Glen Banks ()
My last column discussed the decision in Biotronik v. Conor Medsystems Ireland1 that the Court of Appeals handed down as the column was about to go to press. I promised to further address that opinion.
To briefly summarize, Conor Medsystems Ireland, Ltd., a manufacturer of medical products, entered into a distribution agreement with Biotronik A.G., pursuant to which Biotronik would sell in certain countries other than the U.S. Conor’s drug-eluting stent used in the treatment of coronary artery disease that had the trade name CoStar. The agreement contained a “no consequential damages” clause. In February 2006, after Conor obtained European regulatory approval for CoStar, Biotronik began distributing the product. In February 2007, Johnson & Johnson acquired Conor. At the time of the acquisition, Johnson & Johnson marketed another drug-eluting stent, known as Cypher, that directly competed with CoStar. Also at this time, Conor was engaged in a trial to secure FDA approval to distribute CoStar in the U.S. In May 2007, Conor announced that the FDA trial could not establish that CoStar was equivalent to Taxus, a widely marketed stent manufactured by Boston Scientific. Conor then terminated its FDA application and notified Biotronik that Conor would recall CoStar and remove that product from the worldwide market.
Biotronik sued, alleging that Conor breached the agreement by failing to provide the CoStar product during the life of the agreement. Biotronik demanded $100 million to compensate it for the profits it allegedly would have made selling CoStar had the agreement not been breached. The trial court ruled on a motion for summary judgment that the “no consequential damages” clause in the agreement barred recovery of the claimed lost profits. As a result, Biotronik could recover only nominal damages for the alleged breach. The parties agreed that judgment would be entered dismissing Biotronik’s claim with Biotronik having the right to appeal the court’s decision precluding its lost profits claim. The Appellate Division, First Department, unanimously affirmed the Supreme Court’s ruling. It gave Biotronik leave to appeal. The Court of Appeals addressed whether the claimed lost profits were consequential damages barred by the agreement or general damages that could be recovered.
The party asserting a breach of contract claim can seek to recover damages that would put it in the position it would have enjoyed had the breach not occurred. These damages have been grouped into two categories. General damages compensate a party for the damage directly caused by the loss of the promised performance, while consequential (also called special) damages compensate for other losses incurred as a result of the breach.2 Although the two categories are distinct, the Court of Appeals had noted that determining into which category damage caused by a particular breach fell remained elusive.3
The general rule to categorize the damages had been derived from the English court decision in Hadley v. Baxendale.4 Consequential damages were generally viewed as arising from the loss of benefits that would be gained from arrangements with third parties that were collateral to the breached contract. As the U.S. Court of Appeals for the Second Circuit noted in a case cited by the majority opinion in Biotronik, “[l]ost profits are consequential damages when, as the result of the breach, the non-breaching party suffers loss of profits on collateral business arrangements.”5
The trial judge and the five members of the First Department panel all believed Biotronik’s lost profits claim sought recovery of consequential damages that were precluded by the “no consequential damages” clause in the agreement. Three members of the Court of Appeals agreed. The majority, however, believed that the lost profits were general damages that were not barred by the “no consequential damages” clause.
Court of Appeals Decision
The majority viewed Biotronik’s sales of CoStar as conferring a benefit upon both Conor and Biotronik. The agreement set percentages to divide between Biotronik and Conor the profits that would come from Biotronik’s sales of CoStar. The benefit Biotronik would receive for its performance of the agreement would be its share of the profits from its sales of CoStar. Without that share of the profits, Biotronik would receive no benefit from the agreement.
The majority examined the court’s precedent to discern guiding principles to assist it in determining whether, under the agreement, the claimed lost profits were general damages that could be recovered, or consequential damages that were excluded. Citing American List Corp. v. U.S. News & World Report,6 the majority noted that general damages were the natural and probable consequence of the breach, while consequential damages do not directly flow from the breach. The majority believed lost profits could be either general or consequential damages dependent upon whether the non-breaching party bargained for the right to receive the profits and the profits were the direct and immediate fruits of the contract.
