Termination of contract on the grounds of frustration

NB REFERENCES TO "HPH" OR JUST TO A PAGE NUMBER ARE TO HEFFEY, PATERSON AND HOCKER CONTRACT COMMENTARY AND MATERIALS 8TH ED

1998 (LBC INFORMATION SERVICES)

We now come to the last phase of the contracting process. We are now concerned with things going wrong, either because some disaster has overtaken the contract which cannot be said to be any one’s fault (the subject of the doctrine of frustration) or because one of the parties has committed a breach. We will certainly pay some attention to breach which is a very common problem and of great practical significance. But before we look at breach it is necessary to look at the doctrine of frustration.

It is important to understand the effect of either frustration or serious breach which brings a contract to an end. The contract is terminated by, for example, frustration. This should be distinguished from rescission.

Termination occurs during the running of a contract and the contract just stops so that rights and liabilities in the future no longer apply. Accrued rights and liabilites (those that have already fallen due before the terminating event) are perfectly enforceable.

This is to be contrasted with rescission where the contract is treated as if it had never been. It is a pre-requisite of rescission that it must be possible to go back to the situation before the contract was made. It is logically impossible to sue for breach of a contract that is successfully rescinded.

Remember, rescission is the remedy available when something has gone wrong during the negotiations for the contract, such as misrepresentation or misleading conduct, unconscionable dealing, undue influence, duress or mistake. Termination is the remedy available where either the contract has been frustrated or one party has committed a breach which is so serious that it justifies the other party putting an end to the contract by terminating it.

Having said all this, it must be pointed out that the usage of these two terms (termination and rescission) is often muddled. Judges quite frequently talk of rescission when they mean termination.

The doctrine of frustration - which is effectively a court order that the contract is no longer binding on either party (the contract just stops in its tracks) - is very rarely considered by the courts. The usual way in which the doctrine is raised is where some disaster has overtaken the contract and one party then fails to perform. The other party then complains that the first party is in breach. The answer to this may be that failure to perform is not a breach because the contract has been frustrated as a result of the disaster. In short, frustration, if successfully argued, is an excuse for failure to perform.

The doctrine, as I have said, is rarely argued successfully. This is because the courts have taken the view that one function of contract is to allocate risk and that, if something does go badly wrong, then this is just a risk which the contract ought to have contemplated. See the passage on p 724 last para from the case of Paradine v Jane in 1647 which reflects the idea that contract promises should be kept, whatever the circumstances. In other words, at the very moment that one party finds it very hard to perform, the other party wants an assurance of performance, or at least damages in lieu, because this is what contract is all about. People are paid to take the risk

of difficult performance. The law nevertheless did allow some softening of this absolute principle and developed a doctrine of frustration.

This treatment of frustration will not be as detailed as most of the other areas of the law of contract which we have examined. This is partly because, as already noted, it is a rare in practice and also because we are limited in the time left to deal with the remaining topics in the course.

The development of the doctrine of frustration

HPH 724-727

The case book outlines briefly the history of the development of frustration. The beginning of the doctrine is said to be the case of Taylor v Caldwell in 1863, a case involving the hire of a hall. Before the day on which the hirer was to use the hall, it burnt down. This was held to be a frustrating event which caused the contract to be terminated and neither party was in breach. Frustration cases since then have involved a number of different types of frustrating event. The key question is always: is this an event which excuses the parties from further performance or is it an event which is the type of risk which the contract expressly or impliedly contemplated? If the latter then the contract is not frustrated and, if a party does not perform, he or she is in breach.

The theoretical basis for frustration

The courts over the years have had a great deal of difficulty in deciding what is the proper theoretical basis for the court intervening in the contract and declaring it to be frustrated. The theories have varied and there have been fashions over the years. The three headings below reflect the three phases or fashions, with the last one being the one which courts tend to adopt to-day.

Implied term

The first theory was that declaring a contract to be frustrated was simply another aspect of the court’s ability to imply a term into the contract. If an officious bystander had asked the parties just before they committed themselves to the contract: "What is the result if such and such happens?" the parties would have dismissed the bystander, testily, with an "Of course our contract would be at an end." This was the basis for the decision in

Taylor v Caldwell    HPH 734

You can see that the judgment of Blackburn J on pp 734-736 is centred on an implied term analysis. He concludes on p 735 2nd last para that the existence of the subject-matter of the contract is an implied basis for the continuing of the contract. You can see that this has some parallels with the mistake cases. As was pointed out when we studied mistake, the difference between frustration and mistake is when the disaster struck. If before formation, then it is a mistake case; if after, then a frustration case.

The problem, as always, with implied terms is that it may be very difficult to arrive at a clear conclusion as to what the alleged implied term should be. Remember that it has to be capable of clear expression and it must be so obvious that it goes without saying. Of course the parties will differ about these matters.

As a matter of construction

The second theory is based on construing the obligations in the contract and limiting them to normal circumstances and not to extraordinary circumstances. This is really not very different from implying a term. But instead of adding an implied term, the technique is to construe the express terms. This approach is described by Mason J in his judgment in the Codelfa case, the leading High Court case on frustration. He refers to Lord Reid’s approach in

Davis Contractors v Fareham UDC

Lord Reid HPH 749 where the implied term theory is rejected and instead it is said that the parties never agreed to carry out their obligations in the type of circumstances which have eventuated. This is a matter of construing the principal obligations of the contract. The same idea is reflected in the words of Lord Wright in

Denny Mott and Dickson Ltd v James B Fraser & Co Ltd    HPH 751 2nd (indented) para.

It is appropriate at this stage to return to

Codelfa Construction Pty Ltd v State Rail Authority of NSW    HPH 740 at 749

We looked at this case before when we were examining implied terms. It will be recalled that the building of the eastern suburbs railway in Sydney was overtaken by disaster when residents obtained an injunction which prevented work being done at night. Codelfa, the contractor, had quoted on the basis of being able to work a three 8-hour shift day. It attempted unsuccessfully to argue that an implied term should meet the new circumstances whereby Codelfa obviously could not finish on time and there were extra costs incurred as a result of the new arrangements. The High Court was however prepared to order that the contract had been frustrated. The result was that the contract came to an end once the injunction was granted. In fact Codelfa finished the work. This work had to be paid for on the basis of a fair and reasonable remuneration, that is, on the basis of restitution, because there was no longer any contract to determine how much Codelfa should be paid for the work.

