New South Wales Supreme Court CITATION : North Sydney Leagues' Club Ltd v Synergy Protection Agency Pty Ltd (formerly Joseph Merhi Industries Pty Ltd) trading as Synergy Protection Agency [2010] NSWSC 256 HEARING DATE(S) : 25/02/2010, 11/3/2010, 16-17/03/2010, 1/04/2010 JUDGMENT DATE : 7 April 2010 JURISDICTION : Equity Division Commercial List JUDGMENT OF : Einstein J DECISION : Separate question 3 answered in the affirmative. CATCHWORDS : Damages - Summary of principles in relation to damages generally and contract damages in particular - Separate question orders agreed by parties - Lost profits-competing contentions on treatment of overheads/fixed costs - LEGISLATION CITED : Uniform Civil Procedure Rules 2005 (NSW) CATEGORY : Procedural and other rulings A J Lucas Drilling Pty Ltd v McConnell Dowell Constructors (Aust) Pty Ltd [2008] VSC 315 A J Lucas Drilling Pty Ltd v McConnell Dowell Constructors (Aust) Pty Ltd [2009] VSCA 310 Amann Aviation Pty Ltd v Commonwealth of Australia (1990) 22 FCR 527 Apand Pty Ltd v Kettle Chip Company Pty Ltd [1999] FCA 483; (1999) 162 ALR 505 Bulk Materials (Coal Handling) Pty Ltd v Compressed Air & Packaging Systems (NSW) Pty Ltd (unreported, 17 July 1997, Supreme Court of NSW (Giles CJ Comm D)) Cullinane v British "Rema" Manufacturing Co Ltd [1954] 1 QB 292 Dart Industries Inc v Décor Corporation Pty Ltd [1993] HCA 54; (1993) 179 CLR 101 Ellis-Don Ltd v The Parking Authority of Toronto (1978) 28 BLR 98 CASES CITED : Gates v City Mutual Life Assurance Society Ltd (1986) 160 CLR 1 GEC Marconi Systems Pty Ltd v BHP Information Technology Pty Ltd [2003] FCA 50 Hughes Bros Pty Ltd v The Trustees of the Roman Catholic Church for the Archdiocese of Sydney (unreported, 16 October 1997, Supreme Court of NSW (Giles CJ Comm D)) Hungerfords v Walker [1989] HCA 8; (1989) 171 CLR 125 I & L Securities Pty Ltd v HTW Valuers (Brisbane) Pty Ltd [2002] HCA 41 Leplastrier & Co Ltd v Armstrong-Holland Ltd (1926) 26 SR (NSW) 585 S & D Mechanical Contractors Inc v Enting Water Conditioning Systems Inc (1991) 593 NE 2 d 354 Sunley (B) & Co Ltd v Cunard White Star Ltd [1940] 1 KB 740 TC Industrial Plant Pty Ltd v Robert's Queensland Pty Ltd (1963) 180 CLR 130 Telecom Corporation of New Zealand Ltd v Clear Communications Ltd (1995) 32 IPR 573 TEXTS CITED : Cheshire & Fifoot, Law of Contract, 9th Australian Edition by N.C. Seddon and M.P. Ellinghaus, LexisNexis Butterworths, 2008 Keating on Building Contracts, 7th edition, Tby he Hon Sir Vivian Ramsey and Stephen Furst, Sweet & Maxwell, 2003 PARTIES : North Sydney Leagues Club Ltd (Plaintiff) Synergy Protection Agency Pty Ltd (formerly Joseph Merhi Industries Pty Ltd) t/as Synergy Protection Agency (Defendant) FILE NUMBER(S) : SC 2006/00268578 COUNSEL : Mr F Douglas QC, Mr R J Bromwich SC (Plaintiff/Cross Defendant) Mr KP Smark SC (Defendant/Cross Claimant) SOLICITORS : Lander & Rogers (Plaintiff/Cross Defendant) Carroll O'Dea (Defendant/Cross Claimant) IN THE SUPREME COURT OF NEW SOUTH WALES EQUITY DIVISION COMMERCIAL LIST Einstein J Wednesday 7 April 2010 2006/00268578 North Sydney Leagues' Club Ltd v Synergy Protection Agency Pty Ltd (formerly Joseph Merhi Industries Pty Ltd) t/as Synergy Protection Agency JUDGMENT The state of these proceedings 1 On 4 February 2010, on the further hearing of this matter on the question of damages, the Court acceded to a joint application by the parties that three questions be determined separately, pursuant to UCPR 28.2. 2 One of those questions, referred to hereafter as "question 3", was stated in the following terms: "Whether, in determining the quantum of expectation damages attributable to breach of contract by the cross-defendant ("Norths") by way of net profit that was lost Synergy by reason of such breach, indirect or overhead costs (ie costs not directly related to the provision of services) in the period in which the contracts should have been performed, should be taken into account." 3 The parties addressed submissions to this question and the Court delivered judgment on 12 February 2010, giving reasons for an affirmative answer to question 3 ([2010] NSWSC 52). 4 Synergy notified the Court on 24 February 2010 that there was an issue as to whether the affirmative answer given to question 3 followed from the reasons for decision given by the Court. 5 On 17 March 2010, following a short hearing of the parties, the Court, with the consent of the parties, set aside its judgment of 12 February 2010, so far as it related to Question 3 (but not otherwise), and offered the parties the opportunity of putting such further submissions (both in writing and orally) as they desired as to the answering of question 3. 