Implied terms

Implied terms are commonly divided into terms implied in fact and terms implied in law. What are they and when will they arise?

Terms implied in fact

The original test for when the courts would imply a term in fact into a contract was laid down in 1889 in The Moorcock (where it was argued, and accepted, that there was a term implied in a contract for mooring a ship at the jetty under which the defendant owners of the jetty guaranteed that they had taken reasonable steps to see that the depth of the water around the jetty was such that it was safe for the claimant shipowners to moor their ship at the jetty). This was the business efficacy test: ‘what the law desires to effect by the implication is to give such business efficacy to the transaction as must have been intended at all events by both parties who are business men’ (per Bowen LJ). So under the business efficacy test the courts will imply a term in fact into a contract where it was necessary to do so to make the contract work in the way that was intended by the parties to the contract.

A different test was suggested by MacKinnon LJ in the 1939 case of Shirlaw v Southern Foundries (1926) Ltd (where it was argued, and accepted, that there was an implied term in a contract appointing a managing director of a company for ten years that the company would not remove the director from his position for the period of his appointment, and it would not alter its articles of association so as to enable the director to be removed). This was the officious bystander test: ‘Prima facie that which in any contract is left to be implied and need not be expressed is something so obvious that it goes without saying; so that, if, while the parties were making their bargain, an officious bystander were to suggest some express provision for it in their agreement, they would testily suppress him with a common “Oh, of course!”’

There are problems with both these tests. Consider:

Dodgy: A Finance company sells an investment product to Mug knowing that the product is worthless and that Mug will probably lose a lot of money on the deal. However, selling the product to Mug (and thousands like him) will help Finance avoid the consequences of some terrible investment decisions that it made in the past. Mug has now lost a lot of money as a result of owning this investment product and wishes to sue Finance, arguing that there was an implied term in the contract of sale that Finance would warn the claimant if it knew that the product it was selling him was worthless.

Secretary: Randy appoints Beauty to work for him as a secretary. Randy has always fancied Beauty; in fact, that is the main reason why Beauty got the job. Two days after starting work, Randy tells Beauty he can’t stop thinking about her and would like them both to go away for a naughty weekend in Blackpool. Beauty does not welcome Randy’s advances and wants to argue that there is an implied term in her contract with Randy that Randy will not ask her out or in any way indicate that he is sexually attracted to her.

Neither of these terms need to be implied into the contracts in Dodgy and Secretary respectively in ordert to make the contracts work. Implying a term that Finance will warn Mug if it knows the product it is selling him is worthless will actually negate the contract, as Mug will not contract with Finance if he is given such a warning. And Beauty does not really need Randy to shut up about how much he fancies her to get on with her job of working for him as a secretary. So neither of these terms could be implied under the business efficacy test. And if we apply the officious bystander test, it is obvious that had an officious bystander asked Mug and Finance, ‘Is Finance undertaking to warn Mug if it knows this product is worthless?’ then Mug would probably have said ‘Of course!’ but Finance would have said ‘No, we’re not – it’s for Mug to decide whether or not to buy this product.’ And if an officious bystander had asked Randy and Beauty, ‘Is Randy undertaking not to sexually harass Beauty?’ then Beauty would probably have said, ‘Of course!’ but Randy would have said, ‘I think that’s a bit extreme – if I want to tell Beauty how beautiful she is, I think I should be allowed to do that.’

Maybe we should rest content with that, and say that Mug and Beauty will lose their cases, insofar as they are based on the implication of a term in fact into their contracts with Finance and Randy respectively. However, Mug and Beauty may still have two arguments left to them when arguing that there was an implied term in fact in their contracts:

(1) The Belize argument

In Attorney General of Belize v Belize Telecom Ltd (2009) (where it was argued, and accepted, that there was an implied term in a company’s articles of association that a director who had been appointed under a special procedure that could only be invoked by a shareholder holding a ‘golden’ share in the company and over 37.5% of ‘C’ shares in the company should step down if the shareholder who had appointed him subsequently sold some of its ‘C’ shares so that it no longer held 37.5% of the ‘C’ shares in the company), Lord Hoffmann suggested that both the ‘business efficacy’ and ‘officious bystander’ tests for implying a term in fact into a contract should be superseded by a new test under which a term will be implied into a contract if such a term ‘would spell out in express words what the [contract], read against the relevant background, would reasonably be understood to mean’ (at [21]).

As John McCaughran (‘Implied terms: the journey of the man on the Clapham omnibus’ (2011) 70 CLJ 607, at 614) has acutely pointed out, this test for implying a term in fact into a contract involves applying a reverse ‘officious bystander’ test – instead of the officious bystander asking the parties what they have meant to agree, the parties ask the bystander ‘You know the business background against which we are dealing – what do you think we have agreed in entering into this contract?’ Taking the power to determine the terms of the contract out of the hands of the parties and into the hands of a reasonable bystander might make it easier for Mug and Beauty to win their cases.

However, Hoffmann’s test for implying a term in fact into a contract can be criticised on a number of grounds. (i) He uses the exact same test for interpreting the terms of a contract (see his decision in Investors Compensation Scheme Ltd v West Bromwich Building Society (1997)) as he does for implying terms into a contract, but as Bingham MR pointed out in Phillips Electronique Grand Public SA v British Sky Broadcasting (1995), the two things are very different exercises – implying a term in a contract that the parties did not expressly say they wanted to be part of the contract is a lot more of an intrusion on the parties’ freedom of contract than trying to determine what the parties meant by a term that they did expressly say that they wanted to be part of the contract. (ii) Hoffmann’s test makes it too easy for the courts to impose on the parties to a contract terms that they did not want to be part of the contract, on the basis that a reasonable person with a similar business background to the parties would have thought that that term was part of the contract. (iii) Hoffmann’s test is also very vague and creates a great deal of commercial uncertainty for parties entering into contracts, as they would find it hard to predict what terms a court employing Hoffmann’s test might end up implying into the contract.