In the course of discussion about the proper basis for the operation of the doctrine of frustration, Mason J made it clear that the court’s task is to compare performance of the contract under the new conditions with the performance contemplated by the contract before the changed circumstances. If performance is radically different, then the contract is frustrated. In this case, this was so even though there was a clause - cl 8(2)(c) discussed on p 752 - which appeared to cover the events which arose. But Mason J said that it was not intended to cover such a radically disruptive event - a court injunction - which prevented the basic system of work from being employed.

As a matter of justice and reasonableness

This is really another way of expressing the previous theory. The court will intervene and declare the contract to be frustrated when it would be quite unreasonable to expect the parties, or one of them, to perform under the changed circumstances. The key to this is found at the end of the 1st para on p 758 in an extract from Lord Radcliffe’s judgment in Davis Contractors v Fareham UDC "It was not this that I promised to do."

Just completing the examination of the Codelfa case, note that Mason J examined the question whether an arbitration clause survives the termination of the contract because of a frustrating event. There was a mistaken view that termination of the contract meant that everything came to a halt, including an arbitration clause. This view is now not correct. There are certain matters provided for in the contract which do survive the termination of the contract.

Some examples

We cannot possibly canvass all the frustration cases. Instead we can only get a feel for the sorts of events which might be argued to be frustrating events. You will see a list on pp 788-789 of the casebook. Particular caution must be exercised in relation to number 3. It is not enough to argue that performance has turned out to be difficult or even extremely difficult. For example in Davis Contractors v Fareham UDC (described on p 787) the contract was to build 78 houses for a fixed price in 8 months. Because of labour shortages and bad weather the time it took to build the houses was 22 months. It was held by the House of Lords that the contract had not been frustrated.

Krell v Henry    HPH 736

This is generally regarded as the high water mark of frustration cases, that is, the court taking the most liberal view of the operation of the doctrine. The contract was for the hire of a room overlooking the coronation route for the coronation of King Edward VII. The coronation was cancelled because of the King’s illness. This was held to be a frustrating event. You can see from this case that it is necessary to adduce extrinsic evidence in order to argue frustration, a point specifically made by Mason J in Codelfa. On the face of it this was just a contract to hire a room. The defendant got what he bargained for. Yet he was successful in arguing frustration with the result that he did not have to pay the balance supposedly owing under the contract.

Krell v Henry has been the subject of critical comment but probably it would be decided the same to-day in the light of what was said in the High Court in Codelfa. Nevertheless, it is by no means easy to say what is the correct solution to these kinds of cases. In Krell v Henry one might ask: who should take the risk of the coronation being cancelled - the landlord or the person hiring the room? The answer is not self-evident but it would not be harsh to suggest that the person hiring the room should take the risk (with the consequence that a court would say that the contract had not been frustrated). After all we all risk disappointment when we buy tickets to events, particularly outside events. On the other hand, in the Codelfa case, involving a large infrastructure project, it seems only fair that the government body should bear the risk rather than the contractor (and so the ruling that the contract had been frustrated produced the right result).

Brisbane City Council v Group Projects Pty Ltd    HPH 762

In this case Group Projects (GP) owned some land which it wanted to develop. The land needed to be rezoned. It came to an agreement with the Brisbane City Council that GP would carry out certain work both on the land and off the land when the land was rezoned residential. What happened was that the land was compulsorily resumed by the government for use as a school. The Brisbane City Council argued that, to the extent that GP had promised to do development work off the land, it was still bound to do so. GP argued that the whole deal had been frustrated because the very basis for its ability to make a profit had been removed when the land was compulsorily resumed. This case raises the interesting question whether it can be said that frustration exists when the commercial underpinnings of the contract have been removed. Those members of the High Court who considered the issue had no difficulty in this case in holding that the contract had been frustrated because of the resumption of the land. You can see the conclusion of Stephen J on p 766 4th para and an interesting commentary in the next para on p

766 on the law about frustration and how uncertain it is. He talks of the cases providing little more than single instances of solutions to the question of frustration.

National Carriers Ltd v Panalpina (Northern) Ltd    HPH 789

This case was important because, before it was decided, it was generally thought that the doctrine of frustration could not apply to real estate, including leases. This is because real estate is land and land is for ever. The National Carriers case involved a commercial lease of a warehouse. The only access to the warehouse was cut off by a local authority order which closed the street because of the unsafe state of a building in the street. The lease was for 10 years. The street would be closed for about 18 months. The tenants argued that the lease was frustrated.

Why should the doctrine of frustration not apply to real estate (the traditional position)? In this case, the tenant had the premises the subject of the lease agreement. It does not matter what happens, it could be argued - even if a building is totally destroyed - the interest in the land continues on. But this is a somewhat unrealistic view of the commercial realities. In the National Carriers case the House of Lords said that the doctrine of frustration could indeed apply to a lease but stressed that such cases would be rare. On the facts of this case they came to the conclusion that the lease was not frustrated because the tenant’s deprivation was relatively small compared with the term of the lease (18 months in 10 years).

Self-induced frustration

One limitation on the doctrine of frustration is that a person cannot argue frustration if he or she has caused the frustrating event. This is called self-induced and is no frustration in law. It may be possible to escape this rule if the person who has apparently caused the event can argue that it was not his or her fault. The rule about self-induced frustration is discussed in a rather odd setting in

FC Shepherd & Co Ltd v Jerrom    HPH 767

The case is odd because of the way the argument was put. The contract in question was a contract of apprenticeship. The apprentice was convicted of an offence which had nothing to do with his work. He was sentenced to a term in Borstal - a type of prison for young offenders. When he got out he asked to resume his training but the employer refused. The apprentice then brought an action for unfair dismissal. The employer argued that the contract had been frustrated by the sentence to Borstal and that therefore he had not been dismissed. The apprentice argued that frustration could not work because it was self-induced frustration.

