Clarifying executive necessity and termination for convenience

What you need to know

• Termination of convenience clauses should be included in contracts to provide government with necessary flexibility, however, they need to be well drafted and only used in good faith.
• There is limited case law applying the doctrine of executive necessity or termination for convenience clauses in Australia and questions of law in relation to these clauses remain unsettled.
• Compensation is generally payable when terminating for convenience.

What you need to do

• Review any contracts within your portfolio that may not have the support of a newly elected government.
• Proceed with caution before terminating a contract under the doctrine of executive necessity or under a termination for convenience clause.
• Educate non-government contracting parties about the inclusion of the clause in contracts to increase understanding and reduce the likelihood of protracted negotiations concerning them.

Introduction

It has been generally accepted that a special form of privilege exists in relation to governments as a contracting entity (Nicholas Seddon, Government Contracts: Federal, State and Local, Fifth edition, the Federation Press, 2013, 248). This privilege takes the form of a rule that stipulates that a contract cannot fetter a government's right to govern. This rule has its origin in the doctrine of executive necessity, but typically manifests itself in contract through a termination for convenience (TFC) clause. TFC clauses should be included in government contracts to provide governments with the flexibility necessary to govern.

With the results of the federal election yet to be determined, it is timely to consider the extent to which the doctrine of executive necessity may be relied upon, or TFC clauses used in Australia, particularly in relation to machinery of government changes or the possibility of a newly elected government seeking to rely on either to terminate a commitment made by a previous government. This Commonwealth Alert will explore the doctrine of executive necessity and the government's contractual right to terminate a contract for convenience.

Background

The doctrine of executive necessity is best understood within its historical context. The doctrine is said to have originated in the decision of Justice Rowlatt in Rederiaktiebolaget "Amphitrite" v The King [1921] 3 KB 500 (the Amphitrite) where a contractual undertaking was broken by the government. In that decision it was accepted that a government "cannot by contract hamper its freedom of action in matters which concern the welfare of the state". Accordingly, it has been recognised following this case that governments may be allowed to break a contract where it inhibits the business of governing.

The doctrine of executive necessity has been incorporated into contract through the use of TFC clauses. Both Commonwealth contracts and contracts entered into by State and Territory governments usually contain a TFC clause. The clause typically takes its form in drafting similar to the following:

Clause X, Termination for convenience

In addition to any other rights it has under the Contract, the Commonwealth may at any time terminate the Contract or reduce the scope of the Contract by notifying the Contractor in writing.

In many contracts, it may be followed by related provisions that offer limited compensation to the contracting party. In this respect, the TFC may be seen as the more virtuous cousin of the doctrine of executive necessity that does not require that any compensation be paid. Many contracting parties unfamiliar with the nuances of contracting with government are unaware of this doctrine and its operation or the use of a TFC clause. This means that the use of either provision is often misunderstood and results in unnecessarily protracted negotiations.

Contemporary relevance

Beyond the context of wartime circumstances, the doctrine of executive necessity and TFC clauses continue to pervade modern commercial negotiations, but the inclusion of such clauses is not without criticism.

In Australia, it would appear that the clause is not often actively used and that pragmatic considerations outweigh its practical legal use. Legal commentators have suggested that, while governments may use TFC clauses as a tool, they are ill-advised to use the provision too often as use of them may damage public confidence and draw the attention of international credit rating agencies (Ibid 252).

Depending on the outcome of the 2 July 2016 election there is the possibility that contracts entered into by the Coalition government may seek to be terminated by any new incoming government, should the Opposition form government.

Moreover, if there is a "hung" Parliament, there may be even further uncertainty as to the fate of contracts already in place.

International comparatives

It is useful to consider the United States case law given that there have been so few Australian cases to provide guidance on the application on the doctrine of executive necessity or termination for convenience clauses. The interpretation of termination for convenience clauses in the United States have taken a broad approach.