6 Both parties addressed written submissions to the court on the subject. Although certain of the earlier submissions were taken as continuing to represent the party's positions essentially the parties carefully addressed and may be regarded as having addressed the issues de novo. 7 I have carefully considered the matter at afresh. The defendant's submissions 8 The defendant contended inter alia as follows: i. At a practical level, the answer to question 3 depends on whether the Court considers it appropriate that Synergy's damages ought to be calculated taking into account its overhead costs for the relevant period. The relevant period is the time between breach of contract, and the time the contracts would have concluded, had they not been breached by Norths. ii. By "taking into account", one means whether or not the revenue stream that Synergy would have received in the relevant period from Norths should be reduced : (a) By direct costs only (essentially, the wages paid by Synergy to the security guards who carried out the services); or (b) By way of further reduction, by a "share" of the overhead costs of its overall business, such as office rent and salary for the CEO. iii. It has not been disputed by Norths that Synergy's overhead costs would have been incurred in any event during the relevant period. That is, Synergy would have had to pay to keep its office open, pay its CEO and so on, in order to carry out the rest of its business. iv. Further there is no claim by Norths that Synergy had failed to mitigate its loss. v. Synergy's case is that in those circumstances, the amount of money needed to put it in the position it would have been if the contracts had been performed is equal to the net revenue it lost (that is, the total contract payments it would have received, less its direct costs of obtaining such payments, essentially wages to security guards). This is because such revenue was lost "off the top" of its business. vi. Norths' position is that Synergy ought to have to "apportion" its indirect costs, so as to assign a proportion of those costs to the lost revenue stream. For example, if the lost contracts represented 1/3 rd of Synergy's business for the relevant period, Norths contends that Synergy should have to reduce its calculated lost profit by 1/3 rd of the rent, 1/3 rd of the CEO's salary, and so on. vii. Norths' apparently seeks to support this position by claiming that Synergy's approach somehow involves, indirectly, a claim whereby it seeks to recover from Norths its indirect costs, with the effect as if it had made a direct claim against Norths for recovery of Synergy's rent, CEO's salary etc for the relevant period. Decision 9 For the reasons put by the plaintiffs I am persuaded that the correct answer to question three is in the affirmative: that is to say, Fixed Overhead Costs should be taken into account in determining net profit. 10 I set out below the reasons for this decision. Expectation damages and net profits 11 The measure of expectation damages upon breach or repudiation of contract is that the innocent party is to be put in the same position as if the breach had not occurred. Where the breach was such as to deny the innocent party the opportunity of performing services and so earning a reward, it is obvious that the innocent party must bring to account as against the reward lost (revenue) such costs as would have had to be expended by it in order to earn the reward (expenses). It is for this reason that the parties in the present case agreed that the measure of damages was to be "net profits". 12 The only dispute is whether some proportion of overhead costs have to be brought into account as expenses to be set off against revenue in the calculation of net profits. 13 As a matter of principle, it is difficult to see why overhead costs should not have to be brought into account. If, in order to provide the contractual services, it was necessary for the contracting party to pay expenses including for maintaining an office, insurances, utility bills, maintaining plant and equipment and paying head office staff, why is not some proportion of that expense properly to be regarded as an expense which should be brought into account when calculating net profit? It is to be expected that contract rates for charging out for services will incorporate as an element some amount representing the overheads of the party providing the services. Thus in building contracts, typically contract sums and contract rates build in provision for preliminaries and overheads (as elements either in a fixed price, or in a cost-plus contract). In calculating the real profit of the builder, those items would be deducted from the total contract sum, in order to determine the margin. 14 The contrary argument effectively assumes that at all times fixed overheads were to be paid from revenue streams from other contracts which Synergy had, but not from the Norths contract. There is no basis for making such an assumption. There is no basis for assuming that if the contract had been performed no part of the fixed overheads would need to have been incurred in order to earn the revenue from that contract. 