Reed Smith Client Alerts

The UK Supreme Court recently handed down its anticipated decision in The New Flamenco case, reversing the much debated Court of Appeal decision from last year (see also our client alert on the previous decision as well as our earlier blog focusing on the shipping aspects of this case). The Supreme Court decision provides important guidance on the notoriously difficult issue of accounting for market conditions at the time of a breach, mitigation and causation in the computation of damages. While the facts of The New Flamenco are squarely based in the shipping world, this judgment has a much wider effect on all commercial contracts.

This client alert examines the key principles that can be derived from the Supreme Court’s decision, read alongside the earlier High Court judgment, and how they affect commercial contracts in general, including in particular contracts for the sale of goods.

Authors: Vassia Payiataki Bartek Rutkowski

The arbitration

Arbitration was commenced by the owners against the charterers for recovery of the net loss of profits the owners alleged they would have earned between October 2007 and November 2009. The charterers contended that the difference between the value of the vessel in October 2007 and November 2009 had to be taken into account as a ‘benefit’ the owners gained from having the vessel redelivered early (i.e., they avoided the loss of value of the vessel). The charterers said that credit for this benefit should be given to the owners, effectively wiping out any losses claimed by them.

The sole maritime arbitrator agreed with the charterers, finding that the vessel was sold by way of reasonable mitigation of the owners’ losses, and held that the benefit which accrued to the owners by the early sale should be brought into account. 

The courts

On appeal to the High Court, Popplewell J reversed the arbitrator’s decision. The judge undertook a detailed review of case law relating to benefits of mitigation, from which he formulated 11 guiding principles. The first and foremost of these principles is that, when deciding if a benefit should be accounted for, the fundamental question is whether it was legally caused by the breach. Principles 2 to 9 expand on how this fundamental question should be considered, while principles 10 and 11 add that in some cases additional factors, such as “considerations of justice, fairness and public policy”, may also play a role.

Applying those 11 principles, Popplewell J held that the owners were not required to sell the vessel by way of mitigation. Their decision to do so was an independent commercial decision in respect of their capital investment, with all risks and benefits to be borne by the owners. As such, the legal causation test was not met. Additionally, it would be “unfair and unjust” for the charterers to take away from the owners the fruits of their capital investment.

The Court of Appeal looked at the issue from a different angle, highlighting that it was necessary to take a difference approach to mitigation depending on whether there was an available replacement market at the time of the breach. It held that, in this case, where there was no available market, selling the vessel was a reasonable, and perhaps even necessary, act of mitigation. There was no reason why a benefit derived from this act should not be accounted for. Accordingly, the Court of Appeal overturned Popplewell J’s decision and restored the arbitrator’s ruling.

In the final step of The New Flamenco’s judicial dance, the Supreme Court reversed the Court of Appeal’s decision, reinstating Popplewell J’s judgment. Lord Neuberger, with whom all other Lords agreed, endorsed and focused on Popplewell’s first fundamental principle – the key question was legal causation. Contrary to the Court of Appeal, he considered that the owners were not required to sell the vessel. Conversely, owners would have been able to sell the vessel at any time even if the charterparty had not been terminated. Equally, there was nothing to suggest that the owners would have sold the vessel after its contractual redelivery in November 2009. The logic of the charterers’ argument failed at both ends, and the difference in the vessel’s value between October 2007 and November 2009 was not considered by their Lordships a benefit legally caused by the breach. At most, the premature redelivery was an occasion for, but not a legal cause of, the sale.

What all this means in practice

As recognised by Popplewell J, and echoed by both higher courts, it is not possible to formulate a comprehensive rule for determining when the party in breach should receive credit for a benefit obtained by the innocent party. This remains a grey area, and cases will often turn on their own facts. However, a number of helpful and practical guidelines can be extracted from the recent Supreme Court judgment, especially when read alongside the decision of Popplewell J it reinstates.

1. The starting point is the compensatory principle

The Supreme Court recognised that the underlying consideration in ascertaining the correct quantum of damages is the principle of compensation – i.e., that the innocent party should be placed, as far as money can do so, in as good a position as if the contract had been correctly performed. As discussed in our previous client alert, the principle of compensation requires taking a different approach depending on the availability of a replacement market at the time of the breach. This distinction was also reaffirmed by the Supreme Court.

