Termination of construction contracts – the issue of good faith

22 November 2019
Daniel Middleton, Partner, Melbourne Andrew Archer, Special Counsel, Melbourne

Bundanoon Sandstone Pty Ltd v Cenric Group Pty Ltd [2019] NSWCA 87 (30 April 2019) (Meagher, Gleeson and McCallum JJA).

 

Issue and Outcome

 The NSW Court of Appeal held that a show cause notice issued by a principal under a construction contract was not issued in good faith (because it was redolent of bad faith) with the consequence that reliance on it to terminate the contract was (along with other invalid grounds) a repudiation.

The show cause notice was a pretence.  The principal wanted to rid itself of the head contractor and contract directly with the subcontractor.  That premeditated plan was borne out in the evidence at trial – the principal’s mind was closed and the principal would have terminated the head contract regardless of any cause shown by the head contractor in response to the principal’s show cause notice.

 

Key Takeaway

A party issuing a show cause notice and subsequently terminating the relevant contract should keep accurate contemporaneous records of its assessment and decision making process at both stages of the termination process, that is, (a) when assessing whether or not the defaulting party has shown cause (or reasonable cause if that be the contract’s terms) and (b), if not, the subsequent assessment of what if any powers are to be exercised.

The decision is a salient reminder that the operation of a contractual power, for example, a termination clause, that is wider than necessary to protect the party’s legitimate interests may be subject to an implied obligation of reasonableness and good faith.

 

Background facts

TWT as principal engaged Cenric as builder to perform demolition, shoring and excavation works under an AS4000 1997 head contract.

The site likely included quantities of Sydney yellow block sandstone – used in the repair of historic public buildings.

The planning permit required an assessment of whether any sandstone could be quarried and used.  As matters transpired, valuable quantities of sandstone were found.

Cenric, with TWT’s permission, subcontracted the sandstone harvesting to Bundanoon – a specialist sandstone excavator.  Under the (varied) contractual arrangements, Bundanoon was entitled to sell the sandstone to third parties (including government entities) but pay a percentage ‘royalty’ to Cenric (the head contractor) who in turn passed up a portion only of that royalty to TWT (the principal).

Unsurprisingly, at some point it occurred to TWT that if it contracted direct with Bundanoon it would be much better off because it would get a bigger slice of the royalties.

Disputes arose including the time taken to perform the works under the head contract.  The parties to the head contract entered in to an oral agreement to extend the date for practical completion.   However, the contract contained an express ‘no oral variation’ clause.

TWT issued a show cause notice to Cenric principally alleging that Cenric had proceeded otherwise than diligently and with due expedition and was therefore in substantial breach.  TWT then acted on the show cause notice by taking the works out of Cenric’s hands.  Bundanoon terminated the subcontract.  Unsurprisingly, TWT then contracted directly with Bundanoon.

Proceedings were issued with claims and counterclaims including the usual ‘Mexican standoff’ on the termination issue.

 

The decision on the termination issue 

At trial, McDougall J found that, despite the express ‘no oral variation’ clause, the parties’ oral agreement to extend time and agree a new date for PC under the contract was enforceable.  This neutralised the underlying merit/basis of the time based complaints in the show cause notice.

Against that finding, McDougall J found the show cause notice was invalid for 3 reasons:

  1. The validity of the oral variation agreement agreeing a new completion date meant there was no breach of the time obligations under the contract (namely, to proceed with due expedition and without delay, and not to depart substantially from the programme).
  2. The notice was not issued in good faith. The evidence at trial made it clear that the decision maker was going to terminate the contract no matter what.  At [125] of the first instance judgment McDougall J held: ‘In short, TWT, through Mr Zhang had closed its mind on the subject.  It was not prepared to accept as valid any cause that Cenric might show.  It was determined to take the work out of Cenric’s hands regardless.  TWT’s attitude is redolent of bad faith.’ 
  3. The show cause notice was issued for an ulterior purpose, namely, to contract direct with the subcontractor, Bundanoon, thereby retaining the whole of the royalty payable by Bundanoon.

The Court of Appeal upheld these 3 findings.  On the good faith point Gleeson JA (giving the judgment of the Court) restated the position in NSW, at [154], that:

‘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’.