Perhaps significantly, the caselaw since the Belize case has not expressed much enthusiasm for Hoffmann’s test, with (1) the CA in Mediterranean Salvage & Towage v Seamar Trading & Commerce Inc (2009) endorsing the ‘business efficacy’ test, (2) the CA in Groveholt Ltd v Alan Hughes (2010) endorsing the ‘officious bystander’ test, and (3) a majority of the UKSC effectively disowning the test in Marks & Spencer plc BNP Paribas Securities Services (2015) (at paras [22]-[31], per Lord Neuberger, with Lord Carnwath supporting the Hoffmann test in his judgment) in favour of implying a term when the ‘business efficacy’ test or the ‘officious bystander’ test indicates such a term should be implied (para [21], per Lord Neuberger). (See elsewhere on this website for a detailed casenote on the Marks & Spencer case.) So it is doubtful whether we should seek to rely on Hoffmann’s test in Mug and Beauty’s cases.

(2) The officious bystander argument revisited

Both Mug and Beauty might be able to argue that the ‘officious bystander’ test is satisfied in their cases. Both would rely on the fact that had an officious bystander asked whether Finance was promising to warn Mug if it knew that it was selling him a worthless product, or whether Randy was guaranteeing that he would not sexually harass Beauty, while Finance and Randy might say now that they would not have gone along with the officious bystander’s suggestion, at the time the contract was entered into things would have been very different. The officious bystander’s question would have put Finance and Randy in a very difficult position: they would either have had to confess that, no, they wanted the option of selling Mug or worthless product or sexually harassing Beauty and endanger the deal, or they would have had to act as though they were decent people and say to the officious bystander, ‘Of course we would never sell Mug a product that we knew to be worthless’ or ‘Of course I would never dream of making sexual advances to Beauty.’ Faced with this choice, they probably would have done the latter and suppressed the officious bystander with a testy, though grudging, ‘Oh, of course!’. Given this, Mug and Beauty might be able to argue that the officious bystander test is satisfied in their cases, or at least that Finance and Randy should not be allowed now to argue that the officious bystander test is not satisfied, given that at the time they would have probably been embarrassed (for fear of looking like a really dodgy person) or forced (for fear of endangering the deal) into giving a positive response to the officious bystander’s question.

I think argument (2) would probably work (see, in particular, para [21] of Lord Neuberger’s judgment in the Marks & Spencer case: ‘If one [asks] what the parties would have agreed, one is not strictly concerned with the hypothetical answer of the actual parties, but with that of notional reasonable people in the position of the parties at the time at which they were contracting’), and indicates that the officious bystander test, if sensitively applied, copes well with difficult cases such as Dodgy and Secretary. But less can be said in favour of the business efficacy test – if it would rule out an implied term in cases like Dodgy and Secretary on the ground that the terms were not needed to make the contract work, when such terms would be implied on the officious bystander test, then that seems to indicate that officious bystander test provides a more comprehensive test for implying a term in fact into a contract than the business efficacy test does.

Terms implied in law

It follows from the above that terms implied in fact into a contract are designed to give effect to the intentions of the parties – or what the parties reasonably indicated that they intended – in entering into the contract. Terms implied in law are quite different. Terms implied in law act as default rules for particular, well-established types of contractual relationship, such as those that exist between a business seller of goods and a purchaser of those goods, an employer and an employee, an insurance company and someone purchasing insurance from that company, a shipowner and an owner of goods placed aboard the ship, a builder and a client, a landlord and a tenant, and so on and so on. A default rule is a rule that will apply to a particular relationship unless the parties to that relationship indicate that they don’t want it to apply. Default rules are a huge aid to efficiency in contracting: they allow the parties to a well-established type of contractual relationship to contract with each other safe in the knowledge that a large number of terms will automatically be implied into the contract to safeguard their respective interests and that all they need to focus on in their negotiations are a few terms which need to be fiddled with to fit the circumstances of their case. (In the same way, the fact that when you open a new document on your computer, the fact that document is preformatted according to certain default rules for page size, font, margins, line spacing and so on, means they you can get on with writing what you want to write much more quickly: you don’t specify every aspect of what your document should look like – you can just focus on adjusting particular default rules that you don’t want to apply.)

Once we understand the status of terms implied in law as default rules, two things follow:

(1) We can make sense of the emphasis that the House of Lords placed in Liverpool City Council v Irwin (1977) on the courts’ only implying a term by law into a contract when it is necessary to do so. ‘Necessary’ here does not mean the same as ‘necessary to give business efficacy’ to the contract. If it did, then the House of Lords’ decision in Irwin would have effectively abolished terms implied in law. But it did not: the term that the House of Lords ended up implying in Irwin into the contract in that case between the landlord (the city council) and its tenants occupying a block of flats known as ‘the Piggeries’ was a term requiring the landlord to take reasonable steps to keep the common parts of the let premises in good repair. (In this case, that would have been the lifts and the stairs.) The House of Lords did not need to imply that term into the contract between the landlord and the council tenants in order to make the contract work properly – so ‘necessary’ in Irwin could not have meant ‘necessary to give business efficacy’ to the contract. What the House of Lords actually meant (see, on this, Jane Stapleton, ‘Duty of care and economic loss: a wider agenda’ (1991) 107 LQR 249, 290-1) by ‘necessary’ in this context was ‘The suggested term has to be such that we think it would be reasonable to imply this into any contract of the general type with which this case is concerned, so that from now on that term would become (unless the parties indicated otherwise) a necessary incident of a contract of that type.’ So before the House of Lords could imply a term by law into the landlord-tenant contract in Irwin, requiring the landlord in that case to take reasonable care of the common parts of the let premises, the House of Lords had to be convinced that it would be reasonable to imply such a term into any landlord-tenant contract no matter who the landlord might be and who the tenant might be. And plainly it was reasonable: when you are letting premises to a large number of people, it seems obvious that the responsibility for looking after the common parts of the premises should fall on the landlord and it would be very difficult for the tenants to co-ordinate efforts themselves to keep those common parts in good repair.

