March 21, 2016 Articles

Lost Profits: Direct or Consequential Damages?

Significant sums hang in the balance.

By Wendi J. Berkowitz

The question of whether lost profits resulting from a contract breach constitutes direct or consequential damages has vexed practitioners for decades. While we can hardly claim that the answer is now clear, the primary factor appears to be foreseeability of the eventual outcome at the time of contracting. (This analysis will focus mostly on California, as a jurisprudential leader, though the law in many other jurisdictions is similar.) Of course, lost profits is often the single largest component of a plaintiff’s claim for breach of contract damages, and many contracts exclude recovery of consequential damages in the event of breach. Thus, significant sums hang in the balance. Direct or consequential? That is the question.

Definitions
Direct damages are those damages that “flow directly and necessarily from a breach of contract, or that are a natural result of a breach and are within the contemplation of the parties.” Ash v. North American Title Company, 223 Cal. App. 4th 1258, 1270 (2014) reh'g denied (Mar. 5, 2014) (internal quotation omitted). To determine if damages are direct, the court must ask, “What performance did the parties bargain for?” Lewis Jorge Construction Management, Inc. v. Pomona Unified School Dist., 34 Cal. 4th 960, 971 (2004) (“Lewis Jorge”). 

Consequential damages, in contrast, “are secondary or derivative losses arising from circumstances that are particular to the contract or to the parties.” Lewis Jorge, 34 Cal. 4th at 968. These damages “will not be presumed by mere breach.” Id. at 969. Rather, such damages are only recoverable when “the special or particular circumstances from which they arise were actually communicated to or known by the breaching party (a subjective test) or were matters of which the breaching party should have been aware at the time of contracting (an objective test).” See id. at 968–969. However, “the nature of the contract or the circumstances in which it is made may compel the inference that the defendant should have contemplated the fact that such a loss would be the probable result of the defendant's breach.” Lewis Jorge, 34 Cal. 4th at 970.

Lost Profits
Lost profits are often considered to be the most common form of consequential damages in commercial litigation. George P. Roach, Correcting Uncertain Prophecies: An Analysis of Business Consequential Damages, 22 Rev. Litig. 1, 16 (2003) (“Lost profits is probably the most common claim for commercial consequential damages.”); Glenn D. West and Sara G. Duran, Reassessing the “Consequences” of Consequential Damage Waivers in Acquisition Agreements, The Business Lawyer, May 2008, at 792. However, not all lost profits constitute consequential damages. The vast majority of courts agree that lost profits may be either direct or consequential damages, depending on the circumstances surrounding the particular contract and parties. See Biotronik A.G. v. Conor Medsystems Ireland, Ltd., 22 N.Y.3d 799, 805-06, 11 N.E.3d 676, 680 (2014) (“Lost profits may be either general or consequential damages, depending on whether the non-breaching party bargained for such profits and they are the direct and immediate fruits of the contract”); Cont'l Holdings, Ltd. v. Leahy, 132 S.W.3d 471, 475 (Tex. Ct. App. 2003) (noting that “lost profits damages may take the form of ‘direct’ damages or the form of ‘consequential’ damages”); Imaging Sys. Int'l, Inc. v. Magnetic Resonance Plus, Inc., 227 Ga. App. 641, 643-44, 490 S.E.2d 124, 127 (1997); Westlake Fin. Grp., Inc. v. CDH-Delnor Health Sys., 25 N.E.3d 1166, 1177 (Ill. App. Ct. Jan. 6, 2015) (finding that a limitation of liability provision prohibited damages for consequential lost profits but not direct lost profits); Claredi Corp. v. SeeBeyond Tech. Corp., No. 4:04CV1304RWS, 2010 WL 1257946, at *6 (E.D. Mo. Mar. 26, 2010) (interpreting a limitation of liability provision to limit “only indirect loss of profits and not lost profits which are direct damages”); Penncro Associates, Inc. v. Sprint Spectrum, L.P., 499 F.3d 1151, 1162 (10th Cir. 2007) (“We hold that, in keeping with plain meaning and legal norms, where parties to an agreement exclude liability only for consequential damages, profits lost as a direct result of a breach may be recovered.”); cf. Drews Co. v. Ledwith-Wolfe Associates, Inc., 296 S.C. 207, 210, 371 S.E.2d 532, 534 (1988) (“Profits lost by a business as the result of a contractual breach have long been recognized as a species of recoverable consequential damages in this state.”); Optimal Interiors, LLC v. HON Co., 774 F. Supp. 2d 993, 1012-1013 (S.D. Iowa 2011) (prohibiting lost profits under a limitation of liability provision because “Iowa law reveals that lost profits are routinely regarded as consequential damages and not as direct damages”).

