This month, the Inner House (Scottish appeal court) handed down judgment in Van Oord UK Ltd v Dragados UK Ltd, an appeal from the commercial court concerning the interpretation of an NEC3 contract for the dredging of Nigg Bay, part of the Aberdeen Harbour Expansion Project. Dragados Ltd, the main contractor (and Defender and Respondent) was employed by Aberdeen Harbour Board and subcontracted all dredging works to Van Oord Ltd, the Pursuer/Reclaimer. The subcontract incorporated the standard form NEC3 Subcontract Conditions, main Option B, and the Shorter Schedule of Cost Components (April 2013).
Despite its subcontract with Van Oord, Dragados transferred a third of the dredging works to two other subcontractors. It issued instructions for Van Oord to omit these works and sought to reduce the sum payable under the subcontract by 49% under the NEC3 ‘compensation event’ provisions. The subcontract was later terminated, with much of the work incomplete and with the parties disputing the correct valuation of the termination account. Van Oord sought payment of the original bill rate for the omitted work but Dragados contended a reduced rate was payable under contract compensation event mechanism.
As set out in our article last year, Lord Tyre considered the sums payable in a 2020 judgment. His decision considered first whether Dragados’ transfer of work was a breach of contract and, if so, whether the contract provided that the omission of works should reduce the bill rate payable to the Van Oord for the unfinished work.
Lord Tyre held that on a proper interpretation of the subcontract Dragados was not entitled to omit and transfer the works to other parties; doing so was a breach of contract. This did not however prevent the reduction of the bill rate payable to Van Oord: a breach was still a compensation event and thus clause 63.10 was triggered, reducing the rate.
On appeal, Van Oord argued that Dragados had knowingly manipulated the contract in its favour. Dragados had insisted on a rate that averaged out the cost of easier and harder works. Van Oord had accepted this on the premise of carrying out all such works. Dragados had benefited by transferring away easier works, leaving Van Oord with a disproportionate share of the difficult works for the average rate.
The Inner House considered two questions: (i) whether non-compliance with a good faith clause in NEC3 could bar a party from benefitting from price reductions; and (ii) whether, in this instance, the Dragados breach, which was not disputed, allowed for price reductions.
Good faith: “not merely an avowal of aspiration”
The Inner House’s judgment gave careful consideration both to the price reduction mechanism and, importantly, to Clause 10.1: “the Contractor and the Subcontractor shall act as stated in this subcontract and in a spirit of mutual trust and co-operation”.
Whereas the Outer House considered it “did not add much”, the Inner House thought it “reflects and reinforces the general principle of good faith in contract”. Not “merely an avowal of aspiration”, the Inner House stated that Clause 10.1 aligns with three specific propositions derived from case law:
- a contracting party will not in normal circumstances be able to take advantage of its own breach against another party;
- subcontractor is not obligated to obey an instruction issued in breach of contract; and
- clear language is required to place one contract party completely at the mercy of another.
The requirement of good faith under clause 10.1 was a contractual counterpart of clause 63.10. Under the Scots law principle of mutuality of contract, a party cannot fail to uphold clause 10.1 yet benefit from 63.10. Whether Dragados fell foul of clause 10.1 will be subject to a proof (trial) but, irrespective of the outcome, the principle that a good faith clause is given parity with other contractual provisions has the judicial authority of the Inner House.
“Breach instructions” and price reductions
The Inner House next considered whether the Dragados breach allowed for reduction of the bill rate and prices payable for the remaining work.
If defined costs are reduced under NEC3, Clause 63.10 reduces the contract prices if certain conditions are met. Defined costs were clearly reduced by Van Oord’s non-completion of works, but the Inner House concluded that this did not reduce the prices.
In its view, Clause 63.10 only applied where the contractual change that reduced defined costs was lawful. A “breach instruction”, like that given by Dragados to omit works, did not fulfil the requirement of being given “in accordance with this subcontract” (clauses 14.3 and 27.3) and was therefore invalid. To hold otherwise would be reduce NEC3 to a “charter of contract breaking”.
Van Oord v Dragados shows the Inner House giving good faith a leading role in contractual interpretation: a binding obligation not a statement of aspiration. This decision continues a long, if slow, trend of greater emphasis for good faith in commercial contracts.
The Inner House decision changes how the good faith clauses in NEC3 and their equivalents in NEC4 will be interpreted. Whether this analysis is extended beyond NEC contracts remains to be seen; however, the Inner House was clear that clause 10.1 does not impose good faith provisions but rather “reflects and reinforces” them.
For more information, please contact Iain Drummond, Partner in our property and infrastructure team, at [email protected].