Contract law

Reasonable endeavours obligations

Commercial contracts often contain obligations for which the standard of performance is not absolute but instead requires one party to use its ‘reasonable endeavours’ or ‘best endeavours’ to attempt to achieve the desired outcome. The obligations imposed by these phrases are similar if not identical. In each case the extent of the obligation is governed by what is reasonable in the circumstances.

What is ‘reasonable’?

The key criterion of what is ‘reasonable in the circumstances’ means that little assistance can be gained from decided cases.  It is, however, clear that the circumstances that may affect an obligor’s business can relevantly be taken into account in determining what is reasonable in the circumstances.  In Electricity Generation Corporation v Woodside Energy Ltd (2014) 251 CLR 640; [2014] HCA 7 (Woodside), the majority held that:

  • an obligation to use reasonable endeavours would not oblige the achievement of a contractual object to the certain ruin of the obligor or to the utter disregard of the interests of its shareholders; and
  • an obligor’s freedom to act in its own business interests, in matters to which the agreement relates, is not necessarily foreclosed, or to be sacrificed, by an obligation to use reasonable endeavours to achieve a contractual object.
Reasonable endeavours v best endeavours

Some variations on the standard of ‘best endeavours’ are also not uncommon. These include ‘reasonable endeavours,’ ‘best reasonable endeavours,’ ‘reasonable efforts’ and ‘all reasonable endeavours.’

Whether the standard chosen is ‘reasonable’ or ‘best’ endeavours, the High Court of Australia has consistently proceeded on the basis that the obligations imposed by these phrases are similar if not identical. In particular, whatever words are used, in each case the extent of the obligation is governed by what is reasonable in the circumstances.

Despite this, some recent Australian decisions have drawn distinctions between ‘mere’ reasonable / best endeavours clauses and clauses that use slightly different wording. These include findings that:

  • ‘reasonable endeavours’ does not impart an obligation that is as onerous as one to use “best endeavours” or “all reasonable endeavours” (Stepping Stones Child Care Centre (ACT) Pty Ltd v Early Learning Services Ltd [2013] ACTSC 173); and
  • the addition of the word ‘best’ to the expression ‘reasonable endeavours’ raises the required standard to a level somewhat higher than that imposed by a simple ‘reasonable endeavours’ obligation (Foster v Hall [2012] NSWCA 122).

In practice, these differences may rarely be distinctions of substance. The critical factor will ordinarily be whether the party which is obliged to perform has met the standard of reasonableness.

Use of reasonable endeavours clauses in contracts

Reasonable endeavours clauses were most recently considered by the High Court in Woodside, where  the Court made three general observations about reasonable endeavours clauses, namely:

  • an obligation to use reasonable endeavours is not an absolute or unconditional obligation;
  • the nature and extent of such an obligation imposed in such terms is necessarily conditioned by what is reasonable in the circumstances, which can include circumstances that may affect an obligor’s business; and
  • some contracts containing an obligation to use or make reasonable endeavours to achieve a contractual object contain their own internal standard of what is reasonable, by some express reference relevant to the business interests of an obligor.
Drafting tips

When drafting a reasonable or best endeavours clause, the following matters should be considered:

  • if you wish to bind a party to do (and only do) what is reasonable, then use the phrase ‘reasonable endeavours.’  On current authorities, it would appear that ‘best endeavours’ will impose similar obligations but it is better to avoid any doubt about what is intended; and
  • if what is intended is something different than reasonable endeavours, then it is better to specify what is intended. Similarly, the use of ‘internal standards of reasonableness’ (for example by providing that certain actions will or will not be encompassed by the obligation) should be considered.
Good faith

The law about good faith in the performance of contractual obligations is not settled in Australia.  Most jurisdictions have shown at least some support for the proposition that an obligation or duty of good faith and fair dealing is part of the law of contractual performance in Australia, whether as an implied term or duty imposed on all or some contracts.

For more information, see below or download Gilbert + Tobin’s Guide to Good Faith and Reasonableness in the Performance of Contracts.

Content of the duty to act in good faith

The usual content of the obligation to act in good faith is considered to be:

  • an obligation to act honestly and with a fidelity to the bargain;
  • an obligation not to act dishonestly and not to act to undermine the bargain entered or the substance of the contractual benefit bargained for; and
  • an obligation to act reasonably and with fair dealing having regard to the interests of the parties and to the provisions, aims and purposes of the contract, objectively ascertained.

What is necessary to satisfy the duty will depend on the contractual and factual context (including the nature of the contract or contextual relationship). It does not require a contracting party to prefer the interests of the other contracting party, or to subordinate its self-interest to the other party.

