The costs of litigating or arbitrating a failed IT project are enormous. A party that spends HK$5m or HK$10m arbitrating an IT dispute in the expectation of recovering HK$50m damages will not thank its lawyers if it wins the case but recovers only HK$1m. This article is a gallop through the basic principles of damages in IT cases and looks at some of the heads of loss that have been considered by the courts.

Purpose of an award of damages

The customer who has pulled the plug on a disastrous IT project and terminated the contract might seek to pursue one or more of the following "heads" of claim:

  • the difference in value between what was contracted for and what was delivered;
  • the cost of repair or replacement;
  • loss of anticipated benefits;
  • loss of anticipated savings;
  • extra ongoing expenditure to overcome the defects; and .extra management time expended as a result of the breaches.

Typical claims for anticipated benefits include greater sales/income, staff reductions, lower financing charges (eg, through carrying lower stock levels), lower maintenance and running costs and space savings (eg, if the new system occupies less space).

Contract claims

In claims for breach of contract the court attempts to put the clock forward and put the claimant in the position it would have been in had the contract been fully performed. For example, if the system was expected to make a business earn higher profits, the court can compensate the buyer for the loss of anticipated profits and savings in operational expenses.

Tort claims

When a claim is brought based on a tort such as misrepresentation damages are designed to put the claimant in the position it would have been in had the tort never been committed. For example, where a buyer says that it entered into an IT contract solely on the basis of false promises made during negotiations, the court attempts to put the clock back and award the claimant compensation for the wasted expenditure and effort in getting involved.

Restitutionary claims

Where, for example, a buyer has paid certain instalments for an IT project and subsequently terminates due to the supplier's failure to perform, the buyer may be able to bring a simple claim for the return of its payments on the grounds of total failure of consideration, ie the supplier's failure to provide its consideration.

Where a supplier terminates due to the buyer's breaches, the supplier may have incurred significant costs in its preparations to perform. If no contractual entitlement to payment has fallen due, the supplier may be able to make a restitutionary claim for a quantum meruit payment, ie, reasonable remuneration for the work done.

In both these cases the compensation is restitutionary in nature and the court adopts a restorative approach as in tort claims.

Strategy in contract cases

Suing for loss of anticipated profits in contract is likely to appeal to the buyer initially as the supplier's staff will have painted a rosy picture of the benefits of the system during the negotiations, but it is likely to be a difficult and expensive course to pursue. Complex and contentious expert evidence will be required as to how the hypothetical improved business would have performed.

In most cases however a less risky approach is available. The plaintiff will have a choice between seeking damages on the contractual basis (for loss of anticipated benefits) or contract damages assessed on the tort/restitutionary basis (for wasted expenditure and business opportunities). Even where damages are sought on that basis the claim will still be in contract and the contractual rules on causation and remoteness will apply.

Causation, mitigation and remoteness

In a contract claim to qualify for an award of compensatory damages the innocent party must show that (a) the claimed loss has been suffered, (b) the loss was caused by the wrongdoer's breaches and (c) the loss is not too remote from the breaches to be compensable. Courts use these rules to keep speculative claims in check.

Every claimant is subject to a duty to mitigate its losses: the claimant must take reasonable steps to cease incurring further losses following a breach. Depending on he facts this might, for example, require the buyer of a defective IT system to use what has been delivered as lest it can, or procure an alternative system.

Although a disappointed buyer may usually chose between claiming loss of anticipated benefits or cost of wasted expenditure/opportunities, the duty to mitigate may significantly modify what is recoverable on the former basis. For example, a supplier may have failed to deliver an r system that would have greatly improved the buyer's operating efficiency for a contract sum of $1m. The buyer could have bought a similar system from an alternative supplier for $1.1m. or could have had the defective system fixed for, say, $0.2m. The court would probably find in such a case that the buyer may only recover the difference between the contract price and the market price or the cost of restoration and not full loss of anticipated profits and savings.

