| Reference Date | Version | November 25, 2023 | 1.0 |
| Keywords | Business Efficacy, Implied Terms, Commercial Contracts, Contract Drafting |
| Legislation(s) | The Indian Contract Act, 1872 |
| Jurisdiction | India |
Introduction
Contracts are executed generally for ‘business efficacy’, yet often, ‘business efficacy’ may require a review of the already executed contract. The above statement sounds like a loop and would end up in a loop unless some parameters for defining ‘business efficacy’ are crystallized.
Often, even though the executed contract may contain clearly drafted provisions, the affected party may wish to creatively introduce ‘new meaning’ on grounds including ‘implied understanding’, ‘business efficacy’ or ‘business necessity’.
In an ideal scenario, the plain letter of the contract should be read as-is without introducing any other reference. However, commercial contracts entered into, more often than not, do not factor in every minute detail or scenario that may occur over the course of the contract. In some scenarios, the contracts can be very dynamic, and there might be a need to fill gaps and address the practical commercial and business needs to achieve their intended purpose and align with the parties’ business objectives. Such transactions may involve technology and innovations, where some provisions might be rendered obsolete in light of the rapid advancements in technology or supply contracts where changes in prices/charges based on industry standards may not have been addressed adequately.
Despite the parties putting in their best efforts, gaps and unforeseen circumstances might still exist. The principle of ‘business efficacy’ permits the interpretation of contracts in a manner that promotes predictability and consistency in commercial transactions and ensures that the contracts continue to stay flexible and functional while also aligning with the intention of the parties.
This article aims to share some insights with respect to the ‘business efficacy’ argument in the interpretation of commercial contracts by the Indian Courts over the years. It discusses situations and circumstances where parties may consider incorporating a ‘business efficacy’ clause.
Illustrative Study
In Maharashtra State Electricity Distribution Company Limited v. Ratnagiri Gas and Power Private Limited & Ors (MANU/SC/1230/2023), the Hon’ble Supreme Court examined the circumstances warranting the invocation of the ‘business efficacy’ doctrine.
In this case, the first Respondent, Ratnagiri Gas and Power Private Limited (Seller), a transmission company, entered into a Power Purchase Agreement (‘PPA’) with the Appellant, Maharashtra State Electricity Distribution Company Limited (Purchaser). The term of the PPA was 25 years. Due to an unprecedented nationwide shortage in the supply of domestic gas in September 2011, the first Respondent entered into a Gas Supply Agreement/Gas Transportation Agreement with GAIL (India) Limited (‘GAIL’) for the supply of Recycled(sic) Liquid Natural Gas (‘RLNG’).
The Appellant refused to pay capacity charges on grounds that the Respondent No. 1 was required to take its approval on contracting terms and price before entering into the GSA/GTA contract under the said Clause 5.9. The Appellant argued that it was an implied understanding between the parties that Clause 5.9 should be read while interpreting Clause 4.3. Therefore, Respondent No.1 should have obtained approval from the Appellant as stated in Clause 5.9.
Clauses 5.9 and 4.3 of the PPA, as appearing in the judgment passed by the Hon’ble Supreme Court, are reproduced below:
Clause 5.9:
“the conditions of GSA/GST having commercial implications (for example, bearing on plant availability, contracted quantity, price components, Take or pay provisions, penalties, and damages, etc.) shall be signed separately with the MSEDCL as supplementary agreement. The total required to be Gas/LNG is envisaged procured through short-term contracts, long-term contracts through GAIL and under the directions of GOI, the details of which shall be furnished in due course. RGPPL shall be required to obtain approval of MSEDCL on contracting terms and price before entering into the GSA/GTA contract.”
Clause 4.3 Declared Capacity:
“Primary Fuel for RGPPL is LNG/Natural gas and/or RLNG. Normally capacity of the station shall be declared on gas and/or RLNG for all three power blocks. However, if agreed by MSEDCL, RGPPL shall make arrangements of Liquid fuel(s) for the quantum required by MSEDCL. In such a case the capacity on liquid fuel shall also be taken into account for the purpose of Availability, Declared Capacity and PLF calculations till the time Liquid fuel(s) stock agreed/requisitioned by MSEDCL is available at site.”
While deciding if Clause 5.9 should be read into Clause 4.3, the Hon’ble Supreme Court discussed the doctrine of business efficacy and opined:
“A commercial document cannot be interpreted in a manner that is at odds with the original purpose and intendment of the parties to the document. A deviation from the plain terms of the contract is warranted only when it serves business efficacy better. The Appellant’s arguments would entail reading in implied terms contrary to the contractual provisions which are otherwise clear. Such a reading of implied conditions is permissible only in a narrow set of circumstances.”[1]
(emphasis is ours)
The Hon’ble Supreme Court held that:
“In the present context, bearing in mind the background of the establishment of the first respondent, and the shortfall of domestic gas for reasons beyond the control of the first respondent, such a deviation from the plain terms is not merited and militates against business efficacy as it has a detrimental impact on the viability of the first respondent.”[2]
Arguably, the dispute between the parties in this case may have been avoided if there was an explicit provision for ‘business efficacy’ – as to what may constitute ‘business efficacy’ and how ‘business efficacy’ may be invoked by a party.
In Transmission Corporation of Andhra Pradesh Ltd. and Ors. v. GMR Vemagiri Power Generation Ltd. and Ors. (MANU/SC/0132/2018) the issue was whether “fuel”, as defined by the Parties in the Contract, only included natural gas and not RLNG.
The Hon’ble Supreme Court, in this case, held that the question is not whether RLNG is a form of natural gas but whether the Parties intended to include only natural gas in its natural form under the Contract.
