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Contract Law

Reasonable endeavours obligations

Commercial contracts often contain obligations for which the standard of performance is not absolute but instead requires one party to use its ‘reasonable endeavours’ or ‘best endeavours’ to attempt to achieve the desired outcome. The obligations imposed by these phrases are similar if not identical. In each case the extent of the obligation is governed by what is reasonable in the circumstances.

The key criterion of what is ‘reasonable in the circumstances’ means that little assistance can be gained from decided cases. It is, however, clear that the circumstances that may affect an obligor’s business can relevantly be taken into account in determining what is reasonable in the circumstances. In Electricity Generation Corporation v Woodside Energy Ltd (2014) 251 CLR 640; [2014] HCA 7 (Woodside), the majority held that:

  • an obligation to use reasonable endeavours would not oblige the achievement of a contractual object to the certain ruin of the obligor or to the utter disregard of the interests of its shareholders; and
  • an obligor’s freedom to act in its own business interests, in matters to which the agreement relates, is not necessarily foreclosed, or to be sacrificed, by an obligation to use reasonable endeavours to achieve a contractual object.  
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Some variations on the standard of ‘best endeavours’ are also not uncommon. These include ‘reasonable endeavours,’ ‘best reasonable endeavours,’ ‘reasonable efforts’, ‘all reasonable endeavours’ and ‘all reasonable commercial endeavours’.

Whether the standard chosen is ‘reasonable’ or ‘best’ endeavours, the High Court of Australia has consistently proceeded on the basis that the obligations imposed by these phrases are similar if not identical. In particular, whatever words are used, in each case the extent of the obligation is governed by what is reasonable in the circumstances.

Despite this, some recent Australian decisions have drawn distinctions between ‘mere’ reasonable/best endeavours clauses and clauses that use slightly different wording. These include findings that:

  • ‘reasonable endeavours’ does not impart an obligation that is as onerous as one to use “best endeavours” or “all reasonable endeavours” (Stepping Stones Child Care Centre (ACT) Pty Ltd v Early Learning Services Ltd [2013] ACTSC 173); and
  • the addition of the word ‘best’ to the expression ‘reasonable endeavours’ may raise the required standard to a level somewhat higher than that imposed by a simple ‘reasonable endeavours’ obligation (Foster v Hall [2012] NSWCA 122).

In practice, these differences may rarely be distinctions of substance. The critical factor will ordinarily be whether the party which is obliged to perform has met the standard of reasonableness.

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Reasonable endeavours clauses were most recently considered by the High Court in Woodside, where the Court made three general observations about reasonable endeavours clauses, namely:

  • an obligation to use reasonable endeavours is not an absolute or unconditional obligation;
  • the nature and extent of such an obligation imposed in such terms is necessarily conditioned by what is reasonable in the circumstances, which can include circumstances that may affect an obligor’s business; and
  • some contracts containing an obligation to use or make reasonable endeavours to achieve a contractual object contain their own internal standard of what is reasonable, by some express reference relevant to the business interests of an obligor. 
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When drafting a reasonable or best endeavours clause, the following matters should be considered:

  • if you wish to bind a party to do (and only do) what is reasonable, then use the phrase ‘reasonable endeavours.’ On current authorities, it would appear that ‘best endeavours’ will impose similar obligations but it is better to avoid any doubt about what is intended; and
  • if what is intended is something different than reasonable endeavours, then it is better to specify what is intended. Similarly, the use of ‘internal standards of reasonableness’ (for example by providing that certain actions will or will not be encompassed by the obligation) should be considered.
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Consequential loss

Commercial contracts commonly include a clause that limits the damages one party is liable to pay to another for breach of contract. Typically, the distinction sought to be drawn is between ‘direct’ losses (for which damages are recoverable) and ‘consequential’ losses (which are typically the subject of limitation clauses). The position in Australia is that concepts of ‘direct,’ ‘indirect’ and ‘consequential’ loss do not have settled legal meanings when used in contracts (compared to when used to explain legal principle).

To avoid difficulties, the preferable approach is to either spell out the appropriate test in the definition of consequential loss in a contract, or to specify which types of losses are intended to fall within the definition.

