Avoiding Unintended Consequences of Damage Waiver Provisions

Posted by Eduardo Gallardo, Gibson, Dunn & Crutcher LLP, on Thursday July 26, 2012 at 9:18 am
  • Print
  • email
  • Twitter
Editor’s Note: Eduardo Gallardo is a partner focusing on mergers and acquisitions at Gibson, Dunn & Crutcher LLP. This post is based on a Gibson Dunn client alert by Robert Little and Chris Babcock.

Acquisition agreements often contain provisions that restrict or prohibit the payment of “consequential,” “special,” or “incidental” damages for breach. [1] Principals and their counsel may intend that these provisions prevent liability arising from unknown and unforeseeable future events; however, because these terms are poorly understood in the context of acquisition agreements, the exclusion of these categories of damages may have unexpected consequences for the parties to a transaction. Buyers and sellers should carefully weigh the effect of these damage-limiting provisions and consider alternative, more clearly defined provisions to limit damages under their acquisition agreements.

General Contract Damages

Before examining contract provisions limiting damages, it is important to review briefly the basic principles for recovery of damages due to breach of contract. Damages arising out of the breach of a contract are generally limited by the principles set forth in the English case of Hadley v. Baxendale. [2] Hadley created a rule with two branches: (i) a party may recover for losses that directly and naturally arise from the breach of a contract and (ii) a party may recover for losses arising from special circumstances surrounding the breach to the extent that the breaching party knew of the circumstances at the time the contract was made. [3] Consistent with Hadley, under the default rules of most jurisdictions, recoverable losses arising under a breach of contract are limited to those damages that are reasonably foreseeable to the breaching party. [4]

“Consequential” or “Special” Damages

The exact damages that are included in the term “consequential damages” are not well defined within existing case law. [5] Similarly, practitioners and commentators offer differing interpretations of “consequential damages” and the evils that a waiver of consequential damages is intended to avoid. Consequential damages, also referred to as special damages, may be viewed as damages that arise under the second branch of Hadley–damages that arise from special circumstances known by the parties at the time the contract was made. Although some commentators have suggested that consequential damages are “indirect” damages, as compared to the directly and naturally arising damages under the first branch of Hadley, this idea is “potentially misleading.” [6] Commentators have posited that consequential damages must still be “directly traceable to the wrongful act;” they are “losses directly attributable to and caused by a contract breach as a result of the special circumstances of the non-breaching party that would not have occurred in the ordinary case of a breach of a similar contract not involving such special circumstances.” [7] Another possible interpretation of a waiver of consequential damages is that the waiver shields the breaching party from liability for all damages that would not be applicable to a similar contract, even if the breaching party was fully aware of circumstances that made such damages applicable. [8] In any event, contrary to the understanding of many practitioners, consequential damages can be interpreted to include direct damages in some situations.

A waiver of consequential or special damages may result in the contractual elimination of all damages caused by a particular breach, including damages that would be the reasonably foreseeable result of such breach. For example, if a buyer purchases a company expecting an above-market profit on certain of the selling company’s contracts based on representations in the purchase agreement regarding such contracts’ validity and enforceability, which representations turn out to be untrue, the resulting losses could be labeled consequential “lost profits.” A “boilerplate” waiver of consequential damages could deny the buyer recovery for the breach, even if the lost profits were the buyer’s sole damages and were the reasonably foreseeable result of the breach. The effect of such a waiver is amplified when a buyer formulates its purchase price for a target based on the target’s profits or a multiple of the target’s earnings because the seller’s breach effectively resulted in the buyer’s paying a higher price for the target than the buyer intended.

“Incidental” Damages

Related to, but distinct from, consequential or special damages are incidental damages. Incidental damages “include costs incurred in a reasonable effort, whether successful or not, to avoid loss, as where a party pays brokerage fees in arranging or attempting to arrange a substitute transaction.” [9] For example, if a buyer purchased a factory and the seller breached a representation that the factory complied with all environmental laws, the buyer’s costs to bring the factory into compliance might be classified as incidental damages. Waivers of incidental damages may prevent a buyer from recovering its reasonable costs in attempting to avoid a loss or remedy a breach, and buyers should almost always resist granting a blanket waiver of incidental damages.

