June 30, 2016

The show must go on - Change is inevitable: cancellation, termination and descoping

As the stories of internecine warfare within the political parties continue in the press, this is our first paper in a series on short/medium term contracting strategies following Brexit and its immediate consequences. Following the weekend it is clear that the direction of the construction and engineering markets remains as unknowable as the identity of the country's leadership, their likely policies, the source of their mandate and the attitude of their European and worldwide counterparts. Faced with this uncertainty, it seems likely that many purchasers of building and engineering services might want to hit the 'pause' button on their projects to consider whether to hold, scale back or even cancel them.

As promised this paper will consider the options available to purchasers regarding the suspension and, perhaps ultimately, the termination of existing projects, or the variation of them, perhaps so as to achieve completion of them more quickly or at lower cost.  It will also consider steps and arguments that contractors may deploy to prevent such scenarios or to benefit from them.  We will also look at the twilight zone in which contracts not yet fully signed off might have become effective through the conduct of the parties, a situation readily found by the highest courts when the evidence of agreement on all fundamental contractual terms points that way.

Let's Wait a Moment - Suspension

Without express terms permitting suspension, an Employer who simply suspends the performance of the works while he makes up his mind is living very dangerously.  There is no common law right of suspension – English law will allow a wronged party to terminate a contract in the right circumstances but never to suspend (the exception being the statutory right of a contractor to suspend for non-payment under section 112 of the HGCRA, following the service of notice of intention to suspend,). 

The consequences of wrongful suspension are potentially very serious indeed.  If an employer wrongfully suspends the works, or tries to prevent the contractor from performing its works in some other manner (for instance by not handing over the site or by the slow release of design information) then, at the very least, the Contractor will be entitled to make a claim in damages and/or under the contract for the delay/disruption caused.  In extreme circumstances, such a suspension/interference may give rise to the Contractor having a right to terminate the contract for breach.  Not only will this defeat the very purpose of suspending, rather than terminating, it will have identical consequences to a wrongful termination by the employer (please see below).

Whether a contract may contain specific provisions for suspension by the employer depends upon the chosen contract form.    For instance, under the JCT DB 2011 form there is no express power on the part of the employer to instruct a suspension of the whole or part of the works.  Although the employer has limited powers to impose changes to access, working practices or sequencing of the works (clause 5.1.2) these powers are highly unlikely to allow a significant suspension of the works.  The one possible exception to this is where the parties have agreed that Clause 2.4 applies, in which case the employer may defer the giving of possession of the site or relevant part of it for a period of up to 6 weeks.  This would amount to a suspension (with consequences in terms of extensions of time and loss and expense being claimable by the contractor) if the project is at its very outset.

NEC3 Option A provides a broad power that "The Project Manager may instruct the Contractor to stop or not to start any work and may later instruct him that he may re-start or start it."  Naturally the exercise of this power is a Compensation Event. Whether this power is intended to allow a suspension of all of the works for commercial reasons is unclear, particularly in circumstances where the parties are obliged to act in a spirit of mutual trust and cooperation with each other, and we anticipate that a contractor could argue forcefully that it does not.  The broad nature of the drafting of this provision, the fact that it appears independently and outside the context of (say) the discovery of defective or dangerous works, the fact that there is a right to compensation for time/money and, perhaps most importantly, the termination provisions which provide for rights of termination where no instruction for a re-start has been issued within 13 weeks) strongly suggest that this is a full blown right of suspension for the benefit of the employer, albeit limited to 13 weeks in duration.

But I thought We Had a Deal!

Cancelling a project where the parties have been in negotiations but have yet to conclude a binding agreement should be relatively straightforward and risk free – generally there is no obligation under English law for parties to negotiate in good faith and a contractor which has invested considerable time and resources into a tendering process, but has yet to conclude terms, is unlikely to be able to force the employer to proceed to enter into a contract or recover its costs.  The exception to this is where a contractor has supplied a benefit to the employer on a common understanding that some payment will be made.  This is likely to be difficult to demonstrate in respect of participation in a bidding process.

