What is Discharge by Operation of Law?
Discharge by operation of law is essentially when you no longer are bound by the terms of a contract due to the occurrence of a condition. This condition typically occurs when one party to the contract is no longer able to perform their contractual rights/responsibilities, without breaching the contract. Discharge by operation of law can occur in many ways, but it usually occurs when a party to a contract files for bankruptcy or upon the death of an individual involved in a contract. In the context of a divorce, discharge by operation of law occurs when a property settlement agreement becomes a final judgment from the court, in essence, converting what was once a contract into a legally enforceable judgment.
The import of discharge by operation of law is that the obligation in contract may no longer be enforced. For example, in HD Supply Facilities v. Green Environmental, [2011] NCCA 51, the North Carolina Court of Appeals held that a corporation’s payment obligations under the terms of the contract became unenforceable, when the buyer was dissolved. In the fact pattern of this case, HD Supply sold certain products to RWT. RWT then April 12, 2005, a Certificate of Dissolution was duly filed with the Arkansas Secretary of State and subsequently became effective. HD Supply made a claim against RWT for amounts owed, following which RWT sought DNAI’s indemnification. DNAI responded that RWT’s payment obligations were "discharged by operation of law" when RWT was dissolved and that DNAI had no obligation to indemnify RWT. Following a trial, the court held that the company’s dissolution extinguished the company’s debts .
Evidence submitted by the parties established that on April 11, 2005, RWT was voluntarily dissolved by its members pursuant to Ark.Code Ann.§ 4-27-1401. The next day, RWT filed a Certificate of Cancellation with the Secretary of State reflecting RWT’s decision to voluntarily dissolve. Under Arkansas law, a dissolved limited liability company continues its existence until August 15th of the fifth year following the filing of its certificate of cancellation or August 15th of the year the company filed on, whichever later, to wind up its business affairs. Ark.Code Ann.§ 4-27-1406; Ark.Code Ann.§ 4-27-804. This termination date is known as the LLC’s "winding up period." Ark.Code Ann.§ 4-27-801 (6). Therefore, the endorsement states that if the certificate of cancellation was filed on April 12, 2005, the LLC would have had six years, or until April 12, 2011, to wind up affairs, cure all outstanding obligations and legally terminate its existence. Thus, the court found that the obligation to pay any debts does not survive or bind the LLC after the April 12, 2011 termination date.
In the context of divorce, discharge by operation of law applies to the circumstances where the property settlement agreement becomes a final agreement and divorce decree which is then incorporated into the final decree of divorce. In the context of a final judgment, the fact that a party to a contract has been discharged from or tends to have been discharged from the obligations contained therein means that the court will excuse that party from performance of the obligation in question. However, there is an important caveat in that the contract must still be within the statute of limitations. If it is not, the discharge by operation of law may not be sufficient.
Common Scenarios for Discharge by Operation of Law
There are several sets of circumstances in which discharge by operation of law is most likely to occur – bankruptcy and impossibility of performance are some of the most notable examples. Specific circumstances, however, vary on a case-by-case basis. Here are some examples of circumstances that typically lend themselves to discharge by operation of law:
Insolvency and Bankruptcy
A general principle of contract law is that parties to a contract are expected to perform under the terms of that contract (or risk breaching the agreement and facing consequences). If a party can no longer perform under the contract due to insolvency issues or the filing of bankruptcy, the remaining party may be discharged by operation of law because circumstances out of his or her control typically prevent him or her from adversely possessing the property in question.
Impossibility of Performance
If an obligated party can’t perform the actions that are essential to fulfilling the contract, then that party may be discharged by operation of law. In general, the action must be a physical impossibility, not simply an inconvenience. So for example, an obligated party is unlikely to be discharged from an exotic car rental contract if it is physically possible for him to return the vehicle, but it is inconvenient because it occurred during a holiday weekend. However, it would be different if the future action required by the contract were rendered impossible by a natural disaster, such as a hurricane or earthquake.