 

The good faith issue – a slight historical sketch

It all started with Renard Constructions (ME) Pty Ltd v Minister for Public Works (1992) 26 NSWLR 234 where the NSW Court of Appeal held that the operation of a show cause regime/power that applied to any breach was required to be exercised reasonably.  That required an injection of reasonableness at two points: (a) reasonable consideration must be given to assessing whether or not the defaulting party had shown cause and (b) if the defaulting party had not shown cause, reasonable consideration to whether any power and, if so, which power, should be exercised (for example, terminating the contract or taking the works out of the hands of the defaulting party).

In Renard, the reasonableness ‘brake’ imposed on the power was implied by both fact and law (Priestley JA).

Terms implied by fact are sometimes referred to as terms implied ad hoc (or ‘tacit’ terms).  Implication ad hoc is in a sense a more accurate description because the ‘so called implication in fact is really implication by judge based on the judge’s view of the actual intention of the parties drawn from the surrounding circumstances of the particular contract, its language and its purposes as they emerge from the language and in the circumstances’Renard (Priestley JA) at 256.

The distinction between terms implied by law and terms implied by fact (ad hoc) is important in another way: the burden of proof is reversed.  Terms implied by law are presumed to be present in certain classes of contract – they are implied systematically by law.  The burden is on the party alleging the term should not be implied – Heimann v The Commonwealth (1938) 38 SR (NSW) 691 at 695-696.  Conversely, where a term is implied in fact the burden is on the party alleging the contract includes the term.  That is a function of the law’s presumption, in relation to written contracts, that the contract is complete without the term sought to be implied – Luxor (Eastbourne) Ltd v Cooper [1941] AC 108 at 137.  If the burden is discharged the term is implied ab initioFrobisher v Kiloran Trust Co [1980] 1 WLR 425 at 432.

The approach in NSW was confirmed in Burger King [2001] NSWCA 187 involving, like Renard, a termination provision of very wide power.  Burger King perhaps placed a greater emphasis on the provenance of the restraint being implied by law.  Burger King also made clear that there is no distinction of substance between an implied term of reasonableness and of good faith, at least in the context of the exercise of contractual powers to terminate.

Renard borrowed extensively from the United States jurisprudence where the good faith concept is used flexibly as an ‘excluder’, that is, the concept serves to exclude bad faith.  That is essentially the outcome in the Bundanoon case under consideration here, that is, the presence of bad faith meant an absence of good faith.  Consistent with Renard, that ‘inverse’ approach is the approach that appears to have found favour in NSW and the Federal Court, for example, Pacific Brands Sport Leisure [2005] FCA 288 at [65] (Ficklestein J):

‘ … a good starting point in any particular enquiry is to see whether the impugned conduct  … was motivated in bad faith, or was for an ulterior motive or, if it be any different, whether the defendant arbitrarily or capriciously.  It may also be proper to investigate whether the impugned act was oppressive or unfair in its results.’

That ‘excluder’ approach probably also assists with instances where an outcome might come about prima facie not as a result of a lack of good faith but rather by, for example, inadvertence or oversight.

In one sense though the implication can be viewed not as an additional term but rather an implied restraint on an otherwise overly broad discretionary power.  That view is consistent with the Restatement of the Law Second, Contracts in the United States which, at Section 205, relevantly provides: ‘Every contract imposes upon each other a duty of good faith and fair dealing in its performance and its enforcement’.

Whilst the implication of a good faith/reasonableness requirement has been consistently recognised in NSW (for example, see the cases cited in Cordon Investments [2012] NSWCA 184 at [144]), other jurisdictions have been less receptive/enthusiastic.  The High Court had an opportunity to set things straight in Commonwealth Bank v Barker [2014] HCA 32 but did not.

In Victoria, Byrne J followed Renard on several occasions including Golden Sands [2003] VSC 458.  However, in Esso Australia [2005] VSCA 228 the Victorian Court of Appeal made it plain that in Victoria there is no general obligation of good faith implied into commercial contracts as a matter of law (legal incident).  Both Warren CJ and Buchanan JA contemplated implication in fact (ad hoc) might be possible if the relevant party was particularly vulnerable (note the overlap here with that concept in the context of the duty of care question in pure economic loss cases).

