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Innocent termination

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Shourav Lahiri on how to terminate a contract correctly when it is breached by the other party

The courts of England and Wales have just delivered a cautionary tale in their decision in Shell Egypt West Manzala GMBH (“Shell”) and Dana Gas Egypt Limited (“Dana”) (formerly Centurion Petroleum Corporation) on how the choice of approach to termination could affect the extent of recovery by the innocent party. Let us consider the impact of this ruling on construction contracts in India.

Most standard form contracts include clauses entitling one party to terminate the contract if the other party commits a major breach of contract. The contracts also provide for financial claims the innocent party is entitled to after such termination. (See, for instance, Clause 63 of the FIDIC Red Book 4th Edition 1987 and Clause 15 of the FIDIC Red Book 1999.)

Very often, there will also be a right under the governing law of the contract for an innocent party to terminate the contract upon breach the other party. For contracts governed by Indian law for instance, Section 39 of the Contracts Act provides for the right to terminate upon a party’s refusal to perform the entirety of his obligation, and this principle is also enshrined in caselaw (see, for instance, Khettramohan Dey & Co. v Binode Behari (AIR 1930 Cal 382). To entitle a party to terminate however, the breach of contract must be one that prevents substantial performance of the contract; a minor breach will not be enough.

However, just because one party has committed a repudiatory breach of contract does not mean that the contract is automatically terminated. The innocent party can ‘elect’ how to proceed: he can either accept the repudiation (and thereby terminate the contract) or not accept the repudiation, and affirm the contract, thereby excusing the repudiation. Once a contract has been affirmed, the party cannot subsequently rely on the previous repudiation to seek to terminate the contract.

One might assume that if a right to terminate upon repudiation exists both under the contract and under general law, the consequences in terms of recovery by the innocent party will be the same.

This is not so, and the High Court of England and Wales has sent a timely reminder of this in Shell Egypt West Manzala GMBH and Dana Gas Egypt Limited (formerly Centurion Petroleum Corporation).

The facts

Dana (formerly Centurion Petroleum Company) approached Shell to discuss their participation in a venture to engage in petroleum exploration and exploration activities in Egypt. Shell and Dana entered into a co-operation contract in March 2006 as which stage Shell invested $15 million into the venture.

Partway through the project there was a change of ownership in Dana. Shell claimed that Dana failed to issue the correct notices to it relating to the change of control and that this constituted a repudiatory breach of contract. Shell sought to terminate the contract. A dispute arose between the parties and arbitration proceedings were commenced.

Shell claimed damages for a repudiatory breach of contract. Shell also claimed (in relation to a different breach of contract) that they had contractual right to rescind the contract. Dana denied all breaches of contract and argued that if there was a breach, it was not repudiatory in nature.

Furthermore, it argued that as Shell had terminated the contract by using the contractual mechanism rather than under general law, it was not entitled to damages. Interestingly, for termination for repudiation under the contract, Shell was not entitled to recovery of any sums.

The decision

The issues came up first before the arbitration Tribunal appointed to hear the matter. The Tribunal ruled that Dana was in repudiatory breach but that Shell had not accepted the repudiatory breach as terminating the contract under general law; instead Shell had exercised their contractual right to terminate for a subsequent breach of contract. The arbitrators held that by choosing to terminate under the contract for a subsequent breach, Shell, in effect, was affirming the contract after the previous repudiatory breach (as, according to Shell’s own actions, the contract remained live after the first breach in order to enable Shell to terminate under it for the second breach). Therefore, the Tribunal held, Shell had no right to claim damages for breach of contract. Also, as the contract provisions did not provide for recovery of any sums upon termination under the contract, Shell could not claim any sums upon termination at all.

Shell challenged the arbitrator’s decision before the High Court. The High Court upheld the Tribunal’s decision. The Court said that when Shell issued a notice of termination under the contract, Shell had made a serious error. Instead of relying on their right under English law to terminate due to a repudiatory breach of contract – thus entitling Shell to sue for damages – Shell exercised the contractual termination mechanism which afforded them no right for payment on termination or to claim damages.

As a result of its decision, Shell lost the right to recover its $15 million investment because the termination provision in the contract did not allow for recovery of any sums paid under the contract. Shell may well appeal this decision, and we will have to wait and see if a higher court accepts Shell’s challenge.

What could Shell have done? The High Court gave a possible approach. It said it “… can see no reason why Shell could not have served a notice which accepted the repudiatory breach as terminating the contract but, in the alternative, in case they were wrong in asserting that [Dana] were in repudiatory breach, exercised the contractual right to terminate…”. This is not an uncommon approach as it preserves a party’s right to argue for an alternative argument if its primary argument is held to be unsustainable.

Lessons to be learnt

Firstly, you must ensure you understand the implications of terminating a contract under the contract and your rights upon termination under the governing law. If, as in the Shell contract, there is no right to recovery monies under the contract post termination, you should seek to terminate under general law and recover damages. Sometimes, the contract may provide for a greater scope of recovery than the governing law would – check the terms of the contract and take legal advice before seeking to exercise your right to terminate.

Secondly, be conscious that once an act of repudiation has been committed by the other party, your own acts in response can be very important. By continuing to perform the contract, you may well have taken to have affirmed the contract and excused the repudiation. If that is not your intention, use clear words to express the position to the other party.

Shourav Lahiri is a Partner in the international law firm Pinsent Masons LLP. He wishes to thank Ms Helen Turner of Pinsent Masons LLP for her assistance with this article. Pinsent Masons LLP has been selected as the Global Construction Law Firm of the Year 2009 by Who’s Who Legal and as one of the Top 10 international firms doing India work by the India Business Law Journal in June 2009.

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