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‘Business as usual’: Doctrine of frustration in sale of business contracts

01 August 2023

#Dispute Resolution & Litigation, #Corporate & Commercial Law

Published by:

James Phillips

‘Business as usual’: Doctrine of frustration in sale of business contracts

A standard sale of business contract requires the seller to continue running the business as usual until completion of the sale.  However, during the COVID-19 pandemic, governments of every state brought in a series of public health orders that resulted in unprecedented business interruptions. During that time there were often periods in which carrying on “business as usual” became unlawful.

This raised a question of whether, in those circumstances, the buyer is entitled to terminate the contract because the seller cannot carry on its business as usual.

In the recent case of Laundy Hotels (Quarry) Pty Ltd v Dyco Hotels Pty Ltd [2023] HCA 6, the High Court of Australia ruled “no”. Specifically, the Court held that:

  • the owner of a hotel business was not obliged under its sale of business contract to carry on its business in contravention of public health orders
  • the seller could not terminate the contract due to the restriction on the business’ operations.

Background

In March 2022, public health orders of the New South Wales Minister for Health required that pubs “must not be open to members of the public … except for the purposes of … selling food or beverages for persons to consume off the premises”.

Shortly after the public health order was made, the purchaser of the business informed the owner that it would not complete the contract to buy the business because the owner was not ready, willing and able to complete the contract because the owner was in breach of the contractual requirement to “carry on the Business in the usual and ordinary course as regards its nature, scope and manner”.

In order to comply with the public health order, the business had re-opened, but only for the purpose of selling takeaway craft beer and food.

The purchaser wrote to the owner, stating that the contract for the sale of the business for $11.25 million had been frustrated. Alternatively, the purchaser said it was entitled to issue a notice to complete with which the owner could not comply, thereby enabling the purchasers to terminate the contract and sue for damages. The owner responded on the same day, saying that it was ready, willing and able to perform its contractual obligations and called upon the purchasers to complete the contract.

After the completion date, when the purchaser failed to comply with its obligations, the owner served another notice calling for completion of the sale of the business assets.

The purchaser then commenced proceedings in the Supreme Court of New South Wales, seeking a declaration that the contract had been frustrated, or alternatively, that the owner was not entitled to issue the notice to complete.

Supreme Court judgment

A judge of the Supreme Court dismissed the purchaser’s claim, deciding that the contract had not been frustrated. Despite the decline in the business’ value (by about $1 million), the judge concluded that there was no fundamental commercial difference between the actual and contemplated performance of the contract, nor was there a situation for which the parties had not made provision that was so fundamentally different that it would be unjust to hold the parties bound to the terms of the contract.

The owner was held by the trial judge to not be in breach of the contract due to the way in which it lawfully carried on the hotel business after the public health orders came into effect. The requirement under the contract to carry on the business was aimed at preserving the goodwill of the business, the subject of the transaction.

Court of Appeal’s decision

The Court of Appeal overturned the primary judge’s decision and held that the public health order was a supervening event rendering the owner’s compliance with the relevant clause illegal. They considered that the supervening illegality suspended the contractual obligation to carry on the business, and therefore the owner was not complying with its obligations under the contract at the time it served the notice to complete.

According to the Court of Appeal, because the owner was not ready, willing and able to complete the contract, it was not entitled to issue the notice to complete. The Court of Appeal decided that the owner had therefore repudiated the contract.

High Court’s decision

The High Court overturned the Court of Appeal’s decision and ordered that the purchasers repay the whole of any sum paid by the owner under the orders of the Court of Appeal.

The High Court reasoned that the obligation to “carry on the Business in the usual and ordinary course as regards its nature, scope and manner” incorporated an inherent requirement to do so in accordance with law. The owner was only required to carry on the business in its “usual and ordinary course” to the extent that doing so was lawful.

The hotel business operated under a liquor licence and subject to conditions imposed under the Liquor Act and Regulations. The lawful operation of the business under the licence was central to the agreement by the owner to continue carrying on the business until completion. The other provisions of the contract concerned the transfer of the licences to the purchaser. The owner’s warranty that the licence would not be subject to any conditions “other than any condition already imposed on the Licence or automatically imposed by virtue of the Liquor Act and the Regulations under that act from time to time” was an express acknowledgement that the requirements for the lawful operation of the business were variable.

The High Court observed that the terms of a commercial contract were to be understood objectively, by what a reasonable businessperson would have understood them to mean, rather than by reference to the subjective intentions of the parties to the contract. Accordingly, a reasonable businessperson in the position of the parties would have understood the relevant clause to mean that, from the date of the contract until completion, the owner was required to carry on the business “in the usual and ordinary course as regards its nature, scope and manner” in accordance with law. The owner’s obligation was necessarily moulded by, and subject to, the operation of the law from time to time.

Naturally, a business carrying on in its “usual and ordinary course” under a licence must operate in accordance with law.

Practical considerations

The doctrine of frustration

The doctrine of frustration will only assist in exceptional circumstances. An intervening event may bring a contract to an end where the event has occurred, through no fault of the parties, which makes contractual obligations practically impossible to perform or transforms them into fundamentally different obligations. It is not sufficient that the intervening event has made performance more onerous or expensive.

Force majeure clauses

A “force majeure” (meaning “superior force”) clause in a contract is a mechanism used to allocate risk between the parties, typically by excusing one or both from performing the contract in some way following defined events.

If a proposed contract contains a force majeure clause, it is important to consider what specified events are covered. The scope and effect of any such clause always depends on its construction and drafting. In most cases, the clause will contemplate that performance can be suspended if there are (for example) “acts of God”, extreme weather events, riots, war or invasion, government or regulatory action, strikes, terrorism or the imposition of an embargo.

Change in law clauses

“Change in law” clauses are also common. They anticipate situations where an unforeseen legal requirement affects the ability of a party to fulfil its side of the bargain. A change in law clause will provide for things such as recovery of additional costs, extensions of time to complete or suspension rights.

However broadly drafted, a force majeure or change of law clause cannot completely eliminate the risk of the value of the business subject to sale diminishing. Therefore, it is important to undertake due diligence and gain a proper understanding of the vulnerabilities of the business you intend to purchase.

The time to address these issues is before the contract is signed. If you have any questions about this article or need assistance reviewing a sale of business contract, please get in touch with us.

Disclaimer
The information in this article is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, we do not guarantee that the information in this article is accurate at the date it is received or that it will continue to be accurate in the future.

Published by:

James Phillips

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