The situation can be very different where, despite the parties having not yet signed a contract, the parties have been conducting themselves in such a manner that it would objectively appear that they are in contract together.  A court will look at the detail of this conduct, and try to ascertain whether all of the terms essential to the formation of a contract have been agreed by the parties, to attempt to discover if a contract has been formed.  These issues often arise where the parties began the works subject to a letter of intent or an early works agreement but then subsequently go beyond the relevant caps on time, scope and/or price without either party ceasing to perform the works.  Over recent years the Courts have become increasingly willing to find that a fully binding contract has arisen, even in circumstances where the parties had used express language in their negotiations intended to prevent a contract from arising (such as the words 'Subject to Contract').  As the Supreme Court said in RTS v Muller (2010) where the parties had been conducted themselves as if they were in contract, any 'subject to contract' wording in the negotiations must also have been waived.

Letters of intent, early works agreements and contract formation have long proved to be sources of serious disputes, not only in respect of the unwinding of contracts or contractual negotiations, but also in respect of the valuation of works. 

It's Over!

'Termination', 'determination', 'discharge for repudiatory breach' - whatever name you use attempting to pull out of a contract, any attempt can be incredibly risky.  This is particularly so in circumstances where one or other party terminates for repudiatory breach or operates a contractual termination machinery so as to bring a contract to a conclusion for breach.  We will deal with termination in the event of contractor insolvency in a later paper.

Termination for Convenience

Some forms of contract permit termination at the employer's convenience but a party considering whether or not to take such action better make sure that (1) it follows the contractual provisions to the letter; and (2) fully understands the hidden costs/potential liabilities of exercising such a right.  The FIDIC forms (see for example Clause 15.5 of the Silver Book) do allow termination for convenience, albeit that the employer may not terminate in order to execute the works himself or to engage another contractor to do so.  The costs associated with termination for convenience are somewhat high and unknowable – Clause 19.6 allows the contractor to claim all of its costs for work incurred to date in accordance with the contract plus "any other Cost or liability which in the circumstances was reasonably incurred by the Contractor in the expectation of completing the works."  The contractor, however, is not entitled to recover the profits he would have made had he been permitted to complete the works.

Neither the JCT nor the NEC3 terms permit termination for convenience.  If an employer is determined to determine the contractor's employment he will need to fall on the mercy of the contractor and negotiate an exit.  Unless the contractor has its own good reasons for getting out of the contract, it is likely that a significant ransom will be extracted for such a release.

Termination for Breach

Termination for breach is notoriously tricky and the issues to consider, and punishments for getting it wrong, are set out below.  Often construction contracts will have provisions which will permit termination in particular circumstances and these often include "material breach" or similar grounds.  These contractual methods often have complex notice provisions which must be followed to the letter and also dictate the parties rights against one another in the event of successful termination.  In addition to these contractual rights of termination for breach, the innocent party may also be able to rely upon his rights under the common law – i.e. to treat himself as discharged from further performance under the contract by 'accepting' the guilty party's 'repudiatory breach'.   A 'repudiatory breach' is a fundamental breach of a contract or one which goes to the very root or heart of it. Unless the contract excludes it, there is nothing to stop the innocent party from attempting to get the benefit of both processes, i.e. a contractual termination and a termination at common law, at the same time so as to hedge his bets.

The difficulties of terminating a contract for breach, and the consequences of getting it wrong (see below) have led to a huge quantity of case law over the years on the tests and hurdles faced by parties seeking to get out of a contract.  This paper is not the correct place to look at this case law in detail but, as a snapshot:

A common test to see if the threshold allowing termination has been reached is to ask whether breach of one party deprives the innocent party of “substantially the whole benefit” of the bargain he entered into.  This is a very high threshold and difficult to demonstrate – the Court will normally be asked to take into account a myriad of facts, circumstances and consequences and it is frequently difficult to predict the outcome of a decision on this issue.

Often the abandonment or renunciation of the contract by one party (i.e. walking off site, refusing to perform unless additional conditions are met by the other party) is easier to demonstrate as grounds for termination.

Sometimes a series of moderate breaches can, when taken together, reach the threshold of sufficient seriousness to constitute a 'repudiatory breach,' where none of them individually would do.

Sometimes further action must be taken by the innocent party to change a relatively minor fault into one which will permit termination.  The classic example here is payment, where late payment in itself will not normally allow the creditor to terminate.  However, the creditor may be able to manufacture a repudiatory breach if the creditor puts the payer on notice that he is in breach, and that should payment not be made within a (reasonable) further period, then the creditor will treat him as being in repudiatory breach – this is often known as 'making time of the essence'.  If the creditor can get this process right he can change a breach which would not permit termination into one that will.  However, this is still not without risk.