The majority viewed the dividing line between general and consequential damages as whether the lost profits flowed directly from the breached contract itself or were, instead, the result of a separate agreement with a non-party. The majority believed that Biotronik’s claimed lost profits were general damages because the distribution agreement clearly contemplated Biotronik would sell CoStar to third parties and would benefit from the profits gained from those sales. Accordingly, the majority believed the claimed lost profits directly and naturally flowed from the breach and, therefore, constituted general, not consequential, damages.
The majority believed that in its 1920 opinion in Orester v. Dayton Rubber Mfg. Co.,7 the court had recognized that where the nature of a distribution agreement supported a conclusion that the claimed lost profits directly flowed from the breach, the lost profits were general damages. In Orester, the defendant, a manufacturer of a brand of automobile tires, sought to penetrate a particular market through an exclusive distribution agreement with the plaintiff distributor. Under the agreement, the manufacturer sold and supplied its tires to the distributor at a reduced price and the distributor agreed to “aggressively push” the sale of the tires within an exclusive territory. After the distributor sold 200 tires under the contract, the manufacturer refused to provide more tires and the distributor sued to recover the profits it would have made selling the manufacturer’s tires to third parties.
The Orester court ruled that the distributor could recover damages that would naturally arise from the breach itself, or those that might reasonably be supposed to have been contemplated by the parties at the time of contracting. These damages included the profits the distributor would have made by selling the tires to third parties. The court believed that since the contract contemplated the distributor building up a business for the sale of the manufacturer’s tires and creating a demand for that particular tire, the distributor’s resale profits were not the result of collateral engagements and, therefore, not consequential damages, but were the value of the contract to the distributor. Accordingly, the Orester court concluded the claimed lost profits were general damages since they were the “natural and probable consequence” of the manufacturer’s breach.
The Biotronik majority noted that American List had also followed this “natural and probable consequence” standard. Relying upon Orester and the fact that it believed Biotronik’s claimed lost profits were the natural and probable consequence of the breach, the majority ruled those damages were general damages not barred by the “no consequential damages” clause.
The dissent in Biotronik contended that under American List the profits that would be made on a third-party transaction were consequential damages even when the ability of the non-breaching party to enjoy those profits is contingent upon the performance of the breached contract. The dissent believed that New York law placed Biotronik’s lost profits claim squarely on the consequential damages side of the boundary between the two types of damages. In conclusion, the dissent stated:
Biotronik has devised, and the majority has accepted, a way to circumvent the natural meaning of the limitation-of-liability provision, combining a creative reading of the provisions governing how much Biotronik agreed to pay Conor to purchase the stents with certain aspects of Orester, a 94-year-old decision whose central holding was long ago absorbed into the Uniform Commercial Code in section 2-715(a)(2), dealing with consequential (not general) damages. Creativity on this scale is no boon in the commercial world, ‘where reliance, definiteness and predictability are such important goals of the law itself, designed so that parties may intelligently negotiate and order their rights and duties.’ (Matter of Southeast Banking Corp., 93 N.Y.2d 178, 184 (1999).
The majority had an interesting approach in Biotronik. The First Department had given Biotronik leave to appeal the issue of whether the Appellate Division’s order of affirmance had been properly made. The Court of Appeals had to decide whether the courts below acted properly, in ruling, on a motion for summary judgment, the “no consequential damages” clause barred Biotronik’s lost profits claim. In opposing the motion, Biotronik had argued that the ambiguity of the term “consequential damages” prevented the court from summarily ruling that the parties intended this term to include the damages Biotronik claimed. The record in the Biotronik case arguably presented a triable issue of fact—when the parties agreed to “no consequential damages,” did they intend to preclude the recovery of the lost profit damages that Biotronik claimed.
The court could have reversed the rulings below by concluding that the term “consequential damages” did not unambiguously preclude the claimed damages and, therefore the courts below erred. The Court of Appeals, however, never addressed what the parties intended the term consequential damages to mean at the time they entered into their contract. It ignored the fundamental precept of New York contract law that the court should give effect to the intent of the parties.8 Instead, the court ruled, as a matter of law, that “under the parties’ exclusive distribution agreement, the lost profits constitute general, not consequential, damages.”
