Star Polaris – consequential loss in shipbuilding disputes

An English High Court ruling has examined the meaning of consequential loss in relation to a shipbuilding dispute that will likely have important implications for the interpretation of limitation of liability clauses in a variety of contracts subject to English law.

The owners of the Star Polaris ordered the vessel from a builder using a modified version of the widely used Shipbuilders’ Association of Japan standard form shipbuilding contract (SAJ Form). Just over 7 months after the vessel was delivered, it suffered a serious engine failure which required the vessel to be towed to South Korea for repairs. The builder denied all liability for the incident. The owners commenced arbitration against the builder, claiming compensation for the cost of repairs to the vessel as well as “towage fees, agency fees, survey fees, off-hire and off-hire bunkers caused by the engine failure.” The owners also claimed for diminution in value of the vessel. The arbitrators found that there had been a breach of the warranty provisions, but that the terms of the contract, on its proper construction, excluded liability for the expenses that resulted from the engine breakdown.

The owners appealed the arbitrators’ findings to the High Court.

In this case, the relevant wording of the contract (Article IX(4)) read:

“Except as expressly provided in this Paragraph, in no circumstances and on no ground whatsoever shall the BUILDER have any responsibility or liability whatsoever or howsoever arising in respect of or in connection with the VESSEL or this CONTRACT after the delivery of the VESSEL. Further, but without in any way limiting the generality of the foregoing, the BUILDER shall have no liability or responsibility whatsoever or howsoever arising for or in connection with any consequential or special losses, damages or expenses unless otherwise stated herein”.

Under the standard SAJ Form, the builder’s liability after delivery is limited to the costs of rectifying any defects in materials of workmanship for the period of the guarantee (usually one year from delivery). The builder’s liability for loss of time, loss of profit and other financial consequences caused by the defects is expressly excluded (this language was missing from the modified SAJ Form). This is the common approach in the shipbuilding industry and the buyer’s risk is usually covered through Loss of Hire insurance to protect the buyer from any time lost for unexpected repairs.

Given this common position, many readers might consider that the language of clause Article IX(4) was clear in its exclusion of all loss of hire and similar financial claims. But this is not the conclusion that many English courts have come to. Indeed in another recent (unreported) arbitration a tribunal came to the opposite result (i.e. the attempt to limit liability for loss of time failed) on a similar clause in a similar contract.

In order to understand the importance of this wording, it is necessary to consider the legal context. To many, the term “consequential losses” denotes losses resulting as a consequence of the breach or defect, to include loss of use. But this is not the way that English law generally interprets this phase in an exemption clause such as Article IX(4). The English law authorities are in general agreement that a reference to “consequential losses” has become a term of art that is referring to the second limb of the well-known decision in Hadley v Baxendale.¹

Losses under Hadley v Baxendale are broken down into two limbs:

• Direct losses (the first limb) are losses which arise naturally, or in the usual course of things, or that may reasonably be in the contemplation of the parties when the contract was made. In the case of a major engine failure on a vessel, it is reasonable to expect that owners and builders will be aware that time and money will be lost to effect repairs, and these losses are direct losses.
• Indirect loss or consequential losses (the second limb) are losses that result, from special circumstances, which will only be recoverable if the other party knows of those circumstances. For example, if the owner had a forward (profitable) long term charter that was lost as a result of an engine breakdown (for example, because the repairs forced the owner to miss the delivery window), if the replacement charter rate for a similar long term charter was less than the lost charter, the difference would be a consequential loss.

Following that definition, many in business are surprised to learn that consequential losses does not mean what they would ordinarily consider it would mean. The dichotomy between the legal definition and the lay interpretation of the same phrase represents one of the most counterintuitive issues in modern English law, and a cause of many disputes.

The court agreed with the arbitrators that they were free to interpret the words of Article IX of the modified SAJ Form in their own context (because this clause had not previously been the subject of judicial consideration, and the article provided for a complete code between the parties), and were not bound by the technical legal definition of consequential losses. In other words, the tribunal and the court looked at the clause as a whole to determine the scope of the exclusion. In the event, both the tribunal and the court found that in this contract, consequential losses was not used in the legal sense (i.e. shorthand for the second limb of Hadley v Baxendale), “but in a cause and effect sense”.

The court found that there was no liability above and beyond the express obligations undertaken by the builder, and that financial losses consequent upon physical damage are not covered by the guarantee. The court also found that while diminution in value does constitute a “consequential or special loss”, the obligation of the builder was only to replace or repair or bear the cost thereof and this claim was excluded.

This case shows that the traditionally narrow interpretation of “consequential losses” being limited to the second limb of Hadley v Baxendale may be changing in favor of a more flexible, case by case analysis.

This concept has recently also been challenged by the Court of Appeal in Transocean Drilling UK Ltd Providence Resources Plc² (albeit in obiter) when the court questioned "whether some of [the consequential loss] cases would be decided in the same way today, when courts are more willing to recognise that words take their meaning from their particular context and that the same word or phrase may mean different things in different documents”.

However, a single High Court case is not enough to afford any certainty to this question of interpretation. The message is that parties must be very cautious when drafting exclusionary clauses, as the commonly understood meaning of “consequential losses” remains different to the meaning of the same phrase in the majority of English case law.