Managing the non-performing contractor and preserving contract termination rights

Introduction

Termination of a supply or services contract because of contractor non-performance is not always the Commonwealth’s preferred option. Termination is a drastic step and is usually accompanied by the risk of a wrongful termination potentially involving costly litigation and associated schedule delay.

As an alternative, the Commonwealth may choose to engage in negotiations with the non-performing contractor with a view to getting the project back on track. Such negotiations may produce changes to payment entitlements, scope, schedule and to some of the other commercial terms and conditions. This may culminate in entry into of a supplementary or variation deed. Negotiations may extend over a considerable period and may be conducted through email correspondence, letter and face-to-face meetings.

However, there is always the possibility that a negotiated resolution may not be attainable in which case the Commonwealth may wish to have recourse to an accrued right to terminate. The practical question is whether the right to terminate has survived the negotiation process. There is a clear legal risk that the right may have been lost because of the Commonwealth’s conduct during the process. In assessing this risk there are two fundamental questions to be considered:

• First, what are the legal principles which determine the circumstances in which a right to terminate a contract may be lost by reason of conduct, and
• Secondly, what practical steps are available to the Commonwealth to mitigate the risk while conducting negotiations with the non-performing contractor.

The core legal principles

Under current Australian law a right to terminate a contract may be lost as a result of conduct in the following circumstances:

• by operation of the equitable doctrine of promissory estoppel
• by an election, and
• by failing to exercise the termination right within a reasonable period of time. 

Equitable promissory estoppel

A contracting party will be prevented from exercising an accrued termination right if the following conditions are satisfied:

• the party unambiguously represents that although it enjoys a termination right it does not intend to exercise it
• the counterparty relies on the representation by taking certain action or omitting to take action on the assumption that the termination right will not be exercised, and
• the counterparty having relied on the representation will suffer a material prejudice if the first party were to resile from the representation. 

The underpinning rationale of this form of estoppel is the prevention of unconscionable conduct which is the traditional province of equity jurisprudence. 

Election 

A contracting party confronted by two alternative rights or sets of rights, such as the right to terminate a contract and the right to affirm it and insist on performance, may irrevocably lose one of them by acting in a manner which is consistent only with his having chosen to rely on the other. For example, where a lessor with a right to terminate a lease continues to receive rent such conduct is consistent with his rights as lessor and inconsistent with the exercise of a right to terminate. 

An act amounting to an election must be unequivocal. The Australian courts have noted that the right to terminate is not necessarily lost by a party doing any act consistent with the continuance of the contract if the act is also consistent with the reservation of a right to terminate in certain events. It is always important to examine conduct in the context of the circumstances as a whole. The question to be answered is whether the party having the right to terminate has communicated to the other an unequivocal election to affirm.

The key practical point to note is that an affirmation or election need not be the result of a conscious decision to continue with the contract. A court will decide whether the conduct constitutes an affirmation. 

It is also important to note that a party confronted with a choice between inconsistent rights is not bound to elect at once. The question may be kept open as long as there is no affirmation and the delay does not prejudice the other party. 

At a conceptual level, an election unlike an estoppel, is concerned with what a party does and not what he causes the other party to do. 

Failure to terminate within a reasonable period of time

The Australian courts have recognised that where a party has an accrued right to terminate there is an implication that that right must be exercised within a reasonable period of time. The courts have also recognised that although delay may not in itself constitute an election it may result in the loss of a termination right. In this context the courts have made the point that election is concerned with the conduct of the person who has the right while the implied limitation based on a reasonable time within which to exercise the right is concerned with what is fair and reasonable having regard to the terms of the contract. 

From a purely practical perspective it is, therefore, important to appreciate that although there may be no conduct supporting loss of a termination right by election the right may be lost by reason of delay. Election and delay are independent concepts each of which may result in the loss of a right to terminate the contract. 

The ever present difficulty is the determination of what constitutes a reasonable period of time. This is a question of fact. On this point the courts have stated that what is a reasonable time in any given case may be affected by the nature of the obligation to be performed, for example, whether it is dependent on some third party performance or circumstances outside the control of the party under the obligation. 

Mitigating the risk

While negotiating with a non-performing contractor there are a number of practical steps which the Commonwealth may take to better preserve a termination right. 

First, the use of email correspondence presents inherent risk. The difficulty is that this form of exchange is often conducted in fairly informal language and statements may be made in relation to the enforceability of contractual rights which may be used to establish a promissory estoppel. It is therefore critically important to ensure that such correspondence is well and thoughtfully managed. 

Secondly, in order to minimise the risk of an election by conduct it would be prudent to enter into a standstill agreement with the contractor. This particular device has been recognised by the courts in Australia. The effect of a standstill agreement is that during the period of negotiation nothing that the parties say or do will constitute an affirmation of the contract. Accordingly, if the negotiations turn out to be unsuccessful the Commonwealth will be restored to the position as it existed at the commencement of the negotiations. 

Thirdly, if the contractor will not agree to enter into a standstill agreement the Commonwealth should make it clear in all correspondence and exchanges that it reserves all of its rights under the contract. 

Fourthly, it is important to appreciate the significance of marking a letter or email with the words “without prejudice”. The Australian Federal Court has noted that the mere insertion of the words “without prejudice” does not of itself necessarily clothe correspondence with the character asserted. Whether an exchange of correspondence is protected will depend upon the application of the Commonwealth Evidence Act 1995 and corresponding legislation in the States. Under section 131 of the Commonwealth and New South Wales Acts a communication is only protected where it is made between persons in dispute and in connection with an attempt to negotiate a settlement of the dispute.