Resource companies court peril by ignoring reasonable endeavours clauses, which can have a major impact on their commercial interests in the event of legal disputes.
On 5 March 2014, the High Court of Australia (HCA) held that Woodside Energy and other gas suppliers (the Sellers) did not breach a contractual obligation to use reasonable endeavours to supply gas to Verve Energy (Verve).
The Sellers were within their contractual rights to take into account commercial, economic and operational matters to their commercial benefit, but to the commercial detriment of Verve.
This decision emphasises the significant effect that the language of common reasonable endeavours clauses may have on a party’s commercial interests. Businesses should ensure that legal drafting precisely reflects commercial negotiations and covers all substantive contractual obligations.
Verve is a major generator and supplier of electricity in Western Australia. Under a long-term gas supply agreement (GSA), Verve purchased natural gas from the Sellers to be used in its power stations.
Clause 3.3(a) of the GSA required the Sellers to use reasonable endeavours to supply Verve extra gas, above what it was obliged to supply, at a fixed price (referred to in this article as additional gas). Clause 3.3(b) of the GSA provided that the Sellers, in determining whether it was able to supply additional gas to Verve, may take into account all relevant commercial, economic and operational matters.
An explosion stopped gas production at the Apache gas plant, which caused a temporary 30 to 35 per cent reduction in natural gas supply in Western Australia. The demand for natural gas exceeded the supply and many customers in Western Australia purchased gas from the Sellers at prices far exceeding the fixed price for additional gas under the GSA.
The Sellers informed Verve that they would not supply additional gas under the GSA until the supply shortage eased. The Sellers however, offered to supply extra gas to Verve, at prevailing market price, which far exceeded the price for additional gas under the GSA. Verve sought to recover this difference in price.
Verve argued that the Sellers breached their obligation under clause 3.3(a) of the GSA to use reasonable endeavours to deliver additional gas during the relevant period in accordance with the GSA.
The Sellers argued that their obligation to supply additional gas to Verve under clause 3.3(a) was qualified by their entitlement to consider their own commercial, economic and operational interests under clause 3.3(b) of the GSA – specifically, that the Apache explosion and the resulting market conditions impacted the Sellers' ability to supply additional gas to Verve.
At first instance, the WA Supreme Court held that the Sellers did not breach their obligations under the GSA. Verve successfully appealed this decision to the Court of Appeal of the WA Supreme Court, and both parties appealed to the HCA.
By majority, the HCA found that the Sellers had not breached their obligation to use reasonable endeavours to supply additional gas to Verve, because the Sellers were expressly entitled to take into account commercial, economic and operational matters relevant to their business.
The HCA noted that obligations to use reasonable endeavours were not absolute and:
- Depend on what is reasonable in the circumstances, even if it affects an obligee’s business;
- Do not extend to performing an obligation that would cause ‘certain ruin’ to a business or disregard the interests of shareholders; and
- May include specific standards of what reasonable endeavours means, according to one party’s business interests.
In commercial contracts, terms of reasonableness are determined by what a reasonable businessperson would understand the terms to be. This may be further understood by looking at:
- The language used by the parties;
- The knowledge of the parties of surrounding circumstances; and
- The commercial purpose or object of the contract.
The HCA held that reasonable endeavours clauses require a balancing of the parties’ interests. Clause 3.3(b) did not oblige the Sellers to supply additional gas to Verve when the Apache explosion caused a conflict between the Seller’s business interests and Verve’s interest in obtaining additional gas at a price cheaper than the prevailing market price.
In conclusion, this decision contains two significant points. First (and most importantly), when negotiating commercial agreements, parties should ensure all substantive contractual obligations are described as clearly as possible - avoid unnecessary reliance on reasonable endeavours clauses.
Second, if unavoidable, reasonable endeavours clauses must be carefully crafted to ensure parties properly protect their commercial interests. This may be achieved by using precise language to qualify what constitutes reasonable endeavours in a particular contract.