Legal Briefing

Condition precedents: why, when and how should you use them?


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Corporate and commercial | 01 September 2014

When drafting a commercial agreement, it is prudent to think carefully about the potential issues that may lie ahead once the agreement has been signed and governs your commercial relationship with another party. In particular, where a certain event may trigger an onerous obligation on your part, you should think about whether the clause requires the protection of a condition precedent.


The repercussions of a party’s failure to include a condition precedent can be very significant. The Court of Appeal recently gave judgment in (1) Heritage Oil and Gas Ltd (2) Heritage Oil plc v Tullow Uganda Ltd [2014], where the appellants sought, and failed, to avoid the payment of a tax liability of almost $315m.

Before we consider the ruling, it is helpful to remind ourselves of the basic principle. The breach of a condition entitles the innocent party to treat themselves as discharged from their contractual obligations. The reasoning is aptly put by Fletcher Moulton J in Wallis, Son & Wells v Pratt & Haynes [1910] where he stated:

‘… [conditions] go so directly to the substance of the contract or, in other words are so essential to its very nature that their non-performance may fairly be considered by the other party as a substantial failure to perform the contract at all’.

Where a contract specifically identifies a term as a ‘condition precedent’, there can be little doubt as to the effect of that term. The difficulty arises where the courts are left to determine a condition precedent by implication. In such instances the court looks at the contract in light of the surrounding circumstances and determines whether the parties’ intentions would be best served by treating the clause as a warranty, with recourse to damages only for breach, or a condition precedent.

FACTS OF HERITAGE & HERITAGE V TULLOW

The first appellant, Heritage Oil and Gas Ltd (Heritage) and the respondent, Tullow Uganda Ltd (Tullow) each held a 50% interest in a license to certain petroleum exploration sites near Lake Albert in West Uganda. An agreement between Heritage and Tullow provided Tullow with a right of pre-emption should Heritage agree a sale of its interest to a third party.

In December 2009, Heritage agreed to sell its rights in the exploration areas to Eni International BV (Eni) and entered into a sale agreement. This triggered Tullow’s right of pre-emption and on 17 January 2010, Tullow exercised its right to acquire the remaining 50% interest. As a result, on 26 January 2010 Tullow and Heritage entered into a Sale and Purchase Agreement (SPA) on the same terms as those agreed between Heritage and Eni. The sale price was agreed to be at least $1.35bn. At the time of the SPA, Heritage was a Bahamas company but changed its registration to Mauritius in March 2010, shortly before the scheduled completion date of 26 July 2010.

Article 7.2 of the SPA gave Tullow a right to an indemnity in respect of capital gains tax imposed on Heritage but charged to Tullow by the government of Uganda (the government). Article 7.5(a) stated that Tullow shall give notice to Heritage of the tax claim within 20 business days.

The government considered that Heritage was liable to pay tax in respect of the profit on the sale. Heritage asserted that it was not taxable in Uganda due to the structure of the deal and the double tax treaty between Uganda and Mauritius. As a result of the dispute between Heritage and the government, the government decided to place the burden on Tullow and served notices to that effect on 27 July 2010 and 2 December 2010, copied to Heritage. After a period of negotiation, Tullow and the government agreed and signed a memorandum of understanding on 15 March 2011 for the payment of $313,447,500. On 17 March 2011, Tullow gave Heritage notice that it had received a tax demand from the government.

One of the key issues in the case at first instance and on appeal was whether, by virtue of Article 7.5(a) outlined above, Tullow’s failure to notify Heritage of the tax claim disentitled it to claim under the indemnity provision in Article 7.2. Heritage asserted that the article was a condition precedent.

Decision at first instance

Burton J found at first instance that it was plain that compliance by Tullow with the notice requirement in Article 7.5(a) was not a condition precedent to Heritage’s liability to indemnify Tullow. He stated that it was clear Heritage knew about the tax liability through the notices served by the government and went on to provide four reasons for his decision:

  1. Article 7.4 contained a condition precedent that used the words ‘shall not apply unless’. Burton J stated that in a commercial agreement, it would be expected that a condition precedent would be in such clear terms. He concluded that the inclusion of a condition precedent elsewhere meant that the absence of similar wording in Article 7.5(a) was deliberate.
  2. That on a true and proper construction of the commercial agreement, it was unlikely that a minor breach of the notice requirement would disentitle Tullow to claim under the indemnity.
  3. The wording in Article 7.5 was not limited to sub-article (a) but applied to a number of other sub-articles which were inappropriate as part of a condition precedent.
  4. Tullow referred to Article 15.7 of the agreement which provided for the indemnity to survive a breach of duty by Tullow.
Decision at appeal

Heritage appealed on the basis that Burton J had erred in holding that Article 7.5(a) was not a condition precedent to a claim under Article 7.2. The first of several arguments that Heritage deployed was that the judge had failed to consider Article 7.3 and in particular the concluding words that it ‘is subject to the following provisions of this Article 7’. Heritage submitted that the use of ‘subject to’ indicated that Article 7.5(a) was a condition precedent.