The usual way in which self-induced frustration arises as an argument is illustrated by the Joseph Constantine case which is mentioned on p 768 2nd last para. In that case a ship exploded. The owners argued that the contract of chartering had been frustrated. The charterers argued that the explosion was caused by the negligence of the owners and that therefore the contract had not been frustrated. In fact it was not clear what caused the explosion. It was held that the onus of proving self-induced frustration rests on the person alleging fault and that in this case the charterer must prove that the explosion was caused by default on the part of the owner. This the charterer could not do and so the argument that the frustration was self-induced failed.

Of course, the present case does not really raise the issue of self-induced frustration and, indeed, Lawton LJ said as such in the 2nd para of p 769. What the apprentice was trying to argue here was that the contract was not frustrated so much as it was subjected to a default by himself which would then require some response by the employer viz dismissal. In other words this case was

about breach. This, at least, so it was argued, prevented the employer from arguing frustration because breach and frustration are mutually incompatible. Alternatively, frustration could not be argued because the event which was the basis for frustration was self-induced. It is said in the cases that frustration can only work if the event in question happened without fault on either side. This is turning around the self-induced frustration argument. In the end, these arguments did not work. The court resorted to basic statements of principle such as a person cannot take advantage of his own wrong.

There are still unresolved questions relating to self-induced frustration: what degree of fault is required to attract the rule? Is negligent conduct enough? For example, it was never suggested in the Codelfa case that that was a case of self-induced frustration. But why not? The contractor caused the event which was held to be a frustrating event by making sufficient noise to constitute a legal nuisance (a tort). This merely illustrates that the concept of self-induced frustration has not been fully worked out.

The consequences of frustration

At common law

If it is established that there has been a frustrating event, then the contract stops from that moment on. That means that all obligations up to the moment of frustration are enforceable and that all obligations relating to performance after that moment are no longer binding. Some contract terms survive frustration, as we saw in the Codelfa case where Mason J held that an arbitration clause survived. Other types of terms which would survive would be an exclusion clause and a clause imposing a duty of confidentiality.

If the contractor is permitted to do further work after the frustrating event, then, unless a fresh agreement is made, the contractor is not doing work pursuant to the contract. Nevertheless, the contractor must be paid a fair remuneration for any work done, on the basis of quantum meruit or restitution. This may be more or less than the contract rate. This is in fact what happened in the Codelfa case.

Basically, then, the loss lies where it falls. This can cause hardship. For example, suppose a periodic payment is due to be made on the 10th October and this payment relates to work that has been done over the last month. Suppose the contract is frustrated on the 8th October. This means that the amount is no longer due and payable and yet the work has been done.

Another situation which can cause injustice is where money is paid in advance and then the contract is frustrated before the person who has paid the money gets any return for it. Some of these problems are illustrated by

Fibrosa Spolka Akcyjna v Fairbairn Lawson Combe Barbour Ltd    HPH 796

In this case a Polish company ordered a machine from an English company. The Polish company was obliged to pay £1600 up front when it sent in its order. It paid £1000 of this. The English company started work on making the machine. Then war broke out and the contract was frustrated. The Polish company claimed its £1000 back. The English company said that it had already done a considerable amount of work on the machine.

The House of Lords applied a restitutionary principle which dictates that if there has been what is called a total failure of consideration, then any money paid in advance can be recovered. The expression "total failure of consideration" has nothing to do with the doctrine of consideration. It does not mean that there is no consideration so that no contract has been formed. What it means is that one party has got nothing under the contract. In that circumstance, if he or she has already paid money up front, the money can be recovered. We have come across this idea before when we looked at the judgment of Lord Atkin in Bell v Lever Bros. The principle only applies if the party has got nothing under the contract. The failure must be total. If the party has got something under the contract, however small, then the principle does not work and any money paid up front cannot be recovered, even if it far exceeds the value of what has been received.

So, in this case, the Polish company had received nothing for its money and it could therefore recover the £1000. But this was not a satisfactory result for the English company because it had performed work. Maybe it could find another buyer for the machine but this would depend whether it was a one-off machine or one which was readily saleable.

So the overall result of the common law principles which apply if a contract is frustrated are sometimes not very satisfactory. It is always possible for the parties to specify in the contract what should be paid if the contract is terminated but often the parties do not enter into a commercial relationship with a view to it failing and so they do not provide for such events.

It is because the common law consequences of frustration can be unfair that legislation has been passed in some jurisdictions to attempt to allow adjustments to be made.

Statutory modifications     HPH 799-800

In three jurisdictions in Australia legislation has been passed to try and deal with the problem of frustrated contracts, that is, the "mopping up" after a contract has been frustrated. The legislation attempts to allocate the consequences of the contract being frustrated in a way which is more satisfactory than the piecemeal common law. Each Act is different from the other. The Victorian Act is modelled on the English legislation; the South Australian Act is modelled on the legislation of British Columbia (Canada); and the New South Wales Act is a thing unto itself and is virtually incomprehensible. The best and simplest model is the South Australian Act.

The legislation is described very briefly on p 799. A full exploration of each Act would be a very time-consuming exercise. We cannot embark on such an examination. Basically, the legislation is designed to achieve a fair and just settlement between the parties to a frustrated contract.

 

A Brief Historical Overview

NB REFERENCES TO "HPH" OR JUST TO A PAGE NUMBER ARE TO HEFFEY, PATERSON AND HOCKER CONTRACT COMMENTARY AND MATERIALS 8TH ED

1998 (LBC INFORMATION SERVICES)

For a useful guide to the historical development of the law of contract, see Seddon, N and Ellinghaus M Cheshire & Fifoot's Law of Contract (7th Aus ed 1997) ch 26.

The early law was primarily concerned with keeping the peace. Out of this concern developed the action for trespass which was designed to give a remedy to someone who was wronged so that

they would not resort to self-help remedies. You learn about this and associated remedies in the Torts course. But the wrongs which were the subject of early legal remedies were limited and what characterised the early common law was the writ system whereby you had to be able to fit your particular grievance to a particular formula or writ. If you could not, then you could not get a remedy.

