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21 Jun 2022

Contractual termination: Avoiding problems

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The recent High Court claim of Lombard North Central Plc v European Skyjets Ltd [2022] EWHC 728 (QB) provides some important reminders on what may (and may not) be required to validly terminate a contract, as well as when a right of termination may be lost through 'waiver'. The case concerned default by an airline business on a secured loan and the lender's entitlement to terminate (and thus 'accelerate') the loan. While the case will be of particular interest to financial institutions, the principles apply to all commercial contracts.  

Termination – the basics

Exercising a contractual right of termination under any commercial contract is often not as straightforward as one might expect.

To start with, the law requires that any valid termination notice must comply strictly with any termination conditions set out in the contract. To borrow the analogy of Lord Hoffman in the leading case of Mannai Investment Co Ltd v Eagle Star Life Assurance Co Ltd [1997] UKHL 19 concerning notice validity, “[i]f the clause [in a contract] had said that the [termination] notice had to be on blue paper, it would have been no good serving a notice on a pink paper". Identifying and satisfying termination conditions is often more complex than just using the right coloured paper.

Secondly, even where a termination notice is correctly drafted and validly served, a right of termination can be inadvertently lost where a party acts in a manner which is inconsistent with the termination of the contract. A common example is where a party demands payment of arrears which have accrued under a contract, causing them to 'waive' the right to terminate for those arrears.

The stakes are high when it comes to correctly terminating a contract: if a party incorrectly terminates then they will, in general, be liable to the other party for the losses resulting from that incorrect termination. In high value commercial contracts, the losses could be substantial.

Background

In 2008, European Skyjets Limited (the "Borrower"), took out a loan in the sum of USD 8.77 million for the purchase of an aircraft (the "Loan Agreement") with Lombard North Central Plc (the "Lender"), secured by way of a first priority legal charge over the aircraft.

Between 2009 and 2012, the Borrower regularly paid the monthly instalments late. During this time, the Lender sought to apply late payment charges (in addition to default interest) on any outstanding arrears. Although there was no contractual right under the Loan Agreement to apply late payment charges, the Lender sought to apply such charges as a condition of it not enforcing its rights in respect of future late payments.

In 2012, the Lender emailed the Borrower stating that its account was in arrears and that it remained uncomfortable with the Borrower's payment history and short-term cash flow. Nevertheless, as "a gesture of goodwill", the Lender offered to "allow more time to bring the balance of the arrears up to date". This email contained the statement that it was "… without prejudice and [that the lender] fully reserves its rights in respect of the identified breaches being arrears on the Loan Agreement…" (a so-called "Reservation Statement").

The Loan Agreement provided that the Lender was entitled to terminate "[a]t any time after the occurrence of an Event of Default" (emphasis added) by giving notice to the Borrower (the "Termination Clause"). After receiving advice by an independent firm of accountants that the Borrower was insolvent, the Lender terminated the Loan Agreement by giving notice relying on purported arrears as an 'Event of Default'. The Lender subsequently sought to enforce its security over the aircraft by selling it for USD 3.1 million. Thereafter, the Borrower went into administration.

Whether or not the Borrower was actually in arrears at the date that the notice was served was in dispute (the Borrower maintaining that it had cleared the arrears before the notice was served).

The Lender later brought a claim against the Borrower for the outstanding balance of USD c.5.78 million under the Loan Agreement. The Borrower denied the claim on the basis that the Lender had no entitlement to terminate the Loan Agreement (and thus to sell the aircraft) and counterclaimed for damages of USD 26 million arising for breach of contract and/or conversion.  

Decision

The Court held that the Lender had validly terminated the Loan Agreement (and therefore validly enforced its security over the aircraft). This conclusion was based on the following findings.

1- Did it matter whether the arrears were outstanding at the point of termination (i.e. did the breach need to be continuing)?

No. The Termination Clause did not, as a matter of construction, require the default to be continuing at the date the notice was served. Rather, it specified that the right could be exercised "at any time" after an Event of Default had occurred. Therefore, it was irrelevant whether the arrears were outstanding at the point of termination: there was no dispute that the Borrower had historically been in arrears.

Interestingly, the Court considered that even if the Termination Clause had required the arrears to be outstanding at the point of termination, a failure to pay a sum even as small as $179.99 (which the Lender claimed was an undisputed outstanding sum) would have been sufficient to justify termination1.

2- Did the Lender 'waive' the right to terminate for the arrears?

Yes. The apparent harshness which resulted from a creditor exercising a right to terminate for historic breaches was moderated by the legal concepts of 'waiver' and/or 'estoppel'2. In this case, the Lender had waived the right to terminate by offering the Borrower additional time to pay the arrears and asserting its right to penalty charges on the Borrower's late payments (which was inconsistent with the Lender terminating the Loan Agreement). Although there was a 'no waiver clause' in the Loan Agreement which stated that "[n]o failure or delay in exercising… any right… shall operate as a waiver…", this could not overcome a waiver of this kind, namely one resulting from positive statements and assertions and not merely a failure or delay in exercising the right to terminate3. Nor could the Reservation Statement prevent things previously said or done from having their objective effect.

3- Was the Lender entitled to terminate for another reason?

Yes. Although the notice specified alleged arrears as the reason for termination, the Lender could rely on other reasons not specified in the notice as a basis for termination. This was because the Termination Clause did not require the basis of termination to be specified. This conclusion was consistent with the 'Boston Deep Sea Fishing principle'4, namely that it is possible to terminate at common law for a 'repudiatory breach of contract' without identifying (or correctly identifying) the breaches justifying termination. In this case, there were other reasons which justified termination including (but not limited to) the Borrower's financial position (this being an Event of Default under a so-called 'material adverse change' clause5).

