FAI award declaring a service agreement terminated due to a material breach of contract

Background

Below is a brief description of an FAI arbitral award rendered in a cross-border dispute regarding the termination of a business contract governed by Finnish substantive law. The seat of arbitration was Helsinki, and the arbitral tribunal was composed of three arbitrators, all of whom were of different nationalities (but all with a civil-law background). The factual circumstances of the dispute were as follows:

The principal owners of privately held companies A and B – Mr X (as the owner of company A) and Messrs Y and Z (as the owners of company B) – had entered into negotiations regarding a possible transaction concerning B. The idea was that Mr X would assume the management of B to a certain extent, with a view to improving its profitability, and in relation thereto would acquire an option to purchase a controlling interest in B. Following successful negotiations, the parties ultimately agreed that A – the company controlled by Mr X – had the right to purchase from Y and Z, and the latter correspondingly had the obligation to sell to A, 51 percent of the shares of B on the terms and conditions further specified in the so-called option agreement.

At the same time, Mr X (for himself and on behalf of his company A), on the one hand, and Messrs Y and Z, on the other hand, concluded a separate service agreement (hereinafter the “Service Agreement”), which was governed by Finnish substantive law. In the recitals to the Service Agreement, it was stated that “the parties hereto have expressed mutual interest to enter into agreement whereby Mr [X] would on an executive and consultancy basis take charge over the operational sales, marketing and thereto related administration management of [B] and in relation to that acquire an option to buy [through A] 51 percent of the shares in [B]”. Further, Section 2.4 of the Service Agreement provided that “Mr [X] together with his staff shall provide their services with reasonable care and skill and to the best of their ability as well as use their best endeavour to promote the interests of [B]”. Finally, Section 6.2 of the Service Agreement contained the following provision regarding termination: “Either party may terminate this Agreement forthwith by notice in writing to the other if the other: (i) commits an essential breach of this Agreement which in the case of a breach capable of remedy shall not have been remedied within 30 days of the receipt of a notice from the innocent party identifying the breach and requiring its remedy.”

Soon after the parties had entered into the Service Agreement, various disagreements arose between X, on the one hand, and Y and Z, on the other hand, on how B should conduct its business.  The parties’ relationship deteriorated to such a degree that Y and Z eventually terminated the Service Agreement with immediate effect based on X’s allegedly material breach of contract. Immediately after that, X commenced FAI arbitration proceedings against Y and Z, requesting the arbitral tribunal to declare that the termination had been unlawful and that the Service Agreement remained in force according to its terms. Y and Z, in turn, disputed all claims raised by X and asked the arbitral tribunal to declare that Y and Z had had a justified cause to terminate the Service Agreement and that it was therefore no longer in force, and requested the arbitral tribunal to order X, together with A, to reimburse to B all the payments that B had made to A on the basis of the Service Agreement.

Key findings of the arbitral tribunal

Having carefully assessed all the arguments advanced and evidence produced by each party, the arbitral tribunal found that Y and Z had been entitled to terminate the Service Agreement with immediate effect. The arbitral tribunal gave, inter alia, the following reasons for its determination:

“(…) the Service Agreement was in essence a personal services contract. It was clear to the parties from the outset that Mr [X] would be required to work closely with Messrs [Y and Z] in a business and cultural context which, as noted earlier, he had had substantial opportunity to observe before entering in the Agreement. The Tribunal finds that, in these circumstances, Section 2.4 of the Agreement must be read to include the requirement that Mr [X] exercise his delegated powers with due regard to the particular situation that existed at [B], a family-owned company located in a small town in [the name of the country]. (…)

The Tribunal finds that, as alleged by [Y and Z], [X’s] behavior during his tenure at [B] was not consistent with the terms of the Service Agreement. Two circumstances are particularly relevant in this regard.

The first is [X’s] aggressive behavior towards [Y and Z]. Mr [D] of [A] testified that he witnessed [X] having heated discussions with [Y]. Further details were provided by Mr [E], who described an incident in September [the year] in which [X] had a confrontation with [Y] at [B] in front of other employees (…) According to [E], [X] used an extremely pejorative term in referring to [Y]. It appears from the record that there may have been other similar instances.

Such behavior by [X] was not consistent with his obligations under the Service Agreement. He knew or should have known that within the context of [B] – a family-run business owned by [Y’s and Z’s] family for many years – to confront [Y] in this way, in front of other [B’s] employees, would necessarily undermine [Y’s] authority, sour the parties’ working relationship and sow dissention within the company. By doing so nonetheless, [X] acted in violation of his obligation of due care and loyalty under Section 2.4 of the Service Agreement.

The second important circumstance concerns [X’s] actions vis-à-vis other [B’s] employees. Both Mr [E] and Mr [F] testified that [X] held secret meetings with them in which he discussed his plans for [B] after he assumed a majority ownership position. Mr [E] described himself as a “watch dog” for [X] and testified that [X] frequently asked him not to disclose the contents of their conversations to [Y and Z] or others.

The Tribunal agrees with [Y and Z] that these actions likewise violated [X’s] duty of care and loyalty under the Service Agreement. [X’s] duty was to exercise his authority in conjunction with and through [Y and Z], and in a manner that promoted the company’s interests. He knew or should have realized that holding clandestine meetings with key employees was inconsistent with these duties and would ultimately destroy the relationship with [Y and Z] that was necessary to the parties’ contractual relationship. As such, [X’s] actions in this regard likewise must be deemed a breach of the Service Agreement.

It is important to emphasize that the two circumstances described above appear from the record not to have been isolated events (…) [X’s] behavior towards [Y and Z] was consistently aggressive and confrontational. While [X] may have subjectively believed that his actions were ultimately in [B’s] interests, it appears that he was simply unable to adapt his behavior in a manner appropriate to the business and cultural context that he had voluntarily chosen to enter. In short, he behaved as what he was not – someone who already owned [B] – and in doing so violated his obligations of due care and loyalty under the Service Agreement.

The Tribunal further finds that the breaches described above were “essential” within the meaning of Section 6.2(i) of the Service Agreement. They had the entirely foreseeable effect of fully undermining the relationship between the parties upon which the performance of the Service Agreement depended.

It remains to consider whether these breaches were remediable and, if so, whether [Y and Z] provided [X] with 30 days’ notice as required by Section 6.2(i). The Tribunal finds that [X’s] violations of Section 2.4 were not remediable. At least by early [the year], the damage done to [X’s] relationship with [B’s] owners was irreversible. (…)  Based upon the foregoing, the Tribunal concludes that [Y and Z] were legally entitled to terminate the Service Agreement on [the date]. They did not breach the agreement by doing so.”

With that being said, the arbitral tribunal held that Messrs Y and Z were not entitled to claim reimbursement for the payments that B had made to A as compensation for Mr X’s services during the time period when the Service Agreement had been in force. In the final award, the arbitral tribunal addressed this issue as follows: “In this regard, it is important to distinguish between the work performed by [X] at [B] and his behavior towards [Y and Z] and others. Although [X] violated his duties under Section 2.4 of the Service Agreement through his conduct, it has not been shown that the work he performed – in terms of creating and implementing sales policies for [B] – was worthless or executed in bad faith.” – For these reasons, Y’s and Z’s claim for monetary relief against X and A was rejected.

Reported by Mika Savola
Chair, FAI Board

Posted in FAI cases |