Introduction

When a contractual relationship breaks down it is not always entirely clear whether the contract has been validly cancelled, or by whom.  This difficulty was exemplified in the recent case of Patcroft Properties v Ingram and Knee & Anor [2010] NZCA 275.  The Court of Appeal was required to decide whether a party that had repudiated a contract through its own unlawful conduct could have later validly cancelled the contract on the basis of that same wrongful behaviour, with no change in its stance. 

Origins of Dispute

The case concerned the lease of a property containing a backpackers' hostel and bar in central Auckland.  The property was owned by the appellant, Patcroft Properties Limited ("Patcroft").  Patcroft let the backpackers portion of the property to the first respondents, Mr Ingram and Ms Knee, and the bar area to the second respondent, KIP Investments Ltd (together the "tenants"). 

The lease provided that Patcroft could re-enter the property and cancel the lease if rent was fourteen days in arrears.  Thirteen days after the tenants' rent for a particular month was due, Patcroft re-entered the property, alleging that the tenants were in breach of the lease.  The same day, Patcroft changed the locks, gave the tenants a trespass notice, and told the tenants that it would not allow them to re-enter the property and would oppose any application they made for relief against forfeiture.  The tenants informed Patcroft that they would seek legal advice.

The following day, the tenants did not pay the outstanding rent and the fourteen days permitted in the lease for payment of rental arrears expired.  That failure gave Patcroft a valid right to cancel the lease. However, when Patcroft's solicitors wrote to the tenants' solicitors the next day, they confirmed Patcroft's re-entry and purported cancellation of the lease on the thirteenth day rather than relying expressly on the further failure to pay rent.  Further correspondence followed from Patcroft's solicitors a day later, again making it clear that Patcroft intended to remain in possession of the property based on its actions on the thirteenth day.  The second respondent's solicitors responded two days later, reserving the second respondent's position relating to the lawfulness of the re-entry and mentioning the possibility of relief against forfeiture.  There was no communication from the first respondent.  Importantly, Patcroft's solicitors never stated that it treated the tenants' failure to pay rent on the fourteenth day as a repudiation, which it accepted.

Approximately one year later, the tenants jointly issued proceedings, alleging that Patcroft's re-entry was illegal and that Patcroft had repudiated the lease.  They sought damages for the loss of value to their businesses.  Patcroft counterclaimed for rental arrears.

By the time the proceeding reached the Court of Appeal, the key issue to be determined was whether the tenants had validly cancelled the lease by virtue of their non-payment of rent or bringing of proceedings, or whether it was Patcroft that had cancelled the lease through its continued occupation of the property after the non-payment of rent.

Cancellation under the Contractual Remedies Act 1979

7 Cancellation of contract

...

(2)  Subject to this Act, a party to a contract may cancel it if, by words or conduct, another 
      party repudiates the contract by making it clear that he does not intend to perform his 
      obligations under it or, as the case may be, to complete such performance.

8 Rules applying to cancellation

(1)   The cancellation of a contract by a party shall not take effect -

       (a)    Before the time at which the cancellation is made known to the other party; or

       (b)    Before the time at which the party cancelling the contract evinces, by some overt
 means reasonable in the circumstances, an intention to cancel the contract, if -

               ...

               (ii)    the other party cannot reasonably expect to receive notice of the cancellation because of that party's conduct in relation to the contract.

(2)    The cancellation may be made known by words, or by conduct evincing an intention 
to cancel, or both.  It shall not be necessary to use any particular form of words, so
 long as the intention to cancel is made known.

Repudiation Transformed?

The Court unanimously agreed that Patcroft's re-entry was premature and that Patcroft had consequently repudiated the lease on the day of its re-entry.  The tenants therefore had an election to make.  They could have either cancelled or affirmed the lease. Until an election was made, the Court agreed that the lease remained alive.  From this point on, the Court was split.

O'Regan and Ronald Young JJ, in the majority, considered that for the tenants to have cancelled the lease, section 8 of the Contractual Remedies Act required them to show that they had made it known that they were cancelling the lease, which they would have done if their withholding of rent was an overt action amounting to a refusal to pay, rather than evidence that they were merely equivocating.  Since the tenants had told Patcroft that they would seek legal advice before taking any further action, the majority considered that the tenants' withholding of rent was not sufficiently overt to have cancelled the lease in terms of the Contractual Remedies Act.  As a result, the lease remained on foot throughout the day of the re-entry.

