Termination of construction contracts: the good faith risk

In the recent decision of Bundanoon Sandstone Pty Ltd v Cenric Group Pty Ltd¹ (Bundanoon) the New South Wales Court of Appeal held that a notice to show cause issued by a principal in the context of a termination regime in a construction contract was invalid on good faith grounds, with the consequence that the principal’s subsequent termination of the contract constituted a wrongful repudiation.

Ever since the decision of Priestley JA in Renard Constructions (ME) Pty Ltd v Minister for Public Work² there has been ongoing controversy in the Australian courts as to the existence and content of a duty of good faith in the exercise of contractual powers and discretions, including in respect of the exercise of termination rights such as termination for convenience.

In Sino Iron Pty Ltd v Mineralogy Pty Ltd (No 2)³ Edelman J whilst sitting as a member of the Western Australia Supreme Court said:

The question of implication of a term of good faith into commercial contracts remains a vexed question.

In Commonwealth Bank of Australia v Barker⁴ the High Court had an opportunity to clear the air but declined to do so.

In the absence of any binding High Court authority, the New South Wales Court of Appeal has taken its own path and consistently stated that a duty of good faith in the performance and enforcement of commercial contracts is to be implied as a matter of law. This would encompass construction contracts. In Cordon Investments Pty Ltd v Lesdor Property Pty Ltd⁵ (also a construction contract dispute) Bathurst CJ said:

Lesdor did not dispute that it was appropriate to imply into the Agreement an obligation that the parties would act in good faith towards each other. This is consistent with the approach adopted in a number of decisions of this Court: …

In Bundanoon the New South Wales Court of Appeal continued along this path in dealing with the validity of the relevant show cause notice.

In short compass the facts were as follows.

On 20 June 2017 TWT Property Group Pty Limited (TWT) and Cenric Group Pty Limited (Cenric) entered into a head contract for demolition, shoring and excavation works by Cenric at a site in Pyrmont. Those works included the excavation of yellow block sandstone. With the approval of TWT, Cenric subcontracted the Works to Bundanoon who agreed to pay royalties based on the sale price of the harvested sandstone. Under the head contract Cenric agreed to pay TWT 50% of the realised sale price of harvested sandstone. However, by a letter agreement dated 30 June 2017 it was agreed that Cenric would pay TWT 50% of royalties received from Bundanoon until Cenric had retained $3M for itself. Thereafter the whole of the royalties received from Bundanoon would be payable to TWT.

At a meeting of the representatives of TWT, Cenric and Bundanoon held on 19 February 2018 the parties orally agreed to a variation of the head contract which covered, the following:

1. The head contract would be varied to include the additional so called Bench 4 Works and the subcontract would be likewise varied.
2. TWT would not seek to recover liquidated damages from Cenric for delays up until 19 February 2018.
3. TWT would grant Cenric a 7 week extension of time.
4. Royalties payable by Bundanoon on Bench 4 Works would be $1,200.00m3.

Thereafter, the relationship deteriorated. In particular TWT was dissatisfied with Cenric’s rate of progress. On 9 March 2018 TWT served a notice to show cause under the default and termination provisions of the head contract. The substantial breach alleged was a failure to progress the works diligently and with due expedition. On 19 March 2018 TWT served a take out notice which was in substance a termination of the head contract. On 20 March 2018 Bundanoon terminated the subcontract.

On 23 March 2018 TWT retained Bundanoon to carry out the remaining work under the subcontract.

Cenric commenced proceedings against TWT for damages for the wrongful termination of the head contract and against Bundanoon for recovery of unpaid royalties.

Findings of the primary Judge

The primary Judge, having determined that the oral variation was contractually enforacble, held that the show cause notice was invalid for three reasons:

1. The extension of time granted to Cenric under the oral variation was inconsistent with the alleged substantial breach that Cenric had proceeded otherwise than diligently and with due expedition.
2. The show cause notice was not issued in good faith. The evidence of the decision maker given in the course of the trial left no doubt that he had a closed mind in respect of the show cause notice. He had resolved to terminate the head contract irrespective of the content of any response from Cenric. This constituted a breach of the duty of good faith.
3. The show cause notice was issued for an ulterior purpose in that TWT’s true motivation in issuing the show cause notice was to obtain for itself the royalties derived from the additional work to be performed by Cenric and in turn by Bundanoon.

The orders of the primary Judge

1. TWT was not entitled to either liquidated damages or to the costs to complete the head contract, but was entitled to participate in the royalties received by Cenric from Bundanoon in respect of work carried out prior to termination in accordance with the head contract as amended by the 30 June 2017 letter agreement.
2. Cenric had an entitlement to damages for the wrongful repudiation of the head contract but in this case it did not prove that it had suffered any loss.
3. Bundanoon was not entitled to terminate the subcontract and that Cenric was entitled to royalties on sandstone harvested prior to termination subject to a set off for any unpaid work. In this regard Cenric was entitled to some $3.9 million for which it had to account to TWT in accordance with the 20 June 2017 letter agreement.

The appeal to the Court of Appeal

The Court of Appeal upheld the decision of the primary Judge and the correctness of his reasons for judgment. In delivering the principal judgment of the Court, Gleeson JA noted that the determination as to the enforceability of the oral variation agreement was dispositive of the validity of the show cause notice. Strictly therefore the good faith issue did not arise. However, this does not dilute the significance of Gleeson JA’s conclusion as to the applicability of good faith to the decision to issue the show cause notice.

Gleeson JA in dealing with the applicable legal principles said:

It is well accepted that, where a contractual power is given to one party for a purpose but in terms wider than necessary for the protection of its legitimate interests, the exercise of the power may be constrained by implied obligations of reasonableness and good faith.

His Honour noted the comment by Bathurst CJ in Cordon that the necessity for the implication of a term as to good faith had not been universally accepted. Relevantly, the Court of Appeal of Victoria does not accept that a duty of good faith is to be implied into commercial contracts as a matter of law.⁶

Key points to note

1. This decision highlights once again the inherent risks associated with invoking a termination power under a contract. Accordingly, a contracting party contemplating the exercise of a putative termination right should seek legal advice.
2. The decision to issue a show cause notice under the default and termination regime of a construction contract is subject to a good faith test. That involves acting honestly and not capriciously, arbitrarily or for an ulterior purpose.
3. Essentially, good faith goes to the motivation of the party exercising the relevant contractual power or discretion. As was eloquently demonstrated in Bundanoon, true motivation may be exposed in the course of a rigorous cross examination by a skilled advocate. Under the pressure of such cross examination a party may be unable to conceal motivation.
4. Critically, if a principal to a construction contract terminates the contract following an invalid notice to show cause, such termination will amount to a wrongful repudiation thereby giving the contractor its own right to terminate the contract and to seek loss of bargain damages.