The second ‘chink’ in the armour came with the courts’ increased use of elaborate interpretations of the parties’ obligations with a view to achieving a ‘fair’ outcome (the ‘true construction’ doctrine). This could involve implying conditions (Taylor v Caldwell); finding the scope of the contract did not cover new facts (Davis Contractors Ltd v Fareham UDC); or finding that the fundamental joint assumptions of the parties have transpired to be false (an alternative interpretation of Krell v Henry).
Collins argues that the courts frequently use notions of justice and fairness, disguised under the doctrines of construction and frustration, such that they are applied inconsistently. He questions whether ultimately, the courts should uphold fairness or the free market.
Frustrated contracts and true construction nevertheless set a high standard for termination, which may not in any case be in the interests of the parties. This level of enforceability encourages parties to plan extensively, and ‘get it right first time’. In turn, this drives up transaction costs, creating an incentive for parties to remain in contracts and move to a different mechanism of contract governance: relational contracting and renegotiation.
Empirical studies by Stuart Macaulay, Terrance Daintith and Beale & Dugdale have conclusively shown that parties consistently reject short-term contractual gains in favour of the greater utility of preserving long-term business relationships. Campbell & Harris argue that the classical view completely fails to explain the reality, and efficient long-term contractual behaviour must be understood as ‘consciously co-operative’.
The existence of transaction costs acts as a disincentive for parties to terminate contracts and an incentive to preserve a long-term relationship, even where it may not be enforceable nor the future gains precisely defined. Self-interested behaviour therefore consciously adopts co-operation as the optimal long-term strategy. The other party’s matching disincentives to break the relationship strengthen the relationship of trust between the parties, since both are aware of the other’s interests and incentives. Since both are interested in the other’s set of incentives to continue, neither will intentionally act in a way adverse to the interests of the other. Parties will have an incentive to remain in the relationship so long as their share in the joint profits exceeds their potential net profits from operating independently. They will have a disincentive from breaking the relationship because of the high cost of finding alternative long-term partners. This compels co-operation.
These business realities have developed to cope with the turbulent economic conditions under which they exist. Daintith’s study of iron ore supply contracts, for example, compared contract terms before and after a major devaluation of the US Dollar and a slump in the steel market. He found the later contracts allowed far more flexibility and ongoing negotiation between the parties as parties recognised the importance of these qualities for maintaining business relations in the face of major market fluctuations.
If it is easy to get out of contracts, parties may simply abandon obligations as soon as better opportunities come along. As we have seen above, the courts are weakening the enforceability of contracts – thereby discouraging negotiation – with the doctrines of frustration and construction. Conversely, they are also encouraging renegotiation by enforcing subsequent agreements, to which we shall now turn.
Any renegotiation of a contract traditionally required the three elements of a conventional contract: formalities, consent and consideration. Although the courts still insist on formalities (Morris v Barron), they have moved away from insisting on strict consideration (Foakes v Beer; D & C Builders v Rees) towards recognising the practical consideration of business realities (Williams v Roffey Bros). They have even moved to recognise that consent can be negated by economic duress in certain circumstances (North Ocean Shipping; Pao On). These changes give greater effect to subsequent renegotiations, which increases parties’ faith in the renegotiation process thereby encouraging it.
The courts have also been willing to imply terms into contracts in cases of hardship, thereby making them fairer and encouraging renegotiation instead of breach. In Staffordshire AHA v South Staffordshire Waterworks, a water company agreed to supply a hospital with water at a fixed price in 1927 “for all times hereafter”. Fifty years later, the price of water had risen to twenty times the agreed price, and the water company sought to terminate the contract. Denning MR implied a term allowing termination with reasonable notice. The existence of this term brought about renegotiation. In the recent case of Paragon Finance v Nash, the plaintiffs entered into a mortgage under which the lender could unilaterally vary interest rates. The court implied a term that the lender’s discretion must be exercised “fairly … and not arbitrarily, capriciously or unreasonably”, but set the requirement at Wednesbury level and failed to find a breach. Although finding in favour of the bank in this case, the term increased the fairness of the contract and so promoted renegotiation instead of breach.