In California, lost profits may be considered direct damages when the profits are “part and parcel of the contract itself.” Lewis Jorge, 34 Cal. 4th at 971. The California Supreme Court has explained that lost profits from collateral agreements often constitute direct damages in cases involving crops, goods intended for resale, or an agreement creating an exclusive sales relationship. Id. at 971–72. In those cases, the “likelihood of lost profits from related or derivative transactions is so obvious . . . that the breaching party must be deemed to have contemplated them at the inception of the contract.” Id.

More commonly, though, lost profits are considered to be consequential rather than direct damages. Lewis Jorge, 34 Cal. 4th at 975 (citing 3 Dobbs, Law of Remedies (2d ed. 1993) § 12.4(3), pp. 76-77). And consequential damages can include profits expected from collateral agreements with third parties. See Hydraform Products Corp. v. Am. Steel & Aluminum Corp., 127 N.H. 187, 199–200, 498 A.2d 339, 346-47 (New. Hamp. 1985) (“As a general rule, loss in the value of a business as a going concern, or loss in the value of its good will, may be recovered as an element of consequential damages.”); CR-RSC Tower I, LLC v. RSC Tower I, LLC, 429 Md. 387, 407-08, 56 A.3d 170, 182 (2012) (noting that damages are consequential “when lost profits are claimed for lost income from business operations that would have been made but for the breach”); Airlink Commc'ns, Inc. v. Owl Wireless, LLC, No. 3:10 CV 2296, 2011 WL 4376123, at *3 (N.D. Ohio Sept. 20, 2011) (concluding that lost profits are consequential when they are “contingent upon third-party agreements” not directly tied to the contract that has been breached); cf. DaimlerChrysler Motors Co., LLC v. Manuel, 362 S.W.3d 160, 185 (Tex. App. 2012) (“And it bears repeating that lost profits are not per se consequential damages solely because there will be a subsequent sale to third parties.”).

Proving Lost Profits
So far, so good. But just because damages are definable does not mean they are recoverable. Indeed, lost profits are available only if they are proximately caused by the specific breach of the defendant. Postal Instant Press, Inc. v. Sealy, 43 Cal. App. 4th 1704, 1709 (1996); see also Brandon & Tibbs v. George Kevorkian Accountancy Corp., 226 Cal. App. 3d 442, 457 (1990) (“The only prerequisite to recovery of lost profits is proximate causation: the lost profits must be the natural and direct consequences of the breach.”); Ash, 223 Cal. App. 4th at 1270 (finding that lost profits must “flow directly and necessarily” from the breach). In other words, the breaching party “is only liable to place the non-breaching party in the same position as if the specific breach had not occurred.” Postal Instant Press, Inc., 43 Cal. App. 4th at 1709.

Also, and the core question on recoverability, lost profits damages must be proven with “reasonable certainty.” Sargon Enterprises, Inc. v. Univ. of S. Cal., 55 Cal. 4th 747, 775 (2012). Future profits cannot be recovered where they depend on future contracts that are “uncertain or speculative.” Food Safety Net Servs. v. Eco Safe Sys. USA, Inc., 209 Cal. App. 4th 1118, 1132 (2012) (“[L]ost anticipated profits cannot be recovered if it is uncertain whether any profit would have been derived at all from the proposed undertaking”). Generally, damages for future profits of an unestablished business are not recoverable because such profits are “uncertain, contingent and speculative.” Sargon, 55 Cal. 4th at 775; Shade Foods, Inc. v. Innovative Products Sales & Mktg., Inc., 78 Cal. App. 4th 847, 890 (2000), as modified on denial of reh'g (Mar. 29, 2000) (noting that for new businesses, the “absence of income and expense experience renders anticipated profits too speculative to meet the legal standard of reasonable certainty”).

Takeaways
Answering the question of whether lost profits damages are direct or consequential will almost always require a fact-intensive analysis. The answer to these questions will help guide the way:

  • What were the parties expecting when they entered into the contract?

  • Was the ultimate loss claimed one that the contracting parties actually or reasonably should have expected?

  • Are the damages claimed a “natural result of the breach,” and do they flow “directly and necessarily from the breach?”

  • Or rather do the damages spring from “circumstances that are particular to the contract or the parties?”

  • Were the lost profits damages caused by the specific breach alleged to have been committed by the specific defendant?

When it comes time to proving up lost profits damages, the following should be considered:

  • Is there a limitation of liability clause in the contract precluding recovery of consequential (lost profits) damages?

  • Are the lost profits damages inherently speculative, or is there a sound basis for calculating them, such as historical profits or comparable performance by comparable companies?

Keywords: litigation, business torts, lost profits, direct damages, consequential damages

Wendi J. Berkowitz – March 21, 2016