An implied obligation may be excluded either by express contractual provision or because it is inconsistent with the terms of the contract. However, to the extent that good faith is inherent in contract law, for example, because it requires honesty, it cannot be excluded.

Good faith in an era of uncertainty

Until the existence and content of the duty to act in good faith is resolved, the prudent course is:

  • to exercise broad contractual discretions in a way that is consistent with the imposition of a duty of good faith (ideally for a legitimate, documented business reason); and
  • to draft clauses appropriately where a broad discretion is intended to not be subject to an obligation to act in good faith, or identify the fetters on the discretion that are appropriate, for example, ‘the discretion must be exercised honestly, but may be exercised with regard to the party’s own legitimate self-interest’.

Example 1:  A termination for convenience clause might appropriately be worded to allow a party to ‘terminate for any reason, at any time and in its absolute discretion.’ This, together with a term expressly excluding all implied terms, would indicate the intention of the parties to exclude any imposed additional good faith constraint.

Good faith standards are also imposed into some forms of contracts under some legislative regimes, for example the Franchising Code.

Mitigation

A failure by an innocent party to mitigate its loss following a breach of contract may reduce the amount of damages payable to that party. The law will not require a contract breaker to pay for loss that the innocent party could have avoided by taking reasonable steps.

The ‘reasonable steps’ which are required of an innocent party are not particularly onerous. The innocent party should do what it reasonably can to minimise the loss, while acting within the course of its business. It is not required to sacrifice or risk its property or rights in order to mitigate its loss.

For more information, see below or download Gilbert + Tobin’s Guide to Mitigation of Loss Following a Breach of Contract.

The test for mitigation

Ultimately the test for mitigation is not whether there was a better way of doing things but whether what the innocent party did do was reasonable.  An innocent party is not under any obligation to do anything that is not in the ordinary course of business.

What an innocent party is required to do to mitigate its loss will always be a question of fact to be considered in all the circumstances.  Examples of what may be required might include:

  • entering into a substitute contract for example to buy or sell goods;
  • attempting to re-sell or re-let property; or
  • giving a builder a reasonable opportunity to rectify any defects (but not where the owner has reasonably lost confidence in the willingness and ability of the builder to do the work).

If the innocent party spends money in taking steps to mitigate that cost can also be recovered as damages in court proceedings.

Preliminary agreements

A preliminary agreement is a short-form agreement that is entered into by the parties but which may not set out all of the terms of the contract or have been written or executed in a formal way.  Examples of preliminary agreements include heads of agreement, memorandums of understanding and letters of intent.

Ordinarily, a preliminary agreement will either expressly or impliedly contemplate that a fuller agreement will eventually be drawn up to regulate the rights of the parties. The issue then arises as to whether, and to what extent, the preliminary agreement is binding. The position may be summarised as follows:

  • whether a preliminary agreement is binding depends on the objective intentions of the parties;
  • the courts will have recourse to a system of legal classes in answering that question. However, the facts of a particular case will always be important in determining the result, which puts the matter back in the hands of the parties; and
  • the best way to avoid any uncertainty over whether a preliminary agreement is legally binding is to clearly spell out the extent to which (if any) it is intended to be binding and when that will occur.

Where parties do not intend a preliminary agreement to be binding, the following matters should be considered:

  • a clear statement to that effect should be included in the preliminary agreement;
  • if any terms are intended to form an exception to the non-binding nature of the agreement, a clear ‘carve out’ provision should be included to deal with them (for example, confidentiality);
  • an agreement to negotiate a formal contract in good faith may be enforceable if it is sufficiently certain;
  • consider including an express statement that parties commence work at their own risk; and
  • consider including an express statement that neither party is obliged to continue negotiations or to execute any formal contract that is prepared and may cease negotiations or not execute a formal contract at any time at its absolute discretion.
Warranties and indemnities

One of the principal ways in which a buyer will seek to protect itself in a transaction is by requiring the seller to provide warranties about the business in the business purchase agreement. If it later transpires that the warranty was inaccurate, and this causes the buyer loss, the buyer may have remedies against the seller.

The buyer can also seek to include a requirement that the seller indemnify it against any losses the buyer sustains because of a breach by the seller of a warranty or other provision of the agreement. The difference between warranties and indemnities is explained below.

What is a warranty?

Warranties are promises by the seller as to the state of affairs of their business.  If these promises are inaccurate and cause the buyer loss, the buyer may have remedies against the seller, such as a claim for damages.  Warranties encourage disclosure of information by the seller and protect the buyer against undisclosed matters or liabilities.

