21 May 2007

It's over: Terminating a contract for default

by Alexandra Wedutenko

It is in your interests to think about and specify in your contract how and why it may be terminated. It is very difficult to re-engineer your contract and conduct after the event if your contractor fails to perform.

When a contract does not deliver your desired outcome, your rights to terminate the contract may become an issue.

Your right to terminate a contract may be expressly provided for in the contract, provided for by statute, or arise under common law. Commonwealth contracts will almost invariably include the right to terminate as an express term of the contract and may retain other rights to terminate at law (while this article focuses on Commonwealth contracts the principles apply equally to State and private sector contracts).

The Commonwealth will normally retain a right to terminate for:

  • contractor default
  • convenience on payment of compensation; or
  • "extensive" force majeure event.

In some cases the right to terminate for default will be expressed as a mutual termination right, although Commonwealth contracts do not tend to expressly provide the contractor with a general right to terminate. This does not mean, however, that the contractor does not retain a common law right to terminate for serious breaches by the Commonwealth.

It is preferable to specifically address the events that will enable termination by each party. The Commonwealth’s right to terminate for contractor default will normally specify a range of termination events, as well as retain the right to terminate at law.

The termination clause may also provide a range of remedies for the innocent party. Once exercised, the termination ends each party’s obligations to further perform the contract (on and from the time of termination) but the accrued rights of each party, up to the time of termination, remain enforceable.

The right to terminate

At common law, a right to terminate arises where there is:

  • a breach of an essential term
  • a repudiation
  • a breach causing a substantial loss in benefits; or
  • an event of frustration.

These termination events tend to be mirrored in termination clauses in contracts.

When drafting your contract, the termination clause allows you to specify exactly which breaches you consider to be important and which breaches entitle a party to terminate the contract. It is desirable to be as specific as possible. Termination clauses should be drafted clearly and unambiguously. Indeed, if a clause is ambiguous, the court may seek to "avoid consequences which appear to be capricious, unreasonable, inconvenient or unjust" (Burger King Corp v Hungry Jacks Pty Ltd [2001] NSWCA 187). So when drafting your clause, consider exactly what events will justify termination.

Subject to the comments below, there are no limitations on the events of termination that you can specify. However, what you are seeking to do is to specify events that are truly important to you and not merely a shopping list of possible events that could occur at any time. In essence, when negotiating and managing your contract you will always be balancing relationship issues with a need to ensure that the contractor delivers under the contract.

The courts tend to be reluctant to permit termination for minor breaches. If some-thing is really important to you, you should specify it as an essential term of your contract. Otherwise the law will determine if a term is essential (see Associated Newspapers LTD v Bancks (1951) 83 CLR 322). The courts have developed a test of essentiality, which is:

"whether it appears from the general nature of the contract considered as a whole, or from some particular term or terms, that the promise is of such importance to the promisee that he would not have entered into the contract unless he had been assured of a strict or substantial performance of the promise...and that this ought to have been apparent to the promisor." (Tramways Advertising v Luna Park (NSW) Ltd [1938] SR (NSW) 632 at 647).

If performance on time is an essential requirement for your contract, you should specify this fact in the contract to ensure there is clarity on this point. Otherwise, performance on time may not be deemed to be essential. Rather, the contract may enable performance in a reasonable time without giving rise to a right to terminate.

In Shawton Engineering v DGP International [2005] EWCA Civ 1359, for example, the parties extended the term of the contract but did not clearly specify varied contract delivery dates. As a result, because no final dates for completion were clearly specified in the contract, the contractor had a reasonable time to complete the contract.

Good faith

Another matter to consider where termination of the contract becomes likely is the issue of good faith. There is some debate as to whether there is an implied term of good faith in contract law in Australia. However, it is generally wise to act in good faith when terminating a contract. Even then, the concept of what good faith means needs to be considered. It may involve acting for proper purposes honestly or reasonably, engaging in consistency of conduct, proper communication of decisions and cooperation or consideration of the other party’s interests.

