Mitigating risks in contract termination

16th September 2022

From time to time, you will have undoubtedly been approached by colleagues for counsel on how the business can extract itself from a contract which no longer serves its needs. That is a good place to be, of course, as experience shows that, in many cases, advice is not sought until after steps to terminate a contract have already been taken, by which time it may then be too late to avoid a dispute arising.

Lack of profitability, a change of business direction or reputational concerns are but a few reasons why it may be in the interests of the business to terminate a contract before it has run its course. However, while the commercial rationale might be straightforward, terminating a contract is a risky business which can (and not uncommonly does) result in an unwelcome and costly dispute.

The starting point, therefore, is ensuring that commercial and operations teams are alive to the possibility that terminating a contract could well result in the company having to pay compensation to a counterparty to the contract and put the business at a significant commercial disadvantage.

Having established that there are risks associated with contract termination, the next issue to address is how those risks might be mitigated. Below are some key questions that are important to consider in that context.

What are the implications of terminating the contract?

You may find yourself jumping out of the frying pan and into the fire unless you evaluate the consequential effects that contract termination may have on the business and other relationships.

Thought should be given to the ‘law of unintended consequences’ both in terms of legal and commercial relationships. For example, will there be an impact on other relationships up and down the supply chain or on finance terms and arrangements and if so, what should be done to address these risks? Might commercial partners – including the bank – or the market perceive a contract termination to reflect badly on the business if it comes to light? Is a communications strategy required?

Looking introspectively, will the termination prompt the need for adjustments to the workforce? This point needs to be carefully thought through and the balance of risks considered in conjunction with relevant teams in the business, including HR.

The character of the legal relationship in question may also be highly material. For instance, if the regulations concerning relationships of commercial agents apply, you will need to factor into the risk assessment any risk of liability to compensate or indemnify an agent.

Do you have a right to terminate under the terms of the contract?

However beneficial termination may seem from a commercial perspective, the company may find itself on the receiving end of a damaging breach of contract claim if it purports to terminate a contract without being entitled to do so. Contractual relationships can only be terminated before the end of their term under certain circumstances. It is therefore critical to assess the commercial objective and contract terms against the backdrop of all the prevailing and anticipated circumstances.

The starting point may be to consider whether the parties can terminate on notice “for convenience”. So long as the procedural formalities concerning service of notice are complied with, exercise of such a right carries a low risk of dispute as there is little scope for debate as to whether the circumstances entitling termination have arisen.

It is more likely that the contract will limit termination rights to the occurrence of specific events and the terms will need to be scrutinised to analyse whether a right to terminate has arisen. For example, you may need to advise a colleague hoping to terminate due to a default by the counterparty as to whether the breach meets any ‘materiality’ threshold set out in the contract, whether it is capable of being remedied and, if so, whether notice to remedy needs to be given before the termination right can be exercised. A definition of what amounts to a ‘material breach’ is notorious for its absence from many contracts.

Similarly, where the concern prompting the wish to terminate early is the counterparty’s financial condition and the contract includes provisions for termination in the event of a party’s inability to pay its debts or an insolvency procedure, the precise words in which the ‘insolvency’ events and procedure are described need to be very carefully examined and held up against the evidence of the counterparty’s financial condition.

While the instinct may be to jump ship if it appears the other party may not be able to discharge its financial or other obligations and may be heading towards insolvency, termination on this ground may not be straightforward or the best option in the circumstances and careful thought is therefore required.

Where performance of a contract has been interrupted, prompting thinking on early termination, another aspect to explore is whether there is a ‘Force Majeure’ provision and how it may operate in the circumstances. These provisions commonly provide for the suspension of performance of a contract whether the interruption is for reasons outside the control of a party. They may, however, allow for termination after performance of the contract has been suspended for a specific period of time. This route to an early termination will necessarily therefore require analysis of whether the circumstances fit the events specified in the ‘Force Majeure’ provision in the contract and ensuring that any notice requirements are complied with.

Can you terminate other than under the terms of the contract?

If the contract does not expressly permit termination in the circumstances, the company may be able to rely on implied rights. Unless expressly excluded, a party is entitled to terminate if the other party has committed a ‘repudiatory breach’ which is sufficiently serious that it will deprive the other party of ‘substantially all the benefit it was intended to receive’. A refusal or inability to perform the contract might constitute such a breach but it will depend on all the circumstances in play. Exercise of implied rights should be approached with caution – there may well be a dispute as to whether the breach was sufficiently serious to justify termination which could lead to a breach of contract claim for invalid termination.

In circumstances where the contract would otherwise be perpetual and unworkable, the law may imply a term entitling the parties to terminate upon reasonable notice as it is assumed that the parties cannot have intended the contract to last in perpetuity.

Are there any concerns about delay or waiver?

Once you have established that termination is permitted, if not acting immediately, you will need to beware of losing that right either by delay in acting or by conduct which amounts to an express or implied waiver. For example, allowing more time for payment of an overdue invoice may constitute an implied waiver of a right to terminate on the grounds of late payment.

To minimise risk, you should reserve your rights as early as possible in communications with the other side and be wary of relying on any ‘no waiver’ provisions in the contract.

How should you terminate the contract?

If the method for contract termination is prescribed by the agreement, that process must be followed rigorously to avoid falling at the last hurdle. You must ensure that the delivery method, timing and contents of the notice are compliant to avoid serving an ineffective notice which could lead to an actionable breach of contract if you treat the contract as terminated and cease to perform your obligations.

In any event, the contract notice must be clear and unequivocal. It is also important to ensure that you communicate with your colleagues across the business to avoid the termination notice being contradicted by the actions of other departments of the business – for example continuing to send out invoices as if the contract remained in force.