Projects Insights

12 March 2009

Life after termination - address contractually or leave to the common law?

By Nicholas Tsirogiannis.

Key Points:
There are rights and obligations which are capable of surviving termination.

It is becoming increasingly common for construction contracts to contain not only a clause that sets out the compensation payable by a defaulting party on termination but also a clause that sets out the other consequences of termination, such as the various rights and obligations that survive termination. Given this growing trend, this article will examine the consequences of termination at common law and, in particular, what rights and obligations are capable of surviving termination and some of the issues associated with including such a clause in a contract.

Consequences of termination

When a contract is terminated, it is often said that it "comes to an end" or "ceases to exist". However, these statements are somewhat misleading as the contract not only continues to exist but continues to have operation in some respects. What is in fact "terminated" is the future performance of the contract - that is, the primary obligations of the parties that have been partially performed at the time of termination and those that would have fallen due for performance had the contract not been terminated.

Termination takes effect from the time a party exercises the right to terminate the contract, not from the time that party was entitled to terminate. This is in contrast to "rescission ab initio" (rescission from the beginning) which may be available if there is a defect in the formation of the contract, in which case the contract is annulled from its inception and the parties are substantially restored to the position they held before they entered into the contract.

Which obligations survive termination?

While termination puts to an end the primary obligations of each party, there are other obligations which may survive termination. Those obligations generally fall within one of the following three categories:

  • The first category is comprised of obligations that arise when there is breach of contract. If the contract is terminated in those circumstances, the parties' primary obligations are substituted by a secondary obligation that is imposed on the party in default which requires it to pay compensation to the other party. This secondary obligation to pay compensation survives termination of the contract.[1]

For example, in a construction context, upon termination of the contract by either party, the contractor is relieved of its primary obligation to carry out and complete the works. If, however, the contract was terminated as a result of the contractor’s default, the law imposes a secondary obligation on the contractor requiring it to pay compensation to the owner. That compensation will usually comprise any additional cost incurred by the owner in completing the works that is over and above the contract price.

  • The second category applies to termination for any cause and consists of obligations that are ancillary to the main purpose of the contract. These may be of a substantive or procedural nature. Examples of this type include an agreement to refer differences or disputes to arbitration, an obligation not to disclose confidential information and an agreement as to the choice of forum.
  • The third category consists of terms which regulate the secondary obligations of the parties. In other words, terms which regulate the defaulting party’s obligation to pay compensation to the other party. In the context of a construction contract, commonly found examples of this category, particularly in this resource-constrained market, are terms that limit the contractor’s liability to the owner. These include limiting the contractor’s overall liability, capping the contractor’s liability to pay delay or performance liquidated damages or excluding the contractor’s liability for indirect loss.

Whether or not obligations in the second or third category survive termination is a question of construction and, therefore, will depend on the intention (actual or implied) of the parties in each particular case.

Which rights survive termination?

Rights that have unconditionally accrued prior to termination continue to have effect after termination. Where the contract has been terminated for breach, even the defaulting party may enforce rights that have unconditionally accrued in its favour.

There are generally two types of accrued rights that survive termination:

  • the right to damages for breach of contract. The breach may be one that gives rise to a right to terminate at common law or to a contractual right to terminate. It may even be an earlier breach and not the one which ultimately gave rise to the contract being terminated; and
  • the right to receive performance of a contractual obligation. The most common example of this type is the right to payment of an amount fixed by the contract which has "unconditionally accrued" prior to termination. Whether such a right has "unconditionally accrued" depends on the (actual or imputed) intention of the parties. In the absence of an indication of that intention, the consequences flowing from termination (including whether that right has unconditionally accrued) will be governed by the common law.

A common example of this right in a construction context is the recovery of progress payments or instalments due under the contract. Upon becoming entitled to a progress payment or instalment, a contractor will, except in certain circumstances,[2] be able to recover the amount of the progress payment or instalment from an owner even if the contract is terminated for the contractor’s breach.

Clauses that set out what rights and obligations survive termination

Although certain rights and obligations are capable of surviving termination at common law, there are, at the same time, sound reasons why parties may choose to include a clause in the contract that expressly addresses this issue. The first is to achieve greater certainty and not rely on the common law which may, in some circumstances, produce an outcome that was not contemplated by the parties. The second is that the parties may wish to alter the common law position by stipulating that certain additional rights and obligations survive termination than would normally do so under the common law.

In either case, parties should be aware that the inclusion of such a clause can potentially have some adverse consequences such as inadvertently altering the application of the common law in circumstances where the parties were only intending to restate the common law in the clause. Accordingly, the parties should ensure that the common law in this area is well understood and the clause is drawn correctly.

The parties should also consider whether the inclusion of such a clause may be interpreted as an exhaustive statement of the parties’ intention, particularly where the parties have included a list of rights and obligations that are intended to survive termination. To reduce the likelihood of this interpretation, the contract should provide that the rights and obligations that may survive termination are not limited to those set out in the clause. This should allow the parties to set out a list of rights and obligations that survive termination and, at the same time, not exclude the possibility of other rights and obligations surviving termination at common law.

 

                                   
[1] This secondary obligation to pay compensation also arises when there is a breach of contract that does not result in the contract being terminated.  If the contract is subsequently terminated for another breach or for some other reason, that obligation will, subject to any contrary intention expressed in the contract, survive termination.

[2] Those circumstances include where the contract is held to be an entire contract despite the fact it provides for progress payments.

For further information, please contact Nicholas Tsirogiannis.

Disclaimer
Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this bulletin. Persons listed may not be admitted in all states or territories.