It was held that the Courts cannot apply technical scientific meaning to impliedly include RLNG in the Contract as contracts are to be given a literal interpretation.
It was held that:
“A commercial document cannot be interpreted in a manner to arrive at complete variance with what may originally have been the intendment of the parties. Such a situation can only be contemplated when the implied term can be considered necessary to lend efficacy to the terms of the contract. If the contract is capable of interpretation on its plain meaning with regard to the true intention of the parties, it will not be prudent to read implied terms on the understanding of a party, or by the court, with regard to business efficacy…”[3]
The controversy in this case could have been avoided if the definition of ‘fuel’ specifically excluded RLNG or the agreement contained a well-crafted ‘business efficacy’ provision.
In the case of Satya Jain (D) Thr. L.Rs. And Ors. v. Anis Ahmed Rushdie (D) Thr L.Rs. And Ors. (MANU/SC/1063/2012), the Bench explained the purpose that the principle of business efficacy served, i.e., to read a term into a contract to achieve the result that parties as prudent businessmen intended. However, a caution in this regard was also laid out by the Court that if a contract is capable of literal interpretation and such interpretation in the light of business prudence is justified, then the Court ought not to read the implied terms.
The Hon’ble Supreme Court opined that the Courts cannot go beyond the intention of the parties. Therefore, the principle of business efficacy is applied to read the implied terms into a contract as intended by the parties.
The Hon’ble Supreme Court, in the case of Nabha Power Ltd. (NPL) v. Punjab State Power Corporation Ltd. (PSPCL) and Ors (MANU/SC/1291/2017), while interpreting a clause related to the Energy Charges Formula emphasized and summarized the Penta Test which was first propounded in B.P. Refinery (Westernport) Proprietary Limited v. The President Councillors and Ratepayers of the Shire of Hastings [1977] UKPC 13.
The Court unequivocally stated that in case of ambiguity, the Courts can invoke the doctrine of business efficacy and read the implied terms in a contract only when the following 5 conditions (The Penta Test) are satisfied:
(1) It must be reasonable and equitable
(2) It must be necessary to give business efficacy to the contract so that no term will be implied if the contract is effective without it
(3) It must be so obvious that “it goes without saying”
(4) It must be capable of clear expression
(5) It must not contradict any express term of the contract.
A close examination of the decided cases, as discussed above, reveals that the Courts would like to interpret the plain letter of the contract unless it becomes necessary for business efficacy to read into the contract the implied understanding of the parties, as long as such interpretation does not have a detrimental impact on the viability of the contract with respect to a party.
Arguably, a well-crafted ‘interpretation clause’ is a good idea, particularly in the case of integrated commercial transactions. Such an ‘interpretation clause’ may include a provision for providing flexibility and giving effect to the intention of the parties. On the face of it, it may seem that every contract should have a provision for business efficacy. However, if not drafted meticulously within the context of the transaction, such a provision might become a double-edged sword.
Business Efficacy Provision – Evaluating the Need
The principle of business efficacy does not provide one with the license to reconstruct or improve an agreed contract. It is an established position in law that Courts cannot make any change to a contract that has been entered into between two parties competent to enter into a contract. The Courts cannot interfere in the contract even though a contract might heavily favour one party and impose unfair obligations on the other. In fact, the contract does not even have to make any commercial sense whatsoever, as long as such a contract is within the parameters laid down under applicable law, courts would not typically interfere.
Over the years, the Courts have developed the concept of business efficacy where if the contract does not bring forward the intended understanding, then that understanding needs to be brought forward and nothing beyond that. The powers of the Court are highly confined to interpreting an ambiguous or unclear provision in the contract. Such powers are restricted to the extent they reflect the initially agreed understanding between the parties.
Business efficacy clauses are to serve the purpose of enhancing the flexibility and effectiveness of contracts. In some cases, overly broad business efficacy clauses may lead to disputes by conferring excess discretion upon parties and might even lead to express terms of the contract being overridden. The decision to include clauses for business efficacy depends on specific circumstances, the nature and flexibility of the transaction and the preference of a party. Some contracts might not require a business efficacy clause if the arrangement does not warrant any flexibility.
The following factors may be considered while incorporating a business efficacy clause in a contract:
(i) A business efficacy clause should be clearly worded and align with the true intentions of the parties. If there are elements which parties believe should not be altered in any manner, then stating exclusions would be useful.
(ii) The intention and commercial purpose shall be reflected, highlighting the goals and objectives that are sought to be achieved through the contract. Such goals and objectives should be worded succinctly, not allowing for a wide interpretation.
(iii) The implied terms that are essential for business efficacy may be specified.
(iv) It would be useful to evaluate if reference is required to trade practices or industry standards relevant to the transaction to aid the interpretation and implementation of the contract.
Viewpoint
- The principle of business efficacy has evolved in the Indian legal system over the years, allowing the court to give effect to the tacit understanding/intention of the parties to accomplish the intended purpose of the transaction.
- The inclusion (or exclusion) of a clause for business efficacy in a contract can significantly impact the enforceability of a provision or the interpretation of a contract.
- It would be desirable to evaluate if a ‘business efficacy’ is required in a particular contract.
A business efficacy clause in a contract can become a double-edged sword or may even be (mis)used by a party as part of its larger strategy. Therefore, a proper understanding of the business and commercial landscape in the context of the project contracts is essential to decide if a business efficacy clause is desirable.
Ashwini Panwar (Mr) and Priyanshi Aggarwal (Ms)
Associate at Alaya Legal