(2) When you are doing a problem question which turns on whether you can imply a term into a particular contract, and you have found that no such term can be implied in fact into the contract, it would be unwise to confidently assert that the courts will imply such a term in law into the contract unless you have statute or caselaw to support that assertion. If you do not, and it is a novel question whether the courts would imply a term in law of the type you are considering into this kind of contract, you cannot have any confidence that the courts will imply such a term into a contract, given the huge number of factors the courts would have to take into account in determining whether it would be reasonable to imply such a term into all contracts of that type. (For an account of these considerations see Peden, ‘Policy concerns behind implications of terms in law’ (2001) 117 LQR 459.) So when you are considering whether the courts will find that a term was implied by law into a particular type of contract, stick closely to the existing caselaw and statute law on this issue. And when it comes to the existing law, the two most important terms that will be implied by law into a contract (unless the parties indicate that they do not want the term to be implied – and even then their freedom to avoid that term may be limited by the Unfair Contract Terms Act 1977) that you have to know about and carry around with you in your mental knapsack are: (i) the terms implied into a contract between a business seller of goods and someone buying those goods that the goods will be of satisfactory quality and reasonably fit for the purpose for which the buyer let the seller know he wanted the goods (under s 14 of the Sale of Goods Act 1979); and (ii) the term implied into a contract for the supply of services, supplied in the course of business, that those services will be performed with a reasonable degree of care and skill (under s 13 of the Sale and Supply of Goods and Services Act 1982). Implied term (ii) is particularly useful as it applies in a wide range of circumstances – builder-client contracts; hotel-guest contracts, cinema-customer contracts, restaurant-diner contracts, and so on and so on.

Consumer surplus

What is it?

‘Consumer surplus’ is an economic term, referring to the difference between what someone would have been ready and willing to pay for a particular item and what they actually ended up paying for it.

The irrelevance of consumer surplus to contract damages

As we will see, it has been suggested by some academics and judges that in a breach of contract case, the damages payable to the victim of the breach may in some way reflect or protect the victim’s consumer surplus. This is untrue.

Suppose that you contract to sell me a ticket to a Bruce Springsteen concert for £100. I would have been ready and willing to pay £300 for a ticket (I’m relatively well off, and love The Boss), so my consumer surplus on this transaction is £200. You then tell me that you won’t be able to get me a ticket for the concert after all – your supplier of Springsteen tickets has let you down.

If I can get a ticket from another source for, say, £150, then you will be liable to pay me £50 in damages: the difference between what I would have paid you had you properly performed, and what I’ve ended up having to pay someone else for what I entitled to from you.

If I can’t get a ticket from another source to the concert, then – as this was a contract for fun – I’ll be entitled to sue you for damages for the loss of enjoyment of attending the concert. Awarding such damages requires the court to put a monetary value on how much I would have enjoyed attending the concert. Some might argue that this should be assessed according to how much I would have been ready and willing to pay for a ticket (£300) – but this is a mistake. How much I would have been ready and willing to pay for a ticket not only reflects my assessment of how much I would enjoy going to a Bruce Springsteen concert, but also how much money I have got in my pocket. So I might value the enjoyment of attending a Bruce Springsteen concert at £1,000, but only have been ready and willing to pay £300 for a ticket because I simply don’t have enough money to be able to afford to splash out £1,000 on a Bruce Springsteen concert. One way of putting a monetary value on how much I would have enjoyed attending the concert is to ask – Once I had the ticket, how much would I have been willing to sell it for? It makes sense that I would not have sold the ticket for less than the monetary value that I put on the enjoyment of attending the concert. It’s highly unlikely that once I got the ticket to go to the Bruce Springsteen concert that I would have been willing to sell it just for £300. It’s likely that I would only have been ready and willing to sell the ticket for a lot more money than I would have been ready and willing to buy the ticket for. Let’s say that had I got the ticket, I would have been ready and willing to sell it to someone else for £750. In that case, we should value my loss of enjoyment from not attending the concert at £750 and award me £650 in damages – £750 minus the £100 I have saved as a result of your breach because I no longer have to pay you for the ticket.

So – if you breach your contract with me to supply me with a ticket to the Bruce Springsteen concert, I will either be able to sue you for £50 (if I can get a ticket from another source) or £650 (if I can’t). In neither case can I sue you for £200 – which is my consumer surplus on my transaction with you. My consumer surplus is completely irrelevant to how much I might be able to sue you for.

Consumer surplus in the cases

Despite this, there are a number of cases which say that damages awards in breach of contract cases can be designed to protect the victim of breach’s ‘consumer surplus’.

In Ruxley Electronics and Construction Ltd v Forsyth (1996), Lord Mustill said that ‘the law must cater for those occasions where the value of the promise to the promisee exceeds the financial enhancement of his position which full performance will secure. This excess, often referred to in the literature as the “consumer surplus”…is usually incapable of precise valuation in terms of money, exactly because it represents a personal, subjective and non-monetary gain. Nevertheless where it exists the law should recognise it and compensate the promisee if the misperformance takes it away.’

In Farley v Skinner (2002), Lord Steyn observed of Lord Mustill’s judgment in Ruxley that ‘for Lord Mustill…the principle of pacta sunt servanda [contracts must be kept] would be eroded if the law did not take account of the fact that the consumer often demands specifications which, although not of economic value, have value to him. This is sometimes called the “consumer surplus”… Lord Mustill rejected the idea that “the promisor can please himself whether or not to comply with the wishes of the promise[e] which, as embodied in the contract, formed partof the consideration for the price”.’

Lord Steyn did go on to say that ‘Labels sometimes obscure rather than illuminate. I do not therefore set much store by the description “consumer surplus”.’ Quite right too. It is obvious that in these passages the phrase ‘consumer surplus’ is being misused to act as synonym for ‘enjoyment’ or ‘pleasure’. So when we say (1) ‘The law can award damages to compensate the victim of a breach of contract for the loss of his consumer surplus’ all we are actually saying is (2) ‘The law can award damages to compensate the victim of a breach of contract for the loss of the pleasure or enjoyment he would have obtained from proper performance of the contract’. But if that’s the case, then why not say (2) rather than (1)? We should prefer simple words whose meaning is plainly obvious over complex words whose meaning has to be explained. And we should definitely not borrow concepts from another discipline where they have a particular, technical meaning and then use those concepts to say something completely different. Doing so can only make it even more difficult for other people to understand what we are saying.