Subsequent Merger of Duty
If the obligations under a contract become merged into a duty possessed by the same person at a later date (or time), then that duty is discharged by operation of law.
Prior Breach by the Benefitting Party
If the party who would benefit from the contract breaches its obligations, then the other party can be discharged by operation of law. In some respects, courts and arbitrators will discharge a party who is in breach of contract when the contract is no longer capable of having been carried out as envisioned by both parties (or at the time the contract was originally agreed to).
Legal Principles Behind Discharge by Operation of Law
With respect to the legal principles at issue, it is worth noting that most often a discharge by operation of law is caused by a statutory mandate. However, in some instances this form of discharge can be caused by court rulings. For example, although a surety who has been discharged may still have a claim under an indemnity agreement against its principal, courts have held that a surety has been discharged by operation of law and is not entitled to any post-termination compensation when a final decision on the legality of the discharge is made after the surety’s bond has expired. See, e.g., Chicago Tidal Dock v. City of Chicago, 772 N.E.2d 1039 (Ill. App. Ct. 2002).
Here, the payment bond at issue in the Chicago Tidal Dock case contained a condition precedent that the surety receive a discharge from the owner by reason of completion, default or termination of the contract secured by the bond. After completion of the contract, the surety never sought a discharge, and thus the surety claimed that the owner’s claims against the bond were denied because of the surety’s failure to obtain a discharge of the bond. The state court held, however, that in order for the surety to be discharged, the surety was required to show that the owner "intended to discharge any liability under the bond and the owner’s actions constituted an unequivocal manifestation of that intent." Id.
Sureties also can be discharged by statutory mandates without regard to the surety’s intent. For example, in First Trust & Savings Bank v. Huber, the court held that the surety was discharged because the principal’s rehabilitation proceedings terminated its status as a "proceeding in a bankruptcy or insolvency" as contemplated by the bond. 467 N.E.2d 124 (Ill. App. Ct. 1984). In a statutory forfeiture situation, such as in the land sales context, the surety is discharged because the statute, by eliminating the principal’s right to seek a specific remedy, necessarily releases the surety from its duty of performance, as well. See Hartley v. Webb, 794 P.2d 1387 (Nev. 1990); Diamond Equipment v. Reeder Distributors, Inc., 659 P.2d 428 (Ala. Ct. App. 1983) (surety released because statute required that a foreclosure action proceed expeditiously, and consequently eliminated principal’s right to specific remedy).
Interestingly, some courts have found that a surety cannot be discharged by operation of law until the principal’s rights under the security instrument have been exhausted, meaning that other secured parties with lower priority should not be allowed to enforce the security interest until principal brings suit or indemnitee fails to assert a timely claim. See, e.g., Pacific Highway Constr. Co. v. L.A. Meyer Trucking Co., 515 P.2d 754 (Or. Ct. App. 1973). Other courts hold otherwise.
Discharge by Agreement and Discharge by Operation of Law Distinctions
Aside from performance, the two other ways of discharging a contract are by agreement of the parties or by operation of law. Discharge by agreement, or mutual rescission, occurs where both parties agree to the termination of the contract. This is generally tested in problems where there has been a breach of contract by one party but despite that breach, both parties agree to discharge the contract on terms to themselves. The question is whether a valid variation has been created.
Discharge by operation of law arises independently of the will or agreement of the parties. In certain cases, it is imposed by statute. For example: where the subject matter of the contract has been destroyed; expiry of the period specified in the Limitation Act whereby an action can no longer be brought on the original contract; when a Party becomes insane or bankrupt; or where an event occurs making the performance of the contract impossible.
There is also the category of a non-est contract, which is a contract that never came into existence because it lacked capacity, formalities or required a form of authorization. That would not be classed as it never existed at all because none of the parties was ever legally bound.
