Portfolio Media. Inc. 860 Broadway, 6th Floor New York, NY 10003 www.law360.com Phone: +1 646 783 7100 Fax: +1 646 783 7161 customerservice@law360.com Using A Contractual Consequential Damage Limitation Law360, New York (October 13, 2011, 3:03 PM ET) -- A consequential damage limitation can be a useful tool in limiting a party s product liability exposure. The consequential damage limitation is commonly used in construction contracts but may also be used in contracts for the sale of goods. When combined with the economic loss doctrine, a properly drafted consequential damage limitation can shield a manufacturer from millions of dollars in liability stemming from personal injury, property damage and other economic losses. Although a useful tool, a provision that limits consequential damages creates its own unique challenges, including enforceability and defining consequential damages. This article discusses the strategies a defendant should use and the hurdles defendants must overcome to defend a product liability action using the economic loss doctrine and a contractual consequential damage limitation. For illustrative purposes, this article uses as an example a defendant manufacturer, who supplies industrial equipment that is classified as a good under the Uniform Commercial Code ( UCC ), to another commercial entity, that uses the equipment in a production facility to manufacture a consumer good. The defendant manufacturer employs a consequential damage limitation in its agreement with the commercial buyer, which limits the defendant manufacturer s exposure stemming from the failure of the product to the buyer s direct damages, excluding all consequential damages. Due to a defect in the product, an explosion occurs, which destroys the product and also causes damage to the production facility. This example is useful because a failure in the equipment may cause a host of different types of damages, including damage to the supplied equipment itself, damage to the facility, personal injury, business interruption, lost revenues/profits, and losses suffered from the inability of the buyer to fulfill third-party contracts. The Economic Loss Doctrine Although not directly related to the consequential damage limitation, the first step when preparing for a product liability defense in most scenarios should be attempting to dismiss all tort claims under the economic loss doctrine. The economic loss doctrine prevents plaintiffs from creating a tort action where there is otherwise nothing more than a contract claim. Not only does the economic loss doctrine eliminate all tort actions, but, as discussed in the following sections, it also provides for an easier application of the consequential damage limitation.
The economic loss doctrine provides that where the only damage suffered is loss stemming from the commercial failure of the product at issue, the plaintiff is limited to contract forms of recovery. A.J. Decoster Co. v. Westinghouse Elec. Corp., 333 Md. 245, 634 A.2d 1330 (1994). In other words, unless the plaintiff can show damage to a person or to property other than the product itself, the plaintiff may not maintain a tort action. Id. at 249-50, 634 A.2d at 1332. Take the above example but assume that there was no damage to the facility; only the equipment was damaged. Further assume that the production facility was shut down while the defective product was being replaced. Under these facts, the only damages suffered by the plaintiff are the damages to the product itself and the revenues or profits lost due to the fact that the facility was shut down for a period of time. Under these facts, the defendant should be able to dismiss all tort claims under the economic loss doctrine. Additionally, the economic loss defense does not fail simply because there is damage to property other than the product itself. Some states have adopted a de minimis rule as it relates to damage to other property. See Delmarva Power & Light v. Meter-Treater Inc., 218 F.Supp.2d 564, 569-71 (D. Del. 2002) (minor damage to automobiles was de minimis in light of millions of dollars in damage to electric meters); Florida Power & Light Co. v. McGraw Edison Co., 696 F. Supp. 617, 620 (S.D. Fla.1988). Using our hypothetical again, if the damage to the production facility is negligible in light of the total amount of damages, some courts will apply the economic loss doctrine because it would be unreasonable to allow an insignificant amount of damage to create a tort action where there is otherwise only a breach of contract claim. Rich Prod. Corp. v. Kemutec Inc., 66 F. Supp. 2d 937, 971-75 (E.D. Wisc. 1999) (allowing tort recovery for de minimis damage allows the tail to wag the dog. It blurs the essential fact that this case is more about failed commercial expectations than it is about injuries to persons or property. ) There is a further exception that is particularly relevant to the industrial equipment example. Some courts have expanded their interpretation of the product itself to include the larger structure or facility into which the product is being integrated. Midwhey Powder Co. Inc. v. Clayton Indus., 157 Wis.2d 585, 590-91, 460 N.W.2d 426 (Wis. Ct. App. 1990) (damage to turbines caused by defect in generator down the line was found not to be other property within the meaning of the economic loss rule where the turbines connected to the generator as part of overall apparatus). Under the example, the defendant manufacturer could argue that the equipment supplied was built into a larger machine in a factory; therefore, the product is the entire industrial machine. This integrated system argument would appear to be a powerful tool, however, as discussed below, the defendant manufacturer may find itself making the opposite argument when enforcing the consequential damage limitation. Moreover, in making this argument, the defendant manufacturer may find itself responsible for the damages associated with replacing the entire integrated system, as opposed to replacing simply the product that it supplied. In addition to barring tort claims, the economic loss rule allows for an easier application of the consequential damage limitation. Once the plaintiff is limited to contract and warranty forms of recovery, the defendant can rely heavily upon Article 2 of the UCC. The UCC explicitly endorses contractual consequential damage limitations and provides some clarification as to which damages are direct and which damages are consequential.