In relation to contract-type claims, the law was relatively unsophisticated. It allowed a remedy if someone did something badly (misfeasance) but not if he or she did not do it at all (nonfeasance). There was an exception to this, namely, when someone had failed to pay money. Money claims - called an action in debt- could be brought by a seller if goods had been delivered and not paid for; but a claim could not be brought by a buyer if the goods were not delivered at all. In such a case all that the buyer could was get his or her money back. Ordinary trading exchanges were therefore covered in a fashion. But you can see that the law had not adapted to the needs of a sophisticated trading economy which, as we have seen from the supermarket example, requires the ability to make enforceable promises about the future - called executory promises. If you wanted to be sure that someone would do something in the future, the only way was to get them to promise in a deed under seal. The action was called an action on a covenant. This was the only way of getting a remedy for nonfeasance. It was not until the 17th century that a general contractual remedy (called assumpsit) was developed to cover nonfeasance. So, the development of a general contract remedy was slow in coming. Specific areas of activity had special rules. This can be seen in the next part.

18th Century Paternalism

Before the industrial revolution, society was stratified, each person with his or her own status. Thus in feudal times a person's status was determined by birth and relations between people were principally governed by status rather than contract. What is meant by this is that a person could not really change his or her status by enterprise or endeavour. Property rather than enterprise was the principal source of wealth. This is not to say that there was no trading. There was but traders developed their own special rules, called the "law merchant", which had universal application amongst traders but was otherwise not applicable to day to day life. It was not the common law but rather a private system of law. Contract played a minor role and was mainly concerned with transferring of property. Some contract-like obligations were imposed, not because a person had agreed to them, but because they arose automatically, such as the obligation to pay a physician for services rendered. Even if the parties had agreed to a specific price this was not necessarily binding if it did not conform to community standards. So, obligations would arise in these times irrespective of the parties' wills or intentions.

Executory Promises

The most important feature of early contract law was the fact that executory promises were not enforceable. Thus any promise to do anything in the future could not be enforced by simply making an agreement as it can to-day. Obligations arose in early contract law because something had already been done. Thus the obligation to repay a debt arose because the borrower had had the benefit of the loan. The obligation to pay a builder arose because the work had been done. The basis of imposing an obligation was that one party would be unjustly enriched at the expense of the other if the obligation was not fulfilled.

As already noted, it was possible by a special method to make executory promises binding and that was to use a formal document called a deed under seal. Thus, if there was sufficient ceremony and formality it was possible to create promises binding in the future. Deeds still exist to-day and are used in certain special transactions or to achieve a particular purpose.

The first transformation of the law of contract was to develop a way of enforcing executory promises. This it did by developing an action called assumpsit. If one person promised another to deliver a ton of gravel next Friday, payment on delivery, such an agreement would not have been enforceable. If the supplier failed to show up on Friday, no remedy was available unless the agreement was enshrined in a deed. The action of assumpsit was developed to meet this type of case. It was enough, in order to create a binding agreement, merely to exchange promises. This was of profound importance in the world of industry and commerce which was just starting to take off at the beginning of the industrial revolution. It enabled entrepreneurs to plan ahead. Trading no longer consisted of instant exchanges. Factories and other entrepreneurial enterprises became complex organisations in which reliable forward planning was essential for efficiency. Contract law, through the action of assumpsit, developed to meet this need.

Before turning to the 19th century, it is worth noting that much has been written about the basis of making binding promises. We have already started to explore this question. It is all very well to say that the action of assumpsit laid the ground work for sophisticated forms of exchange. But basic questions have to be asked about the business of promising. What is it that makes a promise binding? Exactly when does it become binding? The doctrine of consideration, as I have already indicated, was about this problem. Originally the word "consideration" probably meant motive or reason for imposing a binding obligation on someone. Thus the law was searching for a good reason to make promises binding. Much of the early law of contract was concerned with this question with different points of view holding sway at different times. This is discussed in the extract from Greig and Davis (HH pp 6-10).

The Moral Obligation Theory Rejected

In the end the law of contract rejected a moral theory, championed by Lord Mansfield, as being the good reason for making promises binding but instead adopted a theory of exchange or bargain - that is, promises were binding if they were part of a process of exchange, but not otherwise (deeds apart). It was not enough merely to promise.

Eastwood v Kenyon    

The decision in Eastwood v Kenyon (1840) 11 A & E 438; 113 ER 482 was an important land mark because it set the seal on the consideration or exchange theory and put paid to the moral obligation theory which had achieved some success in Lord Mansfield's time. The case involved someone who as executor of a deceased estate had taken on himself the task of looking after the deceased's daughter until she became an adult. In doing so he had spent a lot of money and even had had to borrow money at one stage. The daughter, when she came of age and her husband when she married, promised to reimburse the plaintiff. When he was not reimbursed he sued on this promise. The court said that the promise to reimburse was a purely moral obligation. It was not supported by consideration. This was because it was not part of an exchange. What he had done in the past could not constitute part of an exchange. We will see that this idea is reflected in one of the rules of consideration which we will examine, namely, the rule that past consideration is no consideration.

A "Good" Consideration

We will see that much of the doctrine of consideration is about what amounts to a good consideration in the eyes of the law. It is here that there are some somewhat curious rules. The courts had to face the task of trying to define what they meant by consideration.

The basic idea was that there had to be an exchange of something recognised to be a consideration in law between the parties when they made an agreement. This is, of course, circular. The escape from the circle was provided by the accumulation of experience from the cases. In general terms, a consideration was something provided by the promisee (the person trying to enforce the promise) which was either a benefit to the promisor or a detriment to the promisee. An example of a benefit to the promisor is a promise of a sum of money. An example of something which is a detriment to the promisee is a promise to give up a right or to forego an opportunity. Often the consideration is both a benefit to the promisor and a detriment to the promisee, such as a promise by the promisee to pay money to the promisor.

The following case shows a curious example of how the courts struggled with the concept of benefit and detriment.

