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Focus: Construction – December 2007

What is repudiatory conduct?

In brief: Partner Nick Rudge (view CV), Lawyer Nicholas Gallina and Law Clerk Merav Bloch review the decision of the Victorian Supreme Court of Appeal in Sopov v Kane Constructions Pty Ltd. This important decision examines how a court will assess repudiatory conduct leading to the termination of a contract, a principal's right of set off, and whether a 'show cause' notice that wrongly alleges a breach may still be valid.

• The facts
• Victorian Supreme Court of Appeal decision
• Practical considerations

The facts

In August 1999, Cole Sopov and Norma Walker (Sopov) entered into a building contract with Kane Constructions Pty Ltd (Kane). The contract incorporated Australian Standard Contract 2124 (AS 2124).

In August 2000, Kane issued Progress Claim 14. Under clause 42 of the contract:

• the superintendent was required to issue a payment certificate within 14 days of receipt of a progress claim; and
• if a payment certificate was not issued, Sopov was required to pay the progress claim in full.

As Kane delayed in providing information requested by the superintendent, Payment Certificate 14 was issued 22 days after the progress claim was submitted. Sopov refused to pay the certified amount in full, claiming an entitlement to deduct liquidated damages allegedly due under the contract.

In September 2000, Kane issued a notice stating that:

• Sopov was not entitled to deduct liquidated damages;
• the failure to pay the full amount of Progress Claim 14 was a substantial breach of the contract; and
• Sopov was required to show cause.

Despite the contractor's 'show cause' notice and a letter from Kane setting out the relevant case law, Sopov continued to insist upon a right of set off. As a result, Kane suspended work and removed its equipment from the site.

One month later, Sopov made a call on Kane's bank guarantees without providing five days' written notice, as was required by clause 5 of the contract. Sopov claimed that it had acted in an honest belief that it was entitled to do so under the contract. In response, Kane claimed that Sopov had repudiated the contract and purported to terminate the contract by accepting the repudiation.

The trial judge found that Sopov had repudiated the contract and awarded damages on a quantum meruit basis to Kane. Sopov appealed the finding that it had repudiated the contract. Kane appealed the calculation of the quantum meruit damages.

Victorian Supreme Court of Appeal decision

On appeal¹, the court upheld the finding that Sopov had repudiated the contract, and referred the calculation of the quantum meruit damages to mediation.

Set off under AS 2124

The court held that Sopov did not have a right of set off under AS 2124. Justice Whelan, who delivered the leading judgment, confirmed that a right of set off would ordinarily exist, but could be displaced by express words or clear implication in the terms of a contract. His Honour referred to clear and long-standing authority that the right of set off had been successfully displaced by the terms of the contract and that the issue was not even arguable and raised no real question to be tried.

His Honour referred to a previous decision² in which the Victorian Supreme Court held that a contract with payment provisions similar to those in AS 2124 had displaced the right of set off. In that case, the court ruled that it would be contrary to the agreement between the parties to allow a right of set off to the proprietor because the parties had provided for 'a comprehensive scheme for the certification of payments and the adjustments of liabilities between them'. He also referred to Re Concrete Constructions Group Pty Ltd³ in which the Queensland Court of Appeal stated that, under AS 2124, a proprietor could not deduct liquidated damages from a payment certificate because '[w]hat is certified is intended to be paid'.

His Honour also noted that clause 42.1 of the contract, which imposed an obligation to pay 'not less than the amount shown in the Certificate', was inconsistent with a right of set off.

The late issue of the payment certificate

Kane argued that the late issue of Payment Certificate 14 meant that Sopov was obliged to pay the full amount of the progress claim. Sopov argued that it was not obliged to pay the full amount of the progress claim because the late issue of Payment Certificate 14 followed directly from Kane's failure to provide the requested information within the specified time. The suggestion here was that the provision of adequate information was a condition precedent to the superintendent's obligation to assess the progress claim.

At first instance, Chief Justice Warren found that despite the late issue of Payment Certificate 14, Sopov was not obliged to pay the full amount of the Progress Claim 14. Her Honour based this finding on Brewarrina Shire Council v Beckhaus Civil Pty Ltd⁴, in which the New South Wales Court of Appeal found that a superintendent's obligation to issue a payment certificate was subject to a condition precedent that a contractor supported its claim with evidence.