In Torncello v United States (681 F 2d 756 (1982) at 760) the Court held that the clause could only be used where there had been changed circumstances. However, further judgments have broadened the scope further suggesting that, save for not acting in good faith, a government has almost an unfettered right to terminate. By way of example, in McHugh v DLT Solutions, Inc (618 F 3d 1375 (Fed Cir 2010) the government was permitted to terminate a contract where it had wrongly entered into a contract for the purchase of software which was not compatible with existing government ICT systems. It has been suggested that the only limit to the use of termination of convenience clauses in the United States may be found in the scenario of government terminating a contract merely "to obtain a better price from another contractor" (Ibid 258).

Example – The Victorian East-West link

• In 2013 the Victorian Napthine Government considered the business case for the East-West Link road project and decided to proceed. The contract contained a termination for convenience clause. The clause provided compensation for the contracting parties estimated to commence at $900 million, subject to the timing of termination. (Victorian Auditor-General's Office, East West Link Project (December 2015) http://www.audit.vic.gov.au/publications/20151209-East-West-Link/20151209-East-West-Link.pdf at 49) .
• The contract was signed before the caretaker period leading into the November 2014 state election. The Opposition had indicated that it would not defend a legal challenge to the project and there was some suggestion by it that it would not proceed with the project. (Victorian Auditor-General's Office, East West Link Project (December 2015) ix)
• Following the election, the incoming Andrews Labor government suspended the project and by June 2015 had reached an agreement with contracting parties to terminate the contract. (Victorian Auditor-General's Office, East West Link Project (December 2015))
• The State of Victoria sought to minimise its exposure through a negotiation strategy that involved refusing to terminate for convenience. Ultimately, a settlement package of approximately $642 million was negotiated that included reimbursements for project costs and the government taking over the interest rate swap. (Victorian Auditor-General's Office, East West Link Project (December 2015) 48). In effect, the settlement amount was less than the amount stipulated in the termination for convenience clause but more than the contracting parties were likely to have received had the project been terminated by other means.
• The Victorian Auditor-General's Report ultimately concluded that the state incurred in excess of $1.1 billion in costs for the East-West Link project that delivered little benefit to taxpayers. (Victorian Auditor-General's Office, East West Link Project (December 2015) vii). The project is now commonly cited as "lessons-learnt" example for improving future infrastructure projects and public administration.

Example – The ACT Light Rail Project

• A similar situation could be on the horizon in the ACT. The current ACT government has entered into contracts for the building of a light rail route. The Opposition has said that, if it is elected, it will cancel the project.

Legal position in Australia

The doctrine of executive necessity has been recognised in Australia, although to varying degrees. Given the limited instances of relevant case law in Australia it is unsettled as to whether a wide or narrow interpretation of the doctrine is appropriate.

In support of a narrow interpretation is the view expressed by Justice Kearney sitting in the appellate division of the Northern Territory Supreme Court in Northern Territory of Australia v Skywest Airlines Pty Ltd (1987) 48 NTR 20 that suggests that reliance on the doctrine of executive necessity may only be supported in matters of "overriding public interest, such as the exigencies of war". This view accords with the earlier decision in New South Wales v Bardolph (1934) 52 CLR 455 (per Evatt J at 463) that observed "the repudiation of subsisting agreements by a new administration can seldom be ventured upon with success".

In contrast, a wider interpretation like the one propounded in the Amphitrite, that may include changes to government policy, has failed to receive wide support in Australia. In Ansett Transport Industries (Operations) Pty Ltd v Commonwealth (1977) 139 CLR 54 (Ansett) the High Court of Australia considered the views expressed by Justice Rowlatt in the Amphitrite. The Court considered the criticism levelled at the views, namely that the position at law had been "expressed too generally". Justice Mason in Ansett suggested it would be damaging to public confidence in government dealings if government or public entities were permitted to avoid their contractual obligations because the substance of the contracts somehow pertained to public welfare.