Making the decision to terminate

You should pay careful attention to the exercise of your rights under the contract, particularly if the other party is failing to perform. If you fail to acknowledge and exercise your rights, you may find that you have waived your rights or affirmed the continued performance of the contract. Recent cases demonstrate how termination issues arise. An example is Bradmount Investments Ltd v Williams De Broe plc [2005] EWHC 2449 (Ch): Mr Bradmount knew about a particular breach of contract, but did not mention the breach as an issue and indeed consented to the breach continuing for some period of time. When the parties ultimately had a falling out, Mr Bradmount sought to rely on his earlier termination right. The court held that he had affirmed the contract and had given up his right to terminate in not having attempted to enforce it.

What the innocent party must do when faced with a breach giving rise to termination is make a decision whether to terminate or to elect to affirm the contract. The terms "election" and "affirmation" tend to be used interchangeably. If you allow poor contractor conduct to continue over time you may find that you have lost the right to terminate. The reason for this might be that you have, through your conduct, elected to affirm the contract notwithstanding the contractor’s failure to perform. The right of election arises when you have the ability to act in a way that is inconsistent with the exercise of your right to terminate. For example, an event has occurred which entitles you to terminate as the contractor has failed to deliver the goods and services to the required quality or performance standards. If you wish to terminate you need to make an unequivocal act to do so. If you continue on, you need to understand that you may be affirming the entire contract or waiving some of your rights. Indeed you may have expressly decided to continue on with the contract because you want the contractor to deliver the supplies.

You should not just "put your head in the sand" and hope the problem goes away. Nor should you continue on hoping for the best and then decide you never really intended to continue on. In GEC Marconi Systems Pty Ltd v BHP Information Technology Pty Ltd (2003) 128 FCR 1, 92, Justice Finn stated in relation to particular conduct "GEC Marconi’s reported termination was an attempt, opportunistically and too late, to avoid a regretted decision it had long since made." In essence once an election is communicated or you have exercised inconsistent rights, you may lose your right to terminate.

There is a delicate balance between acting on your legal rights to ensure that the contractor actually performs a contract in accordance with its terms, versus maintaining the relationship with the contractor.

You have a reasonable time in which to make your decision to terminate the contract for the other party’s default. Some parties seem to think that they can preserve their termination rights while continuing with a series of "without prejudice" negotiations in relation to contract performance. While you can do this in relation to dispute resolution, as noted above, there comes a point when inconsistent conduct affirming the contract will override "without prejudice" attempts to resolve an issue.

How to terminate

In relation to exercising a termination right you need to be aware that for the most part, termination of a contract is not automatic. You will need to utilise particular words or conduct to give effect to a termination. In particular, "the innocent party" will need to make an election to terminate the contract. There may be notice requirements in the contract that need to be complied with.
If you are thinking of termination you should, as far as possible, strictly comply with the termination notice provisions in your contract.

Another issue that you need to think about is whether your own conduct may be held to repudiate a contract. This occurs when a party manifests an unwillingness or inability to perform a contract at all or in some respects. For example, you may be a customer that is seeking to terminate the contract for the contractor’s default. If you fail to exercise the termination right properly in accordance with the contract you may be found to have repudiated the contract yourself. By doing so you may have entitled the other party to terminate and/or sue for damages: see Commonwealth Australia v Amann Aviation Pty Ltd (1991) 174 CLR 64. Thus you need to pay careful attention in termination matters to ensure that your attempt to terminate a contract does not backfire on you.

A final point to note is that where there is no specific time frame for termination in your contract, you may need to give reasonable notice of termination to the other party. This will not arise if your contract clearly specifies that termination is only possible by complying with a specified notice period. However, your conduct may give rise to a change in that time frame or a waiver of that time frame. You need to have a clearly drafted contract and you need to clearly and properly exercise your rights under that contract.

Protecting your rights

To sum up, it is critical that you ensure that your contract is clearly drafted with a clear scope and clear time lines for delivery.

You need to include and follow contract variation procedures and if you do exercise variations, make sure you specify (where relevant) new delivery times.

You need to properly manage a contract and deal with non performance issues in a prompt manner; if you wish to terminate you need to clearly and specifically follow the termination procedures in your contract.

If time is a critical element in your contract you need to make time of the essence.

If another provision is critical to the performance of a particular contract, again, you need to specify it as giving you a termination right.

If there is a time frame specified for termination you must comply with that time frame.

If you must give notice in a particular way you must comply with that notice requirement.

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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 communication. Persons listed may not be admitted in all States and Territories.