Key Points:

Some problems with a contract can be caught before they even happen, and can be managed proactively to keep the project on track.

We've seen that there are ways to persuade a mediocre contractor to lift its performance. But sometimes persuasion alone may not be enough – sometimes you may need to resort to legal remedies. Understanding your legal remedies and being able to articulate them can often assist attempts at persuasion.

It's also useful to have a Plan B (which might involve escalating legal remedies) in case Plan A doesn't work. If legal remedies are part of that Plan B, you'll need to understand how they work and take the practical steps to maximise their potential effectiveness, and put yourself in a strong position to achieve a favourable outcome. Renegotiation might also be a better option.

The legal remedies which should be considered when devising strategies for managing difficult contracts are:

  • your right to withhold or reduce payment;
  • your right to claim damages for breach;
  • your right of set-off; and
  • termination.

There may be others, but these are usually the most effective ones.

Withholding or reducing payment

Can a client withhold or reduce the payments under the contract when their contractor is not performing satisfactorily? There's no simple answer as it depends on how the payment regime in the relevant contract has been structured.

However, it's fair to say that under most payment regimes, the contractor can become legally entitled to a payment under the contract, even though it has not fully performed all of its contract obligations at the time it submits its payment claim.

For example, the contract may require you to pay milestone payments upon completion of various milestones, even though the contractor has not performed some of its other obligations under the contract. You'll still need to pay the relevant milestone payment in full, subject to any right of set off.

It's the same with construction contracts which require the principal to pay monthly progress payments calculated by reference to the value or percentage of the work that has been completed, or to service contracts where the contractor is entitled to a fixed monthly service fee.

If the construction works are defective then there will generally be a counterclaim for damages against the contractor for an amount equal to the cost of rectifying the works. Likewise, if certain services have not been performed, there is usually a counterclaim for damages for any loss your client suffers as a result of the unperformed services.

Damages for breach of contract

If the contractor has breached the contract, you will generally be entitled to claim damages for the loss suffered as a result of the breach.

This often elicits a lukewarm response from clients, partly because of the potential harm legal proceedings would cause to their relationship with the contractor, but mostly because they have to go to court or arbitration. It's an expensive process.

Commencing legal proceedings will also require internal approvals and will put a spotlight on the contract administration team, who will generally prefer to explore self-help remedies before resorting to formal legal proceedings.

Set-off

Many contacts contain a provision which entitles the principal to set off – that is, deduct from payments which are due from the principal to the contractor – any amounts which are owing from the contractor to the principal.

Some set-off clauses allow the principal to deduct amounts which it claims are due from the contractor, so that there can be no argument that any dispute regarding the amount owing must be determined by a court before it can be set-off.

In effect, a right to set-off effectively provides the principal with a "self-help" remedy for damages which avoids the need to go to court.

If the contractor thinks you have deducted more than it is entitled to, it may take you to court over the difference. But that puts the practical onus of actually commencing legal proceedings on the contractor and, in the meantime, you retains funds.

An express right of set-off in the contract is not required: you can rely on your equitable right of set-off, so long as there is no provision in the contract which indicates an intention to exclude or limit the equitable right of set-off.

But take care not to set-off more than you are entitled to, as doing so could put you in breach of your obligation to pay.

Practical tips for preparing the ground

Many contractors rely on claims to avoid liability for late delivery, and to recover their cost overruns. If you want to protect against such claims and to recover the loss which you are suffering as a result of your contractor's poor performance, you need a strategy for the management of claims, which must include allocating appropriate resources.

Regardless of whether you will ultimately seek damages, set-off or a negotiated settlement, you should start preparing the ground shortly after the first breach.

Claims for damages arising from breach may take years to resolve or settle. If you do not create and collate the documents that will support your client’s position as soon as you become aware of a potential claim, it may be impossible to find the evidence when the matter finally comes before a judge or arbitrator.

Allegations by the contractor need to be thoroughly investigated as and when they are made, including potential counterclaims, and responses produced setting out the position on the relevant facts and merits of each allegation. If the contractor’s claim has little substantive merit, it will often fail to challenge the response effectively, and the response stays on the record to become critical evidence.

Don't let things run or build up

Investigating claims as they are made also enables the claims to be resolved early. When there are faults on both sides it can be tempting to let claims run for a while with a view to ‘horse-trading’ a settlement.

However, the risk is that matters will remain unresolved and the contractor will produce a massive global claim towards the end of the delivery phase, seeking to recover the entire cost overrun on the project.

This can be avoided by taking steps to encourage or require the contractor to put each claim into the contractual dispute resolution process as it arises, rather than allowing claims to drift.