The other possible approach is to decide not to expressly deal with the issue and to allow a Court to decide the matter. While this may save time and effort in contract drafting and negotiation, it would leave your fate uncertain if the matter were to ever be litigated.

The law on the meaning of the term ‘consequential loss’ when included expressly in a contract is currently unsettled in Australia. There are three possible approaches arising out of the case law that may be relevant to how ‘consequential loss’ is interpreted:

  • The traditional, but, some might say outdated, approach determines consequential loss to be those losses falling within the second limb of the test for remoteness of damage in Hadley v Baxendale (1854) 9 Exch 341(‘Hadley’). A plaintiff recovers damages under this limb (in addition to the damages “arising naturally”, which it recovers under the first limb) only where the loss may reasonably be supposed to have been in contemplation of both parties at the date the contract was entered into. Additionally, Australian authority, in, for example, Butler v Egg & Egg Pulp Marketing Board (1966) 114 CLR 185, has accepted dicta from Hadley that if the plaintiff communicates any special circumstances to the defendant before or at the time of contracting, these circumstances are included in the range of matters that can reasonably be supposed to be contemplated by the defendant. Recent Australian case law has largely rejected this approach when interpreting ‘consequential loss’.
  • The second approach comes from Environmental Systems Pty Ltd v Peerless Holdings Pty Ltd (2008) 19 VR 358 (‘Peerless’), in which the Victorian Court of Appeal declined to follow Hadley and held that consequential losses refer to ‘anything beyond the loss that every plaintiff in a like situation would suffer, such as lost profits or expenses incurred through breach’. The decision was adopted by NSWCA without discussion in Allianz v Waterbrook (2009) 15 ANZ Insurance Cases 224; [2009] NSWCA 224.
  • The final, ‘constructional’ approach, from Regional Power Corporation v Pacific Hydro Group Two Pty Ltd (No 2) [2013] WASC 356, and Patersons Securities Ltd v Financial Ombudsman Service Ltd [2015] WASC 321, involves a case-by-case approach that requires the particular contract to be construed as a whole, considering the ‘natural and ordinary’ meaning of the words. Thus, whether a loss is classified as direct, indirect or consequential will depend on the specific contractual context in question.
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Given the current, uncertain state of the law, the key drafting point for consequential loss clauses is to avoid drafting ‘bare’ consequential loss exclusion clauses, that is, where the terms of the contract do not expressly provide for what may be in or out of ‘consequential loss’.

The recommended approach is to specifically name the types of loss or damage that are consequential loss, for example, loss of profits. 

An alternative method is to state the particular test that it is intended apply to the contract, including, for example, the common law position under Hadley v Baxendale. Two simple examples of this are as follows:

Example 1:

(a) Subject to paragraph (b), in no event will either party’s liability include any amount for indirect, special or consequential loss or damage.

(b) Nothing in paragraph (a) will preclude the recovery by [the Customer] of loss or damage which may fairly and reasonably be considered to arise naturally, that is according to the usual course of things, from the breach or other act or omission giving rise to the relevant liability.

Example 2:

Neither party is liable for indirect or consequential loss (where “indirect and consequential loss” means the type of loss described in what is commonly referred to as the “second limb” of Hadley v Baxendale (1854) 9 Exch 341, and does not have the meaning given in the decision in Environmental Systems Pty Ltd v Peerless Holdings Pty Ltd [2008] VSCA 26 (or any similar line of authority in Australia)).

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Liquidated damages and penalties

Parties can seek to create more certainty around the quantum of damages that will be payable for certain breaches by including liquidated damages clauses into their agreements. However, in order to be enforceable parties must ensure that they do not infringe the law’s prohibition on penalties.

While the law since Paciocco v ANZ Banking Group Ltd (2016) 258 CLR 525 (Paciocco) has altered the focus of the inquiry, prima facie a collateral stipulation is a penalty, and it will be unenforceable to the extent that it is appropriate to provide compensation.

A clause will be a penalty if a payment sum (or performance obligation) required by a clause is extravagant and unconscionable or ‘out of all proportion’ with the costs of the impact of the breach on the party’s relevant interest that is sought to be protected by the clause.  If the clause is inserted to secure performance of a collateral benefit it will not have a purpose of protecting a relevant interest and will be a penalty. Merely because a party is unable to negotiate a clause does not mean it will be a penalty at law, however, legislation may provide other remedies in such circumstances. Further, a clause can be found to be a penalty irrespective of whether it is called a ‘liquidated damages’ clause or not.

