Business Law Legal Research Blog

BUSINESS LAW: The Exclusion of Warranties and Consequential Damages and the Limitation of Other Remedies Between Merchants Under the Uniform Commercial Code

Posted by Daniel Lynton on Wed, Sep 22, 2010 @ 17:09 PM

August 10, 2010

Paul Ferrer,

Senior Attorney, National Legal Research Group

It is surprising how much business continues to be done between relatively sophisticated commercial entities based on a casual exchange of forms, despite the potentially ruinous consequences for a buyer of terms contained in an invoice or packing slip sent by the seller along with the item purchased. Consider the following scenario: An engine repair facility (the "buyer") is hired to repair a $1 million race car engine. The buyer needs a $10,000 part to fix the engine. The part consists of multiple blades. If any one of the blades breaks off while the engine is operating, it is likely that the entire engine will be completely destroyed, thus potentially subjecting the buyer to $1 million in liability, at least (assuming no additional damage to the race car). The buyer purchases the necessary part from the manufacturer (the "seller") by faxing a purchase order identifying the part and the price, with no terms concerning warranties or remedies upon a breach of warranty. The seller sends the part to the buyer along with an invoice or packing slip that sets forth, on the reverse side, a series of "terms and conditions," including provisions excluding the implied warranties of merchantability and fitness for a particular purpose, limiting the buyer's remedies to repair or replacement of the defective part, and excluding consequential damages. Do all of these terms become part of the parties' contract? If the part fails and destroys the $1 million engine, is the buyer limited to recovering the value of a $10,000 part from the seller?

Here is how these questions would typically be handled under Article 2 of the Uniform Commercial Code (the "U.C.C."), which applies to transactions in goods and has been adopted in all 50 states: The parties' "battle of the forms" is initially governed by § 2-207 of the U.C.C., which deals with additional terms in acceptance or confirmation of an offer. The buyer's purchase order would be considered an offer, which was accepted when the seller shipped the part. The additional terms in the seller's invoice excluding warranties and consequential damages and limiting the buyer's remedies to repair or replacement would be "construed as proposals for addition to the contract." U.C.C. § 2-207(2). Between merchants such as the buyer and the seller, such terms automatically become part of their contract unless "(a) the offer expressly limits acceptance to the terms of the offer; (b) they materially alter it; or (c) notification of objection to them has already been given or is given within a reasonable time after notice of them is received." Id. In this scenario, the buyer's purchase order did not expressly limit acceptance to the terms of the offer, nor did the buyer object to the terms set forth on the back of the seller's invoice. In fact, like most purchasers, the buyer probably did not even look at the terms until the part failed, the engine was destroyed, and the race car's owner looked to the buyer to recover $1 million in damages. Accordingly, the terms on the seller's invoice became part of the contract unless they "materially alter[ed] it."

The U.C.C. specifically provides "[e]xamples of typical clauses which normally 'materially alter' the contract and so result in surprise or hardship if incorporated without express awareness by the other party," including "a clause negating such standard warranties as that of merchantability or fitness for a particular purpose in circumstances in which either warranty normally attaches." Id. § 2-207 cmt. 4. As such, the seller's attempt to exclude the implied warranties of merchantability and fitness for a particular purpose was probably unsuccessful. See, e.g., Distinctive Cabinetry, Inc. v. Home Depot U.S.A., Inc., No. Civ. 08-10233, 2009 WL 1448954, at *8 (E.D. Mich. May 22, 2009); Tacoma Fixture Co. v. Rudd Co., 174 P.3d 721, 724 (Wash. Ct. App.), review denied, 190 P.3d 55 (Wash. 2008). But it is unlikely that the seller is overly concerned about the existence of these warranties compared to its attempt to limit remedies and exclude consequential damages, which are the real battlegrounds in this instance. As the Illinois Supreme Court has explained:

The two provisions—limitation of remedy and exclusion of consequential damages—can be visualized as two concentric layers of protection for a seller. What a seller would most prefer, if something goes wrong with a product, is simply to repair or replace it, nothing more. This "repair or replacement" remedy is an outer wall, a first defense. If that wall is breached, because the limited remedy has failed of its essential purpose, the seller still would prefer at least not to be liable for potentially unlimited consequential damages, and so he builds a second inner rampart as a fallback position. That inner wall is higher, and more difficult to scale—it falls only if unconscionable.