(i) If there is an available market the position is relatively straightforward, especially in sale-of-goods cases. The Sale of Goods Act 1979 specifies that, where there is an available market, damages are prima facie assessed by comparing the contract price of the goods with the market price at the time of default. The duty to mitigate is, therefore, built into this statutory formula and, where there is an available market, the actual decisions and actions of the innocent party should not – save for exceptional circumstances – affect the calculation of damages. If the innocent party buys or sells against the breaching party, it has mitigated its loss by taking this reasonable step. If the innocent party opts not to go into the market, its damages are still limited to the difference between the contract and market price of the goods.

(ii) If there is no available market the position is less straightforward, and the innocent party is required to consider much more carefully what reasonable steps in mitigation are available to it and which additional losses or benefits may be taken into account. It is here that Popplewell J’s 11 guiding principles and the Supreme Court’s more recent observations will be most relevant.

2. Showing legal causation is key

The Supreme Court clearly endorsed Popplewell J’s first guiding principle, confirming that “the essential question is whether there is a sufficiently close link between [the benefit and the loss]”. This requires demonstrating legal causation, and it will not be enough to show mere factual correlation, i.e., that the breach provided an opportunity or a trigger for the act which led to the benefit. Sufficient causation requires demonstrating that the benefit was directly caused by either the breach itself or a successful act of mitigation.

3. Not every reasonable response to a breach amounts to mitigation

While benefits directly resulting from mitigating acts should be taken into account, not every reasonable reaction to a breach will count as mitigation. For example, if the claimant was not required to take the step in question – i.e., it would not have been criticised for not taking it – such step is unlikely to amount to relevant mitigation. Similarly, steps which could have been taken even if the contract had been correctly performed will be less likely to count as mitigation. All such steps are now more likely to be seen as legally independent commercial decisions, taken at the claimant’s own risk and for the claimant’s own benefit.

4. Difference of nature and/or kind is not determinative but can be very important

Both Popplewell J and the Supreme Court expressly highlighted that a difference in kind/nature between the benefit and the loss does not preclude a finding of sufficient causative link. However, they accepted that, in The New Flamenco, the difference in the nature of the benefit (capital gain) and the loss (income stream) made the connection between them very remote. It is now clear that benefits of the same kind as the loss are more likely to be seen as legally caused by the breach, and vice versa. In particular, windfalls resulting from the disposal of assets are unlikely to be taken into account when considering damages for loss of standard trading profits.

Other takeaways and outstanding questions

The Supreme Court was of the view that, had the market gone up (i.e., had the market value of the vessel increased between October 2007 and November 2009), the owners should not have been able to claim the difference in price as an additional head of damages. This is a logical counterpart to the Supreme Court’s finding that there was no legal causation between the breach and the sale of the vessel, but it remains to be seen whether this obiter part of its judgment will be followed in the future.

In contrast to Popplewell J, the Supreme Court did not refer in its judgment to the considerations of fairness and policy underpinning Popplewell J’s principles 10 and 11. For now, it remains an open question whether these considerations are relevant when deciding which benefits should be accounted for in assessing damages. If they are, the scope of “considerations of justice, fairness and public policy” is even less clear.

Lastly, we note that this case could also indicate that the courts may be becoming more willing to overturn arbitral decisions on mixed questions of fact and law pursuant to an appeal made under Section 69 of the Arbitration Act 1996 (see also our earlier client alert on Section 69 appeals against arbitration awards).

Conclusions

The Supreme Court’s recent decision is certainly helpful and adds much needed clarity to what is a notoriously complex area of law. While there are outstanding questions, and many cases are likely to turn on their specific facts, a number of guiding principles can now be applied where the innocent party is faced with no available replacement market. These considerations will be relevant to the innocent party both when responding to the breach and when pleading its case on the quantum of damages. In particular, it will be important for the innocent party carefully to consider and document its decisions in the wake of the other party’s breach.

Client Alert 2017-160