Second, Heritage argued that the judge was wrong to refer to Article 7.4, which was a long stop provision for indemnity claims. Heritage stated the article did not indicate that indemnity claims were not also subject to compliance with Article 7.5(a).

Third, Heritage stated that the commercial purpose of Article 7.5(a) would be undermined if, notwithstanding a failure to comply with it, questions of causation, the impact of a breach and the damage caused would have to be investigated. It submitted that construing the article as a condition precedent would provide certainty.

Heritage also pointed to Aspen Insurance UK Ltd v Pectel Ltd [2008] to argue that it was the substance of the clause that was relevant to the determination, not the express use of the words ‘condition precedent’. This was referenced in support of a further argument that where there was a list of items in a single paragraph, some may be conditions precedent while some may not. Heritage therefore stated that Burton J was wrong to rely on the fact other sub-articles were inapposite as condition precedents. In summary, Heritage’s submissions were that Article 7.5(a) was to be seen in the context of a balanced system of interlocking rights set up by Article 7.

Analysis by the Court of Appeal

Lord Justice Beatson, in delivering the leading judgment, drew on the general appreciation by the courts that, while classifying a term as a condition precedent may provide certainty, it could also have the effect of depriving a party to a contract of a right because of a trivial breach, which had no or little prejudicial effect on the other or caused no loss. He referred to Lord Roskill’s judgment in Bunge Corp v Tradex International SA [1981] to highlight the courts’ tentative approach to the construction of conditions:

‘… the basic principles of construction for determining whether or not a particular term is a condition remain as before, always bearing in mind on the one hand the need for certainty and on the other the desirability of not, when legitimate, allowing rescission where the breach complained of is highly technical and where damages would clearly be an adequate remedy’.

Beatson LJ also accepted that, while the words ‘condition precedent’ were often expressly used in notification of claims clauses, it was clear that other words could have the same effect so long as the clause was apt to make that effect the clear intention of the parties.

Decision

Beatson LJ upheld the decision at first instance. In particular he made clear that the parties were quite capable of drafting condition precedents in other sections of the agreement, namely Article 7.4, and therefore it was significant that Article 7.5 contained no words to that effect.

He also stated that, in light of the authorities relied upon to underline the court’s reluctance to find condition precedents, the fact that the effects of a breach of the notice requirement might either be serious or minor was also a reason for not finding that Article 7.5 was a condition precedent, absent clear language.

Beatson LJ also reviewed the structure of Article 7.5 and stated the introductory word ‘shall’ which preceded the sub-articles was universally applicable and therefore it could not be the case that compliance with one of the sub-articles was a condition precedent, when compliance with other sub-articles was not. He went on to say that Heritage only received marginal assistance fromAspen Insurance UK Ltd v Pectel Ltd as, in that case, the items in the list were separate and free-standing and had been thematically grouped under a condition which dealt with the claims procedure, whereas, in the present case, Articles 7.5(a) and (b) were introduced by the same sentence where the introductory word ‘shall’ governed each of the two limbs.

Beatson LJ concluded by dismissing Heritage’s assertion that the articles were a careful and balanced system of interlocking rights. He again highlighted the inclusion of express condition precedents in Article 7.4 and stated that construing the words ‘subject to’ (outlined above) would have made each and every individual provision in Article 7 a condition precedent which was an unlikely and commercially unrealistic construction.

COMMENT

As to the ‘why and ‘when’ in the title, condition precedents can provide crucial protections for parties subject to onerous obligations. The first step is to identify those requirements which are so burdensome that they need additional protections. This emphasises the importance of instructing lawyers with experience of the kind of issues that can arise and who can clearly think through the risks. It is unclear why Heritage did not insist on a condition precedent in respect of the capital gains tax liabilities. One possibility noted by the Court was that Tullow had provided its own indemnity, without condition precedent, in respect of other tax liabilities. We do not know if those liabilities would have been equally substantial. It may have been that Heritage had anticipated that its switch to the Mauritius tax code would preclude it from any liability for capital gains tax. However, this did not provide any assistance either. Perhaps neither of these outcomes were predictable at the outset, but the starting point should be to determine your ultimate liability if matters do not go to plan and work backwards from there.

And the ‘how’? Once you have decided that the obligation is significant enough, the next step is to get the drafting right. The lesson from this case is clear. Use consistent language such as ‘shall not apply unless’ and use the phrase ‘condition precedent’ to avoid any argument.