Enforceability of a Contractual Provision Limiting Consequential Damages The enforceability of a consequential damage limitation is not usually a difficult hurdle for commercial entities to overcome, but it can never be considered an absolute certainty. The UCC states that *c+onsequential damages may be limited or excluded unless the limitation or exclusion is unconscionable. UCC 2-719 (3) (2011). Outside the UCC context, courts will enforce consequential damage limitations unless the limitation is unconscionable, in violation of public policy or if enforcement of the provision causes the contract to fail of its essential purpose. See Taylor Inv. Corp. v. Weil, 169 F. Supp. 2d 1046, 1058-59 (D. Minn. 2001). A commercial plaintiff would have a difficult time claiming that a consequential damage limitation was unconscionable or failed of its essential purpose if the provision was reasonable and negotiated as part of an arms-length agreement. A manufacturer should, however, be wary of the enforceability of the provision against a consumer, Hartzell v. Justus Co. Inc., 693 F.2d 770 (8th Cir. 1982) (finding that consequential damage limitation in contract with consumer failed of its essential purpose), and most states will not allow a manufacturer to disclaim liability in the event of its own gross negligence, willful, wanton or intentional conduct. Kalisch-Jarcho Inc. v. New York, 58 N.Y.2d 377, 448 N.E.2d 413 (N.Y. 1983). Under the example above, the manufacturer defendant should not have difficulty enforcing the provision against a commercial buyer, but it should nonetheless take some precautions. Prior to entering into the agreement, the manufacturer should ensure that the damage limitation is negotiated at arm s length as part of the entire agreement. Laidlaw Environ. Servs. Inc. v. Honeywell Inc., 966 F.Supp. 1401, 1413-14 (D. S.C. 1996). From a drafting perspective, the consequential damage provision should be located in its own separate section, and it should be conspicuously placed in the agreement. JPS Elastometrics Corp. v. Industrial Tools Inc., 65 F.Supp.2d 376, 379 (W.D. Va. 1998). Finally, as discussed in greater detail below, the provision should define with clarity what the parties consider and agree are consequential damages. Defining Consequential Damages The next and most difficult step in defending a product liability action with a consequential damage limitation is defining consequential damage if no such definition is included in the agreement. A plaintiff is likely to allege a barrage of claims, including strict product liability, negligence, breach of contract and breach of warranty. In these claims, the definition of consequential damage typically comes from one of two sources: the UCC and the common law. The UCC Definition In the case of a buyer asserting a product liability claim against a seller, the UCC defines consequential damages as follows: (2) Consequential damages resulting from the seller s breach include (a) any loss resulting from general or particular requirements and needs of which the seller at the time of contracting had reason to know and which could not reasonably be prevented by cover or otherwise; and (b) injury to person or property proximately resulting from any breach of warranty. 2-715.
