Side letters and collateral contracts: are they enforceable?

Key Points:

Any collateral contract which varies or supplements a principal agreement should be supported by separate consideration to enable that agreement to stand as a contract on its own

Side deals are often used by parties in a range of commercial transactions. They are typically informal arrangements which are used to supplement, vary or clarify the terms of the main (and more formal) transaction documents. The side deal may comprise an oral agreement or it may be documented in a letter or email. For various reasons the parties may not have wanted or been able to incorporate the side deal into the formal transaction documents, but the parties nevertheless usually intend for the side arrangement to be enforceable. The question is whether they are.

In the recent case of Adicho v Dankeith Homes Pty Ltd, the Court of Appeal of the New South Wales Supreme Court held that a side arrangement was unenforceable because it was inconsistent with the express terms of the main transaction document.

This case serves as a reminder of the importance of ensuring that side letters and similar arrangements are appropriately documented and, if inconsistent with the main transaction documents, meet all of the requirements for contract formation, including the requirement to be supported by its own independent consideration. If doubts exist as to the existence of consideration, then the prudent approach is for a nominal consideration (eg. $10) to be used, or alternatively the separate side deal should be prepared as a deed or the transaction documents amended as needs prior to signing.

Background

Dankeith Homes Pty Ltd was the developer and owner of eight units in a development at Ingleburn, NSW. In August 2007 it entered into a contracts of sale with Mr Adicho (as the purchaser) for the sale of all eight units. Each contract provided for payment on exchange of a deposit equal to ten percent of the sale price. As it turned out, no deposit was in fact paid on exchange of any of the contracts. The trial judge found that this was primarily because an oral agreement existed between Dankeith and Mr Adicho to reduce the amount of each deposit to only $500. It is unclear why this was not properly reflected in the sale contracts, but it appears that the Dankeith may not have wanted the reduced amount of the deposit to be evident on the face of the sale contracts.

Completion of the contracts was due six weeks after exchange, but this did not occur. Dankeith served notices to complete which were not complied with. Following this, the parties entered into negotiations regarding the sale, with Dankeith serving fresh notices to complete in late January 2008. These were again not complied with and Dankeith terminated each of the contracts for breach.

Dankeith eventually sold the eight units to other purchasers and then commenced proceedings against Mr Adicho for damages for breach of each contract, including for non-payment of the full amount of the deposits.

Decision

The trial judge held that Mr Adicho was in breach of each of the contracts in failing to complete in accordance with the January 2008 notices and awarded Dankeith judgment against Mr Adicho for $365,440 (including interest of $79,940).

As mentioned above, the trial judge found that prior to exchanging contracts Dankeith and Mr Adicho had orally agreed to reduce the deposit payable to only $500 per sale, but the formal sale contracts did not reflect this reduction in the deposit.

Despite finding that the oral agreement existed, the trial judge held that it was unenforceable. Since the oral agreement was made in consideration of Mr Adicho entering into each of the contracts for sale and its terms were inconsistent with the written terms of each of those contracts, the oral agreement was not effective.

The trial judge also held that since the side deal related to sales of land and was not in writing it could not be enforced (see section 54A of the Conveyancing Act 1919 (NSW)).

On appeal the Court of Appeal upheld the trial judge's decision that the side deal was unenforceable. In doing so, the Court of Appeal applied the long-standing High Court decision of Hoyts v Spencer. In that case the High Court recognised that the mere act of a party proceeding to enter into a main agreement can itself be consideration to support a "collateral contract" made on or before the main agreement is entered into.

However, the High Court held that this only applies where the terms of the collateral contract supplement or add to the principal agreement. If the collateral contract is inconsistent with the main agreement, then the act of entering into the main agreement will not of itself constitute valid consideration to support the collateral contract. In this way, the principal agreement is essentially treated as the more important of the two agreements, and therefore the terms of collateral agreement will not be permitted to detract from the promises contained in the principal agreement.

Here, the collateral contract was made in consideration for Mr Adicho entering into the principal agreements. He did not provide any separate consideration for Dankeith's promise to accept the reduced amount of the deposits. Since the collateral contract sought to modify the principal agreements, it detracted from the very consideration which supported the side deal promise from Dankeith. It was therefore inadequate consideration and therefore the collateral contract was unenforceable as a contract.

If Mr Adicho had been able to show that he provided Dankeith with some other form of consideration in exchange for the promise to accept reduced deposits, then the collateral contract would have been enforceable as an ordinary contract. In such a case, the latter contract (ie. the sale contract) would be treated as having been varied by the earlier contract (ie. the collateral contract). Unfortunately for Mr Adicho, he was unable to identify any other consideration. Even if he could, the Court of Appeal agreed with the trial judge's conclusion that the collateral contract would have been unenforceable in this instance because it was not in writing.

This relatively technical approach to the consideration requirements for collateral contracts has been criticised by several commentators over the years, but this recent Supreme Court decision shows that it is still the law in Australia. Many would think that the result in this case is unfair because it does not accord with what manifestly were the parties' overall intentions, as evidenced by their very specific and contemporaneous agreement to reduce the amount of the deposits.

While not considered in the case, it is important to note that collateral contracts may potentially be indirectly enforced if the elements of promissory estoppel can be established. Furthermore, a party seeking to enforce a collateral contract may have a remedy for breach of section 18 of the Australian Consumer Law if the elements of misleading or deceptive conduct can be established.

Key implications

This case is a timely reminder that any collateral contract which varies or supplements a principal agreement should be supported by separate consideration to enable that agreement to stand as a contract on its own (the other elements of contract formation should of course also be present).

If doubts exist as to the adequacy of the consideration, a nominal amount of consideration (eg. $10) should be used or alternatively the collateral contract should be documented as a deed or, ideally, the terms of the side deal incorporated into the main transaction document before it is signed.

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this bulletin. Persons listed may not be admitted in all states and territories.