‘Special’ damages requiring prior knowledge of parties to construction contracts

The importance of the ‘governing law’

The particular set of private laws applicable to a contract will play a vital role in determining the types of damages that may be awarded for contractual breach, the conditions under which those damages may be awarded and the amount of those damages. In at least two major respects, the diversity of the ‘governing law’ is evident in this area.

Firstly, not all legal systems apply the same controls on ‘recoverable harm’. For instance, the nature of the commonplace ‘foreseeability’ test differs according to the applicable laws. Secondly, certain legal systems allow compensation even for harm which is unforeseeable when the non-performance is due to ‘wilful misconduct’ or ‘gross negligence’ – a test that itself lacks a single fixed meaning.

Certain laws apply primarily by reason of a territorial link that they share with the contracting parties regardless of what the parties might have agreed as regards the applicable laws. For example, in the United Arab Emirates (UAE), if litigating before the local courts, the parties’ choice of ‘governing law’ will not always be applied and, instead, the law of the local jurisdiction will govern the assessment of damages. Certain other legal systems will recognise party autonomy in this regard and uphold the parties’ choice of ‘governing law’.

Diverse controls on the recoverability of damages

English law controls the extent of recoverability of damages for breach of contract by reference to a test of ‘foreseeability’ having its roots in civil law jurisprudence. This was first recognised in English law in the famous 19th century decision of the Court of Exchequer in Hadley v Baxendale.

According to this simple test, damages must either arise naturally from the breach, known as the ‘first limb’, or “as may reasonably be supposed to have been in the contemplation of both parties, at the time they made the contract, as the probable result of the breach of it” – the ‘second limb’. Claims for damages of a type that does not satisfy one or the other limbs of the Hadley v Baxendale test will be deemed ‘remote’ and not be allowed.

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‘Special’ or ‘consequential’ damages may fall within the second limb, requiring the prior common contemporaneous knowledge of the parties as to the probable result of the breach. Specifically, the liable party must have had knowledge of the actual circumstances likely to give rise to the particular and enhanced loss suffered by the claimant. If it had knowledge of these special circumstances at the time of the contract, the respondent will by implication be presumed to have agreed to bear any special loss arising from a breach in those circumstances, unless it can demonstrate otherwise.

The UAE, meanwhile, has a civil law system that has its roots in Egyptian, French, Islamic, and Roman sources. Under UAE law, contractual liability may be established when there is: a breach of contract by one of the parties; loss sustained by the other party, and a causal link between the breach and the loss. This three-step test was recognised, for instance, in the decisions of the Dubai Court of Cassation in Petition Nos. 41/2007 and 37/2004. 

But to be recoverable in the form of damages for breach of contract, the loss caused by the breach must, at the time of contracting, either have been foreseen by the parties or have been foreseeable by ‘an ordinary person’. If the loss had not been foreseen in this way, then damages are unlikely to be awarded. While UAE law does not define ‘consequential damages’, Article 283 of the UAE Civil Code distinguishes between ‘direct’ and ‘consequential’ damages.  For the latter to be recoverable, there must be a wrongful or deliberate element, and the act must have led to the loss or damage.

The practical challenge of the foreseeability test

The basic challenge posed by the ‘foreseeability’ test is that it relies on the ‘reasonable man’ standard and involves an element of circularity that leaves a wide discretion to the tribunal. As long ago as 1936, two American law professors noted that: “By a gradual process of judicial inclusion and exclusion this ‘man’ acquires a complex personality; we begin to know just what ‘he’ can ‘foresee’ in this and that situation, and we end, not with one test but with a whole set of tests.” The complex fluidity of the test is amply demonstrated by Commonwealth case law.

Practical drafting solutions

A party that apprehends that certain damages may be regarded as remote may be attracted to the use of an indemnity clause or to agreed payment for non-performance. An indemnity clause, per se, establishes neither the requisite contemporaneous, common, knowledge of the loss and/or damage flowing from the breach of contract, nor its ordinariness.

On the other hand, an agreed payment for non-performance provision – whether it is a ‘liquidated damages’ or ‘penalty’ provision – may well indicate that the type of damages flowing from the breach expressly referenced in the provision must have been in the contemplation of the parties at the time that the contract was entered into. Under certain legal systems, the agreed payment for non-performance provision might be struck down on the basis that it is penal and not merely compensatory.

Even if the clause is struck down, however, this does not leave the claimant without any remedy. It will still be able to claim general damages for actual loss occasioned by the breach of contract. And at this stage, the very existence of a provision covering the loss and/or damage actually suffered by the claimant may indicate the requisite foreseeability, if not the parties’ actual foresight, of that loss and damage suffered.

The most straightforward solution to avoiding a ‘remoteness’ defence is for the parties to agree what types of damages are within the parties’ common contemplation, and, by means of a ‘consequential loss’ clause, what is not to be compensated. Such need not be left to the discretion of the tribunal. Sub-Clause 1.15 of the FIDIC Conditions of Contract for Plant and Design-Build affords an example of just such a provision. It states that neither party shall be liable to the other party for loss or use of any works, loss of profit, loss of any contract or for any indirect or consequential loss or damage which may be suffered by the other party in connection with the contract, other than seven exceptions.

All those seven exceptions involve loss and/or damage that was demonstrably contemplated by the parties when they entered their contract with each other. Difficulties of application may arise, however, when an expression such as ‘consequential loss or damage’ is used in an international model contract due to the many different ways that expression may be interpreted to mean. As with most risks of this nature, the basic solution is to be clear and specific as to what types of damages are unrecoverable.

Co-written by Melissa McLaren, Jessica Lyons and Nicholas Brown of Pinsent Masons.