Real-World Discharge by Operation of Law Examples
Discharge by operation of law is often invoked when someone wants to escape their contractual obligations at the end of a deal, but in some cases they can invoke it as a remedy for breach. The most common example of discharge by operation of law in the latter context is when a party is saved by a force majeure clause. In 2004, the English Court of Appeal held that the Defendant could be discharged by operation of law pursuant to a force majeure clause when a severe storm rendered its ship unseaworthy, thereby delaying the construction of a bridge across the River Thames: The Cape Bonny [2004] EWCA Civ 1438.
The Defendant chartered The Cape Bonny to SWS to assist with the construction of a new bridge (the "Millennium Bridge") across the river Thames. The Defendant chartered its vessel in December 1996. In March 2007, the Defendant informed SWS that the Millennium Bridge was not in fact going to be completed at all, and therefore it requested that the vessel be returned to the Defendant.
Three years later, the Defendant informed SWS that, in light of recent massive storms, it would be unable to return the vessel to SWS until 2011. SWS therefore notified the Defendant that it would exercise its right to terminate the charterparty on the grounds of the Defendant’s delay in returning the vessel at the time specified in the charterparty.
A dispute arose between the parties , who sought declarations from the Court as to the validity of SWS’s termination of the charterparty agreement. The Defendant argued that: (1) it was not in breach of the charterparty because the delay in returning the vessel was the fault of SWS; (2) the Defendant was in any event entitled to damages; and/or (3) it was discharged from its obligations under the charterparty in accordance with a force majeure provision.
The only real disputed point in this case was (3). Specifically, the Court had to determine whether the Defendant’s delay in returning the vessel fell within the force majeure provisions of the charterparty. If so, the Defendant could not in fact have returned the vessel when it did, and therefore did not breach the charterparty and consequently, SWS could not terminate the charterparty agreement.
The force majeure clause provided that any consequent delay or non-performance due to ‘Acts of God’ would be dealt with as follows: ‘[I]f the nature of the circumstances is such that it would be impossible for … the Owner to fulfill his part of this contract with safety to the personnel of his vessels, the matter shall be dealt with … according to the procedure of Clause 32.’
Clause 32 set out the procedure in the event that any unforeseen circumstance prevented the performance of the charterparty, and therefore provided that performance shall be resumed as soon as reasonably possible following the cessation of the force majeure event. Accordingly, if the Defendant was discharged from the charterparty by force majeure, then the Defendant’s 2011 delay in returning the vessel would be immaterial. The Court of Appeal held that the storm could not have been prevented, and therefore the Defendant did not have to take steps to ensure the vessel was seaworthy (or suffering from other damage) before the storm.
Implications and Consequences of Discharge by Operation of Law
The most practical outcome for parties facing potential discharge by operation of law scenarios is that they can terminate the contract without incurring damages. This is generally the primary effect of discharge by frustration, though other factors can come into play. It must be emphasized that the common law will prohibit any losses from the party’s breach of the contract in its negligence, though this is distinct from the party who caused the frustrating event being found negligent.
However, discharge by operation of law can have other unforeseen implications. If the contract has been terminated because of illegality, for example, the resulting damage awards may be less that anticipated. The court may not award a claimant damages for losses resulting from the implementation of criminal conduct, since those losses would have never occurred in the absence of the illegality involving the contract. Such is the case in Hilton v Maughan. Conversely, if the contract had been performed and the parties had recouped their losses through damages awards, the court may order the parties to pay back that damages money to one another to reflect the fact that the contract was rendered void ab initio. This was the result in Heather v Paine.
If the contract was terminated due to frustration, release of the parties from their contractual obligations will depend on the circumstances of the particular case. Use of an impossibility of performance clause to bind parties to the previous agreement seems to have little effect. In McElroy Milne & Assocs. Ltd. v Commercial Electronics Ltd, the Court of Appeal ruled that the duty of good faith owed in all contracts meant that parties could not avoid the effect of the termination even where they had specifically included clauses requiring that they agree to a party paying damages in full for failing to complete the contract. This decision has been cited in Baker Perkins, though seemed to be dismissed here on the basis that the contract had not been delivered (the parties were still negotiating it, in favour of Contract A) when the frustrating event occurred. Also, it seems unlikely that a party seeking to rely on causation would be permitted to do so unless the cause was distinctly independent of the supervening impossibility of performance, as seen in Childerley Ltd v Lawrence and Another.
