Terminating a contract – when is it too late to act?
Acting in a commercially sensible way to avoid a dispute rather than terminate a contract can have unfortunate consequences
Managing the performance of contracts in any business is often a legal minefield, particularly when a contractual counter-party is falling short of their obligations and consideration has to be given to terminating the contract (whether under an express right or the general implied right based upon fundamental breach).
In a breach situation parties will often first try to resolve performance difficulties in a commercial manner and work through their differences before resorting to a termination right. The NSW Court of Appeal has ruled in the recent case of Donau Pty Ltd v ASC AWD Shipbuilder Pty Ltd  NSWCA 185, you can easily lose your right to terminate if you sit on your termination right for too long and do not exercise it with due expedition.
Unfortunately, taking a commercially sensible course can have the consequence that your legal rights are compromised.
Donau Pty Ltd v ASC AWD Shipbuilder Pty Ltd  NSWCA 185
In this case, ASC AWD Shipbuilder Pty Ltd (ASC) was part of a consortium appointed by the Commonwealth in 2007 to deliver three Air Warfare Destroyers for the Royal Australian Navy. ASC in turn retained Donau Pty Ltd (formerly known as Forgacs) to build and deliver significant sections of the new ships.
The ships have now been delivered and are being commissioned. However there were a number of delays during the program. In order to address those delays, ASC and Forgacs agreed to reset their timelines and payment terms in a new agreement that supplemented and amended their existing contracts. This is a common and practical way for contractual counter-parties to move forward after a project has stalled.
In the new agreement, the parties gave themselves two months to use their reasonable endeavours to agree upon the new commercial terms. If that did not occur, then ASC was entitled to terminate the new contract and the parties would revert to the existing payment terms. There was no express time limit for exercising the termination right once it had arisen.
The parties were not able to agree upon the new terms within the time allowed under the new contract. ASC therefore had the right to terminate. But not unusually, ASC did not immediately terminate. Instead, it took what might be regarded as a commercially sound decision to continue working with Forgacs in good faith to seek to agree upon the new terms.
Three and a half months after the date on which the right to terminate first arose, ASC realised that new commercial terms were not going to be achievable by negotiation. It therefore exercised its express termination right and terminated the new agreement.
Forgacs cried foul, saying among other things, that it was too late for ASC to terminate and that ASC’s right had expired even though there was no express time limit on ASC exercising its termination rights.
What did the Court say regarding delays in exercising termination rights?
The Court of Appeal agreed with Forgacs that it was too late for ASC to terminate even though the contract did not set a time limit for that right to be exercised. The Court also said that, where a contract is silent as to how long a party has to exercise a termination right, then, under contract law principles, there is generally an implied (unwritten) requirement that it be exercised within a 'reasonable time'.
What is a 'reasonable time'?
The Court said that a reasonable time within which to exercise a termination right will depend upon all of the circumstances.
The Court gave very little useful guidance on how the reasonable time is to be determined by parties to a contract. It concluded that ASC would lose its termination right if not exercised ‘promptly’ and then reached the conclusion that at paragraph :
a 'reasonable time' had long since passed when ASC purported to exercise its right to terminate. It follows that the 2HA was not validly terminated...
What that means in practical terms is difficult to determine in respect of any particular contract. It will depend upon amorphous legal arguments and ultimately a court will declare, after the event, what was reasonable.
However, the Court mentioned on numerous occasions that in this case, there was no reservation of rights by ASC and no standstill agreement. The clear implication was that these devices could make a critical difference in determining a reasonable time.
In the case, the related but distinct legal principle referred to as 'election' was also an issue. It is sometimes referred to as waiver although that is usually not the correct legal characterisation.
Unlike running out of time to exercise a termination right, in this context, election refers to conduct by which a party is taken to have affirmed the continuation of the contract and renounced their right to terminate. This occurs when the party does something that is unequivocally consistent only with continuing with the contract rather than terminating.
Once an election is made, the termination right relating to the triggering event in question is lost for good and cannot be revived.
In Donau, it was also argued by Forgacs as a separate argument, that by continuing to negotiate under the new contract after the termination right had arisen, ASC had elected to affirm the new contract and given up its termination right.
However, the Court held that an election resulting in the loss of a termination right has to have precision and clarity. It is not sufficient that the relevant conduct be consistent with continuing with the contract. It must be inconsistent with preserving any continuing right to terminate.
In this case, the Court held that ASC did not elect (in the legal sense) to continue the new contract. Its conduct in continuing to negotiate was not sufficiently unequivocal as to amount to a renunciation of its termination right.
What can we learn from the case?
The Court of Appeal has confirmed that the parties' conduct when a termination right has arisen is fraught and, arguably, unnecessarily strict.
Acting in a commercially sensible way to avoid a dispute rather than terminate, can have the unfortunate consequences that a termination right is lost if you do not first secure certain acknowledgements or protections. This can mean parties are required to act in a manner that might be unhelpfully contentious at a time when the parties might be sensibly seeking to avoid a legal escalation of their difficulties.
The reservation of rights is absolutely critical. It can, in many circumstances, significantly decrease your chances of losing your termination rights by effluxion of time or by election.
But a simple statement that rights are reserved is unlikely to be sufficient. Losing a termination right can come down to what particular words may have been used in emails or conversations. Consideration needs to go into drafting every communication once a termination right has arisen.
As always, it is best if the parties' intentions at the time are reflected in a new agreement such as a standstill deed or a formal amendment extending time before the termination right is triggered, which is more easily said than done and will depend upon foresight, legal advice and the dynamics of the parties’ relationship.
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