The source of the problem

The blame for the fact that the language of ‘consumer surplus’ has now crept into judgments on assessing damages for breach of contract in cases where the victim of the breach has suffered a loss of enjoyment (and from there has gotten into the textbooks – where even more confusingly, they sometimes distinguish between a claim in contract for distress and loss of enjoyment, and a claim for loss of one’s ‘consumer surplus’) must be laid squarely at the foot of an article published in the Law Quarterly Review in 1979: Harris, Ogus and Phillips, ‘Contract remedies and the consumer surplus’ (1979) 95 Law Quarterly Review 581. The article is not available online, so I will quote in full from the crucial passage in the article where the authors introduce the concept of ‘consumer surplus’ (while discussing the decision of Oliver J in Radford v De Froberville (1977)). The passage is at pp 582-83 of the article:

‘The existence of the wall on the new boundary of his land [in Radford v De Froberville] was worth more to the plaintiff than the increase which the wall would make to the market value of the land; it was argued that he valued the particular architectural style and privacy it afforded more highly than the average purchaser of the land. This is an example of what economists refer to as “consumer surplus”, the excess utility or subjective value obtained from a “good” over and above the utility associated with its market price. (As explained below, the consumer surplus expected by a person who intends to use a good is equivalent to the profit which a businessman expects to make from the contract.) The concept of consumer surplus is important in any attempt to measure consumer losses because, unlike firms, consumers make purchases for the pleasure or utility they confer; this utility has no necessary relationship with the price paid and is of a quite different order from market prices or business profits. It is, of course, difficult to measure utility, but generally economists avoid the conceptual problem by measuring utility in terms of the maximum amount a consumer would pay for a particular purchase. For instance, if a purchaser can buy a plot of land for £1,000, when he would be prepared to pay up to £1,500 for it, the extra £500 represents his “consumer surplus”.’

Notice how the authors end up correctly defining how a purchaser’s ‘consumer surplus’ on the purchase of land is assessed. But for the whole of the rest of the passage, ‘consumer surplus’ is simply identified with the difference between how much pleasure or enjoyment (or, in the authors’ language, ‘utility’) one will obtain from a good, and how much you have paid for that good. That is not how economists define the term ‘consumer surplus’, but unfortunately that does seem to be the definition that has crept into the cases (and from there the textbooks), via the Harris, Ogus and Phillips article.

It is time to stop the rot. Lawyers should stop talking about ‘consumer surplus’ and stick to their knitting. When they are actually talking about damages being awarded for loss of enjoyment or pleasure then they should actually talk in terms of damages being awarded for loss of enjoyment or pleasure. And students should do the same in writing essays and problem answers and avoid at all costs using the phrase ‘consumer surplus’ (unless positively required to do so by the terms of the essay or problem question).

The rule in Hadley v Baxendale

What is it?

The rule in Hadley v Baxendale basically says that if A has committed a breach of a contract that he has with B by doing x, and B has suffered a loss as a result, that loss will count as too remote a consequence of A’s breach to be actionable unless at the time the contract between A and B was entered into, A could have been reasonably been expected to foresee that his doing x was likely to result in B suffering that type of loss, because either: (1) it would have been quite normal or natural for B to suffer that type of loss as a result of A’s doing x; or (2) A was informed before he entered into the contract between him and B of any special circumstances which meant it was likely that A’s doing x would result in B suffering that type of loss.

Why do we have it?

The rule in Hadley v Baxendale is basically a rule of fairness; one of about ten different features of the English contract law that can be seen as requiring the parties to a contract to deal fairly with each other. The reason why we have the rule in Hadley v Baxendale is to give each contracting party a fair chance to decide whether or not they want to enter into the contract, and if so on what terms. A would be deprived of that chance if he were held liable for a loss suffered by B as a result of A’s breach of contract when he had no way of knowing at the time the contract was entered into that B stood to suffer that type of loss if he breached. Had A known this, and known that he might be held liable for that loss, he might have refused to enter into the contract with B, or bargained for an alteration in the terms of the A-B contract to protect himself against being held liable for that loss, or to reward him for running the risk of suffering that loss. As Alderson B remarked in Hadley v Baxendale (1854) itself, of the case where B suffers a loss as a result of A’s breach due to special circumstances that A was unaware of at the time he entered into his contract with B,

‘…had the special circumstances been known, the parties might have specially provided for the breach of contract by special terms as to the damages in that case, and of this advantage it would be very unjust to deprive them.’

A concrete example can make this point clear. Suppose that Loaded enters into a contract with Builder for the construction of a swimming pool in Loaded’s country house. The contract specifies that the swimming pool must be ready for use by June 1st. A few days after the contract is entered into, Loaded tells Builder that he needs the swimming pool to be installed by June 1st because a movie company is taking over his estate during the summer to do some filming in and around it, but they have made it a condition of their contract with him that he have a swimming pool installed as a number of crucial scenes take place in and around a swimming pool. Loaded also tells Builder that the movie company are paying him ‘crazy money’ – £5m – to hire his estate from June 15th – September 15th. Builder does not complete the swimming pool until July 1st, and Loaded’s deal with the movie company falls through.

At the time Builder breached his contract by failing to complete the swimming pool on time, it was perfectly foreseeable that his doing so would result in Loaded suffering a loss of £5m. However – unlike the position in tort law (most of the time) – we do not determine the remoteness or otherwise of a loss suffered as a result of a breach of contract by looking at what was foreseeable at the time the breach occurred. Instead, we look at what was foreseeable at the time the contract was entered into. The reason is that not to do so would be unfair on Builder. Had Builder known that his failing to complete the swimming pool on time might result in his being held liable for the loss of Loaded’s  deal with the movie company, he might have refused the job completely, or negotiated a much higher price for getting the work done on time, or insisted that there be a clause in the contract limiting the scope of his liability. So fairness demands that Builder only be held liable for the losses that he could have contemplated that Loaded might have suffered as a result of his failing to build the pool on time at the time Builder entered into his contract with Loaded, as those were the only losses Builder could have taken the risk of being held liable for when he decided to enter into a contract with Loaded, and on what terms.

