Actual and Consequential Damages - Risk Management And Insurance, Principles of Insurance, B com | Principles of Insurance PDF Download

Terms Don’t Explain Themselves

“These terms don’t explain themselves.”  That’s what Justice Stephen Breyer often says about language in the Constitution — due process of law, unreasonable searches and seizures — and federal statutes that come before the Supreme Court.  He could say the same about “direct” and “consequential” damages, too.  He probably has.

The meaning and content of these terms chronically vexes, yet still eludes, practitioners.  Since 1856’s Hadley v. Baxendale, we’ve grown accustomed to hearing: “direct” damages are those that directly, immediate, and naturally flow from the breach of a contract, while “consequential” damages are those that flow indirectly from the breach. Having become a familiar bromide to generations of lawyers, those words provide little practical help. Regardless of rephrasing, each reformulation leaves us craving something more.

Easier Classification

We propose a different approach to classifying damages as direct or consequential:

• Direct Damages are those damages (a) that a reasonable, ordinary, and prudent person would expect the non‑breaching party to suffer from a breach, (b) where the reasonable, ordinary, and prudent person, though comparable to the breaching party, is a stranger to this particular contract. We measure what our reasonable, ordinary, and prudent stranger would expect at the time the parties entered into their contract.

• Consequential Damages are those damages (a) beyond the direct damages suffered by the non-breaching party, (b) that our reasonable, ordinary, and prudent stranger would not expect, (c) because consequential damages require a more intimate familiarity, not only with the contract itself, but also with: (i) what the non-breaching party has at stake in the contract, and (ii) what fall-out the non-breaching party will suffer if a breach occurs.

• Consequential Damages also are measured based on expectations at the time the parties entered into their contract.  And so, the non-breaching party’s price of admission to these extra-direct (i.e., consequential) damages is to show that at the time the parties entered into the contract, the breaching counterparty contemplated the extra-direct damages that its breach might impose on the non-breaching party.       

To make this analysis even easier, we like using the Road Sign Test as a convenient rule of thumb:

A reasonable, ordinary, and prudent person approaching this sign while driving need not speak the language nor possess any specialized knowledge to recognize what this sign commands — to stop.  Likewise, a reasonable, ordinary, and prudent person needs no specialized or intimate knowledge to expect that if he or she breaches a contract, the non‑breaching counterparty will suffer certain types of damages.  Those damages, predictable without resort to specialized or intimate knowledge, can be categorized as direct damages.

But an English-only speaker needs to acquire specialized knowledge to recognize what this sign means.  Likewise, our reasonable, ordinary, and prudent person (comparable to the breaching party) also needs specialized or more intimate knowledge to predict other types of damages  that, if he or she breaches the contract, the non-breaching party will suffer. Those damages, contemplated only with specialized or intimate knowledge, are categorized as consequential damages.

Restaurant Example

While no example is comprehensive, we present one to illustrate the Road Sign Test approach. Assume a build-to-suit, owner occupied restaurant.  This restaurant’s roof suffers from a defect: the connecting hardware specified to join its roof trusses to the headers atop the walls are not strong enough to keep these members connected in high winds. It’s well known that high winds occasionally blow through our restaurant’s location two or three times per year.  Accordingly, two years after completion, that wind blows through, peeling the roof off of our restaurant like the top off a can of chocolate pudding.

• Direct Damages:  Little controversy would exist that the building’s designer or builder needs no specialized or intimate knowledge to expect that the damage from the under-strength connectors will include the costs to retrofit the connectors and restore the roof.  So, those costs qualify as direct damages.

• Consequential Damages:  But suppose a week before the roof blows off, our restaurateur contracts to sell the restaurant at a handsome profit, and the purchase and sale contract allows the buyer to withdraw if the restaurant building suffers serious damage before closing. The buyer and the buyer’s lender examine the debris and decide that despite the promise of rapid restoration, and seller insurance to pay for it initially, the risk is too great and the buyer exercises its right to withdraw.
  It’s fair to posit that when contracting to design or build the restaurant, our reasonable, ordinary, prudent and comparable stranger designer or builder wouldn’t have expected the owner to contract to sell the restaurant only two years after completion, unless, of course, the stranger is clairvoyant or our restaurateur shared a business plan projecting a sale in 18 to 36 months after opening.  And so, the restaurateur’s lost profit on the sale of the restaurant likely will qualify as consequential damages.       

Why Classification Matters

If you receive Under Construction regularly and take the time to browse it, you probably already know why classifying damages as direct or consequential matters:

• Consequential damages are usually the big damages — the ones clients either badly want to get, or doggedly oppose having to pay.

• More often than not these days, contracts for design and construction waive consequential damages. But contracting parties often have different notions of what qualifies as a "consequential" damage and what does not.  Once a dispute arises, the parties become polarized and their respective notions draw further from each other.  Contractual waivers frequently, but not always, identify these types of damages as consequential:

  • Lost profits from business interruption

  • Lost use

  • Lost sales contracts because of delayed or canceled closings

  • Reduced value because of defective design or building quality

The route to direct damages is wide, straight, bright, and smooth — navigation requires no showing of what a breaching counterparty contemplated in the past. And though sometimes under a limitation of liability that may itself be suspect, direct damages are infrequently, if ever, waived.

By comparison, the route to consequential damages is narrow, windy, shrouded in fog, and strewn with fallen tree trunks, boulders, and potholes.

• First:  The non-breaching party must show that the breaching counterparty contemplated the possibility of these damages when entering into the contract.

• (Frequently) Second:  The non-breaching party must confront its own waiver of consequential damages, often by trying to exclude the damages they suffered out of the waiver, subverting the waiver altogether, or both.

Whether you’re preparing a contract or already in a dispute, deciding which damages are direct and which are consequential is critical to managing budgets and expectations.  That’s why classification matters.

Conclusion

Direct and consequential damages will never explain themselves. But stepping a few paces aside and looking at the road signs might just help you explain them — to yourself, to your clients, to your colleagues, and to the judges and neutrals who hear your cases.