Sometimes damages on the "cost of restoration" basis will be considerably lower than on the loss of anticipated benefits basis. This will often be the situation in IT cases where the cost of restoration may be low and the benefits of restoration high. In other scenarios the cost of restoration may be higher than the lost benefits. For a non IT case see Ruxley Electronics and Construction Ltd v Forsyth [1996] AC 344 where the buyer of a defective but perfectly usable swimming pool recovered small compensatory damages at first instance, in the Court of Appeal recovered significant cost of restoration damages and in the House of Lords recovered only the compensatory damages again.

The party in breach is not liable for all losses that can logically be said to have followed from the breach. It will only be liable for (1) losses that were, or should have been, in the reasonable contemplation of the parties as likely to be suffered in case of breach at the time they entered into the contract and (2) losses which would have be suffered by the particular innocent party in case of breach and of which the wrongdoer had specific notice prior to contracting.

It may be that in IT contract cases the basic measure of damages on the contractual basis can often only be arrived at answering the question what can the particular plaintiff reasonably do to alleviate its loss and what would be the cost of doing so at the time when it could reasonably be expected to do it. If that approach is adopted, the questions of primary recovery and mitigation effectively merge into one investigation.

IT project disasters

In Stephenson Blake (Holdings) Ltd v Streets Heaver Ltd (2 March 1994) [2001] Lloyd's Rep PN 44, a claim against computer consultants for negligent recommendation of a computer system, the judge found that in principle the plaintiff was entitled to claim for anticipated stock savings, as this was within the contemplation of the parties when the consultant recommended the system.

In Salvage Association v CAP [1995] FSR 654 there was a claim for lost savings of four accounts staff and machine room rent. The judge was not satisfied that the staff services would have been dispensed with nor that the machine room would have been disposed of by subletting. The buyer also claimed lost interest as the result of not having achieved a debt reduction of £1 million through improved credit control. The judge found that this claim was too remote, and that the evidence was much too speculative and insufficient to prove the claim. A claim for wasted management time succeeded.

In St Albans CDC v ICL [1996] 4 All ER 481 (CA) a county council contracted with ICL for a major IT system that would calculate the amount of "poll tax" it was required to collect from residents in its area. The system was installed but the software had a major bug and the council calculated and collected too little tax. The council was able to recover from ICL the tax it failed to collect plus interest. An unusual loss of anticipated benefit case.

In South West Water Services v ICL 1999 ITCLR 439 ICL entered into a "turnkey" contract to supply a bespoke IT system to a water utility. ICL could not perform on time and the buyer terminated the contract. Remarkably the utility was able to show that all the goods and services supplied up to termination were of no use to it and the utility could recover from ICL all the money it had paid over up to termination.

Pegler v Wang [2000] All ER (0) 260 is every IT supplier's nightmare. Wang failed to provide the system contracted for and Pegler, a manufacturing company, terminated the contract. Pegler made a full loss of anticipated benefits claim and sought £22m. After a very lengthy trial the court awarded over £9m for loss of anticipated savings, waste of management time and lost opportunity to increase profits.

But the customer is not always right. In Saphena ComputIng Umlted v Allied Collection Agencies Limited [1995] FSR 616 (1989) the supplier claimed that the buyer had prematurely terminated a software development contract. Although the software was not working entirely properly at the time, the CA agreed and the supplier recovered the cost of goods and services supplied up to that time on a quantum meruit basis.

Limitation of liability clauses

Many kinds of suppliers of goods and services include in their contracts clauses limiting or excluding liability for loss caused by breach and IT suppliers have elevated these practices to a fine art. Generally such clauses attempt to exclude all liability for certain types of loss (eg, loss of profit) or to limit overall liability to a fixed cash amount. Given the sort of liability to which IT suppliers would be exposed in the absence of such protection the industry practices are perhaps understandable.