In NSW Rifle Association Inc v The Commonwealth of Australia (2012) NSWSC 818 (the NSW Rifle case) Justice White adopted a critical view of the decision in the Amphitrite, noting it was a judgment that had been delivered with no authorities cited to support its findings. Justice White also highlighted that the English decision on its facts was concerned with military needs and that the finding was unlikely to relate to commercial contracts. This points to the realisation that perhaps the doctrine does not stand on such steady footing as has been previously thought.

The appropriate use of TFC clauses is even less certain. The decision of the NSW Supreme Court in the NSW Rifle case provides slim guidance on the situations that could justify the termination of a contract for convenience because the Commonwealth relied upon the use of the doctrine of executive necessity in that instance.

On its face, termination for "convenience" could be more broadly applied than termination "for necessity". However, the limited case law in Australia provides little guidance. It is likely that the interpretation of the clause will no doubt depend on the terms of the contract as a whole and the circumstances in which the termination or reduction right under the clause is being exercised.

When may a termination for convenience clause be used?

Though they may appear all encompassing, governments should approach the use of TFC clauses with caution. What is clear from the case law is that where a government uses the TFC clause they must do so in good faith. In GEC Marconi Systems Pty Ltd v BHP Information Technology Pty Ltd [2003] FCA 50, Justice Finn noted that the exercise of a termination for convenience clause would be "subject to a duty of faith and fair dealing".

This view received further support from the Victorian Supreme Court in Kellogg Brown & Root Pty Ltd v Australian Aerospace Ltd [2007] VSC 200. This case involved an application for an interlocutory injunction restraining the exercise of a termination of convenience power under a Defence subcontract. The Court considered that Australian Aerospace should be prevented from exercising its rights to TFC under the subcontract because it had become apparent through the evidence accepted that Australian Aerospace had subcontracted the most lucrative part of the work being performed and wished to take back that work.

The meaning of "in good faith" has been debated but we suggest that the following acts could be examples of bad faith:

• engaging in conduct to deprive a contractor of a benefit of the contract; and
• using the termination for convenience clause where other clauses would have been more appropriate.

When should a termination of convenience clause not be used?

The limited case law available in Australia suggests that a narrow interpretation on the use of a TFC clause may be most readily accepted, perhaps with a demonstrable need justifying a reason for the Commonwealth to terminate a contract for convenience.

It would be risky to rely upon a TFC clause to terminate a contractor who is performing badly or if a better price could be obtained from another provider.

What compensation is payable?

Unlike termination reliant upon the doctrine of executive necessity (which attracts no compensation), most TFC clauses are accompanied by compensation clauses.

Often, the drafting of the compensation provision will provide for "reasonable costs incurred by the Contractor that are directly attributable to the termination". Accordingly, the types of compensation payable can include:

• costs associated with purchasing materials for the purpose of carrying out the contract;
• liabilities under finance and security arrangements over materials procured for the purposes of carrying out the contract;
• employment redundancy costs;
• any costs associated with breaking leases; and
• costs of additional insurance that the contractor may have arranged for the purposes of carrying out the contract, which may no longer be required.

The example of the East-West Link in Melbourne highlights how difficult it may be for a government to escape paying compensation, whether it be through the exercise of a termination for convenience clause or a settlement associated with termination.

Conclusion

The limited case law on the use of doctrine of executive necessity and TFC clauses in Australia suggests that governments must err on the side of caution and adopt a conservative approach when contemplating terminating a contract using either legal provision.

If a new incoming federal government were to review contracts on foot to determine whether to continue with them, it should act carefully. As stressed by Justice Kearney "it would be a serious matter for the rule of law if a government were perceived as refusing without proper cause to perform a contract for services to the public entered into in accordance with all the legal safeguards designed to protect the public interest" (Northern Territory of Australia v Skywest Airlines Pty Ltd (1987) 48 NTR 20).