15 The reverse issue has tended to arise for consideration in the context of building, construction and engineering contracts where contractors make claims for damages for delay caused by the principal in breach of contract, including a claim for unabsorbed head office overheads (ie. where head office costs continues but the revenue stream does not continue because of the principal's delay). In such cases, the contractor is seeking to make the principal contribute to the ongoing cost of the contractor's head office arising by reason of the principal's delay. Such claims have a well-established pedigree. Frequently recourse is had to the so-called "Hudson formula" for unabsorbed overheads: Head Office Percentage x Contract Sum x Period of Delay (weeks) 100 Contract Period (weeks) 16 That situation does not provide any great assistance to the present case. Cases in this field do, however, indicate that where increased overheads are to be taken into account in favour of a contractor, it is necessary for the contractor to be able to show that it has suffered loss by reason of being unable to deploy those overheads elsewhere to produce income. Similarly, in the present kind of situation, the contractor is not entitled to the benefit of a presumption that no proportion of its fixed overheads were necessary to be incurred in earning the contract sum unless it puts on evidence showing that to be the case. 17 There have not been many authorities in Australia relating to the question of whether a proportion of fixed overheads is to be brought into account as against a contractor's claim for revenue foregone by reason of the principal's breach of contract, although there have been authorities relating to the reverse position where a contractor is claiming in respect of overheads [See, e.g., Hughes Bros Pty Ltd v The Trustees of the Roman Catholic Church for the Archdiocese of Sydney (unreported, 16 October 1997, Supreme Court of NSW (Giles CJ Comm D)); Bulk Materials (Coal Handling) Pty Ltd v Compressed Air & Packaging Systems (NSW) Pty Ltd (unreported, 17 July 1997, Supreme Court of NSW (Giles CJ Comm D)); GEC Marconi Systems Pty Ltd v BHP Information Technology Pty Ltd [2003] FCA 50]. 18 However, clear guidance is provided in the joint judgment of the High Court in TC Industrial Plant Pty Ltd v Robert's Queensland Pty Ltd [(1963) 180 CLR 130], where, in rejecting the proposition that there had to be an election between loss of profits and wasted expenditure [see pp.138-143], the English case of Cullinane v British "Rema" Manufacturing Ltd was analysed at some length [at p.139.7]. It was observed in the course of that consideration that loss of profit was derived by subtracting from estimated receipts running costs, office expenses, interest and depreciation. The High Court also observed (at p. 140.2] that it would not have been right to award loss of profits without deducting depreciation as well as capital expenses, because that would entail awarding full profit without the expense of earning it [See also Cheshire & Fifoot 9th Australian Edition p [1081]-[1082]; Gates v City Mutual Life Assurance Society Ltd (1986) 160 CLR 1 at [11]-[12]]. That decision should govern the outcome in this case. In remitting the matter, the High Court [at p.143] said: "It may of course be that the learned judge will find it preferable to work out a single calculation, taking the whole of the actual and probable expenditure which the plaintiff would have incurred in performing its contract with the Commonwealth and the probable extension thereof had the crusher been of the warranted fitness, and subtracting the resulting figure from the total receipts the plaintiff would have obtained under the contract and the extension." 19 Read with their Honours' earlier comments, it is clear that what the High Court had in mind to be deducted from gross revenues was all expenses which had to be paid in order to earn that revenue. 20 Also, in the recent decision of A J Lucas Drilling Pty Ltd v McConnell Dowell Constructors (Aust) Pty Ltd [2008] VSC 315, Byrne J dealt with a claim for loss of profit on unperformed work following termination of a cost-plus contract. His Honour found that: "The allowance for overheads … represents the contribution of the project to the general overheads of the contractor for all of its business activities. For this reason it is difficult to understand why it was included in the margin which is applied to a particular activity rather than to the contract as a whole. Perhaps it is merely a convenient way to deal with this contribution from an accounting point of view. For my purposes, however, it is not part of profit because it is part of the expense of conducting the [business], which expense is incurred whatever happens to a given project ". (emphasis added). 