The Lessons of the Decision
The Biotronik case highlights the risk of using legal terms in a contract. A court might later give the term a meaning that is different from what a party understood and intended at the time of contracting. In Biotronik, nine of the 13 judges who heard the case believed the claimed damages were consequential damages precluded by the terms of the contract. Conor likely had the same understanding when it entered into the agreement. Because of the ruling by the Court of Appeals, Conor is now facing a substantial damage claim (the complaint demanded $100 million) that it likely believed it had guarded against in the agreement.
In light of the Biotronik decision, a party granting rights to distribute its product or exploit its intellectual property must realize that a “no consequential damages” clause might not protect it from a substantial claim for “lost profits,” that would result from resale of the product or exploitation of the intellectual property.
Accordingly, that party should consider:
• If using a “no consequential damages” clause, including a definition of the term consequential damages that encompasses any profit or other benefit that would flow from a related transaction with a third party. Alternatively, the clause can preclude “consequential damages and lost profits from whatever source derived.”
• Drafting the limitation on liability clause to put a numeric cap on damages (“Notwithstanding anything to the contrary said herein, damages for breach of this agreement shall not exceed $_____.”)
• Liquidating damages and thereby excluding any other damage award.
• Granting a right to terminate for convenience on “X” days’ notice and giving a notice of termination when the breach occurs, thereby limiting any lost profits claim to the amount of profit that could have been earned in the notice period.
• Changing the economic terms of the transaction to take into account that the party is taking on a risk of greater damage exposure.
The Biotronik decision shows the Court of Appeals will not lightly depart from its precedent when contract rights are at issue.9 That court had noted that stare decisis is most strongly applied in cases involving contract law.10 The majority in Biotronik did not hesitate to base its ruling on a case with similar facts that the court had decided nearly a century ago.
The case also illustrates how facts that are legally irrelevant can leave an impression on the court. The fact that a party may have intentionally chosen to breach a contract should be irrelevant in determining the application of a limitation on liability clause.11 One can only wonder why the majority opinion included language that indicated that Conor may have chosen to stop selling CoStar and breach the agreement because Conor wanted to avoid competition with the stent of its acquirer, Johnson & Johnson.
The Biotronik majority implemented what many, including the three dissenters, would view as a change in the law when it ruled that the profit the distributor would earn on a second contract for the resale of the distributed product constituted general, as opposed to consequential, damages. In so ruling, the court appeared to act more decisively than what it had characterized as its interstitial development of the law at a “snail’s pace.”12
Glen Banks is a partner at Norton Rose Fulbright (Fulbright & Jaworski) and is the author of “New York Contract Law,” a Thomson Reuters publication.
1. 2014 WL 1237514 (N.Y. March 27, 2014).
2. Schoenfeld v. Hilliard, 218 F.3d 164, 176-77 (2d Cir. 2000).
3. American List Corp. v. U.S. News and World Report, Inc., 75 N.Y.2d 38, 42-43, 550 N.Y.S.2d 590, 593 (1989).
4. 9 Exch. 341, 156 Eng. Rep. 45 (1854).
5. Tractebel Energy Marketing, Inc. v. AEP Power Marketing, 487 F.3d 89, 109 (2d Cir. 2007).
6. 75 N.Y.2d 38, 550 N.Y.S.2d 590 (1989).
7. 228 N.Y. 134, 126 N.E. 510 (1920).
8. Greenfield v. Philles Records, 98 N.Y.2d 562, 750 N.Y.S.2d 565 (2002).
9. See Great Northern Ins. Co. v. Interior Const. Corp., 7 N.Y.3d 412, 823 N.Y.S.2d 765 (2006).
10. Eastside Exhibits Corp. v. 210 East 86th Street Corp., 18 N.Y.3d 617, 942 N.Y.S.2d 19, cert. denied, 133 S.Ct. 687 (2012).
11. Metropolitan Life Ins. v. Noble Lowndes Intern., 84 N.Y.2d 430, 618 N.Y.S.2d 882 (1994);
12. Norcon Power Partners v. Niagara Mohawk Power Corp., 92 N.Y.2d 458; 682 N.Y.S.2d 664 (1998).