Direct and indirect losses and damages: a multi-jurisdictional outlook

Following our recent podcast on this topic that forms part of DLA Piper’s ‘Better Contracts’ podcast series, in this article we provide an overview of how direct and indirect losses in commercial contracts are categorised and dealt with differently across different jurisdictions, taking a deeper dive into some of the key points raised by our speakers.

Why do we need to consider the concepts of ‘direct’ and ‘indirect’ loss?

A common feature of contracts, regardless of the governing law that applies to them, is to specify the extent to which one or more of the parties will be compensated if there is a breach of contract. From a practical perspective, the aim is to strike the right balance and allow the party who has suffered the loss to make a reasonable claim for damages but not allow them to recover absolutely everything that they claim may have possibly resulted from the breach. As a shorthand reference, we often use the concepts of ‘direct’ or ‘indirect’ to place losses into different categories, along with the notion of ‘remoteness’, which is the concept that some losses are simply too far removed from the original breach to be recoverable and that it would therefore be unreasonable for the party seeking to recover the losses to be entitled to compensation for them.

How are the concepts of ‘direct’ and ‘indirect’ loss distinguished in different jurisdictions?

Despite being commonly used, the concepts of ‘direct’ and ‘indirect’ loss don’t always fit neatly into the way different legal jurisdictions think about recoverability of losses flowing from breach of contract, and they don’t always mean the same thing. With that point in mind, it is helpful to look at examples from different jurisdictions to see how these concepts best translate.

Direct loss

Turning first to the UK, and applying the longstanding case of Hadley & Anor v Baxendale & Ors [1854] EWHC J70, direct loss is that which naturally results from the breach in the usual course of things, and such loss is recoverable. Whereas in Germany, it is irrelevant whether the damage occurred directly or indirectly, as the key issue is if the loss objectively resulted from a breach of contract, and the concept of ‘direct’ loss applies to a very narrow range of loss that relates to a supplied item only.

In France, to take another example, only direct (foreseeable) losses are compensable by law. But statute does not explain what the concept means. Court decision can possibly go far in identifying a nexus between the loss and the breach. Therefore, in order to mitigate the risk of loss falling within the direct and recoverable brackets in contracts governed by French law, the parties can expressly exclude certain types of loss (e.g. lost profits or loss of data), or they can attempt to specify in advance which losses are direct/recoverable and which are irrecoverable.

Italy follows the principle that limits recoverable damages to what is termed as ‘direct’ damages, which refer to the direct and immediate result of the breach of contract. Typical ‘direct’ damages are financial losses, loss of profits, loss of data and loss of chance. That said, for reasons of substantive fairness, case law has over time extended the concept of ‘direct’ damages to include those damages that – albeit indirect – still appear as a normal consequence of the breach, according to the principle of ‘causal regularity’. Also, recoverable damages must be foreseeable from an objective standpoint, taking into account the socio-economic category to which the parties belong. This principle is designed to limit the extent of liability or, in other words, to make it proportionate to the risk inherent in the service to be provided.

Indirect loss

It is worth pointing out that, as the interpretation of different types of loss vary, so do the ways in which they are labelled. Under English law the terms ‘indirect’ or ‘consequential’ may be used interchangeably to refer to anything that does not fall within the bracket of ‘direct’ losses. These terms do not have a particular legal meaning in civil law jurisdictions, even though contractual practice deriving from originally English (or US) law-governed contract templates tends to use them to mean losses other than direct losses.

In some parts of the world, losses can be recovered even if they are not ‘direct’, as long as the contract does not expressly exclude this and the circumstances to which the losses relate has been considered by the parties in advance. However, the laws of certain other jurisdictions do not permit the recovery of anything other than direct loss, such as in the US. In the US, unless loss: (i) naturally/necessarily arises from a breach; (ii) is foreseeable and can be calculated with certainty; and (iii) was contemplated by the parties because of a breach, it will be deemed not to be direct loss and will not be recoverable.

In Belgium, as in Germany and France, there is no corresponding distinction between direct and indirect loss, and all losses are recoverable if they can satisfy various principles. Belgium law provides a prime example of this, as all damages are recoverable if the damage would not have occurred without the contractual fault, if at the time of the contract damages were foreseeable.

Under English law, indirect losses (known as the ‘second limb’ of the rule established in the Hadley v Baxendale case), are categorised as losses that are not the natural results of a breach, but rather those that arise from special circumstances. Such losses can only be recoverable if they were within the contemplation of the parties at the time the contract was made, i.e. if both parties were aware of the special circumstances causing them to arise at that time. It is therefore important that any special circumstances are discussed between the parties before a contract is entered into.

Japan and South Korea have comparable approaches to distinguishing direct and indirect losses, each categorising ‘ordinary’ and ‘special’ loss. In each case special loss places the onus on the breaching party to know of, or to reasonably assume that circumstances could result in, the breach. In contrast, Hong Kong applies a similar approach to the UK but also applies a ‘assumed responsibility’ test when assessing losses. This is a good example of how laws particular to either a civil or common law source may, as is to be expected, have similarities, but are yet still subject to local variation.

Dos and don’ts when navigating jurisdictional variations

As shown above, when dealing with contracts that have multijurisdictional application, it is not possible to simply categorise the loss that might arise in each relevant jurisdiction into categories of direct and indirect damages to try and assess what losses may be recoverable. Despite the commonalities between the different civil laws, reviewing and amending clauses based on the applicable local law principles is very much needed to avoid having clauses which are unenforceable.

It is helpful for a lawyer drafting a contract with multijurisdictional scope to understand that the approach applied in the jurisdiction that they are qualified to practice will not necessarily match that of a lawyer acting for another party to the contract that is qualified to practice law in another part of the world.

There is no silver bullet to resolve this issue, but an awareness of the fact that laws around the world are particularly nuanced in relation to the issue of different types of loss can only be helpful in finding a suitable resolution and reaching agreement regarding the contractual terms that will apply to a commercial arrangement with multijurisdictional scope. In particular, we would recommend the following dos and don’ts:

• Don’t assume that what works in one jurisdiction will work in another when it comes to damages.
• Do appreciate that the terms ‘direct’ and ‘indirect’ may mean different things across different jurisdictions – or may not have a clear meaning at all.
• Don’t change the governing law of a contract without also considering how this may impact the terminology used to describe recovery of losses.
• Do consider spelling out in the contract what you mean explicitly by providing examples, as this can help avoid misunderstandings.

If you haven’t already done so, please listen to our podcast: ‘Direct and indirect damages: what these terms mean and how they are used in different jurisdictions’ that forms part of DLA Piper’s Better Contracts Podcast series for more discussion of this topic.