Razor v. Hyundai Motor Am., 854 N.E.2d 607, 619 (Ill. 2006), cert. denied, 549 U.S. 1181 (2007).

With regard to these two more important lines of a seller's defense, the U.C.C. also provides "[e]xamples of clauses which involve no element of unreasonable surprise and which therefore are to be incorporated in the contract unless notice of objection is seasonably given," including "a clause . . . limiting remedy in a reasonable manner (see Section[] . . . 2-719)." U.C.C. § 2-207 cmt. 5. Section 2-719 specifically states that the parties' agreement "may provide for remedies in addition to or in substitution for those provided in this Article and may limit or alter the measure of damages recoverable under this Article, as by limiting the buyer's remedies to . . . repair and replacement of non-conforming goods and parts." Id. § 2-719(1)(a). In addition, "[c]onsequential damages may be limited or excluded unless the limitation or exclusion is unconscionable."Id. § 2-719(3). Under this subsection, limitation of consequential damages is not prima facie unconscionable "where the loss is commercial." Id. Taken together, §§ 2-207 and 2-719 seem to indicate that the terms in the seller's invoice limiting the buyer's remedies to repair or replacement and excluding consequential damages did not "materially alter" the parties' agreement and became part of their bargain under § 2-207(2), which would likely come as quite a surprise to the unwitting buyer. Note, however, that not all courts agree on this reading of the U.C.C. See, e.g., Distinctive Cabinetry, 2009 WL 1448954, at *12 (noting that courts are split on this issue, but concluding that the courts "finding that an exclusion of all consequential damages is a material alteration have the better view").

In a state holding that an exclusion of consequential damages is not a material alteration of the parties' bargain, the buyer would be left with only two arguments. First, the buyer could claim that the seller's attempt to alter the terms of their bargain through the inclusion of an invoice or packing slip with the items being shipped to the buyer came too late in the contracting process. Some, though not all, courts have agreed that, in such a case, the parties' contract consists only of those terms on which the parties' forms agree, plus any additional terms supplied by the U.C.C., including those relating to implied warranties and consequential damages. See, e.g., Tacoma Fixture Co., 174 P.3d at 724 (discussing U.C.C. § 2-207(3)).

Second, the buyer could also argue that the limited remedy provided by the seller failed of its essential purpose, thus allowing the buyer to have "remedy . . . as provided in this Act," U.C.C. § 2-719(2), including consequential damages, see id. § 2-715(2)(b) (consequential damages include injury to property proximately resulting from the seller's breach of warranty). There was a time when the majority of courts to consider the issue had held that if a limited remedy failed of its essential purpose, then the seller's attempt to exclude consequential damages failed as well. See Razor, 854 N.E.2d at 616. That is no longer the case, however, and the modern trend is to adopt the so-called "independent" approach, which views subsections (2) and (3) as independent provisions, such that even if a limited remedy is deemed to have failed of its essential purpose, a term excluding consequential damages can still be enforced so long as it is not unconscionable. See id. at 616-17. Arguing unconscionability in a contract between two commercial parties, with no consumers involved, is a tall order. Cf. id. at 622-23.

Returning to our scenario, all of this means that the buyer may well be limited to recovering from the seller only the $10,000 value of the part, while being on the hook for $1 million in damages to the owner of the race car. The lessons are clear. From the seller's perspective, carefully drafted provisions limiting remedies and excluding consequential damages are worth their weight in gold. On the other hand, the buyer, who would ordinarily be entitled to recover its substantial consequential damages in this situation under the rule of Hadley v. Baxendale, must protect itself either in its dealings with the race car's owner or by being more careful in forming a contract with the seller of the part that ultimately destroyed the engine. The buyer can do so either by expressly limiting acceptance to the terms of its offer or by objecting to the additional terms proposed by the seller immediately upon receiving the seller's invoice. See U.C.C. § 2-207(2). It may even be prudent for the buyer to include in its purchase order an express term purporting to nullify any attempt by the seller to exclude warranties or consequential damages or to limit remedies. In that case, the buyer's and seller's conflicting terms would not become part of the contract, which would then consist of those terms upon which there was agreement between the parties, plus any supplementary terms supplied by the U.C.C., including its provisions on warranties and consequential and other damages. See id. § 2-207(3).

Topics: legal research, business law, Paul Ferrer, exclusion of warranties, U.C.C. § 2-207, consequential damages

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