21 On the facts of that case, his Honour applied a ratio of 1.5% (which was the proportion of the contract value of the unperformed work which the contractor's expert had attributed to profit when breaking down the "margin" figure) to the estimated cost of the works, and then adjusted it upwards to reflect the fact that not all of the amount allocated to risk in the margin would have been consumed in performing the works (i.e. not all risk would have come home, so expanding the real amount of profit). This decision was upheld on appeal by the Court of Appeal of Victoria [A J Lucas Drilling Pty Ltd v McConnell Dowell Constructors (Aust) Pty Ltd [2009] VSCA 310]. 22 It would appear therefore that the Supreme Court of Victoria and the Court of Appeal proceeded on the basis that where the contract rates do build in an amount on account of corporate overheads, if there is evidence to establish the true costs of performing the works, and to establish what proportion of the margin is attributable to overheads (as distinct from profits or risk (if applicable), then it is appropriate to deduct overheads in order to establish profits. 23 The correct analysis is that a proportion of head-office overheads should be deducted in calculating the net profit figure, with the question of wasted overheads (arising from their lack of deployment on the Norths contract), subject to mitigation, being the subject of a separate claim being in the nature of a reliance loss claim rather than expectation loss. However, the present plaintiff has not sought to put its case that way and there is simply no reason why the decision of the High Court in TC Industrial Plant should not govern the situation. 24 During address Mr Douglas QC put the central question in relation to the present dispute in the following terms: It seems to us the issue here really is this, that the plaintiff seeks to be compensated on the basis that all of the overheads are for business, were to be met by the other contracts of the business and that this contract was one where, to which no part of the overheads of the business were to be allocated. That is wrong in law in our respectful submission. It's not a question of mitigation, because the plaintiff has to prove its loss. They have elected to sue for profits, not for damages on the basis of reliance, so they're not saying that but for your repudiation of the contract we would not have incurred certain of the costs which we incurred, they've not embarked upon that factual enterprise. So what they're really saying, as we would see it, is that this contract should be able to ride free and the other contracts of the company should bear the general administrative and overhead costs of the business. That just is not the law. 25 Synergy further drew the courts attention to the decision of Finn J in GEC Marconi Systems Pty Limited v BHP Information Technology Pty Limited [2003] FCA 50. At paragraphs 1053-1057 his Honour observed as follows: 1053 The principal way in which BHP-IT now puts its case is premised upon the proposition that a commercial enterprise will not in the ordinary course agree to supply goods or to render services for no return, although on occasion it may be forced to do so. In support of this it draws on the observations of Mason CJ and Dawson J in Amann Aviation Pty Ltd , at 81 that: "In the ordinary course of commercial dealings, a party supplying goods or rendering services will enter into a contract with a view to securing a profit, that is to say, that party will expect a certain margin of gain to be achieved in addition to the recouping of any expenses reasonably incurred by it in the discharge of its contractual obligations." 1054 Having so identified the expectation of a business enterprise, BHP-IT then contends that the sacrifice of profit unavoidably entailed in an activity carried on by a business is a cost associated with the conduct of that business. That is a real and identifiable cost that is measured by the difference between the price charged by the supplier in the particular case and the price necessary to compensate the supplier for the profit it is forced to sacrifice because of the supply: Telecom Corporation of New Zealand Ltd v Clear Communications Ltd (1995) 32 IPR 573 at 593-594. In this BHP-IT seeks to pray in aid the economists' conception of "opportunity cost": cf Dart Industries Inc v Décor Corporation Pty Ltd [1993] HCA 54 ; (1993) 179 CLR 101 at 123. BHP-IT thus contends that GEC Marconi's repudiation obliged it to complete the Head Contract itself and in so doing to tie up its own personnel and resources for a lengthy period and for no return. To so use its personnel and resources involved the relevant sacrifice of profit. It is entitled to be compensated for that sacrifice. 