Australia: Two little words - one big impact: an undefined "consequential loss" exclusion can be an unknown risk in construction contracts

When negotiating a contract, parties will attempt to negotiate the terms to match their risk profiles; concluding those risks they are willing to accept and resisting those they are not. In this context certainty is very much the aim of the game. One key area where there is the potential for risk allocation to be made uncertain relates to the use of the term "consequential loss".

The all too common undefined exclusion for consequential loss has been the subject of academic and judicial debate since 2008, and has been reconsidered recently in the case of Regional Power Corporation v Pacific Hydro Group Two Pty Ltd (No 2) [2013] WASC 356 (Regional Power). The Regional Power decision has placed a very different interpretation to the cases that preceded it as to what is covered by "consequential loss".

What does "consequential loss" actually exclude?

Since the decision of the Victorian Court of Appeal in Environmental Systems v Peerless Holdings¹ (Peerless) in 2008, several state courts have moved towards a broad view of the types of loss covered by an undefined exclusion of consequential loss. This is because the Peerless case saw a departure from the existing judicial understanding of consequential loss, based on the second limb of the Hadley v Baxendale test for remoteness, towards the creation a broader test encompassing all the loss which could not be said to be "naturally and ordinarily" flowing from a breach of contract and expressly including loss of profits as consequential loss.

Peerless considered the types of loss excluded by the term consequential loss in the context of an equipment supply and install contract. It was held that the exclusion for consequential loss meant that where the equipment was faulty, the plaintiff was only able to recover the loss associated with installing and commissioning the new equipment as well as repairing the old equipment which was to be replaced, but had to be used in the meantime.² The additional labour costs to make the new equipment functional, as well as the additional energy costs of continuing to use the old equipment were not claimable as they were characterised as "consequential loss".³

The Peerless case has not been considered by the High Court but has been applied or cited by other state courts when deciding what is meant by "consequential loss".⁴ A recent application of the Peerless approach was in the 2012 South Australian Supreme Court decision of Alstom Ltd v Yokogawa Australia Pty Ltd and Anor (No 7) [2012] SASC 49 (Alstom v Yokogawa), which considered an undefined exclusion for consequential loss within a construction contract for the refurbishment of a power station.

Alstom v Yokogawa accepted the reasoning in Peerless was to be the preferred approach when interpreting the meaning of consequential loss,⁵ and arguably took one step further by finding that in the circumstances of the case the term excluded the ability to claim all loss other than liquidated damages and damages associated with performance guarantees payments, which were expressly provided for in separate clauses of the contract.⁶

Regional Power – a narrower view of consequential loss?

In Regional Power Justice Martin of the Western Australian Supreme Court casts doubt on whether the decision in Peerless was intended to create a new test for determining what loss should be excluded as "consequential".

Background

Regional Power considered the consequential loss exclusion under a Power Purchase Agreement (PPA) between a Contractor and the State Energy Commission of Western Australia (SECWA). The PPA was signed in 1994 and provided that the Contractor build a hydro power station and once operational, supply the energy produced. In exchange, SECWA agreed to purchase a minimum amount of electricity from the power station. SECWA, a statutory entity, had statutory obligations to provide and maintain an "efficient, coordinated and economical supply of electricity".

The PPA contained an exclusion clause, clause 26.1, which stated:

"Neither the Project Entity nor SECWA shall be liable to the other party in contract, tort, warranty, strict liability, or any other legal theory for any indirect, consequential, incidental, punitive or exemplary damages or loss of profits."

In 2006, the power plant suffered a major flooding event and was unable to generate power for two months. It was accepted that the flooding event was the result of the Contractor's breach of the PPA. During the two month shutdown, SECWA arranged for two diesel generators to be delivered to site, along with sufficient diesel fuel and technicians to operate the generators and cranes to mobilise/demobilise the power station.

The Contractor argued that these costs were not recoverable under the PPA, as on the authority of Peerless, they were captured by the exclusion for "consequential loss".