4- Was the Lender precluded from terminating on the basis of the following:

(a) That the Termination Clause was an unenforceable 'penalty'?

No. The Borrower argued that the Termination Clause was a 'penalty' (being a clause that is void and unenforceable due to its oppressive and unconscionable nature). This was on the basis that the Termination Clause entitled the Lender to terminate for what might be a trivial Event of Default, rendering the full amount of the outstanding balance immediately payable. The Court considered this a "hopeless" argument. The events which entitled the Lender to require repayment of the full outstanding balance were ones which, objectively, raised the risk of default.6

(b) That the Lender owed the Borrower a contractual duty of good faith?

No. The Borrower argued that the Lender was subject to an implied contractual duty of good faith (the so-called 'Braganza duty'7). The Court rejected this argument, adopting the reasoning of recent High Court authority that termination rights were not contractual discretions to which such implied duties applied (rather they were 'absolute' contractual rights)8. Note that, even where a 'Braganza' duty is held to apply, it may well have little practical benefit due to the limited nature of such a duty9 (as highlighted by the recent High Court claim of De Boinville v I G Index Limited in the context of a customer agreement relating to a spread betting account10).

The Lender was therefore entitled to terminate, notwithstanding that the reasons which justified termination were not specified in the termination notice.

The Court also held that there was no breach of the Lender's equitable duty to obtain the best price reasonably obtainable for the aircraft, as was also argued by the Borrower.
 

Key takeaways

This case serves as a useful reminder of some of the key issues relevant to the termination of commercial contracts, namely:

(i) While any contractual termination notice needs to comply strictly with all conditions specified in the termination clause, it should not be assumed that a valid termination notice needs to specify (or correctly specify) the reason for termination. Whether or not this is a condition of a valid termination notice will turn on the proper construction of the relevant termination clause(s). Where it is not necessary to specify the reason(s) for termination, it may be advisable to refrain from doing so to ensure that the terminating party is not precluded from subsequently relying on additional or alternative reasons for termination.

(ii) Related to this is another crucial notice drafting point (albeit not one discussed in the Skyjets case). This is that any party seeking to terminate a contract should always consider whether it would be preferable to seek to terminate under the common law for 'repudiatory breach of contract' rather than under a contractual termination clause.11 If so then any termination notice will need to be carefully drafted in a way which seeks to preserve a party's right to rely on repudiation as a primary basis for termination, with contractual termination as an alternative basis for termination (which the High Court has suggested can be validly done)12.

(iii) It should not be assumed that any breach of contract (for example, a failure to make payment by a specified date) needs to be continuing at the date that a party seeks to terminate. As with (i) above, whether or not this is the case will turn on a proper construction of the relevant termination clause(s). A contractual right to terminate which is triggered "at any time", as in the Skyjets case, may allow a party to terminate for historic breaches of contract (subject to the below).

(iv) Care should be taken to ensure that the right to terminate is not lost by that party acting in a manner which is inconsistent with the termination of the contract (amounting to a 'waiver' of its right to terminate). Applying default interest or late payment charges, or accepting late payments, may all waive the right to terminate. While there are mechanisms which can minimise the risk of a party losing its right to terminate (such as labelling communications 'without prejudice', using language which seeks to reserve a party's rights, and relying on 'no waiver' clauses), these are by no means fail-safe, as the Skyjets case demonstrates. For that reason, any party considering termination should seek advice to ensure that any interactions with the defaulting party do not result in the termination right being lost (and it will often be preferable for any communications with the defaulting party to be managed by lawyers).

1 The Court nevertheless considered that there might be jurisdiction in appropriate circumstances to grant relief against forfeiture so far as enforcement of the aircraft mortgage was concerned (para.102).

2 Whereby a party can lose a contractual right to terminate by acting in a way which is inconsistent with the termination of the contract.

3 Para. 87.

4 Arising from the case of Boston Deep Sea Fishing v Ansell (1888) 39 Ch D 339.

5 This having been triggered where, in the opinion of the Lender, a material adverse change occurred in the business, assets, condition, operations or prospects of any  group company.  

6 Neither did the fact that: (i) the rate of interest payable following default effectively quintupled the minimum base rate that became due; (ii) the default interest was compounded (there being nothing inherently penal about compound interest); or (iii) an Event of Default triggered the Lender's right to take possession of the aircraft (para.150).

7 Being a duty which qualifies the manner in which a contractual discretion should be exercised, arising from the Supreme Court's decision in Braganza v BP Shipping Limited [2015] UKSC 17.

8 Relying on TAQA Bratani Limited v Rockrose UKCS8 LLC [2020] EWHC 58 (Comm).

9 Namely that any discretion must not be exercised in a manner which is irrational, perverse, capricious or arbitrary (as opposed to a general duty of reasonableness).

10 [2021] EWHC 3326 (Comm).

11 While it may be preferable to terminate under a contractual termination clause (which is often less risky, due to greater certainty that the right to terminate exists), there may be a substantial difference in the level of compensation that a terminating party will stand to receive (there being a right to potentially much more favourable 'damages' for repudiation).

12 As per Shell Egypt West Manzala GMBH and anor v Dana Gas Egypt Ltd [2010] EWHC 465 (Comm), para.34. 

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