1055 BHP-IT enlarged upon this "opportunity cost" claim in supplementary submissions responding to questions I had asked. It noted that the concept of opportunity cost is well recognised in Australasian Law: see Hungerfords v Walker [1989] HCA 8 ; (1989) 171 CLR 125 at 143-4, I & L Securities Pty Ltd v HTW Valuers (Brisbane) Pty Ltd [2002] HCA 41 (2 October 2002) at para 123; Dart Industries Inc v The Décor Corporation Pty Ltd [1993] HCA 54 ; (1994) 179 CLR 101 at 114 and 123-5; Apand Pty Ltd v Kettle Chip Company Pty Ltd [1999] FCA 483 ; (1999) 162 ALR 505 at 520. 1056 The concept has been applied to the expenditure of funds and to an investment in capital assets. BHP-IT contends there is no reason why it ought not to be applied to the forced deployment of skilled staff to complete a software development project that was the subject of a repudiated obligation owed by a sub-contractor, in circumstances where the expenditure of funds will not otherwise derive any commercial return. There is no logical difference between monies invested in plant and equipment, such as a ship or crane, and monies invested in retaining and deploying skilled software developers. 1057 Despite its allure I am unable to accept the contention as put. I am satisfied that, subject to its bringing to account its receipts from the Commonwealth, BHP-IT is entitled to claim its actual costs in performing the amended Head Contract. Those costs include its direct costs, expenses and charges and, importantly, loss of overheads. It does not include that component of loss of return attributable to loss of profits. The reason for that exclusion is that no presumption, special or default rule entitles BHP-IT to claim such a loss in circumstances such as the present without proof of it. I am not satisfied that BHP-IT has proved it suffered such a loss: cf Sunley (B) & Co Ltd v Cunard White Star Ltd [1940] 1 KB 740 at 747; S & D Mechanical Contractors Inc v Enting Water Conditioning Systems Inc , at 362ff; see also Ellis-Don Ltd v The Parking Authority of Toronto (1978) 28 BLR 98 at 124ff; Keating on Building Contracts , 8-67, 8-68 (7 th ed). 26 Whilst Synergy does not quite put its claim in that way it is important to recognize that what it seeks to say is that it incurred certain costs and is entitled to recover that as loss of profits. That proposition is in the present environment, incorrect. The matter could have been [but was not] put as a reliance loss case. Had that been the approach taken, Synergy would have been subject to the suggestion that it had obtained other contracts and may have been able to defray those costs against other contracts. It is simply incorrect in a loss of profits case, to blithely contend that one has incurred expenditure which is the loss. The different situation where the remedy sought is an account of profits 27 Norths further contended and I accept the following analysis as correct: i. While the above principles clearly govern situations in which damages for breach of contract are being assessed, something should be said of the different situation where the remedy sought is an account of profits, whether for breach of fiduciary duty or intellectual property infringement. ii. The issue was considered by the High Court in Dart Industries Inc v Décor Corporation Pty Ltd (1993) 179 CLR 101. In that case, the infringer Décor successfully argued that it was not wrong in principle to deduct some amount of fixed overheads when calculating the profit it had made by infringing Dart's patent. The High Court held that the infringer bears the onus of showing which overheads were "attributable to" the production and sale of the infringing product [At 118, relying upon Leplastrier & Co Ltd v Armstrong-Holland Ltd (1926) 26 SR (NSW) 585 per Harvey CJ in Eq.]. The reason that this was so was because, as the High Court emphasised, on an account of profits the purpose is not to compensate the plaintiff but to prevent the unjust enrichment of the defendant [at 114-115]. Thus the Court will act on the evidence to determine whether the infringer would be unjustly enriched if it were allowed to deduct a proportion of its general overheads in calculating the profit. iii. The High Court held that the trial judge was wrong to direct that no part of general overhead costs was allowable as a deduction, and the Full Court was correct in directing that the infringer was at liberty to show that overheads were attributable to the obtaining of the profit. In the end, it was to be a question of evidence, and the ultimate answer in that case was not the subject of the High Court consideration, nor any other report [The appeal arose from an application for declaratory relief and/or separate questions, and