If the clause triggers the payment sum or performance obligation by reason of a breach of contract, then it will not be a penalty merely because it is not a “genuine pre-estimate of loss” judged at the time of formation. Instead, it will be a penalty if the payment sum (or performance obligation) is ‘out of all proportion’ with the interest it seeks to protect following breach (or non-performance).

There is now a focus on the interests sought to be protected by the clause and the negative impact on those interests. For example, Allsop CJ stated in Paciocco [2015] FCAFC 50; 236 FCR 199 at [103] that the focus is on the “obligee’s interest in the due performance of the obligation” and the High Court in Andrews v Australia and New Zealand Banking Group Ltd (2012) 247 CLR 205 described it at [75] as “whether the sum agreed was commensurate with the interest protected by the bargain”.

The type of interests that can legitimately be protected by a clause need not be ones that would otherwise be compensable at law or equity (Gageler J in Paciocco at [159]). Examples of interests that can legitimately be protected by a liquidated damages clause include:

  • Requirement to pay a sum of money if there was not timely provision of weapons during time of war, because the interest in timely performance could not readily be quantified in terms of money and the sum chosen was not “out of all proportion” (Clydebank Engineering and Shipbuilding Company v Don Jose Ramos Yzquierdo Y Castaneda [1905] AC 6)
  • Requirement to pay a sum of money every time a product was sold by a retailer below the list price provided by the manufacturer. The interest being protected was preventing disorganisation of a trading system and a market perception of a premium product (Dunlop Pneumatic Tyre Company Ltd v New Garage and Motor Company Ltd [1915] AC 79)
  • Requirement to pay a sum of money should a purchaser of a business breach a non-compete clause, which was designed to protect the goodwill of the business (Cavendish Square Holding BV v Makdessi [2016] AC 1172)
  • Requirement to pay a sum of money if customers chose to overstay the time limit on a free carpark in a shopping centre, which was designed to prevent overstaying customers reducing carspaces which could otherwise affect the goodwill and turnover of customers for the business (Parking Eye Limited v Beavis [2016] AC 1172).
  • Requirement to pay a “late payment fee” if credit card balances were not paid back on time, which assisted the bank protect its business and financial interests including provisioning costs (Paciocco).

However, in some cases the relevant interest is one that can be measured in accordance with usual damages principles. In Ringrow Pty Ltd v BP Australia Pty Ltd (2005) 224 CLR 656 the High Court stated at [21] that In “typical penalty cases the court compares what would be recoverable as unliquidated damages with the sum of money stipulated as payable on breach”, and that approach has been accepted in Paciocco at [33], [160] and [321].

The time for assessing whether a clause is a penalty or not is at the time of the dispute but looking to the time of formation.

As a matter of drafting it is critical to be conscious of the penalty doctrine as courts will still supervise bargains. It is important to identify the interest a party seeks to protect by inserting a liquidated damages clause and whether the likely impact on that interest is appropriately protected by the payment sum or performance obligation being imposed. While it is not necessary to identify the relevant protected interest in the contract itself it is open to parties to do so and may make disputes less likely.

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Good faith

The law about good faith in the performance of contractual obligations is not settled in Australia. Most jurisdictions have shown at least some support for the proposition that an obligation or duty of good faith and fair dealing is part of the law of contractual performance in Australia in some way, whether as an implied term or duty imposed on all or some contracts.

For more information, see below or download Gilbert + Tobin’s Guide to Good Faith in the Performance of Contractual Obligations.

The usual content of the obligation to act in good faith is considered to be:

  • an obligation to act honestly and with a fidelity to the bargain;

  • an obligation not to act dishonestly and not to act to undermine the bargain entered or the substance of the contractual benefit bargained for; and

  • an obligation to act reasonably and with fair dealing having regard to the interests of the parties and to the provisions, aims and purposes of the contract, objectively ascertained.

What is necessary to satisfy the duty will depend on the contractual and factual context (including the nature of the contract or contextual relationship). It does not require a contracting party to prefer the interests of the other contracting party, or to subordinate its self-interest to the other party.

