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Contractual “default” – it means what it says on the tin

Introduction

One of the most important tasks of any commercial contract is to answer the question “how can it all go wrong?”  In other words, what do we mean when we talk about the ‘default’ of one or both of the parties?  In the recent case of ABC Electrification Limited and Network Rail Infrastructure Limited[1], the Court of Appeal provided helpful guidance on this question.

The case

In December 2012, ABC Electrification Limited (“ABC”) entered into a contract with Network Rail to upgrade the power supply to a section of the West Coast Main Line between Whitmore in Staffordshire and Great Strickland in Cumbria.  The contract was subsequently varied in September 2014 to extend the project to include the stretch of track between North Wembley and Whitmore.

The contract was based on an industry standard template – incorporating the terms of the “Institute of Civil Engineers Conditions of Contract, Target Cost Version, First Edition” (the “ICE Conditions”).

Under the contract, ABC was entitled to payment based on the cost of the work carried out, rather than on the basis of any pre-agreed sum.  More specifically, payment was based on:

  1. The “Total Cost” of the work performed (excluding “Disallowed Costs”); plus
  2. “Incentive Payments”; plus
  3. The “Fee” (intended to cover head office overheads and profit); plus
  4. A “Pain/Gain” share mechanism (broadly, if the “Total Cost” was greater than something called the “Target Cost” then ABC took some ‘pain’ in terms of fees, whereas if the “Total Cost” was less than the “Target Cost” then ABC shared in some ‘gain’ in terms of fees).

Broadly, the case centred around what was or was not a “Disallowed Cost” (this being a cost which was NOT recoverable by ABC).  The definition of “Disallowed Cost” was quite detailed, including factors such as (a) things that had specifically agreed to be at ABC’s expense, (b) sub-standard work, and (c) costs which ABC could not justify by reference to its accounts.  More specifically, however, the dispute focused on a particular provision under which “Disallowed Costs” included:

“…any cost due to negligence or default on the part of the Contractor in his compliance with any of his obligations under the Contract and/or due to any negligence or default on the part of the Contractor’s employees, agents, sub-contractors or suppliers in compliance with any of their respective obligations under their Contracts with the Contractor…”

At first instance, it was held that the word “default” should carry its “natural and ordinary meaning”.[2]  Viewed in its context, the court found that “default” meant ‘any failure by a party to comply with its contractual obligations’.  ABC had argued that the word “default” should be construed to mean that only a “wilful and deliberate” failure by ABC to comply with its obligations should constitute a “Disallowed Cost”.  Unfortunately, for ABC at least, this argument was given short shrift by the judge.  ABC appealed.

The law

The Court of Appeal provided a useful reminder of the general principles of contractual construction:

  1. When interpreting a written contract, the court is concerned to identify the intention of the parties by reference to what a reasonable person having all the background knowledge which would have been available to the parties would have understood them to be (using the language in the contract).  Put simply, the courts task is to ascertain the objective meaning of the language which the parties have chosen to express their agreement.[3]
  2. When interpreting a contractual provision, one can only take into account facts or circumstances which existed at the time the contract was made, and which were known or reasonably available to both parties.
  3. When it comes to considering the centrally relevant words to be interpreted, the clearer the natural meaning, the more difficult it is to justify departing from it.
  4. While ‘commercial common sense’ is a very important factor to take into account when interpreting a contract, a court should be very slow to reject the natural meaning of a provision as correct simply because it appears to be a very imprudent term for one of the parties to have agreed, even ignoring the benefit of wisdom of hindsight.
  5. ‘Commercial common sense’ and surrounding circumstances should not be invoked if the effect is to “undervalue” the importance of the language of the provision which is to be construed.  After all, the parties have control over the language they use within a contract.
  6. ‘Commercial common sense’ is not to be invoked retrospectively. The mere fact that a contractual arrangement, if interpreted according to its natural language, has worked out badly (or even disastrously) for one of the parties is not a reason for departing from the natural language.