The letter and the spirit of the rule

For the most part, giving effect to the letter of the rule in Hadley v Baxendale will also give effect to the spirit of fair dealing that underlies the rule. Where the two diverge, though, is where A enters into a contract with B, knowing that B is likely to suffer a particular kind of loss if A breaches that contract, but A does not factor that knowledge into his decision as to whether or not to enter into his contract with B.

If A’s breach does result in B suffering that kind of loss, the letter of the rule in Hadley v Baxendale indicates that A should be held liable for that loss: at the time A entered into his contract with B, it was reasonably foreseeable that if A breached his contract with B, then B would suffer that type of loss.

However, the spirit of the rule indicates that A should not be held liable for B’s loss – at least where he wasn’t at fault for not factoring in the prospect of B’s suffering that type of loss into his decision as to whether or not to contract with B, and if so on what terms. The reason is that holding A liable for that kind of loss would mean that he wasn’t given a fair chance to consider whether or not he should contract with B, and if so on what terms. Had A taken seriously the prospect that he might be held liable for the sort of loss that B has suffered as a result of A’s breach, he might have refused to contract with B, or have contracted on different terms. As he did not take that prospect seriously – and, apparently, acted reasonably in failing to take that prospect seriously – he should not be held liable for the loss that B has suffered.

So the letter and the spirit of the rule in Hadley v Baxendale will go in different directions in the situation where a contracting party foresees that the other party might suffer a particular type of loss if the contract was breached, but does not factor in the prospect of being held liable for that loss in deciding whether or not to enter into the contract, and if so on what terms. But when would such a situation arise?

The Achilleas (2008)– otherwise known as Transfield Shipping v Mercator Shipping – apparently presented one such situation. The defendants hired a ship from the claimants. The ship was due to be given back on May 2 2004. Expecting to get the ship back by May 2 at the latest, the claimants agreed on April 21 to hire out the ship for 191 days to Cargill International SA for $39,500 a day, with the period of hire to start once the claimants got their ship back from the defendants. Under the agreement, Cargill had the option of cancelling it if they had not received the ship by May 8. By May 5, the defendants still hadn’t handed the ship back to the claimants, and there was no prospect of the claimants getting it back by May 8. Fearful that Cargill would cancel the contract to hire the ship, the claimants renegotiated its terms, extending the cancellation date, but at the same time agreeing to a substantial reduction in the rate of hire for the ship – $31,500 a day rather than $39,500 – to reflect the fact that there had been a sharp fall in the general market rates for hiring ships like the claimants’. The claimants finally got their ship back from the defendants on May 11, nine days late.

The claimants sued the defendants for damages, arguing that ‘Had you not been late redelivering the ship, we would now be hiring out the ship for 191 days to Cargill at $39,500 a day rather than $31,500 a day. So we have suffered a loss of about $1.5m (191 x $8,000) as a result of your breach of contract, and you are liable to us for that loss.’ However, the defendants argued, ‘The custom in the industry is that when a ship is delivered back late, all the owner can sue for is the difference between what he could have earned hiring out the ship during the period the ship was wrongfully retained, and what is due under the hire contract for retaining the ship for that period of that time. So we are only liable for $158,000: the extra amount you could have made during the nine days we retained the ship compared with what we have to pay under our contract of hire for retaining the ship for those nine days.’ If the defendants were right – and this is something that is disputed – that the custom in the shipping industry on late return of a ship was simply to sue for the loss suffered as a result of not being able to hire out the ship to someone else during the period it was detained, then it would have been unfair on the defendants to hold them liable for the $1.5m loss that the claimants suffered because the defendants’ hanging on to the claimants’ ship for nine extra days resulted in the claimants losing out on the chance of hiring the ship out to Cargill for $39,500 a day, as opposed to $31,500 a day. This is because the defendants never seriously contemplated that they might be held liable for that kind of loss when they agreed to hire the claimants’ ship, and had they known that they might be held so liable, they would almost certainly have renegotiated the terms of the contract under which they hired out the claimants’ ship.

So if the defendants were right about the custom in the shipping industry, then The Achilleas was a case where the letter and the spirit of the rule in Hadley v Baxendale might have produced divergent results. According to the letter, whether or not the defendants should have been held liable for the claimants’ $1.5m loss depended on whether the defendants contemplated when they entered into the contract with the claimants that their hanging on to the claimants’ ship beyond the hire period would result in the claimants suffering the kind of loss on the follow-on contract of hire that they suffered here.

On the other hand, if we followed the spirit of the rule in Hadley v Baxendale, then we would regard it as irrelevant whether or not the defendants knew what losses might be suffered by the claimants if the defendants held on too long to the claimants’ ship. If the custom in the industry was such as the defendants described, then the scope of the defendants’ liability should have been determined by that custom. To hold the defendants liable on any other basis, and hold them liable for losses they contemplated the claimants might suffer as a result of breach when they hired the claimants’ ship, would be unfair on the defendants as they never seriously contemplated that they might be held liable for those losses, and did not factor in the possibility that they might be held liable for those losses when they decided to hire the claimants’ ship on the terms they did.

As it happens, the House of Lords did not think that the letter and the spirit of Hadley v Baxendale did diverge in The Achilleas as to what the result of the case should be. Lord Rodger applied the letter of the rule in Hadley v Baxendale and found that at the time the defendants hired the claimants’ ship, there was no reason for them to contemplate that a delay in returning the ship would result in the claimants suffering the type of loss that they had suffered on the follow-on contract as the loss was purely due to ‘unusual’ (at [53]) movements in the market rates for hiring ships. Lord Hoffmann’s approach to the case (which I will discuss in more detail below) was much more consistent with the spirit of Hadley v Baxendale and was – for the reasons explained above – consequently not in favour of holding the defendants liable for the losses suffered by the claimants on their follow-on contract. Baroness Hale agreed with Lord Rodger’s approach, though with some doubts about how it applied in this case. The fact that both approaches resulted in the same outcome allowed Lords Hope and Walker to agree with Lord Rodger and Lord Hoffmann, thus resulting in The Achilleas producing no overall majority in favour of whether the letter or the spirit of Hadley v Baxendale should be followed when they diverge.

