Key Points:

Contracting parties should ensure that the principal's rights under the contract's performance management regime are clear ‒ or risk disputes as to when and how the principal can take action for service failures.

The recent UK case of Portsmouth City Council v Ensign Highways Ltd [2015] EWHC 1969 (TCC) examines how performance management regimes in outcome-based contracting arrangements should be drafted to avoid uncertainty and the risk that terms will be implied by the courts.

Background

The Portsmouth City Council was the principal to a contract for highway maintenance. Disputes between the Council and its contractor Ensign lead to the Council seeking declarations from the UK's High Court as to the operation of the contract's performance management regime.

That regime provided for the Council to award "service points" to Ensign for any breaches of the contract, and permitted the Council to terminate the Project Deed if more than 250 service points were awarded over a 12 month period. However, the contract did not clearly specify the time within which the Council could award service points or the number of service points that could be awarded for particular failures.

After executing the contract, the Council formed the view that the contract was unaffordable and began to award the maximum number of service points permitted by the contract for each breach by Ensign regardless of the severity of those breaches, and awarding several months' worth of service points to Ensign at once. Ensign referred the matter to expert determination, claiming that the Council's strategy of awarding service points was intended to force Ensign to renegotiate the terms of the contract with the Council.

The expert found that the main purpose of the performance management regime was to give Ensign notice of service failures so that it could improve its performance. In implementing its strategy of awarding service points, the Council had acted unfairly and in bad faith. The Council subsequently sought declarations from the court concerning its right to award service points under the performance management regime.

A court will interpret unclear terms with commercial common sense

The contract provided for the Council to award service points for any breach by Ensign of its contractual obligations "calculated by reference to" a schedule to the contract. That schedule consisted of a table listing four different types of default and the corresponding "maximum event value" of service points for each default. The parties could not agree on whether the "maximum event value" was a fixed number of service points to be applied to a default (regardless of its severity) or whether the number of points to be applied should be calculated on a sliding scale based on the severity of the default.

The Court found that the relevant provisions of the contract were not clear and could be interpreted in a number of ways. The correct interpretation should be that which most accords with commercial common sense. It did not make commercial sense for the performance management regime to require the Council to award the same number of service points for all defaults, but it did make sense for service points to be calculated based on the severity and duration of the relevant breach.

Courts are reluctant to imply a broad obligation to act in good faith on principals in performance management contracts

The contract did not specify when or how often the Council could award service points or expressly require the Council to act in good faith in doing so. The parties agreed that the contract would need to include an implied term as to the manner in which Service Points could be awarded. However, the parties disagreed as to what that implied term should require of the Council.

The Council argued that in deciding whether or not to award service points, the Council should be entitled to take into account its commercial interests, but be required to act on proper grounds, for proper purposes and without dishonesty or deceit in calculating the number of service points to be awarded and in awarding those points. Ensign argued that the implied term should go further and require the Council to act in an independent, impartial, fair and honest manner in both deciding whether or not to award service points and in calculating the number of service points to be awarded.

The Court found that there was no broad obligation to act in good faith but implied a term requiring the Council when awarding service points to act honestly, on proper grounds and not in a manner that is arbitrary, irrational or capricious.

Commercial implications of the decision in Portsmouth City Council v Ensign

While Portsmouth City Council v Ensign is a UK decision which is not binding in Australia, Australian courts are likely consider it if a dispute concerning similar terms of a performance management contract arises.

The decision also highlights a number of important considerations for drafting performance-based contracts:

  • Any contract that includes a performance management regime should state when and how the principal can take action as clearly as possible.
  • If the performance management regime requires the principal to make a decision (for example, a decision in relation to the number of service points to be awarded for a particular service failure), the basis on which that decision is to be made should also be clearly set out in the contract. If a court needs to imply a term of a contract to allow the regime to work, that term may not operate as the principal intended.
  • The principal should also take care to exercise its rights under any performance management regime in a manner that is consistent with the commercial purpose of that regime. In this case, the purpose of the regime was to notify Ensign of service failures so that Ensign's performance could be improved. The Council's "strategic" use of the performance management regime to attempt to force Ensign to renegotiate the contract was not a valid exercise of the Council's rights under that regime.
  • If parties to a contract intend to be subject to an overarching duty of good faith, they should use clear words to establish the scope and nature of that duty.