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3 Termination, relief against forfeiture and penalties


Acting in good faith through a termination process

The interaction between termination clauses and express contractual obligations to act in good faith was considered by the Full Court of the Federal Court in Neptune Hospitality Pty Ltd v Ozmen Entertainment Pty Ltd.[23] The court held that an obligation to act in good faith would prevent a party from capriciously initiating a termination process. The court also noted the general principle that if one party was responsible for causing the other to breach a contract, then it could not rely on that breach to terminate. However, there were no factual findings that prevented the respondent from exercising its right to terminate the contract. The court in this case also mentioned some other important principles relating to the termination of contracts, including that:

  • there is a presumption (which can be ousted with clear language) that common law rights of termination exist alongside any contractual rights; and
  • if a clause requires a party to 'remedy a breach' (or risk termination), that can be done by putting matters right 'for the future', even if the past breach could not technically be cured.

Relief against forfeiture and penalties

In Kay v Playup Australia Pty Ltd,[24] the NSW Court of Appeal considered a contract provision providing that if the buyer was more than seven days late in paying an instalment, it would lose the benefit of the warranties and restraints in the agreement. The buyer argued that this clause infringed the penalties doctrine or, in the alternative, that it should be entitled to relief against forfeiture. The court agreed that the clause was unenforceable as a penalty, as the consequences of breach were 'out of all proportion' to the seller's legitimate interest in securing payment of each instalment. The court would not, however, have granted relief against forfeiture, as the rights being forfeited were neither proprietary nor possessory.


23 [2020] FCAFC 47.

24 [2020] NSWCA 33.

Neptune Hospitality Pty Ltd v Ozmen Entertainment Pty Ltd [2020] FCAFC 47

Whether parties are entitled to issue breach notices if they have breached good faith obligations – whether breaches are possible to be remedied by 'putting things right for the future'

In this case, the Full Court of the Federal Court considered whether a party to a joint venture was precluded from issuing a notice to remedy breaches because of its (alleged) own bad faith conduct or where it was contended that it was impossible for the joint venturer to remedy the breaches in the notice.

The court rejected the allegation of bad faith. It further held parties may validly issue breach notices in good faith even if they are a repudiating party, as long as the issuer does not act capriciously. The court also held that the correct approach for remedying past breaches is to consider whether the party in breach can 'put things right for the future', rather than whether the party can nullify the effect of past breaches.

This case examines the operation of termination clauses where there are (alleged) breaches of contract by both parties and where one party's contract is repudiatory.

Facts

This case involved a joint venture between the appellant, Neptune, and Kanki Sea Tourism to carry on a hospitality business onboard the vessel 'Seadeck' owned by the respondent, Ozmen. The two parties were to be equally responsible for the daily operations of the business.

Under the joint venture agreement, Neptune guaranteed Kanki an annual net profit of $5 million subject to the vessel being approved to carry 800 passengers. Additionally, Neptune promised to provide Kanki with financial information, to operate the joint venture in good faith and to avoid making unilateral decisions.

The relationship with the parties broke down following the failure to approve the vessel for the specified capacity and Neptune's failure to provide Kanki with the requisite financial information. Kanki served a breach notice on Neptune, requiring certain breaches to be remedied in 14 days, including Neptune's failure to provide financial information required under the contract and the return of the vessel to Sydney after Neptune had unilaterally moved the vessel.

Kanki launched proceedings in the Federal Court to wind up the joint venture and contended that the unremedied breaches entitled them to termination of the joint venture agreement. At first instance, the primary judge concluded the breaches were established and granted relief.

Neptune appealed the decision and contended that:

  • Kanki was disentitled from issuing a breach notice, as Kanki itself failed to comply with the agreement by not fully cooperating or acting in the best interests of the business;
  • that the breaches identified by Kanki were not sufficiently serious to justify issuing a breach notice, and later a notice of termination; and
  • the breach notice was invalid, as Neptune was not capable of remedying the breaches within the time period provided by Kanki.