so there is no report of what in fact occurred on the facts of the case and whether Décor was able to show that overheads were attributable to profit so as to be deductible]. Mr Ellicott QC, senior counsel for Décor had submitted that what costs are deductible is to be determined in accordance with ordinary commercial and accountancy principles [See the case cited in argument at p. 106, Footnote 17], and that unless overheads are allocated against all products, the unjust result is reached where they cannot be allocated against any product. This was in effect, a submission that the infringer's profit was artificially inflated if overheads were not taken into account. The High Court appeared sympathetic to this argument, although as noted above it expressed its findings more narrowly in terms of it being necessary for there to be evidence of a basis of apportionment, which may vary from case to case (or indeed industry to industry) [at 117.6 to 118.5]. iv. In considering the question of whether the trial judge was wrong to declare that no part of general overheads was deductible, the High Court did say that in resolving the question of fact: "the Court must consider such questions as whether the overheads in any particular category were increased by the manufacture or sale of the product, whether they represent costs which would have been reduced or would have been incurred in any event, and whether they were surplus capacity or would, in the absence of infringing product, have been used in the manufacture or sale of other products". v. Nonetheless, it would appear the task of the infringer (or fiduciary) in an account of profits case is to adduce evidence to displace what is a de facto presumption that such costs are not attributable, and not deductible. This must be understood in the context of the High Court's emphasis that the purpose of an account of profits was to prevent unjust enrichment to the defendant. It is submitted that the reluctance to deduct general overheads in the absence of specific evidence is not difficult to understand where the case is one in which the revenue stream really belonged to someone else (such as a patentee or defrauded beneficiary). vi. However, the fact that the High Court said it was for the infringer to prove costs should be deductible cannot be simply translated into the field of damages for breach of contract as if the High Court was saying that there is some onus on a party in breach of contract to show that costs should be deductible. Dart v Décor was not a case laying down any principle applicable to damages assessment, where the purpose is compensation not the prevention of unjust enrichment. Very different considerations apply to fiduciaries and parties the subject of the equitable remedy of account of profits. Although always a matter for evidence, there is not any operative de facto presumption that overhead costs are not attributable to the earning of the revenue stream (and the High Court in Dart v Décor was not saying there was any such principle applicable in cases of breach of contract). vii. If the High Court had intended to overrule TC Industrial in Dart v Décor their Honours would have made that plain; instead they made plain that they were directing their remarks to a particular equitable remedy with an expressly non-compensatory purpose, and not to the question of compensatory damages. The commonality between the two cases is that it is ultimately a matter of evidence as to whether an amount is deductible as attributable to the earning of the profit; the difference between the two cases is one of onus. There is an operative presumption against deductibility by an infringer or defaulting fiduciary; no such operative presumption applies against a party who is merely in breach of contract. viii. Consistently with TC Industrial , the compensatory principle ought to dictate that an allowance be made for those expenses, even if there can then still be a separate claim for reliance damages based on underutilised capacity. As the plaintiff no doubt for good reason has not sought to put its case that way then no such claim ought be permitted. Conclusion 28 For the foregoing reasons as well as those previously canvassed by Norths in submissions, the correct answer to Question 3 is in the affirmative; that is, fixed overhead costs should be taken into account in determining net profit. ***** DISCLAIMER - Every effort has been made to comply with suppression orders or statutory provisions prohibiting publication that may apply to this judgment or decision. The onus remains on any person using material in the judgment or decision to ensure that the intended use of that material does not breach any such order or provision. Further enquiries may be directed to the Registry of the Court or Tribunal in which it was generated.