Decision

Justice Martin considered the previous authority on this topic and, citing academic opinion, concluded that both the Hadley v Baxendale approach and the Peerless approach were wrong, as they resulted in applying a legal perspective rather than approaching the question of what is meant by "consequential loss" from a commercial perspective.⁷

The correct approach, the Judge reasoned, was to follow the general principles of interpretation as set out by the High Court in Darlington Futures v Delco,⁸ which provides that the words in an exclusion clause are to be given their "natural and ordinary meaning, read in light of the contract as a whole" and, in the case of any ambiguity to be read against the party trying to rely on the clause.⁹

Considering the words in clause 26.1 in the context of the PPA generally, Justice Martin decided that the costs sought in relation to the provision of diesel generators, the diesel fuel and operators etc., were direct costs flowing from the breach and were therefore not capable of falling within the meaning of the term "consequential loss".¹⁰

There were several factors which assisted this decision, including:

• the PPA was a bespoke contract arrangement attempting to capture the nature of this project;¹¹
• the long term nature of the PPA (between 1994 and 2021) showed the arrangement was grounded on assumptions about the reliability of the power station;¹²
• there were clauses in the PPA indicating that the parties were aware that SECWA may be required to generate its own electricity if the power plant stopped operating;¹³
• the fact that SECWA's obligations to provide energy were not just commercial, but statutory put it in a more vulnerable position than a commercial commodities trader if there was a shortfall in supply. SECWA's statutory obligations also meant that at the time they entered into the PPA, the parties knew that if there was a loss in power generation, SECWA would have to obtain an alternative power source in order to meet its statutory obligations;¹⁴ and
• a more plausible scope for what is meant by "consequential" in the context of this contract, are those losses suffered by third parties, such as shop owners, who would suffer a loss where they do not receive an electricity supply.¹⁵

Justice Martin's approach in Regional Power resulted in a significantly narrower interpretation of the types of loss covered by the term "consequential loss" than in Peerless or Alstom v Yokogawa. At this stage the Regional Power decision has yet to be considered by any other courts. It will be interesting to see whether other courts will prefer Justice Martin's approach resulting in a shift away from the broad Peerless approach, or whether the Peerless approach will continue to be preferred.

Minimising your risk associated with consequential loss

The best way to minimise this risk is to include a detailed definition of consequential loss when drafting contracts. The more specific the definition is in relation to the project the better – as this will leave less room for judicial interpretation regarding what the parties intended to be consequential losses. In some instances, it may be appropriate to draft "carve ins" (those risks a party will accept), as opposed to "carve outs" (those things a party will not accept).

This issue is a reminder that the more time spent thinking about the types of risks which are likely to occur prior to signing the contract and ensuring that they are dealt with specifically, the greater the certainty around which types of loss a party has or has not accepted.

Footnotes

¹Environmental Systems Pty Ltd v Peerless Holdings Pty Ltd [2008] VSCA 26 (Peerless).
²Peerless at [122] – [124].
³Peerless at [122], [125].
⁴See Waterbrook at Yowie Bay Pty Ltd v Allianz [2008] NSWSC 1451 and approved on appeal in Allianz v Waterbrook [2009] NSWCA 224.
⁵Alstom Ltd v Yokogawa Australia Pty Ltd and Anor (No 7) [2012] SASC 49 at [289].
⁶Alstom Ltd v Yokogawa Australia Pty Ltd and Anor (No 7) [2012] SASC 49 at [292].
⁷Regional Power Corporation v Pacific Hydro Group Two Pty Ltd (No 2) [2013] WASC 356 (Regional Power) at [95] .
⁸(1986) 161 CLR 500.
⁹(1986) 161 CLR 500, 510 as applied in Regional Power at [68], [97].
¹⁰Regional Power at [112] –[114].
¹¹Regional Power at [99].
¹²Regional Power at [110] – [101].
¹³Regional Power at [102] – [103].
¹⁴Regional Power at [104] – [108].
¹⁵Regional Power at [110].

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.