And there will be cases where they will diverge in terms of the result they reach. For example: Executive hails a taxi driven by Driver. Executive tells Driver, ‘Take me to the airport. I have a plane to catch in two hours. A huge deal is riding on my making the plane.’ Shortly afterwards, Driver carelessly crashes the taxi. Executive is unharmed but is unable to make his plane, and fails to close the business deal that he was flying out to negotiate; the deal was worth $5m to Executive. Can Executive sue Driver for this loss? According to the letter of the rule in Hadley v Baxendale, yes he can. At the time Driver let Executive into his car, he knew that if he screwed up driving Executive to the airport, that Executive would suffer this kind of loss. According to the spirit of the rule in Hadley v Baxendale, Executive shouldn’t be able to sue Driver for the loss of his deal. At the time Driver let Executive into his car, Driver wasn’t factoring the possibility that he might be sued for that kind of loss into his decision as to whether or not to take Executive to the airport. In fact, Driver wasn’t making any kind of conscious decision as to whether or not to accept Executive as a passenger – as soon as Executive hailed his cab, he was going to take Executive as a passenger, whatever Executive said. Given this, it would be unfair to hold Driver liable for the loss of Executive’s deal. If Executive wanted to be able to sue Driver for that kind of loss, he should have been much more explicit with Driver: ‘Take me to the airport. I have a plane to catch in two hours. There is a huge deal riding on this, and I will sue you for millions if something happens to stop me catching the plane. Are you happy to take me on that basis?’ But if he said something like that, then Driver’s reaction would almost certainly have been: ‘No, I’m not – hop off mate and find someone else to take you.’ Holding Driver liable for the loss of Executive’s deal when that would have been Driver’s reaction had the possibility of his being held liable for that loss been brought home to him illustrates just why the spirit of the rule in Hadley v Baxendale stands opposed to holding Driver liable for that loss.

Where the letter and spirit of the rule in Hadley v Baxendale diverge, which should we prefer? In favour of following the spirit is simple common sense – the letter is supposed to serve the spirit, and must give way when it fails to do this. But in favour of following the letter in all cases is the desire for commercial certainty. Applying the letter of the rule in Hadley v Baxendale across the board may do injustice in individual cases such as Executive v Driver, but it does at least allow litigants in breach of contract cases to know where they stand so far as their potential liabilities are concerned. In contrast, applying the spirit of the rule in Hadley v Baxendale to determine the scope of a contract breaker’s liabilities requires the court to make difficult inquiries into the contract breaker’s expectations when he entered into the contract as to what he might be held liable for if he breached the contract.

Where Lord Hoffmann went wrong in The Achilleas

I said in the preceding section that Lord Hoffmann’s judgment in The Achilleas was ‘consistent’ with the spirit of the rule in Hadley v Baxendale, as I have explained it above. However, this is not quite true. According to the spirit of the rule in Hadley v Baxendale, a defendant should not be held liable for a loss that he did not take the risk of being held liable for when he entered into his contract with the claimant. (Compare the argument of counsel for the defendants in Hadley v Baxendale: ‘Where the contracting party is shewn to be acquainted with all the consequences that must of necessity follow from a breach on his part of the contract, it may be reasonable to say he takes the risk of such consequences.’) Lord Hoffmann said something different in The Achilleas. He said that a defendant should not be held liable for a loss that he did not agree to be held liable for when he entered into the contract (all emphases added):

[12] It seems to me logical to found liability for damages upon the intention of the parties (objectively ascertained) because all contractual liability is voluntarily undertaken. It must be in principle wrong to hold someone liable for risks for which the people entering into such a contract in their particular market, would not reasonably be considered to have undertaken.

[15] …one must first decide whether the loss for which compensation is sought is of a ‘kind’ or ‘type’ for which the contract-breaker ought fairly be taken to have accepted responsibility.

[26] …[in this type of case] the court is engaged in construing the agreement to reflect the liabilities which the parties may reasonably be expected to have assumed and paid for.

The idea that Lord Hoffman seems to be advancing here – that a contract-breaker’s liabilities to compensate the victim of his breach are attributable to the fact that he has agreed to assume those liabilities in entering into the contract – should be rejected as heretical. As Kyle Lawson has brilliantly pointed out (in ‘The remoteness rules in contract: Holmes, Hoffmann, and ships that pass in the night’ (2012) 23 King’s Law Journal 1), Lord Hoffmann’s language in The Achilleas echoes that of Holmes J in deciding the case of Globe Refining v Landa Cotton Oil (1903) in the US Supreme Court. In that case, Holmes J said that:

‘When a man commits a tort he incurs by force of the law a liability to damages, measured by certain rules. When a man makes a contract he incurs by force of the law a liability to damages, unless a certain promised event comes to pass. But unlike the case of torts, as the contract is by mutual consent, the parties themselves, expressly or by implication, fix the rule by which the damages are to be measured… [In considering what the plaintiff is entitled to recover in this case we] have to consider…what liability the defendant fairly may be supposed to have assumed consciously, or to have warranted the plaintiff reasonably to suppose that it assumed, when the contract was made.’

Holmes’ theory of the basis of a contract breaker’s liability followed from his view – famously expressed in ‘The path of the law’ (1896-7) 10 Harvard Law Review 457 – that someone who commits a breach of contract does not actually do anything legally wrong: ‘The duty to keep a contract at common law means a prediction that you must pay damages if you do not keep it – and nothing else. If you commit a tort, you are liable to pay a compensatory sum. If you commit a contract, you are liable to pay a compensatory sum unless the promised event comes to pass, and that is all the difference’ (ibid, 462). So the only obligation that a contracting party undertakes is either to ensure that something happens or to pay damages instead. It follows that the contract breaker’s obligation to pay damages is traceable to the fact that the contract breaker undertook to pay such damages if he failed to perform.

