost of replacing, repairing or refunding the price of the product (which would be the direct damage and which are typically the sole remedies for a warranty claim). For example, there may be fines by regulatory agencies, money spent canvassing to reach purchasers, internal costs of employees dedicating time to the recall, and costs of field work, among others.
- Breach of Confidentiality. The reason for carving out damages related to a breach of confidentiality out of a consequential damage disclaimer is because the bulk of the damages that arise from a breach of confidentiality will, in fact, be consequential. As with intellectual property infringement claims, in order for a buyer to have an adequate remedy for a breach of the confidentiality provisions, damages resulting from the breaches of confidentiality must be carved out from the consequential damage disclaimer.
Whether or not to include a consequential damage disclaimer and, if included, what types of carve-outs to include, depends on whether you are the buyer or seller, what your relative bargaining power is, and what types of issues are likely to arise.
1. DAMAGES, Black’s Law Dictionary (10th ed. 2014).
2. U.C.C. § 2-715(2)(b).