The point was picked up in Dura (Australia) Constructions Pty Ltd v Hue Boutique Living Pty Ltd (No 3) [2012] VSC 99 concerning the termination regime in AS2124 1992.  Following Esso Australia, Dixon J held that there is in Victoria no general obligation of good faith implied in commercial contracts as a matter of law.  The builder (Dura) could only have resorted to attempting to imply an obligation in fact (ad hoc).  In addressing the well-known criteria for implying a term in fact, Dixon J found that it was not necessary to imply such a term to give business efficacy to the contract on the basis that the commercial relationship was unbalanced in any way or that the builder was especially vulnerable.  Dixon J relied on the trifurcated categorisation of contractual powers set out by the Full Court of Tasmania in Tote Tasmania Pty Ltd v Garrott 2008 TASSC 86.  Dixon J, at [418]:

‘Whether a power conferred upon a party to a contract is fettered by a duty of good faith depends upon the terms in which the power is expressed. Without purporting to compile an exhaustive list, there are at least three types of contractual powers which suggest different results. [1] One is a provision conferring a power in an agreement, such as a partnership agreement, which is concerned with co-operation between the parties to produce a result which benefits all the parties to the contract. In such an agreement, a court might readily imply an obligation to act in good faith in that the party upon whom the power is conferred must have regard to the interest of all the parties to the agreement. [2] Another type of provision is one which confers a power if the donee of the power considers that a certain state of affairs or condition exists. In this case, a court may well hold that the power can only be exercised by an honest decision that the state of affairs or condition does exist, but the honest exercise of the power will not be reviewed by the court. [3] Yet another type of provision is one conferring a power that is quite unqualified. Here, a court may conclude that the power can legitimately be exercised in the interests of the party upon whom it is conferred and that party is to be the sole judge of where its interests lie and may exercise the power for any reason it sees fit.’

Dixon J held that the type of contractual power under consideration was in the second category above (underlined).  That required an honest assessment/decision.  The builder failed at both occasions in the termination process (as outlined above) to persuade the Court that an in fact (ad hoc) implication of reasonableness should be implied.  In relation to the second occasion, Dixon J concluded, at [566] and [567]:

‘What then is the extent of the obligation upon the principal to take into account, or give proper consideration to, the contractor’s response showing cause? Dura submits that the principal must act reasonably, as I have earlier set out when considering the requirements of a valid notice. The power to act under cl 44.4 falls within the second identified category in Tote Tasmania. Hue was required to determine, honestly, whether the contractor had failed to show reasonable cause why the principal should not exercise a right referred to in cl 44.4. A court should be satisfied that the principal has made an honest decision in good faith about that matter enabling it to exercise the contractual rights in its favour provided by the clause. It is not a relevant consideration for a court that the principal’s decision serves only its interests or that the court considers an alternative decision on the part of the principal to have been reasonably open.

On the findings that I have expressed above, I am satisfied that Hue acted reasonably in the relevant sense. It made an honest and careful determination that Dura had failed to show reasonable cause. I find that when Hue gave notice to Dura taking out of its hands the whole of the work remaining under the contract, it acted properly in accordance with the rights and obligations arising under cl 44.’

The position in Victoria following Dura appears to be that an honest decision will discharge any implied (ad hoc) obligation to act reasonably.  But issues remain.  For example, is there a difference between acting honestly and the broader components of the good faith obligation (for example, not to act capriciously, arbitrarily or for an ulterior purpose)?  In Dura, Dixon J relied on category two in Tote which is confined to ‘honesty’ with no express mention of good faith – noting that Tote category 1 expressly incorporates good faith.  However, Dixon J refers to ‘an honest decision in good faith’ – do the words ‘good faith’ add anything to the requirement of ‘honesty’?  Further, why can’t a building contract be caught by category 1 in Tote – it appears on its face to be a paradigm description of a building contract particularly those based on an alliancing model.  Finally, considerations of the extent to which the presuppositions in Tote category 1 (cooperation) and category 2 (honesty) are implied by law in any event – certainly at least the former is well settled in the line of authority commencing with Mackay v Dick (1881) 6 App Cas 251 as affirmed by the High Court in Secured Income Real Estate (Australia) Ltd v St Martins Investments Pty Ltd (2009) 74 NSWLR 618.

 

Conclusion

The overriding issue is that, in the context of the exercise of termination provisions in certain factual settings, the terminating party’s motivation is likely to be under scrutiny.  In order to address and defeat any allegation that the termination was otherwise than a legitimate use of the termination power the terminating party should comply with the steps outlined above.

 

Authored by:

Andrew Archer, Special Counsel

 

This update does not constitute legal advice and should not be relied upon as such. It is intended only to provide a summary and general overview on matters of interest and it is not intended to be comprehensive. You should seek legal or other professional advice before acting or relying on any of the content.

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