By the following day, the tenants' rent was 14 days in arrears, in breach of their obligations under the lease.  The majority noted that the tenants could have preserved their right to cancel the lease at this time by paying the outstanding rent.  However, as they had not done so, the majority held that the tenants had themselves repudiated the lease and consequently the election to cancel or affirm the lease shifted to Patcroft.

Since Patcroft had changed the locks, given the tenants a trespass notice, told the tenants that it would not allow them to enter the property on the day of re-entry and had continued to occupy the property after the rent fell due, the majority held that Patcroft had sufficiently evinced the required intention to cancel the lease.  Given that the lease had been validly cancelled by Patcroft, the majority ruled that the tenants had no claim for damages for the loss of value to their businesses.

Wrongful cancellation in disguise?

Priestley J dissented.  His Honour held that, in light of the confused situation that ensued, it was both artificial and unreal to endeavour to construct a situation whereby one party had accepted the other party's repudiation of the lease.  Patcroft remained in breach as a result of its unlawful re-entry and did nothing to remedy the situation. 

His Honour held that the Contractual Remedies Act envisages a causal nexus between one party's contractual breach and the other party's corresponding cancellation.  Here there was no evidence to support the proposition that Patcroft had elected to cancel the contract as a result of the tenants' repudiation on the fourteenth day.  Rather, His Honour considered that Patcroft had deliberately continued its stand-alone repudiation of the lease and had relied on its incorrect belief that it was entitled to re-enter the property and cancel the lease on the thirteenth day.  Consequently, His Honour considered that Patcroft's earlier repudiation could not have transformed into a valid basis for cancellation over time without some new act by Patcroft.

Without relying on the point, His Honour further buttressed his approach by noting that Patcroft's high-handed actions and stance demonstrated that, on the fourteenth day, it was not ready and willing to perform the contract, which is arguably a prerequisite if a party wishes to cancel. 

These reasons in combination prevented Priestley J from agreeing with the majority's decision that Patcroft's initial repudiation was extinguished by a valid cancellation of the lease the following day.

His Honour held that although the tenants had reserved their right to seek relief against forfeiture and damages, in the meantime, they had themselves repudiated the lease by failing to pay the outstanding rental arrears.  Priestley J was therefore of the view that the lease continued on the somewhat strange basis that both parties had a right to cancel, but neither of them did so until the tenants brought proceedings over a year later.

Consequences

The majority's decision effectively allows an act, which is initially a wrongful repudiation of a contract, to transform into the basis for the contract's valid cancellation following a later repudiatory act by the other party, without the cancelling party changing its behavior or taking some other step.  Here, the transformation from repudiation to cancellation occurred over the course of a just one day, but that period could conceivably be longer.

It is easy to sympathise with the tenants' position.  Patcroft had re-entered invalidly and simply remained in possession.  In the majority's view, if the tenants wished to preserve their right to cancel the lease, they would have had to pay Patcroft the outstanding rent on the same day that Patcroft had unlawfully locked them out of the property.  Furthermore, the majority decided that Patcroft had demonstrated a sufficiently overt intention to cancel the contract, even though its continued conduct and stance relied on a breach which did not exist when it took those steps.  This situation is quite different from where a contract is cancelled for a bad reason where an unknown good reason also exists. 

Yet, if Patcroft's repudiatory act is not treated as having transformed into the basis of its cancellation, the lease would have arguably remained deadlocked, with neither side having validly cancelled it and neither side performing it, until the tenants initiated proceedings over a year later.  The possibility of a lease under which the tenants were deprived of possession of the property and Patcroft received no rent remaining on foot for this extended period of time is not likely to be what either party could have intended.  However, it would allow both Patcroft and the tenants to both be treated as being in breach of the lease and for their respective damages awards to be set off against each other.

The Supreme Court has recently granted the tenants leave to appeal.  The approved ground of appeal is: in circumstances in which Patcroft's re-entry on the thirteenth day was invalid, whether, and when, either of the parties thereafter validly terminated the lease.

Until the Supreme Court's decision is given, the law in this area remains uncertain.  However, the possibility of a repudiatory act transforming into the basis for a contract's valid cancellation highlights the importance of promptly responding to contractual breaches and clearly communicating the election made to the repudiating party.