Shadwell v Shadwell    

The peculiar nature of what the law considered to be a detriment and a benefit is revealed by the case of Shadwell v Shadwell (1860) 9 CB (NS) 159; 142 ER 62. In this case an uncle promised his nephew an annual sum of money if he married one Ellen Nicholl. The nephew duly married Ellen Nicholl and the money was paid for some time. The uncle died and his executor refused to pay the money. It was argued that this could not be a contractual obligation. What was the consideration provided by the nephew? Did he provide a benefit to his uncle or did he suffer a detriment? It does not seem so. Yet the court was prepared to say that when young Lancey - for that was the nephew's name - actually married Ellen Nicholl he was providing a consideration which made the uncle's promise binding. It was said that the nephew had either incurred a detriment by marrying Ellen Nicholl or had conferred a benefit on his uncle. What benefit? It was thought that the uncle must have wanted his nephew to marry Ellen Nicholl and that therefore it was a benefit to him when Lancey married her. The case is, to say the least, peculiar.

Carlill v Carbolic Smoke Ball Co     (HPH 37)

Another taste of the mysteries of consideration is the famous Carbolic Smoke Ball case. I won't go into the case in detail now because we will return to it. In that case Mrs Carlill responded to an advertisement by buying the defendant's product, a carbolic smoke ball, which was touted as a wonder cure for all sorts of maladies. The advertisement promised £100 to anyone who used the ball and yet contracted influenza. Mrs C duly obliged and sued for the £100 which the company had refused to pay. The case raised a number of basic issues about formation of contract. Can an advertisement be the basis of a contract? Can Mrs C's buying the smoke ball be consideration for the company's promise? Remember that her buying the smoke ball was a consideration for the smoke ball itself. Was getting the 'flu the consideration? and so on. Mrs C won her case and thereby provided law students for the next century at least with a taste of the mysteries of the law of contract. The case is important in establishing that a contract does not necessarily involve the exchange of executory promises. This type of contract, where only one party comes under an enforceable obligation - the company in this case - is called a unilateral contract. It takes the form: if you do this then I promise to do something in return, usually pay you money. The promisee is never under any obligation to do anything. He or she can take it or leave it. The promisor, on the other hand, is under a contractual obligation once the promisee has responded appropriately to the offer.

19th Century Laissez Faire

As a reaction to the stratified society of the 18th century and earlier, a new philosophy took hold. The philosophy of liberalism supposed that an individual should not be allocated a status at birth but instead should be free to compete equally with his or her neighbour. Such a person should not be hampered by oppressive laws. They should be kept to a minimum. Society was to break away from hierarchical organisation. Law was to play its most significant and strictest role at the level of the state. Government was subject to strict rules so as to prevent despotism. Law would then have a diminishing role as it descended through society. It would play a small role in industry and commerce and almost no role at the level of the family.

These ideas were taken up by economic thinkers whose place in society became increasingly important as economic activity started to burgeon.

Many of the principles of contract law which you will be studying reflect the philosophy of last century, what came to be known as laissez faire which means "leave alone". Its modern expression is "de-regulation" and the view that government should not interfere in the market place. Let the market decide who wants what. The economists call this the theory of perfect competition which envisages a market in which buyers and sellers are free agents, each of whom cannot influence the price or quantity of goods. The price of, say, tomatoes is determined by supply and demand; if there is an oversupply the price will fall, an undersupply the price will rise. If it rises too far people will stop buying but at the same time more suppliers will turn to tomato growing and supply will increase, thus bringing the price down again. This equilibrium was praised by 19th century economists and by free market adherents to-day as providing the perfect system for distributing goods and services. The quantities and prices of goods and services were determined by the very many individuals in the market who acted freely and rationally in making choices which were both in their own individual best interests and in the overall interests of the economy. Much of this is dealt with in the Law in Context course.

By contrast, other systems of distribution of goods and services, for example, by state direction were thought to be inferior. In communist countries there was traditionally no free market and the state determined who should get what and at what price.

Bound up with the philosophy of 19th century laissez faire were various beliefs which concerned the welfare of the individual. A person, free of constraints, acting rationally would be able to determine for himself or herself what he or she should buy and sell. The idea of individual autonomy was extolled to be the best state for people. They were free to make choices and free to make mistakes. If they made too many mistakes, then they would fall by the wayside and more talented people would come to the fore. The system thus ensured that the competent succeeded, with every person in theory having an equal opportunity to compete and to succeed. This was survival of the fittest, something which, in the natural world, Darwin had discovered in the 19th century and which had such a huge impact not just on science but also on philosophy.

When two people came together to make a deal, they would determine what was the fairest exchange. They could write into their contract whatever they pleased, free of state intervention or imposition. This became to be known as the will theory whereby the sole task of courts was to give force to the parties' intentions as disclosed by their agreement. It was not the court's job to write the contract for the parties or to impose a just solution on them. Justice was "blind". (This symbol of justice is still used to-day). The expression "freedom of contract" was the catch cry for this approach, namely, that the parties and not the state should determine the contractual arrangement. The idea was that a contract was a voluntarily assumed set of obligations. This is to be contrasted with other areas of the law, particularly torts. An obligation arises in tort because the law says so - the obligation is imposed. In contract, on the other hand, the parties, acting as free agents, decide for themselves what obligations they are prepared to take on. That was, at least, the theory.

A good statement of the will theory can be found on p 22 of Greig and Davis Law of Contract in the quotation from Cohen (1933) Harv L Rev 553 at 558. This, too, reflects the 19th century philosophy of laissez faire.

Another aspect of the 19th century view of commercial relations was that the rules under which business people operated should be very clear and as precise as possible. It was thought that business efficiency would be promoted with a legal system which promoted certainty and security in transactions. We will see that, for example, the rules of offer and acceptance are very precise and assume a certain degree of orderly and predictable behaviour. It was thought that certainty was more important than justice if the two values competed. So, for example, the rule that you are bound by a contract which you have signed, whether you have read it or not, promoted certainty at the expense of those who were unsophisticated or naive and either did not read or could not understand what they were signing.

