July 10, 2012
Acquisition agreements often contain provisions that restrict or prohibit the payment of “consequential,” “special,” or “incidental” damages for breach. 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. 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. 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.
“Consequential” or “Special” Damages
The exact damages that are included in the term “consequential damages” are not well defined within existing case law. 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.” 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.” 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. 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.
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.” 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.
Parties to an acquisition agreement should consider carefully the effect of waivers of categories of damages. In particular, we recommend the following:
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.
 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).
Gibson, Dunn & Crutcher’s lawyers are available to assist in addressing any questions you may have regarding these issues. Please contact the Gibson Dunn lawyer with whom you work or any of the following:
Dennis J. Friedman – New York (212-351-3900, email@example.com)
Jonathan K. Layne – Los Angeles (310-552-8641, firstname.lastname@example.org)
Barbara L. Becker – New York (212-351-4062, email@example.com)
Eduardo Gallardo – New York (212-351-3847, firstname.lastname@example.org)
Lois F. Herzeca – New York (212-351-2688, email@example.com)
Stephen I. Glover – Washington, D.C. (202-955-8593, firstname.lastname@example.org)
John F. Olson – Washington, D.C. (202-955-8522, email@example.com)
Jeffrey A. Chapman – Dallas (214-698-3120, firstname.lastname@example.org)
Robert B. Little – Dallas (214-698-3260, email@example.com)
Brian E. Robison – Dallas (214-698-3370, firstname.lastname@example.org)
Michelle Hodges – Orange County (949-451-3954, email@example.com)
Christopher D. Dillon – Palo Alto (650-849-5325, firstname.lastname@example.org)
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