Legal Briefing

When diamonds aren’t forever… mishandling termination of contracts

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Corporate and commercial | 01 November 2014

Terminating a commercial contract can be fraught with pitfalls and too often a decision is taken to terminate without a full appreciation of the legal and financial consequences. The High Court underlined those risks in the recent case ofComau UK Ltd v Lotus Lightweight Structures Ltd [2014], and took the opportunity to lay down guidance on the interplay between so-called ‘termination for fault’ provisions and ‘termination for convenience’ provisions, in the context of a damages claim for repudiatory breach. 


An interesting case on its facts, and acknowledging upfront the first instance nature of the decision (and that it was an application for summary judgment), the decision has wider implications for the assessment of damages in repudiatory breach cases generally. Taken to its logical conclusion, the Comau decision effectively limits the damages which might be awarded to innocent parties faced with a repudiatory breach of contract, should that contract include a termination for convenience clause, as many often do.

Even if claimants get over the hurdle of proving repudiatory breach, which is often hard to surmount, they may yet be faced with the prospect of recovering only minimal damages as opposed to full ‘loss of bargain’ damages over the life of the contract. This can be the case whether or not evidence is adduced that a convenient termination would have occurred in reality. The judge in this case seemed to treat the very existence of the clause itself as a reason to limit the damages.

FACTS OF COMAU

Comau (which is part of the Fiat group) contracted to supply goods and services for a new production line (to manufacture chassis) at a Lotus factory. The contract provided for staged payments of the contract price in accordance with a payment schedule. Lotus failed to make two payments of £293,061 and £586,122 respectively.

The contract contained a relatively standard ‘termination for fault’ clause, allowing either party to terminate if the other committed a ‘material breach’ of a condition of the contract, having failed to remedy that breach within 30 days of written notice. It also contained a ‘termination for convenience’ clause which allowed Lotus, if it was not in breach of any payment obligations, to terminate the contract immediately, whereupon its liability to Comau would be limited to the price of any work completed and not paid for, plus additional specified costs.

Following Lotus’ failure to pay up, Comau suspended performance of its own obligations and pressed Lotus for payment of the outstanding sums. While Lotus subsequently paid the first invoice in full and 10% of the second, it failed to settle the balance, some £530,000. Comau wrote alleging that Lotus’ failure to do so amounted to a material breach of contract and served notice requiring the breach to be rectified within 30 days, otherwise the contract would be terminated. Lotus did not pay up, or even respond to the letter, so Comau proceeded to terminate. Comau argued, among other things, that the non-payment by Lotus amounted to a repudiatory breach of contract which it accepted by notice of termination.

Comau commenced a claim for the balance of its unpaid invoice, as well as damages equal to its lost profits on the entire project as a result of the termination of the agreement. Lotus consented to judgment on the sum outstanding under the second invoice, but resisted Comau’s wider damages claim. The principal question before the Court on a summary basis was whether Lotus was in repudiatory breach of the agreement by failing to pay the sums outstanding, the effect of which would have significant commercial impact.

REPUDIATORY BREACH

At common law, a party can terminate a contract if the other party has repudiated that contract (i) by renouncing their liabilities under it; (ii) by making performance of the contract impossible by their own act; or (iii) by total or partial failure of performance which goes to the root of the contract. The expression ‘repudiatory breach’ also encompasses a situation where one party breaches a condition of the contract, for example where the parties have expressly agreed that a time/date for delivery of a product is ‘of the essence’, and the delivering party fails to perform. All of these circumstances can be grouped together under the concept of termination at common law, which is distinct from termination pursuant to an express contractual term.

It can be a matter of considerable importance to distinguish termination under a contractual provision from termination at common law. A contractual right to terminate can be exercised even if the breach is not sufficiently serious as to justify termination at common law, and even if there is no breach at all. The path chosen can make a substantial difference to the amount of damages recoverable so making a prudent choice is critically important.

With termination pursuant to a contractual term, the innocent party will be entitled to damages for breach of any obligations which took place prior to that termination, and also to any damages specifically provided for in the contract. The picture can be much bigger, however, with a common law termination for repudiatory breach, as the innocent party may be entitled to full ‘loss of bargain’ damages to put them in the position they would have been in had the contract been honoured (subject to their duty to mitigate their loss). The repudiation route can therefore include profits that would have been earned over the whole life of the contract.

It must be remembered that repudiatory breach of a contract does not by itself discharge further performance of the contract and therefore the innocent party must choose whether to accept the breach and bring the contract to an end, or affirm the contract and claim damages for losses suffered as a result of the breach. There is no set form of communication by which the innocent party must accept a repudiatory breach, but it requires clear and unequivocal wording (oral or written) or conduct. Best practice is therefore that the termination notice makes clear whether termination is under the contract or at common law or perhaps alternatively at common law and contractually, to cover the situation where it is found that no repudiation has in fact occurred – Shell v Dana Gas [2010].

