It is a fact of life that circumstances change, sometimes when the virtual ink is still wet on a contract. Parties fail to perform their obligations, new opportunities arise that make existing contracts unprofitable and sometimes a global pandemic or invasion intervenes to change the economic climate. When something changes, the question for businesses is whether they and their counterparties are bound to continue to perform their obligations until the contract comes to an end or whether it is possible to terminate early, claim damages for any breaches of contract and move on to pastures new.
This article highlights key practical considerations for businesses from a litigator’s perspective.
Terminating a contract is a serious step. Before terminating it is vital for businesses to take a step back and ensure they get it right. Even if it seems clear that the other party has breached its contractual obligations, there are a number of interconnected issues to consider before terminating. Getting it right will maximise the innocent party’s commercial and legal leverage and give the best chance of a good outcome. Getting it wrong can mean losing the right to terminate and even handing the party in breach the right to terminate the contract and sue for damages for wrongful termination.
Grounds for termination
There are broadly two avenues for terminating a contract. The first is by exercising a right to terminate provided for in the contract. The second is by terminating for a repudiatory (ie, fundamental) breach of contract at common law.
Is there a contractual termination clause?
A party wishing to terminate should check the contract for a termination clause. This might simply allow one or both parties to terminate at any time by giving notice. Using such a clause is a low-risk route to termination because there is no need to prove a breach by the other party. However, the contract will remain in force until the notice period has expired, which can sometimes be a considerable period.
If a contract is open-ended or has become a rolling contract after a fixed period ends, it may be possible to terminate on notice. Doing so would require implying a term into the contract that it can be terminated on reasonable notice. That will usually be possible, but it is less straightforward than relying on an express clause.
Many contracts also contain clauses which allow for termination if a specified event happens. The most common are force majeure clauses which may give a party the right to terminate if the other party is prevented from performing its obligations by an event outside the parties’ control. Commercial contracts also often contain clauses to allow a party to terminate if the other party becomes insolvent. In both cases it is important to look closely at the wording of the contract to be certain that the right to terminate has been triggered before purporting to terminate.
Is the contractual termination right triggered?
A contractual right to terminate for breach often gives parties more control over when they can terminate compared with relying on the common law position. Usually, the contract sets a threshold of seriousness and gives the innocent party the right to terminate if the breach reaches that threshold. When drafting a contract it is difficult to capture all the nuances of what might happen, so there are often disputes about whether the threshold has been reached.
Some of the most common clauses provide that a party can terminate if the other party commits a "serious" or "material" breach. Courts have provided guidance on interpreting these terms. In practice, courts will often focus on the extent of the breach’s impact on the innocent party. That provides flexibility but inevitably means it can be difficult to predict whether the court will agree the threshold has been met in particular circumstances.
Is there a right to terminate at common law? Is the breach sufficiently serious?
If the contract does not contain an express termination clause, or if it has not been triggered, the other avenue to consider is whether the contract can be terminated for repudiatory breach at common law. A repudiatory breach is one that goes to the heart of the contract and deprives the other party of substantially all of the benefit of the contract. That is a relatively high hurdle and is a fact-specific question which has been the subject of much litigation. There are numerous nuanced judgments on whether breaches of contract are repudiatory breaches which provide helpful guidance, but this question is often a battleground.
Is terminating the contract the best commercial approach?
It is important to remember that a repudiatory breach does not automatically terminate the contract. It gives the innocent party the right, but not the obligation, to terminate. That gives rise to a key strategic question: is termination the right course for your business? There are many factors to consider, including the economic value of the contract, the availability of alternative customers or suppliers, the length of the relationship with the other party and, perhaps, any reputational consequences of terminating. Sometimes it is preferable to give the defaulting party an opportunity to remedy the breach, to seek damages for any losses caused by the breach and seek to vary the terms of the contract.
A party considering terminating should also remember that terminating a contract without a right to do so will itself amount to a repudiatory breach which the other party could accept and then sue for damages. Once notice of termination has been given, it cannot generally be revoked. An overly aggressive approach can therefore quickly turn a strong position into a much weaker one.
How long do I have to terminate the contract?
When relying on a contractual right to terminate the deadline will depend on the wording of the termination clause. Such clauses often include a deadline for terminating once a breach has arisen and those deadlines can be quite short. If notice is not given in time, the right to terminate can be lost.
When seeking to rely on the common law right, the innocent party has a reasonable time to investigate the breach and to decide to terminate. What is "reasonable" will turn on the facts, but generally courts have ruled that the longer the term and more complex the contract, the more time is allowed. If a party does not terminate within a reasonable time, the right can be lost because it is seen as having implicitly accepted that the contract should continue. Parties should also be mindful of affirming the contract inadvertently through continuing to perform contractual obligations.
Are there any procedural requirements?
Whether terminating under contractual provisions or at common law, the terminating party must give notice to the other party. Any procedural requirements in the contract must be followed or the termination may not be effective. The contract might simply prescribe a method of delivery of the notice or may set out in more detail the form notice must take. In the absence of specific requirements in the contract there is no prescribed form of notice, but it must be clear and unequivocal that you intend to terminate. It is also generally important to set out the grounds for termination and when termination will be effective.
Parties should also check whether the contract has a dispute resolution clause that might restrict the right to terminate. Some contracts set out various escalatory steps to encourage the parties to seek to resolve their differences, which must be followed before the contract is terminated.
Implications of termination
What clauses, obligations and accrued rights survive termination?
Termination does not undo a contract as if it had never existed. Instead, the contract continues to exist after termination, but the parties are usually released from their primary obligations. Contractual obligations that survive generally relate to ancillary obligations which can nevertheless be important, including duties of confidentiality, the return of property or information belonging to the other party, indemnities, and dispute resolution and jurisdiction clauses.
A party’s rights that accrued before termination also generally survive termination. These include a party’s right to be paid for goods or services provided under the contract, rights relating to intellectual property, restrictive covenants, liquidated damages and causes of action. The length of survival of those rights will depend principally on any express term of the contract but will ultimately be restricted by statutory limitation periods.
Is there a claim for damages?
A party in breach of contract will be liable for any damages arising from that breach whether or not there is a right to terminate and whether or not the contract is actually terminated. The basic principle is that damages should put the innocent party into the position it would have been if the contract had been properly performed. Where the contact has been breached, subject to any alternative provision in the contract such as a liquidated damages clause, damages would include losses directly caused by the breach and potentially also losses caused by the fact that the contract has been terminated (ie, expectation losses).
A claim for damages can be very valuable. Pursuing a claim is likely to strain an ongoing contractual relationship, but commercial leverage may be lessened if the contract has been terminated. The value of a claim must be considered carefully against the costs and risks of pursuing it, alongside the question of whether or not to terminate.
This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.
© Farrer & Co LLP, December 2022