Terms to Know: Consequential Damages

Many contracts have a provision like this:

NEITHER PARTY WILL BE LIABLE TO THE OTHER IN ANY EVENT FOR ANY SPECIAL, INCIDENTAL, INDIRECT OR CONSEQUENTIAL DAMAGES, INCLUDING WITHOUT LIMITATION, (i) ANY DAMAGES FOR LOSS OF BUSINESS PROFITS, BUSINESS INTERRUPTION, OR LOSS OF BUSINESS INFORMATION, OR (ii) CUSTOMER OR CUSTOMER’S END USER’S RELIANCE ON OR USE OF INFORMATION OR SERVICES PROVIDED, EVEN IF THE OFFENDING PARTY HAS BEEN PREVIOUSLY ADVISED OF THE POSSIBILITY OF SUCH DAMAGES. BECAUSE SOME STATES DO NOT ALLOW THE EXCLUSION OR LIMITATION OF LIABILITY FOR INCIDENTAL OR CONSEQUENTIAL DAMAGES, THE ABOVE LIMITATIONS MAY NOT APPLY.

What exactly does it mean?

Consequential damages occur when you have a special situation that will be caused by a breach, and the other party knows that this situation could occur. If you are ordering an expensive custom-made product for immediate resale at a profit, you might be able to recover your lost profit if the seller knew of your second transaction. Or, if you are supplying goods or services to someone that has a penalty for late performance, or a bonus for early performance, your breach might cause you to pay consequential damages in the form of the penalty or bonus that is affected by your breach. If you install plumbing for a cold room in a pharmaceutical research lab, and the pipes leak, causing release of a pathogen into the building, you might be responsible for medical bills as well as the cost of the equipment that was damaged.

Why do contracts limit consequential damages? Often sellers of goods or providers of services want to limit their damages in case of a breach. Known damages let a company calculate their costs in a worst-case scenario. One way to do that is to agree that if there is a breach, the recovery will be limited to direct damages only.

Should you agree to this limitation? In every contract, it is important to assess the risk. Limitation of liability through warranties, disclaimers, and limiting certain damages are not useless “boilerplate” provisions. These provisions get to the bargain struck by the parties and can affect the cost of doing business, and thus, pricing.

It is important to think about what the risks are in a specific situation, and what is fair if something goes wrong. The damages should be tailored to the specific risks of a breach. One approach is to carefully list the major risks of the project and make express provisions for the types and amounts of damages in case of a breach. Other solutions are to limit the total amount of damages or to insure for specific risks.