Contractual Damages Overview

As discussed in the legal sections of this tool under the common and civil law, the valuation of a contract claim turns on the contract, the applicable law, and the damages case pleaded.

Expectation Damages/Lost Profits

When not excluded by the contract, the quantification of contract damages often turns on what would have happened absent the breach, including both direct (general) damages and consequential damages. The question in these damages cases is what would it take to put the claimant back in the position it would have been in absent the breach. These types of forward-looking damages may be referred to as expectation damages and include lost profits, unless excluded by the contract. In many civil law countries, this is the basic damages standard for breach of contract, provided causation can be established, which may be a relatively high bar.

Calculating expectation damages or lost profits often requires a “but-for,” counter-factual analysis of what would have been expected to occur absent the breach to determine what damages resulted from the breach, which is the difference between the value taking the breach into consideration (what did happen) and what would have happened absent the breach (called the “but-for” or the counterfactual scenario). This requires developing a counterfactual scenario and calculating forward-looking damages based on a quantification of the risk of actual and but-for future cash flow streams and often resembles a DCF analysis.

Reliance Damages

An alternative basis for determining contract damages is reliance damages, which is the damage a party incurs due to its reliance on the other party to perform under the agreement. Reliance damages are backward-looking and ask what damages are required to place the party back in the situation it would have been had it not entered into the agreement at all. Calculating reliance damages therefor requires a determination of what position the claimant would have been in had it not entered into the agreement, including what costs it incurred in reliance on the agreement.

Contractual Limitations

Contracts may prescribe different valuation definitions and assumptions, the detailed application of which may require an approach different from that required by general valuation standards. This can be the case when the contract includes a liquidated damages provision or precludes certain types of damages or includes a damage cap. These types of damage provisions usually stem from a desire at the time of contracting to create increased certainty and to limit risk in the case of perceived breaches of the agreement. As a result, their application often leads to a more straight-forward quantification exercise than would otherwise be the case.

Liquidated Damages

A liquidated damages clause prescribes the damages to be paid when a particular breach of contract occurs. By assigning a value to a loss that may otherwise have been difficult to quantify, liquidated damage provisions give the parties a more precise means to value the cost of breach. Liquidated damage clauses also limit the arbitration risk by establishing boundaries around the amount of damages a tribunal can be expected to award (which may be higher or lower than the actual loss incurred). The increased certainty of the result is counter-balanced by an agreed amount or formula that does not reflect the harm actually suffered but rather is the result of the parties’ relative bargaining power and expectations at the time of contracting.

Issues often arise as to whether liquidated damages clauses are enforceable. While enforceability depends on the law and the contract terms, a good rule of thumb is that liquidated damages can be agreed upon as long as the amount agreed is reasonable in light of anticipated or actual loss caused by the breach they are meant to cure. In a common law jurisdiction, such a clause will not be enforced if it is not reasonable in proportion to the actual or anticipated damage, and/or if it is designed to penalize the breaching party. Civil law jurisdictions are more likely to enforce penalty clauses provided they are not excessive, so again a reasonableness criteria is applied.

Damage Exclusions

In order to further limit their risk, parties often include provisions in their commercial agreements excluding lost profits and other consequential damages (as well as many warranty claims) and/or capping their total liability to an agreed amount. Including clauses in contracts that determine the amount or limit the scope of damage, claims may (i) provide enhanced certainty to the parties, (ii) simplify the dispute resolution procedure, and (iii) induce performance of the contract. However, this comes at the cost of dissolving the link between the actual loss and the damage. By excluding or limiting lost profits and consequential damages, the parties preclude the commercial damages claims raising the most difficult quantification questions and hence the most risk of unexpected awards. When contracts exclude lost profits and other consequential damages, this typically eliminates the need for the tribunal to take decisions based on uncertain future events (which may limit the amount of the Award).