Good faith in commercial contracts (or, “The scrap about scraps”)

Most people know that FOMO is the Fear Of Missing Out, but what about the fear of being locked in (for example, to an unprofitable commercial contract?) We might have to start calling that “foam-o”, as a result of a recent case on the subject, which involved a dispute about a contract for the sale of scrap foam produced as a byproduct of mattress making.  The buyer, which was trying to get out of the contract,  argued that the contract contained a duty of good faith which required the seller to cooperate in the termination of the contract.  The results of that argument, however, were anything but good.

The facts

Comfort Group, the seller, is in the business of making mattresses.  It seems that making mattresses produces an awful lot of offcuts in the form of scrap foam (Comfort Group was producing 210 tons of scrap per month, enough to fill fourteen 40-foot shipping containers). Fortunately, however, Comfort Group had a buyer for the scrap – a company called Primary Flooring, which makes carpet underlay (for which scrap foam is the key raw material).

The Sales Agreement by which the scrap foam was sold was made in 2011, when Comfort Group purchased the mattress making business from Pacific Brands.  At the time of the Sales Agreement, Pacific Brands also owned the carpet underlay business.  Accordingly, to ensure that the carpet underlay business would continue to have access to quality scrap after the sale (and to ensure that the mattress making business would continue to have a buyer for its scrap) the Sales Agreement required all scrap produced by mattress making business to be sold to, and purchased by, the carpet underlay business.

in 2017, Pacific Brands sold the carpet underlay business to Primary Flooring. Although Primary Flooring agreed, when it bought the carpet underlay business, to take an assignment of the Sales Agreement, Primary Flooring was aware that the Sales Agreement was an unprofitable contract to be taking on.  The reason for this was that Primary Flooring was obliged to pay Comfort Group $1 per kilo for all scrap foam at a time when:

  1. Primary Flooring could purchase scrap foam from other Australian producers for approximately $0.57 per kilo; and
  2. The “world price” for scrap foam, including freight, was about $0.54 per kilo.

So, Primary Flooring could just terminate the contract with Comfort Group, yes? Well, no – that wasn’t how the Sales Agreement worked.

The termination clause in the Sales Agreement

The relevant provision of the Sales Agreement was in the following terms:

6 Term and Termination

6.1 Duration of agreement

This agreement commences on the Commencement Date and will continue until terminated by mutual consent in writing, or as a result of this clause 6. For the avoidance of doubt, it is the parties’ intention that this agreement continue to bind the parties’ successors or assigns, and it may not be terminated, whether by a party giving reasonable notice or by any other means or on any other grounds, except as provided by this clause 6. [emphasis supplied]

(Other parts of clause 6 referred to termination in circumstances where, for example, a party became insolvent. None of those provisions were relevant in the present case).

The express exclusion, in clause 6, of a right to terminate by giving reasonable notice was a serious problem for Primary Flooring.  This is because in commercial contracts in Australia, where there is no express termination provision, the law will usually imply a term permitting the contract to be terminated on “reasonable notice”.  However, no term can be implied where that term is inconsistent with an express term, and so there was no room for an implied term allowing termination on reasonable notice given the language of clause 6.  So, how was Primary Flooring going to get out of the contract?

The arguments advanced by Primary Flooring was that because the contract required the parties to cooperate, there was, accordingly, a duty on the part of Comfort Group to act reasonably in consenting to the termination of the Sales Agreement (or, alternatively, that Comfort Group was bound by an obligation of good faith in relation to any request made by Primary Flooring for termination of the contract).  However, the Court found that Primary Flooring’s arguments were, well, primarily flawed.

Good faith in commercial contracts

The Court considered contractual obligations of good faith at a level of detail which is unnecessary to reproduce here; however, the most important reminder from the Court’s consideration is that even where a duty of good faith does exist, that duty does not require a party to subordinate its own legitimate interests to the interests of the other party.  Comfort Group had a legitimate interest in having a buyer which was obliged to buy the scrap foam (which Comfort Group would otherwise have had to sell elsewhere, or to dump in landfill).

Accordingly, even if Comfort Group was under a duty of good faith in relation to its response to any request to terminate the Sales Agreement, Comfort Group was entitled to consider its own interests in refusing consent to the termination of the Sales Agreement.  Although Comfort Group was obliged “to act with fidelity to the bargain”, that obligation did not extend to acting in such a way as to maximise the profits, or commercial benefits, to be made by Primary Flooring.

The lessons from the case

One of the issues which the Court emphasised was that Primary Flooring knew, when it purchased the carpet underlay business, that the Sales Agreement was in place and was unprofitable (and the judgment included extracts from emails between a director of Primary Flooring and directors of Primary Flooring’s parent company on this subject).

The review of any contracts which are to be assigned is an essential part of the due diligence on an acquisition, and the due diligence here appeared to identify the risk, but did not identify a way of resolving it.  If the answer is, as appears to be the case, that Primary Flooring was prepared to take on the commercial risk, the lesson is that if you go to court complaining of a commercial risk which you have knowingly assumed, you not should not expect a commercial court to be unduly sympathetic to your position.

There is also a lesson in relation to termination provisions more generally – breaking up, as the song tells us, can be so very hard to do, and the position can be made more difficult if the contract does not have well-thought-out termination provisions. When the agreement is being made, it is natural to focus on the beginning rather than the ending, but the circumstances in which the contract may come to an end should also be carefully considered.  There may be situations in which resort to implied terms (or to a duty of good faith) will save a poorly drafted contract, but careful drafting is the best protection against the sort of contractual scraps which will keep you awake at night.

For more on our commercial law capabilities, contact Philip Stevens or Leonard Lozina or William Han

For more on our litigation and dispute resolution capabilities, contact Dennis Vuaran or Angus Macinnis or Grace Hur

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March 9
Commercial Law Litigation and dispute resolution