The decision in Brewarrina appeared to depart from earlier case law, which indicated that the late issue of a payment certificate was to be treated as though a payment certificate had not been issued. Given that Brewarrina was handed down in 2003, Justice Whelan was of the view that:

• it was reasonable for Kane to argue, in 2000, that the late issue of Payment Certificate 14 required Sopov to pay the full amount of Progress Claim 14; and
• Kane's insistence, in 2000, that Sopov was obliged to pay the full amount of Progress Claim 14 was at least arguable and did not constitute repudiatory conduct.

Repudiatory conduct

Justice Whelan, with whom President Maxwell and Justice Kellam agreed, held that repudiatory conduct could not be excused simply because the repudiating party had acted under an honest misapprehension as to its contractual rights. The determination of whether conduct is repudiatory depends on the nature of the conduct and what it objectively conveys, rather than the subjective mindset of the repudiating party. His Honour referred with approval to the principle that:

Repudiation is not ascertained by an enquiry into the subjective state of mind of the party in default; it is to be found in the conduct... of the party in default which conveys to the other party the defaulting party's inability to perform the contract... or his intention not to perform it or to fulfil it only in a manner substantially inconsistent with his obligations and not in any other way.

President Maxwell and Justice Kellam indicated that to determine whether conduct is repudiatory, courts will have regard to both the degree of error involved in an incorrect interpretation of a contract, and the nature of the conduct taken on the basis of this incorrect interpretation.

They stated that, where a party merely asserts an incorrect interpretation of a contract, an inference of repudiation would not readily be drawn, because, for example, the party may be willing to perform the contract or recognise its error once the proper interpretation of the contract is explained.

By contrast, an inference of repudiation would more readily be drawn where a party relies on an obviously untenable interpretation of a contract and acts or threatens to act unilaterally on the basis of that interpretation, despite communications from the other party pointing out the error. These statements indicate that parties may disagree on, and even robustly debate, the proper construction of contractual terms without there necessarily being an inference of repudiation.

In this case, Sopov's insistence on a right of set off was not only obviously untenable, but the error had been pointed out by Kane. Moreover, Sopov later ignored clause 5 of the contract by calling on Kane's bank guarantees without notice. It was for these reasons that Sopov's conduct was characterised as repudiation.

Although the contractor's show cause notice asserted a position that was later shown to be incorrect, this assertion did not amount to repudiatory conduct because it was arguable at law, at least at the time the assertion was made.

Show cause notices

Sopov argued that the contractor's show cause notice was invalid because it identified the failure to pay the full amount of Progress Claim 14 as the alleged substantial breach. The trial judge found that no such obligation existed. Justice Whelan held that the notice was valid, despite the fact that the alleged substantial breach was not, in fact, a breach. He indicated that, so long as there was a substantial breach subsisting as a matter of fact, it was irrelevant that the notice failed to properly identify it. The approach is consistent with the common law principle that a party with a valid ground of termination does not deprive itself of that ground simply by giving notice of an invalid ground of termination.

Practical considerations

Courts will assess conduct in relation to the observance of contractual obligations objectively, that is, by asking: what message does the conduct send to the other party? A position that is honest and firmly held, but wrong, may amount to repudiatory conduct.

When debating contractual obligations, it is important to take into account the other party's views on these obligations. This is especially important when the other party refers to case law that purportedly supports its views. Failing to take account of these views may be a factor that leads a court to draw an inference of repudiation.

If there is a dispute about a breach alleged in a contractual show cause notice, parties should consider whether breaches existed at the time the notice was served, other than the breaches specified in the notice, that would justify termination. If such breaches can be shown to have existed, the show cause notice, and subsequent termination, will still be valid.

Before exercising a right of set off and paying less than what is demanded by the other contractual party or certified by a third party, consideration should be given to the relevant contractual terms and whether the right of set off has been excluded expressly, or by implication as a result of a detailed payment mechanism.

Footnotes

1. Cole Sopov and Norma Walker v Kane Constructions Pty Ltd [2007] VSCA 257.
2. LU Simon Builders Pty Ltd v HD Fowles & Ors [1992] 2 VR 189.
3. [1997] 1 Qd R 6.
4. (2003) 56 NSWLR 576 (Brewarrina).

For further information, please contact:

• Nick Rudge Partner, Melbourne
  Ph: +61 3 9613 8544
  Nick.Rudge@aar.com.au
• John CooperPartner, Sydney
  Ph: +61 2 9230 4804
  John.Cooper@aar.com.au
• John BaartzPartner, Brisbane
  Ph: +61 7 3334 3254
  John.Baartz@aar.com.au
• Stephen McComishPartner, Perth
  Ph: +61 8 9488 3767
  Stephen.McComish@aar.com.au

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