The individualistic creed could not in practice survive in a pure form. The theory of perfect competition in which each player in the market is an individual who cannot by himself or herself exert any influence on supply or demand had to give way in the face of increasing concentration of economic power. Large corporations used their bargaining power to extract or impose conditions which were far from ideal on both employees and consumers. Freedom of contract meant freedom to exploit. For example, large railway companies could exempt themselves from liability in the event of an accident. The passenger had no choice but to accept the conditions imposed by the railway company. The result was that legislation was passed to curb the excesses of the railway companies (Railway and Canal Traffic Act 1854 (UK)). This was the beginning of the consumer revolution. A similar thing happened at the beginning of this century in Australia with the passing of the Sea-Carriage of Goods Act 1904 (Cth), documented by Greig and Davis Law of Contract on p 31, which curbed shipowners from unreasonably exempting themselves from liability. So the idea of freedom of contract and the idea that obligations were voluntarily assumed by free agents did not match the reality of economic power which, in effect allowed big players to dictate to little players. Standard form contracts were imposed by the powerful and if you wanted to do business with them you could take it or leave it. You could not bargain. Standard form contracts have been called a form of private legislation.

In fact, the 19th century was far from a time of laissez faire. The principal reason for this was that there was an early revulsion against the excesses of the entrepreneurs. In particular, the commodification of labour, that is, the treatment of people as a commodity - just another in-put to the manufacturing process - excited political response. Early in the 19th century laws were passed to control the employment of children in factories, to control hours of work and safety conditions.

20th Century Social Welfare

The spirit of the 19th century has given way in part to a more paternalistic concern for the individual. It is no longer assumed, as it was in the 19th century, that the individual is a free agent who can protect his or her own best interests. The market can be a cruel mechanism. People in a market model are merely units of production. There was a natural revulsion against this view and its consequences. The changes could be seen in legislation initially. Governments were prepared to intervene in the contract relationship in certain areas. The overall effect of such intervention was to protect the underdog against undue exploitation. Thus in the field of safety at work the onus was shifted from the worker to the employer to maintain proper standards. Compensation for injuries suffered in the workplace was assured by workers' compensation statutes. The common law changed too so that, for example, the complete defence of voluntary assumption of risk which prevented injured workers from claiming successfully, was greatly circumscribed. Landlords no longer had the freedom to impose whatever conditions they liked. Finance companies were controlled in their lending practices. People who sold goods had to guarantee

certain minimum standards of quality. And so on. Now there are to be found legislative provisions which actually say in broad terms: you must make fair contracts. We will examine this legislation in this course.

The judges were slower to respond to the new spirit of welfarism. Many cases in the 20th century reflect the older views of laissez faire. One area where judges did respond to the facts of economic life, namely, that big corporations tended to wield their power to the detriment of consumers, was in the area of exemption clauses. Judges employed all sorts of tricky devices to strike down harsh exemption clauses. But it is significant that they never said: "that is not allowed because it is unfair". Instead they would find that the exemption clause had not been properly drafted or that it had not been sufficiently drawn to the attention of the person whose rights were taken away by the clause. Thus "freedom of contract" still operated as the basic principle in that a business could exempt itself from liability if the clause was well enough drafted.

In the last ten years or so in Australia the High Court has shown an inclination to develop the law along more welfarist lines. It could be said that this is a delayed reaction. The movement for de-regulation, for returning to a more market-oriented economy, is strong in the political sphere. Yet the judges are arguably moving in the opposite direction. We will see some quite remarkable examples in this course of how the law of contract is moving from the cut-and-dried, survival of the fittest, 19th century model to a softer, more uncertain law which expects commercial people to behave fairly towards each other.

Another curious phenomenon is that perfect competition, so beloved of economists, often does not work. Business people actually try to make sure that it does not work by combining together in cartels. Such practices are now illegal under the Trade Practices Act 1974 (Cth). So in one part of the Trade Practices Act (Part V) you will find consumer protection provisions which are needed to protect consumers against the power of big business and in another part of the Act (Part IV) you will find sections which consciously promote competition by forbidding anti-competitive practices. It is ironic that government intervention in the form of legislation is needed to promote free markets.

 

Intention to create legal relationsNB REFERENCES TO "HPH" OR JUST TO A PAGE NUMBER ARE TO HEFFEY,

PATERSON AND HOCKER CONTRACT COMMENTARY AND MATERIALS 8TH ED 1998 (LBC INFORMATION SERVICES)

We now come to what is sometimes referred to as the third essential ingredient for formation of contract. It is, however, doubtful whether it is an essential ingredient. The reason for this is that it is very rarely an issue and that the intention to create legal relations goes without saying in the vast majority of contracts. It has even been argued (by the United States contract writer Williston) that this is not so much an ingredient of formation of contract so much as part and parcel of the doctrine of consideration. We saw something along these lines in the Australian Woollen Mills case where the High Court argued that what Australian Woollen Mills did was not an acceptance nor was it a consideration. The Court did not mention intention to create legal relations.

So, this question of intention is not of much practical significance. We need to have an overview of this area. You will see from the reading guide that there are four areas dealt with.

Firstly, in ordinary commercial contracts, there is a strong presumption that intention is present. It is possible to displace this presumption, but it is very difficult to do so.

Secondly, in domestic and family arrangements there is a weak presumption that there is no intention to create legal relations. This presumption can be easily displaced.

Thirdly, certain types of government arrangements, of which the wool subsidy scheme in the Australian Woollen Mills case is an example, do not generate contractual relations. But, of course, ordinary government contracts are just contracts in the usual sense.

Finally, there is a bit of a problem in analysing what goes on when a club or other voluntary association makes a contract. A voluntary association which has not incorporated is not a legal entity. It is a collection of individuals. There are problems of contractual analysis when this collection of individuals deals with the outside world and when they make rules for the conduct of their own, joint enterprise.

Business arrangements

It is here that there is a very strong presumption that there is an intention to create legal relations. For anyone to come along after they have made an ordinary commercial contract and argue that there was no intention to create legal relations would be wasting their time.