Judgment

Deciding the appeal, Justices McKerracher, Markovic and Anastassiou found that, on the substantive issues, The Trial Judge was correct and the appeal was dismissed, notwithstanding minor grounds of the appeal being upheld.

The right to terminate and obligations of good faith

The court found, however, that Neptune had not proved the allegations of bad faith against Kanki on the basis of issuing the breach notice. The primary judge also correctly found that Neptune had either repudiated the contract or breached the contract's terms. However, the court noted that the parties' rights to issue notices are limited where they act 'capriciously.'

In making this finding, the court identified that merely issuing a default or breach notice is not demonstrative of bad faith. The court relied on the fact that the rights to terminate following a breach notice in the contract, in addition to the obligation to act in good faith, indicated the parties contemplated circumstances where breach notices could be issued in good faith.

The court also identified that there is no general law principle that prevents repudiating parties from exercising their rights to terminate, such as where both parties are found to have repudiated the contract or one party is a victim of fraud, citing the decision of Justice Perram in Allphones Retail Pty Ltd v Hoy Mobile Pty Ltd (2009) 178 FCR 57 [56]. The court also confirmed the well-established principle that a contractual regime for terminating (following a breach) does not, in the absence of clear words, oust common law rights to terminate.

Remedying breaches by 'putting things right for the future'

Having found that Kanki could validly issue the breach notice and that Neptune did make serious breaches of innominate terms of the contract, the Full Court rejected Neptune's argument that it was impossible to remedy past failures to provide financial information within a specified window as the period for delivery had lapsed.

The court found that the correct test to be applied for determining when past breaches were technically no longer able to be cured was to assess whether the party in breach can 'put things right for the future', citing the House of Lords decision in L Schuler AG v Wickman Machine Tool Sales Limited [1974] AC 235.

The court identified that Neptune was able to provide the historical financial information upon receiving the breach notice and substantially comply with provision of future information, provide the details of the catering contract and return the ship to Sydney within fourteen days, as required by the breach notice. Neptune failed to provide the balance of the financial information to Kanki and refused to return the ship to Sydney within the prescribed window, both of which the court found to be possible. The court identified that, even where the breach notice was not effective to bring about automatic termination, Neptune's omissions allowed Kanki to treat the contract as at an end when Neptune failed to comply with any of its requirements.

Kay v Playup Australia Pty Ltd [2020] NSWCA 33

Dependent and independent contractual obligations – whether ‘clear words’ are required to find a relation of independency between obligations– penalty doctrine extends beyond payment of a stipulated sum of money to deprivation of contractual rights; relief against forfeiture – whether doctrine confined to proprietary or possessory rights, as distinct from mere contractual rights

In this case, the New South Wales Court of Appeal considered:

  • whether there was a relation of independency between contractual obligations in the absence of 'clear words' to that effect;
  • whether the doctrine of relief against forfeiture could be available in circumstances where the subject of the forfeiture was a mere contractual right, as opposed to a proprietary or possessory right; and
  • whether the penalty doctrine extends beyond the payment of a stipulated sum of money to the deprivation of contractual rights.

The decision is significant because it:

  • rejects the notion that 'clear words' are required in order to make a finding of independency between contractual obligations, instead emphasising that the intention of the parties is paramount;
  • extends the penalty doctrine to accrued contractual rights, despite the doctrine's 'standard application' being to the payment of a stipulated sum of money; and
  • upholds the traditional view of the doctrine of relief against forfeiture, being that it is confined to proprietary or possessory rights and does not extend to mere contractual rights.

Facts

Mr Kay and Playup entered into a contract for the sale and purchase of Mr Kay's 100% shareholding in a company for $1.6 million. Of that sum, $1 million was payable on exchange, with the remaining $600,000 to be paid in 24 monthly instalments following the 22 May 2018 'completion date' stipulated in the contract.

The seller gave a number of warranties regarding the state of the company and agreed to restraints on operating a competing business for three years. Clause 4.3(b) of the contract stipulated that if the buyer was more than seven days late making any of the monthly instalment payments, the warranties and restraints were immediately 'void ab initio' and the total amount of the remaining monthly instalments became payable immediately.