All this is nonsense. It is not possible to argue that a contract breaker’s liability to pay damages to the victim of his breach is attributable to the fact that the contract breaker agreed to pay those damages if he did not perform. A couple of examples show this:

(1) A enters into a contract with B. Under the contract, A undertakes to pay B the penal sum of £1m if he breaches his contract in any way at all. On breach, B will not be allowed to sue A for £1m but will instead be confined to suing for the actual loss he has suffered as a result of breach. This is so even though A undertook to pay B £1m if he breached his contract with B, and not to compensate B for his actual loss.

(2) A enters into a contract with B. The contract specifies that A’s liability on breach will be capped at £5,000, whatever the nature of A’s breach, and whatever the extent of B’s losses as a result of A’s breach. It is held that the clause limiting A’s liability is invalid under some statutory provision. A is then held liable for the actual loss suffered by B as a result of A’s breach, even though A never agreed to be held liable for that loss, but only £5,000.

Examples like these show that a contract breaker’s liability to pay damages to the victim of his breach is imposed on him by the law, and is not assumed by him under the contract. So the rule in Hadley v Baxendale cannot be explained as existing to give effect to a defendant’s intentions at the time he entered into a contract as to what liabilities he was agreeing to assume under that contract. Instead, the rule operates to prevent the law imposing on the defendant a liability to compensate the claimant for a loss that the defendant did not take the risk that the law might hold him liable to compensate the claimant for that loss when he contracted with the claimant. Any suggestion to the contrary in Lord Hoffmann’s judgment in The Achilleas is to be regretted.

(Though see para [13] of his judgment, which is entirely consistent with the analysis of the basis of the rule in Hadley v Baxendale advanced here: ‘The view which the parties take of the…risks they are undertaking will determine the other terms of the contract and in particular the price paid. Anyone asked to assume a large and unpredictable risk will require some premium paid in exchange. A rule of law which imposes liability upon a party for a risk which he reasonably thought was excluded gives the other party something for nothing.’)

The fact that Lord Hoffmann adopted an unworkable theory of the basis of contractual liability in The Achilleas should not lead us to think that his refusal simply to give effect to the letter of the rule in Hadley v Baxendale in The Achilleas was a mistake. As we have seen, the letter and the spirit of the rule in Hadley v Baxendale can diverge and in such a situation, a case can be made for adhering to the spirit rather than the letter of the rule.

Intention to create legal relations

The fictional nature of this area of law

An agreement will not be legally binding unless it was intended to be legally binding. However, the only cases where there will be an issue as to whether or not the parties to an agreement intended it to be legally binding are cases where it is impossible to tell whether or not they intended it to be legally binding.

For example, in Granatino v Radmacher (2010) – where the UK Supreme Court had to decide whether or not to give effect to the parties’ pre-nuptial agreement that neither party would seek to make a claim to property belonging to the other party if they got divorced – there was no issue as to whether that agreement was intended to be legally binding. It was obvious that it was intended to be binding. The only issue the UK Supreme Court had to decide was whether the public interest demanded that they should refuse to give effect to it. (On which issue, they split 8:1 in favour of giving effect to the pre-nuptial agreement so long as it was freely entered into, and did not prejudice the interests of the children to the marriage.)

Again, in Cobbe v Yeoman’s Row (2008) – where the claimant’s work in obtaining planning permission to develop the defendant’s land was wasted because the defendant pulled out of a provisional agreement to sell his land to the claimant – there was no issue as to whether or not the claimant and the defendant intended their provisional agreement to be legally binding. It was obvious that they did not. The only issue the House of Lords had to decide was whether the claimant was entitled to a remedy even though he had not yet entered into any kind of contract with the defendant. (On which issue, the House of Lords ruled that the claimant was entitled to a reasonable sum – a quantum meruit – for the work he had done in trying to obtain the planning permission.)

So the issue as to whether or not the parties to an agreement intended it to be legally binding only ever comes up in cases where it is impossible to resolve that issue because what the parties intended is shrouded in obscurity. It follows that in a case – like Balfour v Balfour (1919) and Jones v Padavatton (1969) – where there is an issue as to whether the parties to an agreement intended it to be legally binding, when the court tries to determine whether or not that agreement was intended to be legally binding, that is not, and cannot be, what it is actually doing. This is because it is impossible to determine whether or not the parties intended that their agreement be legally binding in these kinds of cases.

So what were the courts doing in cases like Balfour v Balfour or Jones v Padavatton? The answer is pretty simple – They were trying to decide whether or not to find that the agreement reached in those cases was legally binding. In other words, in a case like Balfour v Balfour or Jones v Padavatton, the court was trying to decide whether the reasons for finding that the agreement was legally binding outweighed the reasons against.

So when the courts say that they will ‘presume’ that domestic agreements are not intended to be legally binding, and that they will ‘presume’ that commercial agreements are intended to be legally binding, what they are really saying is that in a case where it is impossible to tell whether or not an agreement was intended to be legally binding, the balance of reasons applying to the case will usually come down in favour of refusing to enforce a domestic agreement and will usually come down in favour of enforcing a commercial agreement.

I’ll now substantiate this argument by looking at Balfour v Balfour and Jones v Padavatton in more detail.

Balfour v Balfour (1919)

In Balfour v Balfour, a husband and wife were based in Ceylon, where the husband had a job. They came back to England when the husband was on leave. When his period of leave expired, he went back to Ceylon; on the other hand, his wife stayed in England as she was too ill to travel. The husband promised to send his wife £30 a month while she had to stay in England. After he got back to Ceylon, he wrote to his wife saying that he thought it would be better if they remained apart. He subsequently failed to keep up the promised maintenance payments of £30 a month, and so his wife sued him for the money.

It seems not to have been noticed that the wife had supplied no consideration for the husband’s promise (though Warrington LJ observed that ‘The wife…made no bargain at all’). Instead, the case was regarded as turning on the issue of whether the husband’s promise had been intended to be legally binding. This was obviously impossible to resolve (otherwise there would have been no issue as to whether the promise had been intended to be legally binding) and so, in ‘resolving’ this issue, the Court of Appeal was really determining whether or not they ought to find that this agreement was binding.