For such an argument to succeed there must be a very clear and explicit statement. One way in which this can happen is if parties who are negotiating for a contract want to make absolutely sure that their negotiations do not inadvertently become a contract. We looked at this issue earlier when we examined

Masters v Cameron     (HPH 23)

The way to do this is to use the words "subject to contract" in all correspondence or on any documents which may be used to help the negotiating process, such as a Heads of Agreement document, or suchlike. We saw what the effect of the use of the words "subject to contract" were and that there is a very strong presumption that they delay the creation of contract until a formal document is executed. The words represent a condition precedent to formation of contract.

Another way in which intention may be displaced is to include a clause in the agreement itself saying that this agreement is not intended to be a contract. Of course, why anyone would want to do this is a bit of a puzzle but there is at least some authority for this being a possibility. The case is

Rose and Frank Co v JR Crompton & Bros Ltd     (Discussed HPH 195)

This case is discussed in Edwards v Skyways Ltd. In Rose and Frank the three parties entered into agreement in which the following clause appeared.

"This agreement is not entered into, nor is this memorandum written, as a formal or legal agreement, and shall not be subject to legal jurisdiction in the law courts either in the United States or England, but it is only a definite expression and record of the purpose and intention of the 3 parties concerned to which they each

honourably pledge themselves with the fullest confidence, based on past business with each other, that it will be carried through by each of the 3 parties with mutual loyalty and friendly co-operation."

One of the parties broke this agreement. It was held by the court that the clause was effective to displace contractual relations. This type of arrangement is sometimes called a "gentleman's agreement". It has been said by a judge (Vaisey J) that "a gentleman's agreement is an arrangement which is not an agreement entered into between two persons, neither of whom is a gentleman, with each expecting the other to be strictly bound, while he himself has no intention of being bound at all."

There is a problem if someone drafts a clause like the one in Rose and Frank. It is illegal to attempt to oust the jurisdiction of the court. In other words, it is not possible to make a contract and then say that it is not possible to enforce it in a court. Yet, it is perfectly legitimate to say that the agreement is not a contract. The line between these two can be very fine. In fact, the trial judge in Rose and Frank thought that the clause was illegal and void.

There is one area where attempts have been made to ensure that no contract comes into being and that is with such things as football pools. The terms relating to the competition include an "honour clause" and such a clause has been held to be effective to exclude contract.

The next case which illustrates the intention issue in the commercial context and which underscores the point that it is very difficult to argue that there is no intention to create legal relations in this context is

Edwards v Skyways Ltd     (HPH 194)

The airline company promised to make an "ex gratia" payment to its redundant airline pilots. This followed on from an industrial dispute in which BALPA, the pilots' union, represented the pilots. The payment was described as "approximating to the company's contributions for each member of the pension and superannuation fund." Having made this promise, Skyways then decided not to make a payment to the pilots.

The issue was whether the promise to make the ex gratia payment was a legally binding promise. It was conceded that there was a consideration for the promise. What was it?

The argument used by Skyways was that there was no intention to create legal relations because of the words "ex gratia". There was also an argument that the payment was supposed to be a non-contractual payment because it was intended that there would be no tax payable by the pilots when they received it.

Megaw J rejected these arguments. On p 195 end of middle para Megaw J makes the point that the person who is trying to argue that there is no intention in a commercial setting bears a heavy onus. The use of the words "ex gratia" was not, according to Megaw J, significant. They are often used in settlement or compromise agreements yet they are clearly legally binding. See p 196 top para.

In the 2nd para on 196 he turns to an argument that "ex gratia" here had a special meaning because of the tax implications. It was argued that everyone knew and intended that the payments should not be legally binding so that they would not attract tax. But this argument failed too on the basis that the supposed intentions of the parties which was asserted was simply not proved in evidence.

The fourth case in this category is rather different. I have mentioned from time to time that parties who are in the process of negotiating for a contract use various types of documents, such as memoranda of understandings, heads of agreements, letters of intent, etc. The general position is that these types of documents are not contracts, though in a particular case it may be that the surrounding circumstances indicate that such a document is intended to create a contractual relationship. Such a case was the Air Great Lakes case.

In the next case we deal with a document of this kind, but a rather special kind of document which is called a letter of comfort. A letter of comfort is a Clayton's guarantee. It can be used in a variety of situations but a typical situation is where a bank is seeking a guarantee from a parent company to support a loan made to a subsidiary company. The bank asks for a guarantee but the parent company refuses to give one. The bank may be content to be given a letter of comfort instead. This letter usually says things like the parent company stands behind its subsidiary and it is the policy of the parent company to ensure that its subsidiary can at all times meet its obligations, etc.

The issue which arises with a letter of comfort (as with all documents of this ilk) is whether it has any legal effect. Basically, the answer is No. After all, it is not a guarantee. And, indeed, there have been a number of cases where the courts have decided just that. For example, the English Court of Appeal decision in the Kleinwort Benson case, which is discussed on p 198, is an example. Another example of a case where a letter of comfort was found not to have any legal content was Commonwealth Bank of Australia v TLI Management Pty Ltd mentioned on p 202.

Banque Brussels Lambert SA v Australian National Industries Ltd     (HPH 197)

This case involves a letter of comfort but, it should be noted, it does not conform to the usual result in cases of this kind. Rogers CJ decided that the letter used in this case did give rise to legal liability. In this case Spedley Securities wanted a loan facility from the bank. The bank wanted some kind of assurance from ANI which owned 45% of Spedley's parent company, Spedley Holdings. A letter of comfort was provided by ANI to the bank. The terms of the letter are set out on p 197. You will see that ANI gave some reasonably precise undertakings, namely, that it would provide notice to the bank if it (ANI) intended to sell its shareholding in Spedley and that, if this did happen, then the debt would become immediately payable. The letter also said that ANI would ensure that Spedley could meet its financial obligations.

What happened was that ANI sold its shareholding in Spedley without giving the bank notice and Spedley then went bust. BBL (the bank) then tried to enforce the letter of comfort.

ANI argued that there were no promissory statements and no intention to create legal relations. Rogers CJ surveyed the somewhat uncertain legal position concerning letters of comfort, including how they are treated in countries such as France and Germany.

He turned to the claim based on contract, that is, that the letter contained contractual promises in 2nd para of p 200. Rogers CJ referred to the Edwards v Skyways case pointing out the heavy onus which rests on a person who tries to argue no intention in a commercial context.