An implied obligation may be excluded either by express contractual provision or because it is inconsistent with the terms of the contract. However, to the extent that good faith is inherent in contract law, for example, because it requires honesty, it cannot be excluded.

Good faith in an era of uncertainty

Until the existence and content of the duty to act in good faith is resolved, the prudent course is:

  • to exercise broad contractual powers and discretions in a way that is consistent with the imposition of a duty of good faith (ideally for a legitimate, documented business reason); and
  • to draft clauses appropriately where a broad power is intended to not be subject to an obligation to act in good faith, or identify the fetters on the power that are appropriate, for example, “the discretion must be exercised honestly, but may be exercised with regard to the party’s own legitimate self-interest”.

Example 1: A termination for convenience clause might appropriately be worded to allow a party to ‘terminate for any reason, at any time and in its absolute discretion.’ This, together with a term expressly excluding all implied terms, would indicate the intention of the parties to exclude any good faith constraint.

Good faith standards are also imposed into some forms of contracts under some legislative regimes, for example the Franchising Code.

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Mitigation

A failure by an innocent party to mitigate its loss following a breach of contract may reduce the amount of damages payable to that party. The law will not require a contract breaker to pay for loss that the innocent party could have avoided by taking reasonable steps.

The ‘reasonable steps’ which are required of an innocent party are not particularly onerous. The innocent party should do what it reasonably can to minimise the loss, while acting within the course of its business. It is not required to sacrifice or risk its property or rights in order to mitigate its loss.

For more information, see below or download Gilbert + Tobin’s Guide to Mitigation of Loss Following a Breach of Contract.

Ultimately the test for mitigation is not whether there was a better way of doing things but whether what the innocent party did do was reasonable. An innocent party is not under any obligation to do anything other than in the ordinary course of business.

What an innocent party is required to do to mitigate its loss will always be a question of fact to be considered in all the circumstances. Examples of what may be required might include:

  • entering into a substitute contract for example to buy or sell goods;
  • attempting to re-sell or re-let property; or
  • giving a builder a reasonable opportunity to rectify any defects (but not where the owner has reasonably lost confidence in the willingness and ability of the builder to do the work).

If the innocent party spends money in taking steps to mitigate that cost can also be recovered as damages in court proceedings.

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Preliminary agreements

A preliminary agreement is a short-form agreement that is entered into by the parties but which may not set out all of the terms of the contract or have been written or executed in a formal way. Examples of preliminary agreements include heads of agreement, memorandums of understanding and letters of intent.

Ordinarily, a preliminary agreement will either expressly or impliedly contemplate that a fuller agreement will eventually be drawn up to regulate the rights of the parties. The issue then arises as to whether, and to what extent, the preliminary agreement is binding. The position may be summarised as follows:

  • whether a preliminary agreement is binding depends on the objective intentions of the parties;
  • the courts will have recourse to a system of legal classes in answering that question. However, the facts of a particular case will always be important in determining the result, which puts the matter back in the hands of the parties; and
  • the best way to avoid any uncertainty over whether a preliminary agreement is legally binding is to clearly spell out the extent to which (if any) it is intended to be binding and when that will occur.

Where parties do not intend a preliminary agreement to be binding, the following matters should be considered:

  • a clear statement to that effect should be included in the preliminary agreement;
  • if any terms are intended to form an exception to the non-binding nature of the agreement, a clear ‘carve out’ provision should be included to deal with them (for example, confidentiality);
  • an agreement to negotiate a formal contract in good faith may be enforceable if it is sufficiently certain;
  • consider including an express statement that parties commence work at their own risk; and
  • consider including an express statement that neither party is obliged to continue negotiations or to execute any formal contract that is prepared and may cease negotiations or not execute a formal contract at any time at its absolute discretion.

Warranties and indemnities

One of the principal ways in which a buyer will seek to protect itself in a transaction is by requiring the seller to provide warranties about the business in the business purchase agreement. If it later transpires that the warranty was inaccurate and this causes the buyer loss, the buyer may have remedies against the seller.

The buyer can also seek to include a requirement that the seller indemnify it against any losses the buyer sustains as a result of a breach by the seller of a warranty or other provision of the agreement. The difference between warranties and indemnities is explained below.