Finally, the law requires the innocent party to elect whether to "accept the repudiatory breach" and treat himself as discharged (i.e. terminate) or to "affirm the contract" (i.e. insist on the performance ) and claim damages instead.  Most behaviour of an innocent party which tends to show that he is operating the contract (employers issuing instructions, contractors making applications for payment, etc.) will affirm the contract leading to a permanent loss of the right to terminate.  Delay is also the enemy here, although careful attempts can be made to reserve the innocent party's rights while he decides how to act.

Getting it Wrong

The consequences of a wrongful termination are a little like playing Russian roulette.  If you cease performing a contract because you think that the other party's conduct is so despicable that you ought to be released from your own obligations (i.e. he is in repudiatory breach) then, if a Court or adjudicator subsequently disagrees with you, by ceasing to abide by the contract yourself you will probably have committed your own repudiatory breach of contract.  This will normally permit the other party to terminate on the basis of your own despicable conduct instead. 

In terms of consequences, if an employer incorrectly asserts a right to terminate, and is himself found by the court to be in repudiatory breach then (subject to any limitations in the contract), he will be liable to pay for the work done to date, the cost of the contractor demobilising and disentangling itself from the site/the job plus the profits that the contractor would have made/overheads that would have recovered, had the contractor been permitted to complete the works.  The employer would potentially be left with a partially completed project, a demobilised contractor and a liability to write a substantial cheque for both damages and court costs in the contractor's favour.

The secret is to make and to implement any decision to terminate a contract not so quickly as to do so before any right has arisen, not so slowly as to run the risk of any right expiring, balancing the commercial gains of successful termination against the potential losses of getting it wrong, whilst exercising the judgment of Solomon in assessing all of the surrounding circumstances and thereby accurately predicting the opinion of the court/adjudicator.  This is often harder than it sounds.

Descoping – "I'll tell you what – we'll just omit the balance of the contract works…"

Whenever an employer wishes to cancel the works in difficult circumstances, someone will always come up with this ruse.  While it is true that modern building and engineering contracts contain very wide powers for employers/their agents to change the scope of works by issuing a variation instruction (see for instance the definition of "Change" at clause 5.1 of the JCT DB 2011), and these powers appear unfettered on the wording of the various standard form contracts, the Courts have historically read those wide powers in a manner which does not permit a change to the very nature of the bargain between the parties.

There are three important points to bear in mind here:

First, where there is an insistence by the employer that the contractor obeys an instruction to fundamentally change the scope of works, so that the scope is now of an entirely different nature to that bargained for by the parties, such insistence can amount to a breach of contract by the employer, possibly a repudiatory breach.  An omission of a very substantial amount of works, tantamount to cancellation of the project, might well meet this test; it is easy to imagine that a Court may have little sympathy for an employer who arrogates to himself the effective power to terminate for convenience when the contract says nothing of the sort.

Second, it is a well-established general rule that an employer may not omit works from a contract with the intention of doing it himself, or letting the works to another contractor, .  JCT and NEC3 are silent on this issue and so are likely to be subject to this principle.  The FIDIC terms make this position clear (see clause 13.1).  By way of warning employers should be careful of communications, whether internal or external, which demonstrate that the true nature of the decision to omit is, in fact, to defer the omitted works, for instance by using terms like 'suspend' or 'mothball'.  If the Employer then engages another contractor to finish the works when the economic outlook changes it may find itself subject to a claim from the first contractor for damages.

Third, employers should also be aware of the hidden costs of successfully omitting a significant chuck of works.  In some circumstances it may have the effect of relieving the contractor of the effect of a period of historic delay (the major forms do have a provision for shortening the time for completion ) and a contractor will probably argue that it is entitled to be paid for any inefficiencies incurred/profits foregone as a consequence.

Conclusion

It is a risky strategy to attempt to substantially descope, suspend or terminate a live contract without a clear contractual right to do so, or without agreement from the other party.  Any decision to do so will need to be balanced against the potential outcome of getting it wrong.  However, this doesn't mean that it is not a valid strategy – many terminations have been ultimately agreed on a commercial basis following one party asserting a right to terminate, descope or suspend in circumstances where, on closer analysis, the existence of that right is suspect to say the least

In our next paper we will assume that contracts continue, and will look at the likely strategies of employers, contractors and sub-contractors relating to performance of the works and payment in these uncertain times.

This is the second in a series of updates - click here for the first article.