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Technology, Media & Telecommunications

Focus: The importance of being earnest – defining termination events

8 November 2010

In brief: A ruling of the New South Wales Court of Appeal last week highlights the desirability of defining termination events in commercial contracts with clarity and specificity. Special Counsel John Dieckmann reports on a decision that has particular relevance to the technology sector, where contracts often deal with projects and services having complex requirements.

How does it affect you?

  • Last week, the NSW Court of Appeal concluded that a failure by a party to comply with its 'main' obligations under a contract did not necessarily amount to 'material' non-compliance' with the terms of the contract, and that instead it was necessary to consider whether it had materially failed to comply with its obligations under the contract 'as a whole'. The court also made comments to the effect that it was arguable that defects in the construction work required to be performed under the contract in question, which posed substantial risk, were costly to rectify and required immediate rectification, would not necessarily amount to 'material non-compliance' with its obligations as a whole.
  • This decision has implications for many commercial contracts, particularly those used in the technology sector, which commonly limit a party's ability to terminate the contract to situations where there as a been 'a material breach' by the other party of its obligations, yet often specify very detailed technical requirements which need to be met.
  • Customers should avoid placing heavy reliance on generic rights to terminate for 'material breach' in technology contracts. If a right to terminate the project is required in specific scenarios, those scenarios should be defined in the contract as far as possible to avoid later dispute (and potential liability for wrongful termination).

Background

In 2006, Lucas Stuart Pty Ltd agreed to construct, for Hemmes Hermitage Pty Ltd, a restaurant and bar known as 'The Ivy' in Sydney. Lucas Stuart provided various performance bonds to Hemmes Hermitage as security for the performance of its obligations under that contract.

The contract entitled Hemmes Hermitage to call upon that security if Lucas Stuart failed to comply with the terms of a notice given under clause 16.2 of the contract. That clause entitled Hemmes Hermitage to notify Lucas Stuart of a breach of the contract, and the actions required to remedy it and the timeframe for doing so, if Lucas Stuart 'has not materially complied with its obligations under this contract'.

Practical completion certificates were issued in respect of the development, but those certificates noted the existence of 'major defects and outstanding Practical Completion deliverables' and cited them as reasons for not releasing the performance bonds. Notices were subsequently issued by Hemmes Hermitage and its project director under clause 16.2 of the contract, citing numerous defects and requiring their rectification by specific dates. Lucas Stuart then sought an injunction to restrain Hemmes Hermitage from calling upon the performance bonds, on the basis that the condition in clause 16.2 of the contract had not been satisfied and hence the notices issued under that clause were invalid. The case concerned whether there was a serious question to be tried as to whether or not there had, in fact, been a 'material non-compliance' by Lucas Stuart with its obligations under the contract, so as to justify the issue of an interlocutory injunction. Lucas Stuart was unsuccessful at first instance and appealed to the New South Wales Court of Appeal.1

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The decision at first instance

At first instance, the trial judge noted some of the potential meanings of the word of 'material' in the context of non-compliance, including 'genuine', 'essential' and 'of much consequence'. However, his Honour found that it was not necessary to resolve that issue, because the requirements of clause 16.2 were satisfied if it could be established that Lucas Stuart had breached one of its 'main obligations' in the contract. His Honour went on to conclude that a generic, overarching obligation in the contract requiring Lucas Stuart to construct the relevant premises was one of the 'main obligations' under the contract, that the obligation had been breached and hence that the requirements of clause 16.2 had been satisfied. On this basis, the court found that the issue of whether the notices issued by Hemmes Hermitage were valid did not raise a serious issue to be tried, and declined to grant the injunction.

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On appeal

The Court of Appeal, in overturning the original decision, ruled that the question of whether there had in fact been 'material non-compliance' by Lucas Stuart with its obligations under the contract did raise a serious question to be tried. The key difference between the approaches of the lower court and the Court of Appeal was the interpretation given to clause 16.2, and in particular what was meant by a failure of Lucas Stuart to 'materially comply with its obligations under the contract'.

In delivering the main judgment of the Court of Appeal on the legal effect of the contract, Appeal Justice Macfarlan commented that the interpretation adopted by the lower court would have meant that any failure, however minor, by Lucas Stuart to comply with its overarching obligations under the contract would have resulted in clause 16.2 being triggered, and would have rendered the word 'materially' in clause 16.2 redundant. This led his Honour to conclude that, on a proper construction of clause 16.2, what was required to justify the issue of a notice was that Lucas Stuart had 'failed materially to comply with its obligations under the Contract, with those obligations being looked at as a whole', and that this was not the same as simply considering whether there had been a breach of one of the 'main' obligations under the contract.

Appeal Justice Macfarlan also commented that there was evidence presented at trial to the effect that some of the defects specified in Hemmes Hermitage's notice 'posed substantial risks, are costly to repair and do require prompt rectification'. His Honour stated that while those defects might have amounted to material non-compliance by Lucas Stuart with its obligations under the contract, it was not clear whether or not there had in fact been material non-compliance. In other words, Hhis Honour recognised that it was possible that such defects, on their own, were not sufficiently serious as to amount to 'material non-compliance' with the terms of the contract as a whole.

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Lessons to be learned

Although, given the nature of the proceeding, it was not necessary for the Court of Appeal to make a final determination as to whether Lucas Stuart had failed to materially comply with its obligations under the contract, the decision does illustrate the potential danger in relying too heavily on generic concepts such as 'material breach' when defining key rights of the parties under a contract. This is particularly relevant to contractual rights of termination in technology contracts, which are often linked to there having been some 'material breach' or 'material failure' of a party in relation to the performance of its obligations under the contract in question, even though the contracts themselves often prescribe a range of detailed technical specifications and requirements for the products or services in question and involve a relatively high degree of implementation risk.

As the Lucas Stuart decision shows, the question of whether a right of termination will arise in particular circumstances will depend on the proper interpretation of the contract as a whole (judged objectively), and may not necessarily align with the circumstances which either party may have presumed or intended would justify termination. This is not a novel legal principle. However, the decision provides a salient reminder of the importance of achieving clarity in relation to termination rights, given that the improper termination of a contract will itself constitute a repudiation of the agreement which entitles the other party to recover damages from the 'innocent' party.

In contracts involving complex projects or services, such as IT implementation projects and outsourcing arrangements, a range of things may go wrong that, may not necessarily be found to be 'material' in light of the totality of the supplier's obligations under the contract as a whole, but the operational impact of which may be sufficiently serious to justify, from the customer's perspective, termination. Organisations entering into contracts for technology projects or services should therefore give consideration to defining particular circumstances which, in addition to more generic concepts such as 'material breach', will justify the termination of the contract. Common examples of such events include:

  • failures to achieve key milestones by a prescribed date;
  • failures to rectify defects identified through an acceptance testing process within a prescribed time period after the date for completion of those tests;
  • the standard of services falling below specified thresholds of acceptability; and
  • the occurrence of a prescribed pattern of service level breaches (indicating systemic problems).

It is sometimes difficult to envisage, at the outset of a project, all of the circumstances in which one might wish to bring the project to an end – particularly at a time when the focus of all concerned is on making the project a success. However, the careful drafting of such provisions at the outset can help to avoid the pain of a failed project being compounded by the need to negotiate the termination of the project, in circumstances where the customer's rights to terminate the contract are not clear.

Footnotes
  1. Lucas Stuart Pty Ltd v. Hemmes Hermitage Pty Ltd [2010] NSWCA 283.

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