A contract is not terminated automatically by its breach

Xenos Travel Ltd v. Panasoft A.E., Civil Appeal No. 116/2011, Supreme Court of Cyprus (Appellate Jurisdiction), judgment dated 21 February 2017.

Breach of a material term versus fundamental breach — A contract is not terminated automatically by its breach — The innocent party must actively exercise the right of termination — Total failure of consideration

The facts

By an agreement dated 23.1.2002, the plaintiff, a Greek software company, sold to the defendant, a company operating a travel agency, a travel-agency management program ("Travel Force 2000") for CY£30,000 plus VAT, payable in instalments. The program was installed and appropriate training was gradually provided to the staff, yet the purchaser paid only CY£7,500, refusing any further payment.

Its defence rested on clause 14 of the agreement, under which the vendor undertook to create an interface between Travel Force 2000 and the purchaser's existing accounting program (LK). The interface, despite the efforts made, never functioned, the purchaser contending that the installed program was left without value and that, whether by reason of breach of a material term or of total failure of consideration, nothing further was owed. Notably, the agreement also afforded the purchaser an express right to return the program within nine months and recover its value, a right it never exercised, just as it never expressly terminated the agreement; on the contrary, for months it continued to confer with the vendor with a view to achieving the full operation of the program.

The trial Court held that clause 14 was a material term and that it had been breached, but that the breach did not of itself nullify the agreement; it merely conferred on the innocent party a right of termination, which was never exercised. The agreement remained alive, and judgment was entered for the balance of the price (€38,443.50) plus interest and costs. The purchaser appealed on six grounds.

The legal issues

1. Breach of a material term does not amount to automatic discharge of the contract. The Court of Appeal upheld the central first-instance finding: breach of a material term does not "self-annul" the contract (Photo Production Ltd v. Securicor Transport Ltd [1980] A.C. 827). It confers on the innocent party a threefold right, to terminate, to claim damages, and to be relieved of its own obligations, but that right must be exercised. Until then, the contract remains alive and binding on both parties, including the obligation to pay the price.
2. The distinction between a material term and fundamental breach. The judgment clarifies a frequently confused distinction: a fundamental breach (Suisse Atlantique [1966] 2 All E.R. 61, Bauer v. Diogenis Herodotou & Sons Ltd (1994) 1 C.L.R. 325) renders the performance of the agreement entirely different from that originally contemplated, it "uproots" the agreement. In the present case, the interface was one of ten programs listed in the annex to the agreement, with no separate price attributed to it; its failure did not undermine the purpose of the contract. In any event, and this is the critical point, even a fundamental breach does not annul the agreement of itself, but merely gives rise to a right of termination.
3. Termination requires active steps. With reference to Metaxas Loizides Syrimis & Co v. L.K. Globalsoft Co Ltd (2007) 1 C.L.R. 54 and the authoritative approach in Johnson v. Agnew, the Court of Appeal recalled that the innocent party has an election between terminating and affirming the contract, and that the exercise of the option to terminate is a question of fact requiring "active steps" and, at times, notice to the party in breach. The purchaser's letter of 2005, sent only after payment had been demanded, by which it merely denied any obligation to pay, could not objectively be regarded as a termination, all the more so where the purchaser continued to keep the program, never returning it despite the express contractual facility to do so.
4. Total failure of consideration. The plea of failure of consideration was likewise rejected: the failure must be total, since the consideration is "entire and indivisible" (Rover International Ltd v. Cannon Film Sales Ltd (No.3) [1989] 3 All E.R. 423). The program was delivered, installed and functioning; the problem concerned a material yet partial term. A total failure would have existed only if the program had never been delivered at all or had not functioned whatsoever.
5. Distinguishing Marketrends. The Court of Appeal distinguished the purchaser's reliance on Marketrends (Capital Market) Ltd v. Synthesis Software Ltd (2009) 1 C.L.R. 514 concerning entire contracts and the impermissibility of apportioning consideration: in that case, the issues of the right of termination and the right to return the subject matter of the contract, decisive in the present case, had not arisen. Moreover, the fact that the plaintiff had pleaded installation "to the full satisfaction" of the purchaser, whereas a breach of clause 14 was found, did not result in a failure to prove its pleaded case.

The outcome

The appeal was dismissed in its entirety, with costs against the appellant, and the first-instance judgment for payment of the balance of the price was affirmed. The successful respondent was represented by our firm.

Significance of the judgment

The judgment is a point of reference for one of the most misunderstood chapters of the law of contract, with particular practical value in IT and technology-supply agreements.

First, it dispels the mistaken yet widespread perception that a breach of contract by one party automatically "releases" the other. The party faced with a breach, even of a material term, even a fundamental one, is not discharged by inaction. It must elect: either to terminate by clear and active steps and claim damages, or to affirm the contract, in which case it remains bound by all of its own obligations, including payment. Choosing the "middle road", retaining what was delivered, continuing discussions, refusing payment, is legally the worst possible course.

Secondly, it demonstrates the importance of contractual exit mechanisms: the purchaser possessed an express right to return the program and recover the price, which it allowed to lapse. The courts will not substitute, after the event, remedies which the party itself failed to invoke.

Thirdly, it strictly delimits the plea of total failure of consideration: where the principal subject matter of the contract has been delivered and is functioning, the failure of a particular function, however important to the purchaser, does not reduce the consideration to nothing and does not justify a wholesale refusal to pay. The lesson for purchasers of software and complex systems is clear: critical functionalities should be reflected in the contract with a separate price, milestones and express termination rights, and, when a breach occurs, those rights must be exercised promptly and unequivocally.

This text is intended for general information purposes only and does not constitute legal advice. For any information regarding the judgment or for tailored guidance, please contact our firm.