THE ‘MINIMUM PERFORMANCE’ OR ‘LEAST ONEROUS OBLIGATIONS’ RULE

Before turning to the Court’s findings in Comau, it is worth explaining the other key legal issue which underpins the decision. This is the so-called ‘minimum performance’ or ‘least onerous obligations’ rule, which is derived from cases such as Paula Lee v Zehil Ltd [1983], Durham Tees Airport v BMI Baby [2010] and the much earlier Abrahams v Herbert Reiach Ltd [1922].

In essence, this rule states that where a defaulting party to a contract had an option to perform that contract in several ways, damages will be assessed on the basis that they would have performed it in the way which would have benefited them most (or, to put it another way, would have cost them the least).

THE COMAU JUDGMENT

In the Comau case, the Court held that Lotus had a real prospect of successfully defending the allegation of repudiatory breach, on the basis that (among other things) Comau’s letters at the time had referred only to contractual termination and not to termination for common law repudiation. Although the judge did not rely on Shell v Dana Gas, it is clear that the decision is consistent with the principles emerging from those cases. In particular, the judge gave some guidance on how Comau might have successfully preserved the right to rely on a common law termination case:

‘It was open to Comau to send a further letter making quite clear that it was proposing now to rely on its rights at common law, and to that end it was making time of the essence and that it would treat continued unexplained failure to pay as in repudiatory breach. 
It did not do this.’

The Court disagreed with Comau’s argument that it was entitled to the loss of profits it expected to earn over the whole life of the contract. The judge noted that, in certain circumstances, the terms of the contract allowed Lotus to terminate the contract early for convenience, which would limit the compensation that Comau would otherwise be entitled to. He therefore applied the ‘least onerous obligations’ rule and held that damages were to be assessed on the assumption that, but for Comau’s termination, Lotus would have immediately exercised its right to terminate for convenience. Interestingly, no evidence was adduced to support that this is what Lotus would have done – the existence of the clause itself seems to have been treated as determinative by the judge.

Comau’s contractual ‘expectation interest’ was therefore limited to the profit it 
might have made until such time as Lotus chose to exercise its right to terminate 
for convenience. On that basis, the Court held that even if Comau had established liability, it would only have been entitled 
to nominal damages.

COMMENTARY

There are broad legal issues that were not expressly addressed in the Comau decision. For example, does a contractual power to terminate exclude a common law right? Should the termination notice make clear whether termination is under the contract or at common law? However, the answers to these questions are implicit from the judge’s comments, which highlight all too clearly how easy it is to get a contract termination wrong and find that a termination notice has effectively affirmed the contract and precluded any ability to argue subsequently for repudiatory breach and whole of contract damages.

What the Comau decision does comment on clearly, however, and to the claimant’s detriment, is the potential impact of a termination for convenience clause on a damages claim for expectation loss or loss of profits. Termination for convenience is the ‘lesser’ obligation, compared with the alternative of making all the payments due under the full life of the contract, and, applying the principle that the defendant would have fulfilled their obligations in the way least onerous to them, the judge held that a claimant’s ‘loss of bargain’ damages in a claim for repudiatory breach will effectively be capped by any applicable termination for convenience clauses in the contract.

To highlight the potential effect of the decision with an extreme example: if a party wrongfully terminated a ten-year year contract in year one, but that contract contained a termination for convenience clause allowing early termination on three months’ notice, it is likely that a court would only award a maximum of three months’ lost profits to the innocent party (unless that party could adduce sufficient evidence to rebut the presumption of early termination – which would lead to a certain amount of ‘crystal ball gazing’) on the basis that the other party would have availed itself of the right to terminate on this notice. To decide otherwise, on the judge’s reasoning in Comau, would be to assess damages on the basis that the claimant had made a better bargain than it in fact had made.

The Comau decision can, however, be contrasted with another recent case, 
Gul Bottlers (PVT) Ltd v Nichols plc 
[2014], where a defendant had repudiated a five-year distribution contract which gave the claimant an option to renew for five years. The Court in that case held that the ‘least onerous obligations’ rule did not apply on the facts and therefore awarded the claimant full loss of bargain damages on the basis that it would have run a profitable operation and would have renewed the agreement for a further five years. The judge in Gul Bottlers seemed to place some significance on what he described as ‘disgraceful’ behaviour by the defendant. This is a salutary reminder of how a court may be prepared to interpret evidence in favour of one party when it has formed a very poor view of the other.

CONCLUSION

Although Comau was only a first instance decision on an interim application, it is a powerful reminder that claimants should be alive to the fact that their ‘expectation interest’ (and any related damages for repudiatory breach) can be seriously curtailed in circumstances where the applicable contract contains a termination for convenience provision. This has implications both for how contracts are initially drafted and on deciding whether, and how, to terminate. Termination for convenience clauses will, however, continue to make sound commercial sense in many contractual situations; the key is to understand beforehand what they bring and what they might take away.