Conclusion

Parties to an acquisition agreement should consider carefully the effect of waivers of categories of damages. In particular, we recommend the following:

  • Keep in mind that contract law generally limits damages to those that were reasonably foreseeable by the parties when the contract was made. Many parties consider waivers of consequential damages to be important to avoid unknown and unforeseeable liabilities down the road that could create some undefined amount of liability exposure. It is important to remember that the default rules of contract law, which already limit damages to those reasonably foreseeable to the contracting parties, render a waiver for such purposes unnecessary. In addition, as described above, the inclusion of the unnecessary waiver can result in the waiver of direct damages that may otherwise have been intended to be recoverable.
  • If the concern is the extent of exposure to damages, consider setting a cap on the amount of damages, rather than including a waiver of certain types of damages. Where the parties are concerned about the potential amount of damages payable for breach of a contract, it may make more sense to cap losses at a certain amount than to rely on ambiguous waivers of “consequential damages.” Such a cap can prevent damages in excess of the purchase price, for example, while avoiding the risk that losses actually and directly suffered by a non-breaching party are found to be waived.
  • Buyers should resist waivers of “incidental,” “lost profits” or “multiple of earnings” damages. Incidental damages are direct damages suffered by the buyer in an attempt to remedy the seller’s breach. In addition, because “lost profits” and “multiple of earnings” damages may qualify for recovery under Hadley under certain circumstances, they should not be categorically waived. For example, if a seller’s breach renders a target company inoperable for a time, lost profits may be the direct and natural consequences of the breach (and the only damages the buyer suffers). Likewise, if a target company is priced based on a multiple of earnings, any loss in earnings arising from a breach may be a direct damage to the buyer in the form of an overstated purchase price, which damage the buyer would not want to waive.
  • Consider listing types of damages permitted, rather than damages waived. A waiver of damages other than those that “directly and naturally arise” from the breach or are the “reasonably foreseeable” result of a breach can provide greater clarity than a waiver of “consequential damages.” It may be useful to spell out the rule in Hadley and to document any special circumstances of which the parties are aware. This approach allows the parties to recover losses which directly flow from any breach, while preventing the non-breaching party from raising a dispute as to the precise special circumstances of which the breaching party was aware at the time of the contract.

Damage waiver provisions in M&A agreements, like many other contractual provisions long considered “boilerplate,” would benefit from practitioners’ elimination of legal jargon and ambiguous terms. Resisting the use of the poorly understood term “consequential damages” in these waivers, and understanding the ramifications of waiving other categories of damages, will help to align the contractual language with the expectations of the parties and eliminate unintended consequences in the event of a breach.

Endnotes

[1] See “2011 M&A Deal Terms Study,” Shareholder Representative Services LLC, available for download at http://www.shareholderrep.com/content/ (survey of 196 private target acquisitions from July 2007 to September 2011 found that 34% of transactions expressly excluded consequential damages and 27% of transactions expressly excluded incidental damages).
(go back)

[2] 9 Exch. 341 (1854).
(go back)

[3] Id. at 355–57.
(go back)

[4] See, e.g., Applied Equipment Corp. v. Litton Saudi Arabia Ltd., 869 P.2d 454 (Cal. 1994).
(go back)

[5] Glenn D. West and Sara G. Duran, Reassessing the “Consequences” of Consequential Damage Waivers in Acquisition Agreements, 63 The Business Lawyer 777, 780 (May 2008).
(go back)

[6] Id. at 792.
(go back)

[7] Id. at 791–92 (internal quotation marks and citations omitted).
(go back)

[8] David Leinwand, Considering the Consequential Damages Waiver, October 2011 Mergers & Acquisitions and Corporate Governance 6.
(go back)

[9] Restatement (Second) of Contracts § 347 cmt. c (1981).
(go back)

  1. [...] full article  via Avoiding Unintended Consequences of Damage Waiver Provisions — The Harvard Law School Forum on Cor…. Share OptionsPrintEmailMoreFacebookLinkedInStumbleUponTwitterPinterestRedditDiggTumblrLike [...]

    Pingback by Avoiding Unintended Consequences of Damage Waiver Provisions — The Harvard Law School Forum on Corporate Governance | Accounting and Small Business /Beverly Shares — July 27, 2012 @ 8:01 pm

 

Add your comment below:

(required)

(required but not published)

RSS feed for comments on this post. TrackBack URI

 
  •  » A "Web Winner" by The Philadelphia Inquirer
  •  » A "Top Blog" by LexisNexis
  •  » A "10 out of 10" by the American Association of Law Librarians Blog
  •  » A source for "insight into the latest developments" by Directorship Magazine