Get out flaws

What constitutes a ’material breach’ is becoming a central problem for those wishing to terminate long-running IT contracts. By Sarah Walker and Carolyn Greene

Contracts for the provision of IT services commonly provide for a right to terminate in the event of a ‘material breach’. Given the frequency with which this provision arises, it is surprising that parties to the contract and their lawyers often have differing views as to what is meant by the term. Material breach is not a term of art. Contracts do not always define what is intended, and in the absence of such contractual definition the court will be obliged to ascribe a meaning to it by construing the intentions of the parties at the time of contracting. Complex IT contracts are often long term and high value, involving multiple obligations and a high degree of mutual cooperation. The impact of termination on either side is likely to be significant.

Termination at common law

Contractual termination rights, for material breach or otherwise, coexist with a common law right to terminate for repudiatory breach. At common law, breach of any less serious kind will give rise only to a right to damages, not termination. For a breach to be repudiatory it must be of such gravity as to “affect the very substance of the contract” or “frustrate the commercial purpose of the venture” – by way of example, a total failure of the software to perform is likely to be repudiatory. In the context of an IT contract, often involving delivery against milestones over an extended period of time, it may be difficult for a party to point to a breach that is sufficiently fundamental as to be repudiatory. More often a dispute involving an alleged breach will be waged in the middle ground of materiality.

Meaning of material breach

Parties to commercial contracts have historically made the assumption that material breach has the same meaning as repudiatory breach. The courts have made it clear in the past 10 years that this is not the case. The first of such decisions is that of National Power v United Gas Company (1998). The contract provided that either party could terminate with immediate effect if notice of a material breach had been served and the breaching party had not taken steps to begin remedy of the breach within seven days of receipt of the notice. ‘Material breach’ was not defined. The breach in question involved the alleged failure on the part of National Power to provide certain information on request. National Power sought to argue that ‘material’ had the same meaning as ‘repudiatory’ and that its breach had to amount to common law repudiation before the clause could apply. The court rejected this argument. In doing so it had regard to the fact that the contract provided for a “cure period”, which suggested to the court an intention not to limit the application of the clause to repudiatory breach. In considering the definition of ‘material breach’, the court held it to be one which is “serious in the wide sense of having a serious effect on the benefit which the innocent party would otherwise derive”. Applying that test, the court concluded that the breach in question was not material. For the purpose of general application, National Power suggested that a significant diminution of the benefit of a contract would constitute material breach, whereas a party must be deprived of substantially the whole benefit of the contract to give rise to repudiatory breach.

Rice v Great Yarmouth Borough Council

The later case of Rice v Great Yarmouth Borough Council (2001) concerned a four-year contract for the maintenance of leisure facilities that provided for an immediate right of termination in the event of “any breach”. The court was asked to consider the meaning of “any breach” and concluded that the parties could not have intended a right to terminate in the event of “any breach”, no matter how trivial. Rather, the court determined that, on a common sense commercial reading, “any breach” must be construed as meaning any repudiatory breach. The court then considered whether a series of minor breaches could cumulatively constitute a repudiatory breach even though the individual breaches would not be repudiatory. On the facts, the cumulative effect of the breaches were found not to be serious enough to be repudiatory. In deciding whether the breach was sufficiently serious, the court said the breaches needed to lead to a total breakdown in relations and “an inference that the contractor would continue to deliver a substandard performance” going forward.

Dalkia v Celtech

This rationale was confirmed earlier this year in Dalkia Utilities Services v Celtech International Services (2006). Dalkia involved a contract for the supply of energy services to a paper manufacturer that provided for the right to terminate with immediate effect in the event of material breach of payment obligations. Celtech defaulted on three consecutive monthly payment installments out of a total of 174 installments and Dalkia sought to terminate for material breach. The court found for Dalkia and in doing so expressly confirmed that material breach does not have the same meaning as repudiatory breach and that a series of minor breaches could constitute material breach. In reaching its decision the court had regard to a number of factors: that the sums in question were not trivial and that the missed payments were consecutive and that Celtech appeared to have no better prospect of being able to meeting future payment obligations. Celtech challenged the claim of material breach by highlighting the serious financial consequences to it of such a finding – namely the payment of a large termination sum. The court accepted that, while the consequences to the defaulting party should be borne in mind, the primary focus must be the character and gravity of the breach.

High-risk termination

The court’s reasoning in Rice and Dalkia suggests that the threshold for terminating a long-term IT contract for undefined material breach is high. A terminating party should have regard to the overall circumstances and its position would be strengthened if it could point to a breakdown in relations and the prospect of continuing a substandard performance. A word of warning: the possible consequences of seeking to terminate in circumstances where the materiality of the breach is questionable are potentially extremely serious. The party allegedly in breach may, upon receipt of a termination notice, seek to argue that the purported termination is itself a repudiation of the contract by the terminating party. The party that sought originally to rid itself of a problem-ridden long-term contract may well then find itself on the receiving end of a substantial damages claim. The absence of an accepted common law definition of ‘material breach’, coupled with the limited number of reported IT cases, makes it difficult to predict whether or not a specific breach, or series of breaches, will be regarded as ‘material’. To limit the possibility of dispute, draftsmen and parties to an IT contract should consider expressly defining, on a non-exhaustive basis, what they intend by ‘material breach’.

Sarah Walker is a partner and Carolyn Greene is a senior associate at Bird & Bird