In favour of finding that the agreement was binding was the fact that the husband had a moral responsibility not to leave his wife destitute and that he had acknowledged that responsibility in promising to send her £30 a month for her maintenance. (This was the reason why the first instance judge had found in favour of the wife.) However, the Court of Appeal thought that this reason was outweighed by two reasons against finding that the agreement was binding.

The first was that finding that this agreement was binding would fix the husband’s obligation to pay maintenance at £30 a month when a change of circumstances might mean that it was important that he pay his wife more, or might mean that he could only afford to pay his wife less than this sum. For Warrington LJ this made it ‘quite impossible’ to find that the husband’s promise to pay his wife was legally binding: ‘If we were to imply…a contract in this case we should be implying on the part of the wife that whatever happened and whatever might be the change of circumstances while the husband was away she should be content with this £30 a month, and bind herself by an obligation in law not to require him to pay anything more; and on the other hand we should be implying on the part of the husband a bargain to pay £30 a month for some indefinite period whatever might be his circumstances… it seems to me that it would be impossible to make any such implication.’ So finding that the husband’s promise here was legally binding would freeze an element of the husband’s relationship with his wife – how much he would give her by way of support – that needed to remain flexible if the husband and wife’s relationship were to be able to cope with unexpected changes of circumstances

Secondly, the Court of Appeal was concerned that finding that a promise like this was legally binding would be ‘a possible fruitful source of dissension and quarrelling…it would lead to unlimited litigation in a relationship which should be obviously as far as possible protected from possibilities of that kind’ (per Duke LJ). This is because turning a married couple into contracting parties might have a damaging effect on the nature of their relationship. Marriage is supposed to be a partnership focussed on achieving shared goals together, while people in a contractual relationship use each other in order to achieve their own goals. So finding that a married couple are in a contractual relationship might encourage them to stop thinking of themselves as being in a partnership and start thinking of each other in more antagonistic terms. Their relationship would become less ‘What can I do for you?’ and more ‘What have you done for me lately?’ It was because of these kinds of concerns that Atkin LJ famously observed that: ‘Agreements such as these are outside the realm of contracts altogether. The common law does not regulate the form of agreements between spouses. Their promises are not sealed with seals and sealing wax. The consideration that really obtains for them is that natural love and affection which counts for so little in these cold Courts.’

On balance, then, the Court of Appeal thought it would be undesirable to find that the promise in this case was legally binding. Of course, they dressed up their conclusion in terms of a finding that the promise was not ‘intended’ to be legally binding – but that was not what they were really deciding, as it was completely unclear whether or not the promise was intended to be legally binding.

Jones v Padavatton (1969)

In Jones v Padavatton, a mother was suing to recover possession of a house from her daughter. The mother lived in Trinidad. She had bought the house for her daughter to live in while her daughter studied for her Bar exams. In 1962, the mother had persuaded the daughter to give up a good job working in the Indian Embassy in Washington DC, and travel to England with her son in order to qualify as a barrister. (The mother’s plan was that once her daughter became a barrister, she would come back to Trinidad and practise there.) The mother had promised to give the daughter an allowance of (what turned out to be – there was some misunderstanding between the mother and daughter as to how much she would get) £42 a month to help cover her expenses while she studied for the Bar.

The mother subsequently suggested – and the daughter agreed – that instead of paying her £42 a month, she would instead buy a house for the daughter to live in with her son, and the daughter could let out rooms in the house and use the rent money to cover her expenses. The house was purchased in 1964. In 1967, the mother – unhappy that her daughter had provided her with no information as to how much money she was making by letting out rooms in the house – travelled to England to find out what was going on, and commenced proceedings to recover possession of the house from her daughter. The daughter argued that the mother could not do this, as she was bound by her agreement to allow her daughter to live in the house so long as she was studying for the Bar, and the daughter had still not passed all her Bar exams. (In fact, even in 1969, when the case was considered by the Court of Appeal, the daughter had still to do some of her Part I exams, and had passed none of the Part II exams.)

The Court of Appeal disagreed over whether there was a binding contract between the mother and daughter in this case. Salmon LJ thought that the Court should find that the mother’s promise to support her daughter was legally binding. The fact that the mother had induced her daughter to give up a very good job in Washington and travel to England by making that promise was a very weighty consideration in favour of finding that the mother’s promise of support was legally binding on her: ‘I cannot think that either [the mother or the daughter] intended that if, after the daughter had been in London, say, for six months, the mother dishonoured her promise and left her daughter destitute, the daughter would have no legal redress.’ However, he thought that the mother’s promise of support was not unlimited:

‘The parties cannot have contemplated that the daughter should go on studying for the Bar and draw the allowance until she was seventy, nor on the other hand that the mother could have discontinued the allowance if the daughter did not pass her examinations within, say, eighteen months. The promise was to pay the allowance until the daughter’s studies were completed, and to my mind there was a clear implication that they were to be completed within a reasonable time.’

Salmon LJ thought that five years was a ‘reasonable time’ for passing the Bar exams, and so by the time the mother came to England, the five years was up. The mother was therefore no longer bound by then by her promise of support, and could recover possession of the house.

Danckwerts and Fenton Atkinson LJJ thought that the mother’s promise of support was never legally binding. Fenton Atkinson LJ seemed to think that there was actually no issue over whether the promise of support was intended to be legally binding: he thought it was obvious from the evidence (in particular, the open-ended and imprecise nature of the arrangements between the mother and the daughter, and the daughter’s being aggrieved at the idea of her mother taking legal action against her) that the mother’s promise of support was not intended to be legally binding and that the daughter was simply trusting her mother to come through with the promised support, and the mother was trusting her daughter to get through the Bar exams reasonably quickly. Danckwerts LJ thought that the need for flexibility in how the mother would support her daughter counted against the Court’s finding that the mother’s promises to her daughter were legally binding: ‘What was required was an arrangement which was to be financed by the mother, and was such as would be adaptable to circumstances, as it in fact was… It was not a stiff contractual operation…’