A New Take on Consequential Damages

I am always on the lookout for a fresh take on familiar material, and I must admit, it had never occurred to me that the rule from Hadley v. Baxandale might be either alien vomit or intelligent design, as I had come to understand those terms.  Tara Chowdhury, Faith Chudkowski, Amanda Dixon, Rishabh Sharma, Madison Sherrill, Hadar Tanne, Stephen J. Choi, and Mitu Gulati (the Authors) have made me rethink that position.  They suggest that we should re-imagine contractual limitations on consequential damages as either one or the other in Consequential Damages: Alien Vomit or Intelligent Design, available for download now on SSRN.

Hadley, of course, provides nothing but a default rule, around which the parties can freely contract.  The Authors reviewed over 1300 contracts and interviewed over 100 practitioners.  They discovered that negotiated consequential damages provisions "are often hopelessly ambiguous and that their inclusion in contracts is sometimes more habit than intention."  The Authors begin with a real classroom exercise.  Students were presented with a typical no consequential damages (NCD) clause from a contract negotiated between sophisticated parties.  The provision was in ALLCAPS, which shows you right off the bat that the parties aren't as sophisticated as they think they are.  The students quickly remarked that the provision was "incomprehensible gibberish."  And so a research project was launched.

At the heart of the matter is a puzzlement.  The Hadley default rule is that you cannot get consequential damages unless they were within the contemplation of the parties at the time the contract was formed.  If the default is no consequential damages, what is there to contract around?  Perhaps sophisticated parties want to specify the consequential damages that they do contemplate.  Nope.  Time constraints and inertia lead to the retention of boilerplate provisions that nobody pays attention to.  NCD clauses do not reflect any careful consideration or negotiation by the parties.  Once again, even the lawyers don't know what the contracts they draft and negotiate say.  Practitioners and scholars fall into two camps on NCD clauses.

The Alien Vomit Theory

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A prominent practitioner, Glenn West, traced how NCD clauses found their way into M&A transactions.  He concluded that the clauses were borrowed from construction and supply contracts.  Hence, I suppose, alien vomit.  In the M&A context, they either protect against irrelevant risks or just create confusion by importing undefined language about "special," "indirect," "consequential," or "unnatural" damages.  The obscurity of these clauses introduces risk, as it is unclear to courts what they are intended to exclude.  

Alien vomit is especially dangerous to buyers in M&A transactions.  The categories of damages potentially excluded through NCD clauses represent precisely the value one is trying to achieve through an acquisition.  That is, the sale price of a business entity is linked to its potential to generate future profits.  If such profits are excluded from recovery, what is there left for buyers to recover?

I must admit that I am part of the problem.  The Authors identify terms that practitioners have found to be in need of definition.  I expect my students to know the difference between direct, incidental, and consequential damages.  Last year I used a casebook for Sales that had exercises in which students were supposed to name the category into which different types of damages fell.  The casebook authors' answers all made sense to me, and thus I was under the illusion that it was possible to distinguish among the categories. 

For example, it seems to me that future profits to be generated from the acquisition of a business entity are direct damages, not consequential.  They may be problematically speculative, but they would arise directly from a breach.  Experienced attorneys apparently think otherwise.  It would be nice if we had some evidence of how courts treat such NCD clauses, but it may just be that nobody gives much thought to alien vomit, because it, like much boilerplate, never generates disputes that result in litigation.  If the disputes arise in such transactions, the parties might agree to walk away from the deal, or the transactional attorneys can just iron our the wrinkles themselves rather than leaving things to the really scary aliens, litigators.  

Similarly, practitioners see no need to exclude "exemplary," "punitive," or "treble," damages, none of which would be recoverable for breach of contract in any case.  But that also doesn't seem right to me.  Why aren't these clauses useful to prevent, e.g., exemplary damages that would arise from a fraud claim or a breach of fiduciary duty claim in connection with a breach of contract, or statutory damages that might allow for punitive or treble damages?  When I taught Remedies, I learned that punitive damages are more often awarded on contracts claims than on torts claims because there are hundreds of statutes that provide for punitive damages for certain kinds of breach of contract.

Optimal Design

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Meanwhile, academics writing in the tradition of law and economics have argued that NCD clauses are the product of parties that have carefully considered the matter and negotiated the most efficient allocation of risk.  They have rejected Hadley in favor of an allocation of exposure to liability tailored to the needs of their clients in connection with this particular transaction.  The Authors' research calls this theory into question.  

An aside: I have devoted some time to working through Victor Goldberg's work on contracts damages (I need to get back to that project!).  He seems to have a foot in both camps.  He certainly sometimes speaks the language of optimal design theory, but he also notes how often fuzzy contract terms get the parties in trouble.  However, I think Professor Goldberg is inclined to blame courts for the confusion, at least in part.  At least sometimes, the parties have made very clear that they intend to contract around default rules, but the courts resist, often in a misguided effort to promote what they think are the efficiency and fairness goals best achieved through adherence to common-law defaults.

The Authors' review of NCD clauses in three categories of commercial contracts indicates that use is steady, even in the face of determined warnings from experienced M&A attorneys like Glenn West about their dangers.  They are less common in M&A for public deals, perhaps because of federal statutory regimes that make NCD clauses unnecessary.  However, given the Authors' thesis that NCD clauses are largely unnecessary, inertia seems the more likely explanation.  That is, for whatever reason, NCD clauses did not make their way into the standard boilerplate of these types of transactions.  Alien vomit has spread to 10%-20% of such transactions, but in most cases, either the aliens are vomiting elsewhere or some keen-eyed lawyers is saying, "Ew, that's alien vomit!  We've got plenty of our own vomit in this deal without borrowing language from a different transaction!"

The Authors break down the problematic clauses into three categories: deadly, redundant, and ambiguous.  While there are ups and downs over time, all three categories have enjoyed remarkable staying power since 2010.  That is, while their use fluctuates over time, and while some terms are more likely to appear in one category of transactions rather than another, there is no general trend of decline in use. 

When questioned on the meaning of consequential damages, one set of lawyers gave confident '"incorrect" answers.  Given that the Authors' argument seems to be that the term has no fixed meaning, this seems a tad unfair to the respondents. What is a correct answer? A second set consisting of junior lawyers mostly shamelessly admitted that they had no idea and that it didn't matter because NCD clauses are meaningless boilerplate that never get litigated.  A third set, consisting of more senior lawyers had more specific ideas about consequential damages, but nobody thought that NCD clauses achieve anything beyond Hadley.  

When M&A gurus are interviewed on the subject, they give very different answers.  It seems that the only reason NCD clauses get negotiated is that some gurus want them out, and when they ask for them to be taken out, out they go.  Nobody cares, because liability caps and insurance render them irrelevant anyway.  As it turns out, this too is incorrect.  If a buyer allows a limitation on lost profits to survive the negotiation, that buyer may not be able to recover anything, and insurance and liability caps won't even come into play, assuming, contrary to argument above that lost profits are not direct damages or have been expressly excluded.  In any case, careful attention to caselaw establishing the contractual default provisions is not a factor.  Transactional attorneys look at other transactions, not at case law, when deciding what language to include in the agreement.

This article is a delightful read and has given me a great deal to think about beyond its catchy title, so congratulations to the Authors!  It is very encouraging to see a project that begins in the classroom, goes out into the world of empirical legal scholarship and that can return to the classroom by giving contracts professors new insights into dealmaking.