Warranties in this context are promises by the seller as to the state of affairs of the business. If these promises are inaccurate and cause the buyer loss, the buyer may have remedies against the seller, in particular, a claim for damages. Warranties encourage disclosure of information by the seller and protect the buyer against undisclosed matters or liabilities.

A warranty in a business purchase agreement is in the strict sense, as with any other warranty, merely a term of the contract itself, breach of which will give rise to damages or, in rare circumstances, rescission or termination (e.g. where the breach of warranty is fundamental or if the seller is unable to transfer title to an essential asset of the business).

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An indemnity is a promise by one party to protect another party from, or to reimburse that party for, loss or damage suffered or any expense incurred on the occurrence of a specified event. The event may, but need not, include a breach of contract or some other legal duty by the indemnifying party. For example, an indemnity may require a party to compensate another party on the happening of an external event such as a fall in the exchange rate.

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The quantum recoverable for breach of a warranty is governed by ordinary contractual principles, meaning that that quantification of damages is subject to the principles of mitigation and remoteness. With an indemnity, it is the terms of the indemnity that govern what may be recovered. This means that it may be possible to recover a greater amount under an indemnity compared with a warranty claim if the indemnity so permits.

Both indemnities and warranties can be limited by the inclusion of contractual restrictions such as a threshold before claims are payable, or a time limit in which to bring any claims or a cap.

Warranties will be construed by the courts applying ordinary principles of construction, that is, by ascertaining what a reasonable person would understand by the language in which the parties have expressed their agreement. 

Indemnities are strictly construed. This means that where it is possible any doubt as to the construction or operation of an indemnity exists, it will be resolved in favour of the indemnifier

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Guarantees and indemnities

A contracting party can seek to reduce its possible exposure for loss caused by breach of contract by requiring the other party or a third party to provide contractual promises in the form of guarantees or indemnities.

While they are common contractual clauses, particularly in commercial bargains, guarantees and indemnities are subject to special rules of interpretation and need to be drafted carefully. Guarantees and indemnities can be used separately or together, and can also be used with other risk allocation clauses such as liquidated damages, exclusion, warranty and insurance clauses.

 

As noted above, an indemnity is a promise by one party to protect another party from, or to reimburse that party for, loss or damage suffered on the occurrence of a specified event. The event may, but need not, include a breach of contract or some other legal duty by the indemnifying party. For example, an indemnity may require a party to compensate another party on the happening of an external event such as a fall in the exchange rate.

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A guarantee is a promise by the other contracting party or a third party that certain promises of a party will be performed, failing which the guarantor will be liable for the non-performance or defective performance.

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A guarantee is a secondary obligation, in the sense that the guarantor is promising performance by another party. An indemnity is a primary obligation because it is a promise to hold the other party harmless from loss, and the obligation is not triggered by a breach of performance by another party, but instead by the threat or the event of the suffering of loss.

With both guarantees and indemnities the scope of the obligations depends on how they are drafted and their proper construction.

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Both guarantees and indemnities are subject to special rules of construction. While courts look to the natural and ordinary meaning of words, where there is ambiguity in the possible meaning or operation of a guarantee or indemnity a court will choose a construction that favours the party providing the indemnity or guarantee.

Further, a guarantor will not be bound by a guarantee if the obligations that have been guaranteed have been changed without the guarantor’s knowledge and approval, for example where a guarantee promises loan repayments and then the loan terms are altered. However, guarantees can be drafted as continuing obligations that will not be affected by any changes to the performance obligation that has been guaranteed to ensure that the guarantee remains effective.

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Construction of commercial contracts

Commercial contracts in Australia are given an objective, businesslike construction on the assumption that the parties intended to produce a commercial result. The meaning of commercial contracts is established by considering the language used in its context of the document, the surrounding circumstances and the commercial purpose or objects to be secured by the contract.

The courts take a reasonably narrow approach to the admission of the surrounding circumstances. Such circumstances must have been facts objectively known to the parties at the time of formation of the contract. That material is admissible to construe a contractual provision in all cases, whether there is ambiguity or not.

For more information, download Gilbert + Tobin’s Guide to the Construction of Commercial Contracts.