Ring-fence disputes

Putting claims into a formal dispute resolution process can also be an effective way of ring-fencing a problem. Maintaining collaborative relationships can be problematic when there are unresolved claims.

On one train manufacturing project, there was a major dispute between the parties in relation to the first two tranches of trains. A third tranche was required, but the existence of the dispute made negotiation of a new contract extremely difficult. The parties agreed to deal with all of the claims and counterclaims in an expedited arbitration process, so that negotiation and delivery of the third tranche would not be burdened by the historic disputes.

Termination

If the contractor is breaching the contract, you may have a right to terminate the contract.

Of course, termination of the contract may not be an attractive option. It may not be possible to engage another contractor to perform the relevant obligations within the required timeframe, or at all.

Even so, it is often useful to consider carefully whether you have the right to terminate, as it can be a powerful tool when persuading a contractor to lift its performance, or renegotiating the contract.

The following is a conceptual map as to whether you have a right to terminate:

Click here to view image.

Your analysis should usually start with the termination clause in the contract, ie. your contractual right to terminate.

Most written contracts include a provision which entitles a party to terminate if the other party breaches specific requirements of the contract. Some allow termination for any breach of amaterial term, or for a material breach of any term. Indeed some even allow termination for any breach of any term.

A contractual right to terminate can only be exercised in accordance with its terms. If the right to terminate under your clause only arises if the contractor has been given notice and an opportunity to rectify the breach, then you must comply with these requirements in order to exercise the contractual right to terminate.

Indeed, if you purport to exercise a contractual right of termination but fails to comply with the relevant requirements, then your wrongful termination could amount to a repudiation of the contract which entitles the contractor to terminate the contract and claim damages for your anticipatory breach.

Common law right to terminate for breach/repudiation

While your analysis should start with the relevant clause in the contract, it shouldn't end there. You may also have a common law right to terminate, even if the contract includes a termination clause which doesn't apply to the circumstances. Your common law rights to terminate can only be excluded by clear words to that effect, such as a provision stating that the contract can only be terminated in accordance with the termination clause.

Whether the breaches or other conduct by the contractor gives you a common law right to terminate depends on whether you can fit the breach or conduct within one of the three boxes at the bottom of the conceptual map.

Is the term which has been breached a condition, being a term goes to the root of the contract such that a breach of it is likely to cause serious loss or detriment to your client?[1] If it is, then any breach of that condition will give rise to a right to terminate.

The second box deals with intermediate terms. Most contractual terms fall into this category. A breach of an intermediate term will only give rise to a right to terminate if the breach is sufficiently serious. This will turn on the consequences of the breach. If the consequences are such that you are deprived of a substantial part of the expected benefit of the contract then they will be considered sufficiently serious to entitle you to terminate.

The third box deals with the concept of repudiation. If you can demonstrate that the contractor is not ready and willing to perform contractual obligations, or won't, at the required time, be ready and willing to perform, then the contractor will be taken to have repudiated its contract obligations. You can then elect to accept the repudiation and terminate the contract, provided the absence of readiness or willingness is sufficiently serious. The absence of readiness or willingness to perform will be sufficiently serious if:

  • it extends to all of the contractor's obligations, or
  • it extends to obligations which if breached would give rise to a right to terminate, ie. obligations falling within boxes 1 or 2 at the bottom of the conceptual map.

Repudiation is usually established by reference to what the contractor has said or done. For example, if you write to the contractor asking it perform specific material obligations, and the contractor writes back saying that it will not or cannot perform those obligations, you should be able to establish a repudiation by the contractor.

If the contractor says it won't do something because it isn't obliged to do it, can this amount to a repudiation? It can if the contractor has misinterpreted the contract. One needs to be careful before claiming one is not obliged to do something based on one's interpretation of the contract. And as mentioned before, wrongful termination can also amount to repudiation.

Renegotiation

Legal remedies may not provide a complete solution to the problem. If the outcomes which the contract was to achieve are critical to the success of your business, and replacing the non-performing contractor is not a viable solution, then you may find that the best option is to renegotiate the terms of the contract.

For example, if the root cause of the problem is that the contractor has mispriced the work and will continue to incur significant loses if the contract continues, then you may find that your long-term interests will be better served by renegotiating the contract on terms which are more favourable for the contractor than attempting to hold the contractor to the existing bargain – especially if holding the contractor to the existing bargain could make it insolvent.

Renegotiation might also be the best option:

  • if the existing contract contains perverse incentives which need to be removed;
  • if you are wholly or partly in the wrong and you need to settle; or
  • if your circumstances have changed.

With any renegotiation, the key to success is to:

  • understand the current problem that needs to be fixed; and
  • carefully plan a negotiation strategy before commencing negotiations.

Having a Plan B if negotiations stall or fail can be critical.