Neither the buyer nor the seller performed any of their completion obligations on the 22 May 2018 'completion date'. The following events then occurred:

  • 7 June 2018: the seller performed all but two of his completion obligations. From this date onwards, the parties acted as if completion had occurred.
  • 22 June 2018: the first monthly instalment fell due, being one month after the 22 May 2018 'completion date' stipulated in the contract.
  • 16 July 2018: the seller performed one of his remaining completion obligations, which was to calculate an adjustment amount that was due to be paid upon completion of the transaction. (The seller's other remaining obligation was to provide the buyer with updated lists of liabilities and debtors, which he did not ultimately comply with.)
  • 8 August 2018: as the buyer had not made any monthly instalment payments, the seller served a creditor's statutory demand for the $600,000 total of the monthly instalments minus the adjustment amount.
  • 13 August 2018: the buyer began making instalment payments to the seller, but did not pay the full amount of the statutory demand.
  • 10 September 2018: the seller commenced winding up proceedings against the buyer.

In order to procure dismissal of the winding up proceedings, the buyer paid the outstanding balance of the monthly instalments. The buyer then commenced proceedings for declaratory relief that the restraints and warranties were not void, contending that:

  • Its obligation to pay the monthly instalments was suspended until the seller had agreed to the adjustment amount. As that did not occur until 16 July 2018, its obligation to pay the monthly instalments commenced on 16 August 2018. Given that this was three days after it made its first instalment payment, clause 4.3(b) was not engaged.
  • Clause 4.3(b) was void as a penalty.
  • Alternatively, if clause 4.3(b) was not a penalty, it should be granted relief against forfeiture.

The buyer succeeded at first instance, with the primary judge agreeing (albeit via different reasoning) that clause 4.3(b) had not been engaged. Had it been necessary, the primary judge would have rejected alternative arguments that clause 4.3(b) was an unenforceable penalty or that relief against forfeiture should be granted. The seller appealed the primary judge's principal finding, with the buyer cross-appealing the judge's findings on the alternative arguments.

Judgment

In deciding the appeal on the primary judge's principal finding, the court had to determine whether the buyer's obligation to pay the monthly instalments was independent of the seller's obligations to calculate the adjustment amount and provide the updated lists of liabilities and debtors. In doing so, the court held that, on its proper construction, the contract dealt with two distinct concepts that were not to be conflated:

  • the 22 May 2018 'completion date' – the date on which the parties were obliged to complete the transaction; and
  • 'completion' – the word used by the contract to describe the actual event of completion.

The fact that the parties failed to complete on 22 May 2018 meant that they were in default of their contractual obligations – this did not alter the meaning of the term 'completion date'.

The buyer's obligation to pay the monthly instalments was linked to the 'completion date', whereas the relevant obligations of the seller were linked to the concept of 'completion'. As such, there was no relation of interdependency between the two sets of obligations, and the buyer's obligation to make the monthly instalments had not been suspended by the seller's failure to discharge some of his completion obligations.

Although clause 4.3(b) would have been engaged by the buyer's failure to make the instalment payments on time, the court unanimously held that the clause was an unenforceable penalty as to the warranties and restraints.

Justice Brereton further observed that if clause 4.3(b) was not a penalty, relief against forfeiture would not be available, given that no proprietary or possessory rights had been forfeited. Justices Macfarlan and Simpson declined to express a view on relief against forfeiture, as it was not necessary to resolve the appeal.

Independency

The court held that, on proper construction of the contract, the buyer's obligation to pay the monthly instalments was not dependent upon the seller's obligation to calculate an adjustment amount, nor the seller's obligation to deliver updated lists of liabilities and debtors.