He then let fly in the 2nd para on p 200, starting with a somewhat obscure reference to something apparently said by Lord Justice Scrutton "there will be no Alsatia in England". This is a reference to a precinct in London (White Friars) where thieves and debtors were able to have sanctuary from the law. In other words an area where the normal processes of law did not apply. In the present context, the reference is pertinent to the enquiry whether there are legal consequences

flowing from the letter of comfort. The passage in the same para starting "There should be no room in the proper flow of commerce for some purgatory..." is Rogers CJ at his best.

This still left the problem of whether the language in the letter was sufficiently promissory. If, for example, it was merely a statement of intention or of policy, then it could not be the basis of contractual obligation. Rogers CJ pointed out that it was a mistake to subject such a letter to a minute textual analysis and then proceeded to subject this letter to a minute textual analysis. He dealt with this on p 201 and concluded that there were, indeed, promissory statements.

Rogers CJ also considered the possibility that the letter generated legal liability on the alternative grounds of estoppel and under s 52 of the Trade Practices Act but these passages are not extracted in your case book.

Domestic arrangements

Where an agreement is reached between family members or friends in a domestic context, then the presumption is that there is no intention to create legal relations. This presumption is, however, a weak one and is easily rebutted. It is rebutted, in particular, if husband and wife are in the process of splitting up. We saw an example in Popiw v Popiw where, you may recall, the husband and wife had separated and they then made an agreement that he would transfer to her an half share interest in the family home if she returned to live with him. The courts will very readily accept that such an agreement is intended to create legal relations.

An example of a case where the presumption against an intention to create legal relations was not rebutted is

Balfour v Balfour     (HPH 202)

You can see from the extract from Atkin LJ's judgment on p 203 that a promise by a husband to pay his wife an allowance, even if it could be said that there is a consideration for the promise, is not binding because neither party intended that such a promise should generate legal liability. This case is the one which is always cited to support the presumption that domestic or family agreements do not amount to contracts.

There are a number of different domestic arrangements which have come before the courts. Often the issues are not just whether there was an intention to create legal relations, but also issues of uncertainty or possibly consideration. This is because these types of arrangements are often somewhat vague and ill-defined. An example was a 19th century Victorian case called Dunton v Dunton (1892) 18 VLR 114 where a husband promised his estranged wife an allowance so long as she conducted herself "with sobriety, and in a respectable, orderly and virtuous manner". There was no doubt about intention to create legal relations in that case. Instead, the issue was whether there was a consideration. The majority judges concluded that she had provided a consideration, dwelling with some relish on what she might have got up to in the absence of such a promise.

The truth is that in many of these cases the last thing that was in the parties' minds was the possibility of legal consequences. But, when they quarrel, then legal issues arise and, if they are not settled, then a court has to do its best to sort out the mess. Usually, a court will not just dismiss the case on the basis of no intention to create legal relations.

Another group of cases is where someone who is old and unable to look after himself or herself asks another person to live in and look after him or her in exchange for being left the house in the

old person's will. In these sorts of cases, the courts have been prepared to interpret the arrangement as a contract. (See Cheshire & Fifoot's Law of Contract (7th Aus ed 1997) para 5.7)

Government schemes

There is really no need to spend any time on this point. The Australian Woollen Mills case is the best illustration of this point. There are some types of government dealings where it is simply inappropriate to pin the label of "contract" on the arrangement. There have been other, similar cases one of which is mentioned in your reading guide, namely,

Administration of Papua New Guinea v Leahy     (HPH 203).

In this case the government carried out a tick eradication scheme. Government officers carried out the necessary work but the landowner had to provide labour for mustering the cattle. It was alleged that the spraying was done very badly and that this was a breach of contract. The claim failed on the basis that the arrangement was simply not a contract.

Another example is given on top of p 204 of HPH. Where a local council provides information or does something else which it is required to do by statute and it charges a fee for the service, this is not a contract. Coshott v Woollahra MC illustrates.

A further example, is where the government hands out money to individuals or groups to achieve certain public purpose. For example, money is granted to community law centres to provide free legal services to people who cannot afford a private solicitor. These grants usually have detailed conditions attached. Such grants on conditions are almost certainly not contracts. The government would not be able to sue for damages if the conditions of grant were broken and the recipient would not be able to sue for the money if the government failed to pay. The government, of course, does have the ultimate sanction, namely, not to grant money in the next round of grants.

But, remember that in any other respect the government makes contracts just like anybody else, although there are some problems which are peculiar to government contracts (as to which see N Seddon, Government Contracts: Federal, State and Local (Federation Press 1995)).

Voluntary associations

The principal problem here is whether the rules of a club, political party or other voluntary, unincorporated association are binding legally on their members. The traditional answer is that they are not legally binding and that the internal disputes of such bodies are matters for them to sort out and not for the courts.

Cameron v Hogan (HPH 204)

illustrates this approach. This was a case involving the Australian Labor Party.

In more recent times this hands-off approach has been questioned. You can see the detailed criticism of that approach in

McKinnon v Grogan (HPH 205)

where Wootten J says that it is simply not good enough for the courts to opt out of disputes in important institutions, such as political parties or large sporting clubs. In that case Wootten J was at least prepared to make a declaration - an equitable remedy whereby the court simply declares what the legal position is - as to the members' rights. A similar approach was adopted in a more recent case of Baldwin v Everingham [1993] 1 Qd R 10.

The whole problem can be avoided by incorporating such bodies under legislation which has been specifically designed to meet this kind of problem. The legislation exists in each State and Territory and is called the Associations Incorporations legislation. You can see an example on p 206.

The legislation first of all constitutes the club (or whatever) as a legal entity - a legal person. This solves the problem of making contracts with the outside world. The contract is with the incorporated legal entity and not with a shifting collection of individuals.

The other important feature to note is that the rules of the club (or whatever) are binding between all the members as if they had entered into a deed under seal - see s 11(2) of the Associations Incorporation Act 1983 (NSW).

That is all I am going to say on the subject of intention to create legal relations.