A warranty in a business purchase agreement is in the strict sense, as with any other warranty, merely a term of the contract itself, breach of which will give rise to damages or, in rare circumstances, rescission or termination (e.g. where the breach of warranty is fundamental or if the seller is unable to transfer title to an essential asset of the business).

What is an indemnity?

An indemnity is a promise by one party to protect another party from, or to reimburse that party for, loss or damage suffered, or any expense incurred on the occurrence of a specified event.  The event may, but need not, include a breach of contract or some other legal duty by the indemnifying party.  For example, an indemnity may require a party to compensate another party on the happening of an external event such as a fall in the exchange rate.

Key similarities and differences between warranties and indemnities

The quantum recoverable for breach of a warranty is governed by ordinary contractual principles, meaning that the quantification of damages is subject to the principles of mitigation and remoteness. With an indemnity, it is the terms of the indemnity that govern what may be recovered.  This means that it is possible to recover a greater amount under an indemnity compared with a warranty claim if the indemnity so permits.

Both indemnities and warranties can be limited by the inclusion of contractual restrictions such as a threshold before claims are payable or a time limit in which to bring any claims.  In the case of indemnities, consideration should be given to expressly providing that the contractual principles relevant to remoteness of damage and mitigation will apply to limit the amount covered by the indemnity.

Warranties will be construed by the courts applying ordinary principles of construction, that is, by ascertaining what a reasonable person would understand by the language in which the parties have expressed their agreement.

Indemnities are strictly construed. This means that where it is possible any doubt as to the construction of an indemnity will be resolved in favour of the indemnifier.

Guarantees and indemnities

A contracting party can seek to reduce its possible exposure for loss caused by breach of contract by requiring the other party or a third party to provide contractual promises in the form of guarantees or indemnities.

While they are common contractual clauses, particularly in commercial bargains, guarantees and indemnities are subject to special rules of interpretation and need to be drafted carefully. Guarantees and indemnities can be used separately or together, and can also be used with other risk allocation clauses such as liquidated damages, exclusion, warranty and insurance clauses.

What is an indemnity?

As noted above, an indemnity is a promise by one party to protect another party from, or to reimburse that party for, loss or damage suffered on the occurrence of a specified event. The event may, but need not, include a breach of contract or some other legal duty by the indemnifying party. For example, an indemnity may require a party to compensate another party on the happening of an external event such as a fall in the exchange rate.

What is a guarantee?

A guarantee is a promise by the other contracting party or a third party that certain promises of a party will be performed, failing which the guarantor will be liable for the non-performance or defective performance.

Key similarities and differences between guarantees and indemnities

A guarantee is a secondary obligation, in the sense that the guarantor is promising performance by another party. An indemnity is a primary obligation because it is a promise to hold the other party harmless from loss, and the obligation is not triggered by a breach of performance by another party, but instead by the threat or the event of the suffering of loss.

With both guarantees and indemnities the scope of the obligations depends on how they are drafted and their proper construction.

Construction of guarantees and indemnities

Both guarantees and indemnities are subject to special rules of construction. While courts look to the natural and ordinary meaning of words, where there is ambiguity in the possible meaning or operation of a guarantee or indemnity then then a court will choose a construction that favours the party providing the indemnity or guarantee.

Further, a guarantor will not be bound by a guarantee if the obligations that have been guaranteed have been changed without the guarantor’s knowledge and approval, for example where a guarantee promises loan repayments and then the loan terms are altered. However, guarantees can be drafted as continuing obligations that will not be affected by any changes to the performance obligation that has been guaranteed to ensure that the guarantee remains effective.

Construction of commercial contracts

Commercial contracts in Australia are given an objective, businesslike construction on the assumption that the parties intended to produce a commercial result. The meaning of commercial contracts is established by considering the language used in its context of the document, the surrounding circumstances and the commercial purpose or objects to be secured by the contract.

The courts take a reasonably narrow approach to the admission of the surrounding circumstances. Such circumstances must have been facts objectively known to the parties at the time of formation of the contract. That material is admissible to construe a contractual provision in all cases, whether there is ambiguity or not.

For more information, download Gilbert + Tobin’s Guide to the Construction of Commercial Contracts.

More information on contract law

For more information on contract law, contact:

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Deborah Johns
Partner
djohns@gtlaw.com.au
+61 2 9263 4120
+61 410 540 978
Sydney

Hiroshi Narushima
Partner
hnarushima@gtlaw.com.au
+61 2 9263 4188
+61 410 541 779
Sydney