The judgment

At appeal ABC slightly rowed back from its previous position.[4]  This was probably a wise move given that Lady Justice Carr (with typical understatement) regarded ABC’s previous arguments as being “a very difficult interpretation to maintain”.[5]  Instead, ABC argued that “default” should mean ‘a default where there has been an element of fault on the part of the contractor’.[6]  In other words, the word “default” should denote “fault” in the sense of blameworthy or culpable behaviour in compliance with contractual obligations (as opposed to a breach of contract for which there has been no such blame or culpability).[7]

Despite the change of tack, the Court of Appeal also rejected that interpretation, holding that “default” “means just what it says, namely a failure to fulfil an obligation”.[8]

The Court did accept ABC’s argument that Network Rail’s interpretation made some of the other terms of the contract (particularly those that were in existence before the contract was amended) effectively redundant.  Nonetheless, it held that this did not, of itself, make the contract unworkable or mean that it did not capture the meaning that the parties had intended.  Indeed, the Court accepted that redundancy of some terms was “almost inevitable when a lengthy standard form of contract is then the subject of wholesale amendments”.[9]

Of relevance to the Court was the fact that the clause itself identified the relevant duty (in other words, a ‘default on the part of the Contractor’).[10]  The Court also gave weight to the fact that the contract was a “Target Cost Contract” – meaning that it was “plain that the contractor was intended to bear the risk of its own breach of contract”.[11]  This being the case it did not support ABC’s contention that “default” had to involve some kind of blameworthy or culpable conduct on ABC’s part.  Moreover, the Court found that ABC could not “point to a workable alternative construction” of the clause in question.[12]

Lessons in the land of ISDA?

The use of ICE Conditions is widespread within the rail sector and was commonly used by Network Rail.[13]  In that sense, it is a standard form contract, much like the ISDA Master Agreement.

The ISDA Master Agreement dedicates a whole section (Section 5(a) – “Events of Default”) to defining what a ‘default’ is.  Nonetheless, on three occasions, events are still fundamentally defined simply by reference to the word “default”.

Firstly, the “Default Under Specified Transaction” provision makes reference to (a) “default…under a Specified Transaction or any credit support arrangement”[14], (b) “default…in making any payment due…[in relation to]…a Specified Transaction”[15], and (c) “default in making any delivery due under…a Specified Transaction”[16]

Secondly, the “Cross-Default” provision makes reference to (a) “default…under one or more agreements or instruments relating to Specified Indebtedness”[17], and (b) “default…in making one or more payments under…agreements or instruments [relating to Specified Indebtedness]”.[18]

Finally, interest accrues on late payment (or compensation is due) if a party “defaults in the performance of any payment obligation” (or default with respect to any obligation required to be settled by delivery).[19]

Parallels can be drawn between the ICE Conditions and the ISDA Master Agreement.  Both identify the relevant duty to which a ‘default’ relates (in the case of the ISDA Master Agreement this is a ‘default in relation to a Specified Transaction’, ‘a default in relation to Specified Indebtedness’, ‘a default in making a payment’ or a ‘default in performing an obligation’).

The ISDA Master Agreement differentiates between ‘fault-based’ “Events of Default” under Section 5(a) and ‘no-fault-based’ “Termination Events” under Section 5(b).  It also details the specific consequences which flow from an Event of Default via the close-out methodology found in Section 6(e).  As such, it could also be argued that the parties to an ISDA Master Agreement are ‘intending to bear the risk of their own breach’ arising under either Default Under Specified Transaction or Cross-Default (both of which arise under Section 5(a)).

So, ultimately, it seems more than likely than not that “default” under the ISDA Master Agreement would not have to be “wilful”, “deliberate”, “blameworthy” or “culpable”.  Instead, ‘default’ is simply a default in the performance of the relevant obligation.  Whilst some may regard this as a statement of the blindingly obvious the Court of Appeal regarded it as worthy of clarification.  Either way, it’s reassuring to know that default is just what it says on the tin.


[1] [2020] EWCA Civ 1645

[2] Paragraph 16

[3] Paragraph 19

[4] Paragraph 5

[5] Paragraph 27

[6] Paragraph 29

[7] Paragraph 4

[8] Paragraph 30

[9] Paragraph 78

[10] Paragraph 37

[11] Paragraph 53

[12] Paragraph 75

[13] Paragraph 6

[14] Section 5(a)(v)(1)

[15] Section 5(a)(v)(2)

[16] Section 5(a)(v)(3)

[17] Section 5(a)(vi)(1)

[18] Section 5(a)(vi)(2)

[19] Section 9(h)(i)(1) and (2)

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