UK: Offshore Oil & Gas Briefing - Termination Trap

Last Updated: 14 January 2011
Article by David Bennet and Mark Walsh

The issue

Terminating a contract using contractual termination provisions can have unforeseen consequences. Most significantly, this may include losing the right to sue for loss of profit on the terminated contract.

Background

Absent clear provisions to the contrary, when faced with a repudiatory breach of contract by a counterparty, English common law permits the innocent party to 'accept' the breach, terminating the contract (generally with immediate effect), and sue for the loss of profit. This is a valuable remedy - loss of profit is likely to be uninsured, and can be substantial, especially in a market where day rates have moved significantly since the contract was agreed.

The problem of 'affirmation by termination'

This problem arises because, when faced with a repudiatory breach of contract, as a matter of English common law, the innocent party has two mutually inconsistent options: either to 'accept' the breach and bring the contract to an end, claiming damages for loss of profit, as mentioned above; alternatively, to continue with the contract – known as 'affirming' the contract.

The innocent party must chose one or other option. There is some flexibility about how quickly this choice must be made, but if left too long, a party will be deemed to have made a choice - usually to have decided to continue with the contract. Other circumstances in which the innocent party may be deemed to have chosen to continue with the contract include where it has taken steps which would be inconsistent with terminating the contract - for example by continuing to perform the contract, or insisting on performance of the contract by the counterparty.

There are many cases where the common law right to terminate has been lost by the innocent party saying or doing things which the court has considered amount to an 'affirmation' of the contract. In two cases reported in 2010 the English courts had to grapple with the question of whether an innocent party could affirm a contract (thereby losing its right to sue for loss of profits) by terminating it pursuant to an express contractual provision – hence the problem of 'affirmation by termination'. The decision in one of these cases proved expensive for Shell.

The Shell Egypt case

In Shell Egypt West Manzal GmbH v Dana Gas Egypt Ltd1 the question of 'affirmation by termination' arose in the context of a 'farm-in agreement'. The premise of the deal between Shell and Dana was that, by various steps, Shell would acquire a 50% interest in relevant concessions – this was termed 'closing' in the contract. The agreement provided that if closing had not occurred within a period of nine months, Shell could terminate the agreement by 30 days notice in writing.

There was, however, a twist. A further clause provided that if Shell terminated as above, but the reason closing had not occurred within the stipulated nine month period was because Dana had not completed its acquisition of concessions from a third party, then Shell was entitled to a refund of the approximately USD15 million they had already paid to Dana.

Closing did not happen. Shell were under the impression that this was because Dana had not completed their acquisition from third parties. This was not the case, and so, although Shell were entitled to terminate the agreement pursuant to the contractual provisions, they were not entitled to a refund of the USD15 million. At the same time, for quite separate reasons that we shall not set out here, Dana were in repudiatory breach of contract, and Shell had a right to terminate the agreement at common law and sue for loss of profit. That could have been a very large claim indeed, and therefore termination at common law was a valuable legal option.

Shell wrote to Dana giving them the 30 days' contractual notice of termination. The letter did not specifically refer to the contractual termination clause, but it did refer to the right to a refund to which Shell, erroneously, believed they were entitled, and so it was fairly clear to the reasonable recipient that Shell had in mind their termination rights under the contract, rather than at common law, when they wrote that letter.

Dana, quick off the mark, waived the 30 day period of notice, and that was the end of the contract – it was terminated. When the position became clearer to Shell, they brought arbitration proceedings seeking damages for loss of future profits based upon Dana's repudiatory breach of contract. Those proceedings ended up on appeal before the High Court in London on a point of law. Shell argued that their letter could properly be regarded as communication of their acceptance of Dana's repudiatory breach of contract, thereby terminating the contract at common law. Dana contended that, rather than being an acceptance of Dana's repudiatory breach of contract, Shell had given a termination notice which indicated that the contract would in fact continue for a further 30 days terminating at the end of the notice period.

The court held that the letter would have been understood by a reasonable recipient to operate the contractual termination provision. Critically, the court then went on to hold that choosing to operate the contractual termination provision was inconsistent with choosing to treat the contract as terminated at common law. The court considered that relevant factors pointing to such an inconsistency were that, to be triggered, the contractual termination clause did not require a breach of contract on the part of Dana and also that it made certain provision for the consequences of its operation. Accordingly, by operating the contractual provision, even though it was a provision terminating the contract, Shell had in fact affirmed the contract in law and lost their common law right to sue for loss of profits.

Conclusions

Whilst in this case the contractual right of termination was triggered by an event (the failure of 'closing' by a certain date) rather than by a breach of contract2, nevertheless, the purpose of the provision was to bring the contract to an end. The case highlights the importance, before exercising any contractual right to terminate a contract, of considering the possible consequences not only under the terms of the contract, but to your common law rights.

In practice

  • Do not exercise contractual termination provisions (especially when your counterparty is in breach of contract) without considering the position at common law; in particular, whether you may also have a common law right to terminate, and pro's and con's of terminating under the contractual provisions versus pursuant to your common law rights.
  • Consider whether it is possible validly to terminate the contract by a notice expressed to be given in the alternative; generally, the first choice will be termination at common law, and in the alternative,in reliance on the relevant contractual provision.
  • Bear in mind that delay can be fatal to both contractual and common law rights to terminate.
  • If you need to buy time to consider the position, responding with the following language may assist, but in any event you should seek advice as soon as possible:
    "We refer to [insert details/facts of the breach of contract], which amounts to a serious breach of the contract between us. We are considering our position and our response and will revert to you shortly. In the meantime, we reserve all our rights and remedies and no step taken by us, or on our behalf, is, or should be interpreted as, a waiver of any of those rights and remedies, or a representation that we will not rely upon them, or as an affirmation of the contract."

We are happy to discuss any of the matters raised in this briefing note on an informal basis.

Footnotes

1 Shell Egypt West Manzal GmbH & Another v Dana Gas Egypt Ltd [2010] EWHC 465

2 The problem of affirmation by termination had also arisen in a case concerning the operation of a contractual termination provision triggered by a breach of contract: Stocznia Gdynia SA v. Gearbulk Holdings Ltd [2010] QB 27. In that case the High Court had also ruled that 'affirmation by termination' had occurred, and that by operating the particular contractual provision for termination in the face of Stocznia's breach of contract, Gearbulk had lost the right to sue for loss of profits. In a decision that attracted criticism from some commentators, the ruling was overturned by the Court of Appeal who considered that, in the particular case, the contractual termination provision was to be read as the parties' codification of the common law right to terminate for repudiatory breach, and no question of Gearbulk having to 'choose' one or other option arose.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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