The court's ruling is significant in that it rejects the notion that 'clear words' are required in order to make a finding of independency, instead emphasising that the intention of the parties is paramount. The court identified a number of factors that indicated the parties did not intend the two sets of obligations to be dependent upon one another:

  • Where interdependency was intended in relation to other obligations in the contract, the contract stipulated this expressly.
  • The adjustment amount was to be paid on the actual date of completion, and was not connected to, or paid out of, the monthly instalments (which were triggered by and ran from the 'completion date' stipulated in the contract, not the actual date of completion).
  • The doctrine of merger tends against the notion that post-completion obligations would be dependent on obligations to be performed upon completion.
  • The seller's obligation to calculate an adjustment amount and ensure that it was paid was not a condition precedent to completion. The seller's failure to tender the adjustment payment might have entitled the buyer to refuse to complete, but the buyer did not do so.

Consequently, the court held that while the buyer was entitled to retain the objectively correct adjustment amount out of the monthly instalments, it was not entitled to treat the obligation to pay the monthly instalments as suspended until the seller had agreed to the adjustment amount.

The court also observed that seller's obligation to provide updated lists of liabilities and debtors was not necessary to give content to any of the seller warranties, as any new liabilities that would have been disclosed in the updated lists were already covered by an indemnity provided by the seller. The court therefore held that there was no relevant connection between the seller's obligation to provide the updated lists and the buyer's obligation to pay the monthly instalments.

Penalty

The court held that clause 4.3(b) was a penalty insofar as it operated to avoid the seller warranties and restraints, and was thus unenforceable. This finding is significant in that it extends the penalty doctrine to accrued contractual rights, despite the doctrine's 'standard application' being to the payment of a stipulated sum of money.

Although the parties did not dispute that the penalty doctrine could apply to accrued contractual rights, the court nevertheless noted that restricting the doctrine to its standard application would 'elevate form over substance'. When determining that clause 4.3(b) , in substance, a penalty, the court identified two key factors:

  • Restraints and warranties are a fundamental protection of the goodwill of the subject business, so as to ensure that the buyer actually gains the benefit of the business. Avoidance of the restraints and warranties is a severe consequence that is 'out of all proportion' to the seller's legitimate interest in securing the payment of each monthly instalment.
  • The clause operated indiscriminately – it applied not only in the case of a total failure to pay, but also in the event of a delay of one day after the grace period in paying the very last monthly instalment.

The court also noted that while clause 4.3(b) was the product of robust negotiation between two properly advised parties of comparable bargaining power, this did not alter the fact the clause was penal in character.

Relief against forfeiture

Justice Brereton further held that if the court was wrong and clause 4.3(b) was not a penalty, relief against forfeiture would not be available as an alternative. This finding is significant in that it upholds the traditional view of the doctrine, being that it is confined to proprietary or possessory rights and does not extend to mere contractual rights.

Justice Brereton made the following observations in response to Justice Edelman's suggestion in Mineralogy Pty Ltd v Sino Iron Pty Ltd (No 6)[1] that the scope of the doctrine could be broadened beyond proprietary rights:

  • Although there have been cases that suggested or assumed that relief against forfeiture might be available for a contractual license, these can be distinguished from the facts at hand. The present case deals with a mere contractual or personal right, whereas the licensee in each of the precedent cases held not merely a contractual license but also an equitable interest in land. None of the precedent cases extended the doctrine to a bare licence – relief was only granted where there was some estate or interest in land that equity would protect.
  • It is true that a foundational rationale for the doctrine – that it is a constraint on the unconscionable exercise of contractual power – is not tied to the existence of a proprietary right. However, the precedent cases are against the application of the doctrine to merely contractual rights, as distinct from proprietary or possessory rights. Although this may mean that the court's inquiry then becomes what is a 'proprietary' right for the relevant purpose, it is nevertheless an identifiable discriminator of the scope of the doctrine.
  • Expanding the scope of the doctrine to all contractual rights and leaving control of its use to judicial discretion would 'offend against the well-recognised need to ensure that equity does not undermine the certainty of the law'.

Although Justice Brereton held that relief against forfeiture was not available for the above reasons, he noted that had the doctrine been applicable, he would have granted relief on discretionary grounds.


1 [2015] FCA 825.

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