It has been hard to escape discussion of force majeure, frustration and material adverse change in the early stages of the pandemic. These principles and provisions are likely to govern the circumstances in which a party is permitted to extract itself from a long-term agreement. However, it is perhaps inevitable that many parties who purport to bring an agreement to an end will be found to have done so in breach of contract. In effect walking away from the contract without the right to do so.
In the current circumstances, calculating the damages due following such a breach gives rise to a further headache. It is extremely common for damages to be assessed by reference to the state of the available market at the time the contract was breached. But what happens when there is no market? What steps should parties take to seek to mitigate their losses in those circumstances? Those are very real practical and commercial problems with which businesses will need to grapple. In this update, we look for guidance in a number of judgments which arose against the backdrop of the Global Financial Crisis.
The normal calculation – contract price less market price
Parties who have been involved in supply chain or similar disputes in the past will be familiar with the standard approach of looking to the difference between the market price and the contract price as at the date of breach as a means of calculating damages. The effect of the calculation is to apply two general principles of contract law, being:
- First, the innocent party is entitled to be put in the position it would have been in had the contract been performed (in which case it would have been paid the contract price).
- Second, the innocent party is not entitled to recover losses which it could have avoided by taking reasonable steps in mitigation.
When there is an available market for the goods in question, the most obvious step for the seller to take in mitigation is to sell the goods at the market price at the time for performance. The price the goods would command in the market is therefore commonly factored into the damages calculation. This common law position is reflected in the Sale of Goods Act 1979 which provides at section 50(3):
“Where there is an available market for the goods in question the measure of damages is prima facie to be ascertained by the difference between the contract price and the market or current price at the time or times when the goods ought to have been accepted or (if no time was fixed for acceptance) at the time of the refusal to accept.”
But what if there is no market for the goods? The short answer is that the court will base its damages award on the general rules applicable to mitigation of loss. The cases summarised later in this article illustrate how those principles have been applied in practice in the context of extreme market disruption.
The Global Financial Crisis cases
This question was considered by the Court of Appeal in a 2013 case, Hooper v Oates1, which concerned a property sale which fell through in the wake of the Global Financial Crisis. The court observed that whilst the normal rule is that damages should be assessed at the time of breach, that rule is applied flexibly, particularly when the claimant has deferred reacting to the breach for a good reason.
With that in mind, the Court of Appeal held that:
"The breach date is the right date for assessment of damages only where there is an immediately available market for the sale of the relevant asset or, in the converse case, for the purchase of an equivalent asset."
Applying the general principles relating to damages and mitigation, the court held that absent any failure by the seller to take reasonable steps to mitigate its loss following a purchaser's breach, the eventual resale price, rather than the value of the property at the date of the breach, was likely to be the figure to be set against the contract price for assessment of damages because it showed the loss which the seller had suffered.
In the event, the sellers were unable to sell the property and after about a year they decided to move back in. The court awarded damages assessed by reference to the difference between the contract price and the market value as at the time the seller decided to retain the property having been unable to sell it.
Hooper v Oates concerned an asset – property – for which the court doubted there would ever be an immediately available market. However, it is arguable that the same reasoning should apply to any commodity for which there is no immediately available market at the time of breach.
Similar issues have been considered a number of times in the context of a string of shipping disputes arising against the backdrop of the Global Financial Crisis, starting with The Wren2 and The Kildare3, and including the judgment of the Supreme Court in The New Flamenco4.
The defendants in those cases had entered into long-term charters of the claimants' vessels before the crash. As the crisis took hold, the shipping market collapsed. In breach of the long-term charters, the defendants returned the vessels to their respective owners several years early, refusing to make further payments.
In each case, the court found that at the time of breach there was no available market for equivalent long-term charterparties. The owners of the Wren and Kildare were left to take their chances on the spot market, and the New Flamenco was sold.
In The Wren, Blair J summarised the legal consequences of that finding as follows:
"The market price on an available market at the date of breach/termination is deemed by the law to represent reasonable mitigation. But if there is no available market at the date of termination, then… one has to fall back on the broader question of asking what sum would put the claimants in the same financial position which they would have been in had the charterparty been performed, by making a comparison between their "lost" and actual financial positions."
The owners of the Wren and the Kildare were therefore able to recover the difference between the stable earnings anticipated under the long-term agreements with the defendants, and the patchier earnings they were actually able to achieve on the spot market.
The New Flamenco involved a different issue. Following breach of the charter, the owners sold the vessel for around $23 million. By the time the contractual redelivery date arose in 2009, the market value of the vessel was only around $7 million.
The charterers sought to offset the benefit to the owners – in the form of the higher purchase price – against the damages award. This argument failed, on the basis that the sale of the vessel was not an act of mitigation, as there was not a sufficiently close causal link between the charterers' breach of the charterparty and the owners' decision to sell the vessel. In reaching that conclusion, the Supreme Court made the following general statement of principle:
"In the absence of an available market, the measure of the loss is the difference between the contract rate and what was or ought reasonably to have been earned from employment of the vessel under shorter charterparties, as for example on the spot market. The relevant mitigation in that context is the acquisition of an income stream alternative to the income stream under the original charterparty."
Market disruption in the wake of COVID-19
This issue might be encountered in the context of virtually any agreement between a seller and a purchaser, and given the wide reaching impact of the pandemic, the number and variety of permutations is for all practical purposes limitless.
Contracts for the sale and purchase of goods are probably the most obvious context in which this issue will arise, although it is by no means confined to that context, and indeed many of the decisions referred to above arose outside the sale of goods context. The following are examples of scenarios that could well give rise to similar issues in the near future:
- Hydrocarbons: The oil and gas sector has seen profound market disruption as a result of recent geopolitical developments, exacerbated by a drop off in demand caused by the pandemic.There are likely to be numerous disputes associated with consequent changes in equipment hire rates similar to the shipping cases referred to above.In addition, disputes arising out of localised instances where there are a lack of willing buyers in the market due to storage issues are a possibility.These may well give rise to novel issues, including the extent to which sellers can recover storage costs on top of the lost contract price.
- Retail:Similarly, the retail sector has been adversely affected by the pandemic and many retailers have cancelled or reduced orders.As with the sectors referred to above, suppliers may find themselves holding goods which no-one is willing to buy.In these circumstances, suppliers will need to make difficult decisions as to whether those goods can be put to other use, should be stored until demand increases, or should simply be disposed of.
In a sense, the difficulties discussed in this article are as much practical and commercial as legal. When there is an immediately available market for goods, in most cases a seller will be expected simply to go back into the market after a buyer default, and damages will be assessed by reference to the market price accordingly.
When there is no market, however, all bets are off. Sellers will instead be expected to take any steps which are reasonably available to them to limit their losses. This may involve exploiting a different market (like the owners of the Wren and the Kildare), waiting for things to improve or (like the sellers in Hooper v Oates) simply walking away if a sale proves illusory.
Those are very real practical and commercial problems with which businesses will need to grapple. However, decisions should be taken with one eye on the court's approach to mitigation. As we mentioned above, many commercial parties are taking advice on force majeure and MAC clauses and frustration as they seek to exit long-term contracts which suddenly look expensive. However, for every party which validly exercises a termination right, there will be another party who gets things wrong. Parties who are likely to become embroiled in termination disputes should be considering these issues carefully when deciding how to proceed.