When is it safe to terminate under a contract?

Volcanoes – we have rather a lot of them in Asia, but even we’ve been obsessing about the infamous Icelandic one, this week. Though 6000 or more miles away from the action, Japanese car manufacturers relying on components from Ireland and Korean mobile phone suppliers ready to send their wireless wares to a waiting world, have been among those frustrated as the volcanic ash cloud has choked airfreight routes. Which got me thinking…not so much about force majeure (I’ll leave that to my holidaying partners examining their insurance documents to seek support for their compensation claims!) but about the options a contracting party faces when the party with whom he’s entered into an agreement has breached a material provision (say, a delivery date): should he accept that party’s repudiation and sue for damages or simply terminate it in accordance with the procedure provided for in the agreement?

The recent English Court of Appeal case of Shell Egypt West Manzala GmbH v. Dana Gas Egypt [2010] EWHC 465 (Comm.), albeit not exactly a construction case, dealt with this particular dilemma which is of considerable significance for construction contracts. In this case, Dana Gas acquired drilling rights in the Nile Delta from the Egyptian Government and brought in Shell as a partner in the petroleum exploration project. Under the contract, Shell agreed to make an initial investment of US$15m and also to make further substantial contributions. However, 8 months later, disputes arose between the parties and Shell alleged that Dana Gas had failed to notify a change of control in the company; and that their failure constituted a repudiatory breach of the contract.

As we all know, if a party commits a serious breach which goes to the root of the contract – that is, a repudiatory breach – the innocent party is confronted with two options. It may decide to assert that the contract has been ‘repudiated’. This will provide the innocent party with a right to treat the contract, and its obligations under it, as terminated with immediate effect and sue for damages for the breach of the contract. Alternatively, it may decide to act in a way as if the contract is still in effect, or in another words, to ‘affirm’ the contract’s continuing existence. If the innocent party decides to take the latter option, its right to terminate (in respect of that particular repudiatory breach) will be lost.
In the Shell Egypt West case, instead of informing Dana Gas that it was terminating the contract for repudiatory breach and in doing so, exercising a contractual right of rescission, Shell issued a termination letter to Dana Gas which invoked a clause under the contract allowing it to terminate the contract on giving 30 days’ notice (based on, sadly, a mistaken view on the situation on the assignment of concession rights). As we shall see, that decision was to have a significant consequence…

On appeal to the High Court, Shell argued that it had made a mistake in its termination letter (as it mistakenly believed that Dana Gas had failed to obtain an assignment of the concession interests granted by the Egyptian Government to another party) and it should not be deprived of its rights to recoup their investment. Essentially, a termination letter may be issued pursuant to the contract under two separate provisions – Clauses 3.1.8 and 3.1.9. Clause 3.1.8 provides that if the agreed closing date of the project was not achieved, Shell may terminate the contract but Dana Gas would not be obliged to repay Shell’s initial investment; whilst Clause 3.1.9 provides that if the agreed closing date of the project was not achieved because of Dana Gas’s failure to obtain an assignment of the concession interests granted by the Egyptian Government – Dana would need to repay Shell’s initial investment. Here, on the mistaken belief that the assignment was not effected, Shell issued the termination letter pursuant to Clause 3.1.9 even though it was also aware of Dana Gas’s repudiatory breach based on the change of ownership.

Despite Shell’s arguments based on their mistake, that is – Dana Gas should have realized that Shell had misinterpreted the events and that Dana Gas was in repudiatory breach of the contract, the court held that, even if Dana Gas had realized Shell’s mistake, such knowledge would not have “remove(d) the essential thrust of the letter”, namely – Shell wished to terminate the contract under the termination clause and not in respect of the repudiatory breach. In doing so, Shell had acted in a way which ‘affirmed’ the existence of the contract. This in turn deprived Shell both of a right to damages and a right to recover the US$15million investment which it had contributed under the contract. Clearly, what Shell should have done was to accept Dana Gas’s failure to notify the change of control as a repudiatory breach of contract. Had this occurred, Shell could have reclaimed its investment based on its contractual right of rescission. And even if Shell doubted this route, it could have stated in its termination letter that, in the alternative, it was exercising the 30-day termination right.

This case suggests that if an agreement and the general law provide a party with alternative rights, not only will the innocent party be required to carefully consider the options available to them (as they may lead to very different consequences) by observing proper contract management, but that it should also communicate their election in appropriate terms. Parties should not be too quick to decide to turn to their termination rights under the contract but should instead, thoroughly investigate all of their options based on the correct interpretation of factual circumstances and frame the ‘termination letter’ tactfully to broaden the remedies available to them. Now, turning back to those frustrated mobile phone suppliers desperately waiting for the ash clouds to clear, one would imagine they should probably be a little less worried now (assuming they’ve taken good legal advice), when they next find a ‘termination letter’ in their letter box, yet…they will be asking themselves: “Hmm…I wonder if there’s anything wrong with this termination notice?”.

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