Many contracts contain clauses which allow a party to terminate or take other action if the other party commits a “material” breach of the contract, but what is meant by “material” in this context? A recent decision of the Supreme Court of Western Australia sheds some light on the issue.
Who needs to know?
Anyone who is involved in drafting contracts or who is seeking to rely on a material breach to terminate a contract.
Background
In Apache Oil Australia Pty Ltd v Santos Offshore Pty Ltd [2015] WASC 318( click here for a copy of the case), the Supreme Court of Western Australia considered a Joint Operating Agreement (JOA) between Santos (45%) and various Apache parties (collectively 55%).
The joint arrangement related to the ‘Spar’ gas field and part of the nearby ‘Halyard’ gas field, both located offshore in the Canarvon basin near the Pilbara coast of Western Australia about 70km from Apache’s processing plant at Varanus Island. The venture was originally 100% owned by Santos until it sold down some of its interest to Apache around the same time that the JOA was entered into.
Under the JOA, Apache was appointed as the “Operator” of the joint venture. The JOA stated that all “Joint Operations” were to be conducted by the Operator as agent on behalf of the parties under the overall supervision of a joint operating committee.
The JOA also set out the parties’ respective rights and obligations in relation to petroleum (including gas) exploration activities within the joint venture area and the development and production of any discoveries. Those activities were to be conducted jointly. The JOA forbade the parties from carrying on any other operations in the area, although there was an exception which permitted one of the parties to conduct “Exclusive Operations” if certain procedures were followed and notices given etc. Critically, however, the sale agreement under which Santos sold 55% of the venture to Apache contained a clause which restricted Apache from giving an “Exclusive Operation Notice” for a period of 3 years from the date of the sale agreement.
Removal as Operator for Material Breach
Apache could only be removed as operator if it committed a “material breach” of the JOA.
In high level terms, Santos alleged that Apache breached the JOA by unilaterally carrying out unauthorised development within the joint venture area. It was essentially alleged that Apache had undertaken unauthorised preliminary development so that matters could readily be accelerated once the 3 year restriction on giving Exclusive Operation Notices had lapsed. Santos further alleged that these breaches were “material”. It then sought to remove Apache as the operator.
Apache denied that it had breached the JOA. The Court held that it had. Apache then argued that the breaches were not “material” and therefore Santos was not entitled to remove it as operator.
What is “material”?
The key points to note from this case are:
- the phrase “material breach” should not be equated to “fundamental breach”. The latter term is used by the common law to determine whether a breach is of such magnitude or seriousness to entitle the innocent party to terminate the contract;
- the focus should be on the materiality of the breach, rather than the materiality of the obligation that is breached; and
- to be a material breach the breach needs to “substantially adversely affect the interests of the other party” or be “important” or of “significance”.
Decision
In this case, the Court held that the breaches by Apache were material because the unauthorised development circumvented the overall supervision of the Operating Committee. The Court considered that control of the joint venture via this committee was “fundamental to the operation” of the joint venture, so circumventing it was indeed “significant”.
Apart from undermining the Operating Committee, the Court also held that Apache’s actions “deprived” Santos of the opportunity to apply the procurement procedures required by the JOA for the award of contracts for work in the joint venture area. This meant that Santos was denied its right to have “significant input” into the procurement process.
Interestingly, Apache argued that there was no material breach because Santos did not suffer any loss or damage as a result of the breach. In this regard, all of the costs (which were many millions) associated with the unauthorised development were in fact paid for by Apache out of its own funds rather than from the venture’s joint account. The court rejected this argument:
It is not an answer … to say that Santos Offshore did not suffer any damage as a consequence of the steps taken in progressing the GESP. Santos Offshore was deprived of the benefit of the provisions of the Spar JOA which entitled it to influence or have input into matters of budgets, contract awards and timing in relation to the project.
Practical Points to Take Away
- This case demonstrates the importance of abiding by the agreed governance arrangements in a joint venture. That’s not to say that every minor non-compliance will be “material”, but if, as here, the non-compliance was part of a deliberate agenda to circumvent the procedures in order to do things that the other joint venture party did not want to be done without its approval, then it is very likely to be a “material” breach.
- It is important to note that the innocent party does not necessarily need to show it has suffered any loss or damage in order for a breach to be material.
- When assessing the materiality of a breach, it is important to have regard to the surrounding circumstances (including any other agreements between the parties) as these circumstances may help to shed light on how important or significant certain matters are to the parties. For example, in this instance, the restriction in the sale agreement which prevented Apache from issuing an Exclusive Operation Notice for a period of 3 years served to reinforce the importance of the need for the parties to comply with the joint operation governance procedures. This made Apache’s unauthorised circumventing of those procedures more significant (i.e. more likely to be material) when viewed against this backdrop.
- Material breaches are often used as triggers to terminate a contract pursuant to an express clause. If you purport to terminate on this basis, but it eventuates that the relevant breach was not in fact material, you are likely to be in breach yourself for wrongfully repudiating the contract and may then be liable for damages for loss of contract. It’s therefore critical to undertake a full analysis before deciding to pull the trigger on this type of termination clause.