The fact that the contract has been terminated can also change the duties of the parties depending on the circumstances. Rekhviashvili v Gordi, involved a relationship that was founded on no contract or any formal agreement at all. Once it was terminated, the relationship of trust and confidence that had previously existed obviously ceased to exist along with the contract.
In Baker Perkins, the importance of determining whether the claim was contractual was identified as a key factor for whether the burden of proof lay on the defendant to show that the plaintiff failed to discharge its duty of care or whether the burden was reversed under the non-delegable duty approach whereby the claimant invoking the breach could escape liability for failing to discharge his duty of care. In addition, the court ruled that Hadley v. Baxendale allowed claims for loss of profit only when that loss was reasonably foreseeable or within the parties’ contemplation, or in the alternative, when the loss was ascertained as special damages under the contract, and thus the defendants were not liable to pay for the loss of profits arising from the plaintiff’s sale of the mill.
This general approach indicates that parties to a contract, where a dispute arises over discharge by operation of law, would be well advised to seek a resolution of their problem through negotiation before proceeding through litigation. Of course, the implications of discharge by operation of law will differ depending on the facts of the specific case, but parties will do well to factor in these general considerations prior to commencing proceedings.
Of course, the most important consideration for parties might be prevention. Anticipating a discharge by operation of law and preparing appropriately can avoid a great number of the costs.
Frequently Asked Questions on Discharge by Operation of Law
Here are the answers to some common questions on discharge by operation of law:
What circumstances lead to the release of a debt?
Discharge by operation of law occurs in a number of situations, including:
- if a statute gives a debtor the right to exercise a statutory lien over land, insolvency proceedings (business rescue and liquidation) of the debtor, or if security mentioned in the underlying agreement has been disposed of or is no longer capable of being realised.
- discharge of a debt in terms of an agreement entered into between the creditor and debtor.
- The consolidation of debts or set off of debts.
- Ignorability of the claim due to prescription.
- Automatic rescission of a judgement.
- Commutation of an annuity.
- Release of a bank guarantee by the issuing bank.
In other words, discharge by operation of law occurs where a creditor’s debt claim against a debtor (i.e. the underlying agreement) is extinguished as a matter of law.
What is a statutory lien and when does it occur?
A statutory lien is a right provided for in legislation, which gives a person a lien over a third party’s property if that third party caused damage to the property. If a creditor has a statutory lien over the debtor’s property in terms of the Act, the creditor must preserve the property and dispose of it in accordance with the provisions of the Act and then apply the proceeds to the payment of any amounts due to the creditor. Any balance must be restored to the debtor . If the current creditor obtained the property from the previous creditor in the previous paragraph with notice of the statutory lien, the current creditor would also be bound by the terms of this paragraph.
What does insolvency proceedings in the business rescue and liquidation environment refer to?
In business rescue proceedings, it is compulsory for the company or insolvent estate to give security to the creditors in cases where the creditors have security rights. Therefore in terms of the underlying agreement, which gave rise to the debt, the creditor could have a right to realise its security against the debtor’s estate. In liquidation proceedings, the creditor could again have a right to realise its security against the debtor’s estate. If the security is realised, then the underlying debt will be extinguished. For example, let’s say that the creditor holds a tile over the debtor’s vehicles, registered account and stock. In the previous example, the creditor could rely on its tile in relation to some of the debtor’s vehicles, the registered accounts for some of the debtor’s customers and some of the debtor’s stock. If the creditor realised its security, then the underlying debt will be extinguished.
What does consolidation of debt or set off of debts mean?
If the creditor and debtor are both companies, or a company and an individual, the debt that the debtor has in relation to the creditor arises from the same underlying agreement. In this event, the creditor could rely on the underlying agreement to set off its debts with the debtor and vice versa.