The courts also enforce renegotiation in some cases with by placing a duty on parties to mitigate their losses by entering into renegotiation where possible. If parties fail to renegotiate, they will not be allowed to claim full damages. In Payzu v Saunders, two parties contracted to sell and buy goods at a reduced price for nine months. After the first payment was late, the seller assumed the buyer did not have the means to pay and demanded full price and cash payment for all future deliveries. The buyer did not accept, the market price rose, and the buyer sued for their lost profits. The Court of Appeal allowed only those losses that the buyer would have incurred had he accepted the seller’s revised offer. This legal mechanism penalises parties for failing to co-operate and renegotiate.
In conclusion, the evidence suggests that the courts will very rarely let parties off, and then only in cases of extreme changes of circumstances where the contract is regarded as frustrated. The current legal situation seems to be to uphold the enforceability of contracts, moderated by a widening of the doctrine of consideration to give effect to renegotiation, use of implied terms, and imposition of a duty to mitigate loss to encourage renegotiation.
Peter Brogden.
Bibliography
Statutes
Law Reform (Frustrated Contracts) Act 1943
Cases
Blackburn Bobbin Co Ltd v TW Allen & Sons [1918] 2 KB 467
D & C Builders v Rees [1966] 2 QB 617
Davis Contractors Ltd v Fareham UDC [1956] AC 696
Foakes v Beer (1884) 9 App Cas 605
Krell v Henry [1903] 2 KB 740
Morris v Barron [1918] AC 1
North Ocean Shipping Co v Hyundai Construction Co (The Atlantic Baron) [1979] QB 705
Pao On v Lau Yiu Long [1980] AC 614
Paragon Finance plc v Nash [2001] EWCA Civ 1466
Payzu Ltd v Saunders [1919] 2 KB 581
Staffordshire Area Health Authority v South Staffordshire Waterworks Co [1978] 1 WLR 1387
Taylor v Caldwell (1863) 3 B & S 826
Williams v Roffey Bros and Nicholls (Contractors) Ltd [1991] 1 QB 1
Journals
Beale, H. & Dugdale, T., ‘Contracts Between Businessmen’ (1975) 2 Brit. J. Law and Society 45.
Campbell, D., and Harris, D., ‘Flexibility in Long-term Contractual Relationships’ (1993) 20 Journal of Law and Society 166.
Daintith, T., ‘The Design and Performance of Long-term Contracts’ in T. Daintith and G. Teubner (eds) Contract and Organisation. Berlin: W de Gruyter, 1986.
Macaulay, S., ‘Non-Contractual Relations in Business’ (1963) 28 Am. Sociological Rev. 55.
Macneil, Ian, ‘Contracts: Adjustment of Long-term Economic Relations under Classical, Neoclassical, and Relational Contract Law’ (1978) 72 Northwestern University Law Review 854.
Other Materials
Beale, H.G., Bishop, W.D. & Furmston, M.P. Contract: Cases and Materials (4th Ed). London: Butterworths, 2001.
Collins, Hugh. The Law of Contract (4th Ed). London: Butterworths, 2003.
Daintith, T. ‘The Design and Performance of Long-term Contracts’ in T. Daintith and G. Teubner (eds) Contract and Organisation, (Berlin, W de Gruyter, 1986) 164.
Campbell, D., and Harris, D., ‘Flexibility in Long-term Contractual Relationships’ (1993) 20 Journal of Law and Society 166.
Collins, Hugh. The Law of Contract (4th Ed). London: Butterworths, 2003, at 300.
Macaulay, S., ‘Non-Contractual Relations in Business’ (1963) 28 Am. Sociological Rev. 55.
Daintith, T., ‘The Design and Performance of Long-term Contracts’ in T. Daintith and G. Teubner (eds) Contract and Organisation. Berlin: W de Gruyter, 1986.
Beale, H. & Dugdale, T., ‘Contracts Between Businessmen’ (1975) 2 Brit. J. Law and Society 45.
Campbell, D., and Harris, D., ‘Flexibility in Long-term Contractual Relationships’ (1993) 20 Journal of Law and Society 166.