In Hong Kong the Control of Exemption Clauses Ordinance (Cap 71) ("CECO") and the Misrepresentation Ordinance (Cap 284) ("MO") regulate such clauses. The chief effects of the CECO are that (a) a term may not exclude or restrict liability for negligence except insofar as it is reasonable, (b) where one party deals on a supplier's "written standard terms of business" the terms may not exclude or restrict liability for breach, or permit performance substantially different from that reasonably expected of the party, except insofar as they are reasonable and (c) a term may not exclude or restrict liability for breach of implied undertakings as to quality, conformity of goods with description or sample or fitness for a particular purpose unless it is reasonable.

The MO has the effects that (a) damages are recoverable for innocent pre-contractual misrepresentation in the same way as for fraudulent misrepresentation, that is on the tort measure of damages for deceit, and (b) contract terms excluding or restricting liability for misrepresentation are void unless they are reasonable.

When deciding whether a term is reasonable the tribunal is to have regard to certain matters, in particular the resources available to the supplier, how far it was open to the supplier to obtain insurance, the strength of the bar- gaining positions of the parties, whether the buyer could have entered into similar contracts with other persons without a similar term, whether the customer knew of the term having regard to customs of the trade or previous courses of dealing and whether the goods were manufactured, processed or adapted to order.

The decided IT cases

In Saivage Association the supplier had limited its total liability under the contract to £25,000. The evidence was that its management had themselves already considered raising the limit in its standard terms. The court held that in light of that evidence the limit was not enforceable.

In St Albans ICL limited its liability to £100.000. This was held to be unenforceable in view of the risk to the council if things went wrong and the actual loss suffered.

In South West Water Services the effect of an exclusion clause in ICL's conditions was that if the system supplied failed the acceptance tests then ICL had to refund the price paid, but if the contract was terminated before the system was ever supplied then the liability was limited to £250,000. This was held to be manifestly unreasonable in light of the project risks.

In Pegler an exclusion of certain liability "...arising out of the supply..." of a system was read as not addressing liability for failure to supply. The risk of unsuccessful implementation was higher than Wang had led Pegler to believe. It was held that it was unreasonable for Wang to rely on its indirect loss exclusion clause and time bar clause to exclude liability where it had misrepresented what it was selling and the extent to which breaches of contract were likely. This approach focuses on the circumstances of contracting rather than the workings of the clauses.

In Horace Holman Group Ltd v Sherwood International Group Ltd (2000 WL491372, 12.04.00) Holman purchased an IT system on Sherwood's standard terms. They included an entire agreement clause, exclusions of certain heads of loss and a limit on total liability to the contract sum. Evidence was led showing that such clauses are very common in the IT industry. The judge struck down the entire agreement clause because it excluded the implied warranty as to fitness for purpose (a warranty of compliance with spec was considered not enough). The judge also struck down the exclusions of liability for lost anticipated benefits, consequential loss and the cap on liability.

This case, if followed, will have serious implications for IT suppliers. It was not cited in the next case, Watford Electronics Ltd v Sanderson CR. Ltd [2001] All ER (0) 290 {23.02.01), and it may be that Watford represents the approach that courts will take in future.

Watford purchased a bespoke IT system on Sanderson's standard terms. They included an entire agreement clause, a 'non reliance on misrepresentations' clause, an exclusion of consequential losses and a limit on liability to the contract sum, The judge held, as in the well known Thomas Witter case [1996] 2 All ER 573, that because the limitation clauses excluded liability for pre-contract misrepresentation they were unreasonable in their entirety. The Court of Appeal however, robustly favouring the supplier for once, considered that the limitation clauses should be construed in light of the existence of the entire agreement and non reliance clauses - as the parties had agreed that there was to be no liability for pre-contract misrepresentation the limitation clauses could not have been intended to apply to that. Accordingly they were not unreasonable. The court was influenced by the fact that the parties were of equal bargaining power, in particular the fast that Watford itself limited its liabilities in its standard terms and condition.

First published in Asian Lawyer. Co-written with Graham Smith.