California Court of Appeals Rejects “Constructive Termination” as a Viable Theory of Contractual Recovery

Here’s an interesting case from the California Court of Appeals dealing with a unique issue that can arise in beverage distribution contracts – can a supplier “constructively terminate” a distribution agreement through its conduct?  The California Court of Appeals said “no,” and held that the general rule under California common law is that a party may not seek contractual recovery on the basis of constructive termination.

In Carolina Beverage Corp. v. FIJI Water Co., LLC, Fiji entered a distribution contract with Carolina Beverage, a distributor, granting it an “exclusive” right to distribute the Fiji water to retailers within Carolina’s territory. However, that right was a qualified one, because the distribution agreement granted Fiji the right to invade Carolina’s territory by selling and delivering its product directly to retailers in that territory as long as it paid Carolina an “invasion fee,” and granted Fiji the right to terminate the contract “for any reason in its sole discretion” upon giving written notice as long as it paid Carolina a higher “termination payment.” Fiji ended up invading around 85 percent of Carolina’s territory but never invoked its right to terminate under the contract — despite this, Carolina continued to perform under the distribution agreement.

Carolina sued and went to trial on the theory that Fiji had constructively terminated the contract, and a jury awarded Carolina $1,993,670 — the amount of the “termination payment” set forth in the contract. The trial court also awarded Carolina over $4.3 million in attorneys fees and costs. Fiji appealed.

The case presented the question of whether “constructive termination” of a distribution contract is a viable theory of recovery under California common law. The California Court of Appeals held that it is not. The Court further held that, critically, constructive termination was not a theory contemplated by the contract. The Court further held that even if constructive termination was a viable theory, the contract was not constructively terminated because Carolina continued to operate under the contract, and thus did not satisfy one of the prerequisites of constructive termination: “whenever the doctrine of constructive termination is available, a contract will be deemed to be constructively terminated only if the party claiming constructive termination ‘puts an end to the contract.’”

The Court of Appeals reversed both the award of the termination fee and the award of attorney’s fees.

The Court’s holding was based on “the core tenets of California contract law” that parties to a contract—and especially sophisticated parties who enter into commercial contracts—are empowered to define for themselves, through the contract’s terms, the rules that will govern their relationship and that California courts will enforce—rather than alter—those terms. Thus, if a contract does not itself recognize the concept of constructive termination, the courts are not permitted to graft that concept onto that contract.

The Court noted that this general rule has two exceptions in which the California courts have engrafted onto contracts a constructive termination provision—namely, (1) employment contracts, where an employer may “constructively discharge” an employee and (2) lease contracts, where a landlord may “constructively evict” a tenant. But recognized that these exceptions exist for very specific policy reasons—chiefly, to give the economically weaker party (the employee and the tenant) a means of severing what has become an intolerable relationship to protect that party from further abuse under the contract.

If you’re wondering why Carolina did not make a claim for breach of the implied covenant of good faith and fair dealing, it did. And it lost that one too. On that argument, the Court said: “the implied covenant exists to “protect the express covenants or promises of a contract but it cannot be used to prohibit a party from doing that which is expressly permitted by an agreement or to otherwise vary the express terms of an agreement. Simply, Fiji’s conduct was expressly permitted by the distribution agreement.

Key Takeaways

First, in California, constructive termination of a contract is not a viable theory of recovery unless it is provided for in the contract or it fits within one of the narrow public policy exceptions. So, when negotiating distribution agreements where the supplier has the type of control Fiji had here, consider negotiating a constructive termination provision, which might specify the conduct of either part that would constitute termination.

Second, the product here was bottled water. In a beer, wine, or spirits distribution agreement, the analysis might be different because there may be statutes – such as franchise laws – in place that prohibit the type of conduct exhibited by Fiji – regardless of what the contract says. For example, under California law, regardless of the parties’ agreement, a supplier may not terminate a wholesaler solely for wholesaler’s “failure to meet a sales goal or quota that is not commercially reasonable under prevailing market conditions.” Some supplier-distributor relationships, particularly those involving large suppliers, could be covered under the California Franchise Relations Act.

Third, if there is any chance at winning on a constructive termination theory, the aggrieved party must actually terminate the contract – if it continues to perform as if the contract has not been terminated – any claim for termination will likely be barred.

Fourth, while this is a California case, governed by California law, it appears consistent with other jurisdictions.

Finally, note that the Fiji case deals with a dispute between private parties. The analysis would almost certainly be different in a situation where the government is a party to the contract. This is because there is a doctrine of constructive termination for convenience in government contracts, and there has been some recent discussion about whether and how the Government can use the doctrine retroactively to avoid a breach claim.

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