The definition contained in subsection (a) is difficult to pin down, but that may not necessarily be bad for the manufacturing defendant. Rather than focus on a particular category of damages, subsection (a) focuses on the seller s knowledge at the time of contracting. The defendant seller can argue that it had reason to know of the buyer s particular requirements, thereby increasing the amount of consequential damages excluded by the provision. This, however, is a double-edged sword. If the particular needs and requirements of the buyer were so apparent at the time of contracting, the court may find that the resultant damages were direct damages. Adding to the ambiguity, most courts employ a known or should have known standard under this subsection. Everett Plywood Corp. v. U.S., 512 F.2d 1082, 1091 (Ct. Cl. 1975). The should have known argument may increase the amount excluded; however, it also increases the likelihood that a claim would survive a dispositive motion on the consequential damage issue. One way to guard against this uncertainty is to add language to the agreement explicitly naming certain categories of damages as excluded under the limitation (i.e., lost profits, losses sustained under third-party contracts, personal injury, etc.) The simplest definition of consequential damage is subsection (b) related to breach of warranty claims. In a breach of warranty action, the buyer is entitled to the difference in the product as warranted, and the product supplied. UCC 2-714(2) (2011). Injury to a person or property is considered consequential. Id. 2-715(2)(b); Signal Oil and Gas Co. v. Universal Oil Prods., 572 S.W.2d 320 (1978). This is the strongest language for the manufacturing defendant. This allows the manufacturing defendant to essentially exclude all damages except for the cost to repair or replace the defective product. Notice, however, that this argument is inconsistent with the integrated system argument discussed above. A commercial defendant may wish to forgo the integrated system argument under the economic loss doctrine and instead choose to call those losses other property excluded by the breach of warranty definition of consequential damage. The Common Law Definition The common law definition of consequential damage will vary by state, but it is generally a version of the definition stated in "Black s Law Dictionary." Consequential damages are those that do not flow directly and immediately from an injurious act but that result indirectly from the act. Black's Law Dictionary 416 (8th ed.2004); see also Hadley v. Baxendale, 156 ER 145 (1854). This definition leaves plenty of room for interpretation, but courts have reached some consensus on certain classifications of damages. Most courts hold that lost profits and other types of business interruption are consequential. See R.K. Chevrolet Inc. v. Hayden, 253 Va. 50, 56, 480 S.E.2d 477, 481 (Va. 1997); but see Mood v. Kronos Products Inc., 245 S.W.3d 8, 12 (Tex. Ct. App. 2007) (stating that lost profits may be direct or consequential). Personal injury is also generally consequential. Johnson v. Scandia Associates Inc., 717 N.E.2d 24, 31 (Ind. 1999). The cost of a substitute service or the cost of rental equipment is frequently considered consequential, as well. Mercedes-Benz of North America Inc., v. Garten, 94 Md. App. 547, 552, 618 A.2d 233, 235 (1993). The picture, however, is not as clear as it relates to other property. Using the example, it would seem illogical that the damage to the production facility did not flow directly and immediately from the explosion, yet this is what subsection (2)(b) of the UCC suggests.
Here, the defendant manufacturer is presented with competing definitions of consequential damage that dictate varying degrees of liability exposure. This underscores the importance of using the economic loss doctrine to eliminate all tort claims where possible. This ensures that the defendant manufacturer is able to rely upon the favorable provisions of the UCC. As suggested above, it would also be useful here to list the specific categories of damages that are disclaimed. Conclusion A consequential damage limitation that is bargained for between contracting parties can be a useful tool in limiting millions of dollars in potential product liability exposure. When drafting the provision, the drafter should conspicuously place the provision in the agreement. The drafter should also consider explicitly naming the categories of damages, which are covered by the provision, including lost profits, personal injury and damage to other property. Should litigation arise out of the failure of the product, the defendant manufacturer should first use the economic loss doctrine to eliminate all tort claims. Eliminating the tort claims will also limit the sources from which a plaintiff could draw upon the most favorable definition of consequential damage. The defendant manufacturer should rely heavily upon the favorable provisions in the UCC, in particular, upon the consequential damage definition for breach of warranty actions. This allows the defendant manufacturer to eliminate all damages other than those strictly related to the product itself. In this sense, the consequential damage limitation accomplishes what the economic loss doctrine cannot; it reduces what could otherwise be a tort claim with massive damages to a simple contract claim where the only damages at issue are the cost to repair or replace the product. In sum, a consequential damage limitation should be an essential provision in every agreement between commercial entities, especially where the potential exposure is limitless. --By Michael J. Halaiko (pictured) and Matthew P. Phelps, Miles & Stockbridge PC Michael Halaiko is a principal, and Matthew Phelps is an associate, in the products liability practice group in the Baltimore office of Miles & Stockbridge. The opinions expressed are those of the authors and do not necessarily reflect the views of the firm, its clients, or Portfolio Media, publisher of Law360. This article is for general information purposes and is not intended to be and should not be taken as legal advice. All Content 2003-2011, Portfolio Media, Inc.