Member Article

A recent judgement of the Court of Appeal brings welcome clarification of the principles regarding the recovery of wasted expenditure claims in IT disputes.

Summary

Whist wasted costs arising from failed IT implementations often form part of a subsequent loss of profit claim, the two forms of loss are separate and distinct. Consequently, in order to be effective, exclusions must specifically refer to wasted costs. Exclusions in respect of loss of profits claims will not effectively exclude such claims.

The Dispute

In Soteria Insurance (formerly CIS General Insurance) v IBM the Court of Appeal overturned an important element of the first instance judgment of O’Farrell J in a high profile and long running technology implementation dispute.

In essence, Soteria involved the failed implementation of a complex enterprise IT system. The implementation was delayed and went significantly over budget leaving the parties at an impasse. The supplier, IBM, wrongly sought to repudiate the contract for non-payment of an invoice and the customer, CIS, issued a wrongful repudiation claim for c.£120m losses associated with the project. Some £78m of those losses related to CIS’s wasted costs incurred in procuring and then seeking to implement the system.

At first instance, O’Farrell J found that the system supplied by IBM was defective and that they had wrongly sought to repudiate the contract. However she went on to hold that the majority of CIS’s claim was irrecoverable, principally because the wasted expenses claim fell within a contractual exclusion which applied to “indirect or consequential Losses…loss of profit, revenue, savings (including anticipated savings), data…goodwill…[and]… reputation…” with the result that CIS’s recovery was capped at just under £13m.

The first instance judgment came as a surprise to many commentators (including the author) who pointed out a tension between the first instance judgment and O’Farrell J’s earlier judgment in Royal Devon and Exeter NHS Foundation Trust v ATOS, in which she has concluded that a claim for wasted expenditure could proceed, despite a contractual exclusion for loss of profits, revenue or anticipated savings, where the intended benefit of the IT system was non-pecuniary.

A fuller account of the issues in the first instance judgement can be found here and our earlier comments on the CIS and Royal Devon decisions are here.

The Court of Appeal Judgment

Coulson LJ held that a claim for wasted expenditure was a significant and distinct head of loss from a claim for loss of profits which could not be excluded without clear wording to that effect. In particular, he found that:

• Loss of profits and wasted expenditure fundamentally different: On a natural and ordinary reading of the exclusion for loss of profits was plainly something different from an exclusion of claims for wasted expenditure. A loss of profits claim related to expected future profits whereas a claim for wasted costs related to expenses which had already been incurred.
• Need for clear language to exclude an obvious remedy: The likelihood of wasted expenditure was one which the parties would have clearly anticipated to be a significant consequence if the project failed. For such a significant risk to be effectively excluded, the exclusionary language would need to be “clear and obvious”, which it was not - particularly having regard to the Court’s earlier conclusions that loss of profits and wasted expenditure were fundamentally different remedies.
• Wasted expenses (and loss of data?), not a consequential loss: As a matter of construction of the exclusion itself, it was logical to distinguish between claims for wasted expenses (which were known, or at least quantifiable, at the date of termination) and consequential losses such as loss of profits (which were forward looking and would require consideration of various counterfactuals to calculate the loss) and the other sorts of loss referred to in the exclusion.
  
  The Court went on to comment that data, goodwill and reputation claims are also in effect loss of profit claims. In the authors’ view, this line of reasoning is somewhat questionable and may be an area for further disputes. Loss of data claims in particular can involve significant losses which are quantifiable at the point of breach (such as the cost of assembling a database and/or buying data from third parties), albeit some elements of such claims (such as the costs of reconstruction and trading losses) will be consequential.

• Approach to be taken in repudiation claims: O’Farrell J’s judgment in Royal Devon was correct, but it was incorrectly applied in this case. The correct approach to wasted costs claims was (in summary):
  • The starting point for any repudiation claim was that lost savings, revenue and profits would be recoverable.
  • A claim for wasted expenditure is a distinct basis for claiming compensation in those circumstances. There is a rebuttable presumption that wasted expenditure will be recouped as part of a lost profits claim, but that was simply the starting point for the Court’s damages assessment.
  • Accordingly, a claim for wasted expenditure was a clear a distinct form of loss and the presumption that this would be covered by a loss of profit claim did not change the fundamental nature of the claim.
  • This was an important point of principle which was not limited to the situation in the Royal Devon case, where the claimant was a not for profit organisation which would never make any profit from the system. The principle had to be one of general application. For example, many profit-making businesses would also buy systems which were not intended, wholly or in part at making a profit (e.g. they might have other intangible benefits such as improving employee welfare).

The judgment went on to deal with further issues between the parties regarding the correct approach to calculation of the contractual cap, whether IBM’s repudiation was valid and causation, which are specific to the facts of the case.

The judgment provides welcome clarity. However, with IBM seeking leave to appeal to the Supreme Court, there remains uncertainty over exclusions for loss of profits and wasted costs.

Implications

The decision has a number of implications for lawyers drafting IT contracts and parties involved in IT disputes.

• It is a reminder of the importance of considering the individual types of loss that might arise from a dispute and specifically deciding whether they will be excluded, particularly where they are obvious forms of loss that might arise from non-performance. Even if the decision is reversed on appeal, it will plainly be safer for exclusions to specifically name wasted costs if the intention is to exclude them.
• It provides welcome clarification that wasted expenditure is a distinct form of direct loss which might arise from termination of an IT contract.
• In practice, the reiteration that it is purely an assumption that wasted expenditure will be included within a loss of profit claim, may make it more likely that claimants will seek to claim additional wasted expenditure which relates non-profit making systems (or the non-profit making elements of systems which provide a mixture of benefits).
• The suggestion that loss of data claims are ones for consequential loss is likely to require further judicial scrutiny as some data claims plainly (at least in the author’s view) involve direct loss.