Omitting work from contract - variation or termination?

Contractually, in the absence of default by the contractor, a principal can only effectively remove work from a contractor if the contract gives the principal a right to:

• omit work; or
• terminate the contract for convenience.

In relation to the former, courts have been reluctant to allow the principal to omit work from a contract unless the contractual terms expressly allow it. The High Court found that the principal could not omit work from the contractor simply to redirect it to a third party, unless the contractual term was so specific as to prescribe that right (Carr v JA Berriman Pty Ltd (1953) 89 CLR 327).

In relation to the latter, where the contract entitles the principal to terminate for convenience (ie. unilaterally and without any cause) the law has developed such that a termination for convenience clause is likely to be read down and rendered unenforceable, unless it is clear and unambiguous and strictly complied with.

In a recent Federal Court decision, BAE Systems Australia Ltd v Cubic Defence New Zealand Ltd [2011] FCA 1434, Justice Besanko considered both concepts, and found that:

• the right to reduce or omit the scope of work under a contract does not of itself result in termination of the contract; and
• a party which has reduced the scope of work to be performed in the future under the contract to nil can be found to have terminated the contract, if the reduction was in "substance" a termination.

In his decision, Justice Besanko appears to have moved away from a traditionally strict approach taken to the right to terminate for convenience, by considering the substance of the parties' actions, and not merely their conduct pursuant to the relevant contract.

The contract, subcontract, and purported termination

The Commonwealth had entered into a contract with Cubic Defence for the supply and operation of a live-simulation range instrument and information system for its Combat Training Centre (Prime Contract). Cubic Defence subsequently entered into a subcontract with BAE Systems, which included the operate and support/manage phase (O and S/M) of the Prime Contract.

The Prime Contract provided that the Commonwealth may vary or terminate the contract with Cubic Defence without cause, subject to certain provisions. In turn, the Subcontract permitted Cubic Defence to terminate the Subcontract with BAE Systems, or to reduce the scope of the contract, if it received a "corresponding notice to that effect from the Commonwealth".

The Commonwealth proposed to separate the acquisition and the support elements of the Prime Contract so that, in effect, the O and S/M components of the Prime Contract would be removed, and form part of a separate contract between the Commonwealth and Cubic Defence. Some time later, a deed and a new contract were executed between the Commonwealth and Cubic Defence.

Cubic Defence subsequently told BAE Systems that the Commonwealth had terminated for convenience a portion of the Prime Contract which included all O and S/M requirements and, in turn, that Cubic Defence was terminating for convenience all of the corresponding O and S/M requirements pursuant to the termination clause of the Subcontract.

Reduction in scope or termination?

BAE Systems sought a declaration from the Federal Court that the deed between the Commonwealth and Cubic Defence did not amount to notice under the relevant termination clause of the Prime Contract. As no such notice was given, BAE Systems submitted that Cubic Defence could not have terminated the Subcontract, given that it lacked the "corresponding notice… from the Commonwealth" and therefore the clause was not engaged.

In characterising the deed and subsequent contract between the Commonwealth and Cubic Defence, Justice Besanko noted that, if the effect of what had occurred was a variation which amounted to a reduction in the scope of the Prime Contract, then Cubic Defence was bound to pass on that reduction under the Subcontract.

Justice Besanko ultimately found that what the Commonwealth purported to do was to reduce of scope of the Prime Contract and, even though this resulted in a reduction to nil, it did not constitute notice to Cubic Defence of the termination of the Prime Contract.

"The substance of what occurred"

Although Justice Besanko found that the effect of the Commonwealth documents was to reduce the scope of the Prime Contract, rather than to terminate the Prime Contract for convenience, he concluded that "it is the substance of what occurred which matters" and, ultimately, the substance of what has occurred under the Prime Contract and under the Subcontract was the same. On this basis, Justice Besanko held that Cubic Defence had validly terminated the Subcontract.

In essence, Justice Besanko's decision was that a reduction in the scope of work under the Prime Contract, which had the effect of removing all future work to be performed under the Subcontract, allowed Cubic Defence to terminate the Subcontract for convenience. This is despite the fact that when the relevant clause is read literally, Cubic Defence could only exercise that right if the Commonwealth had given notice of termination under the Prime Contract.

A wider adaptation of the "substance" approach?

Justice Besanko's holistic approach – that "it is the substance of what occurred which matters" – seems a novel one in relation to termination for convenience clauses in contracts. It may, if it is more widely accepted, open up the possibility that parties could terminate for convenience even if an express provision of the contract is not strictly adhered to.

Given that the approach has not been tested, it will be interesting to see whether there will be a wider adaptation of the "substance" approach. Such a development could, however, be problematic given the level of uncertainty it might create around termination for convenience clauses. Indeed, just where one draws the line may be quite arbitrary.

In the present case, for example, it could be argued that the substance of what occurred was that the work to be performed by Cubic Defence had not materially changed; rather, the change was to the contractual framework in which it was to be performed. In other words, the work that was taken away formed part of a new contract between the Commonwealth and Cubic Defence, but the same work no longer was to be done by BAE Systems.

More than 50 years ago, the High Court stated in Carr v J A Berriman Pty Ltd (a case which was not referred to in Justice Besanko's judgment) that, unless the contract expressly provided for it, a principal cannot remove work from a contract only to have the work performed by somebody else. It is arguable that not passing the work the subject of the new contract onto BAE Systems could fall foul of the decision in Carr v J A Berriman Pty Ltd where the clause under consideration did not expressly provide that the work being omitted may be passed onto a third party.

It is the authors' opinion that, notwithstanding that the Federal Court has taken a wider approach, parties should seek to strictly adhere to the contractual terms, in particular when exercising a contractual right to terminate. The risk of not doing so will amount to unlawful termination and entitle the other party to accept the conduct as repudiation and, in turn, lawfully terminate the contract.

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