TERMINATION FOR CONVENIENCE AND ISSUES RELATING TO THE CONTRACTUAL RESERVATION OF A UNILATERAL RIGHT OF TERMINATION
By Jon athan P. Sauer
One provision that we have been seeing increasingly more frequently in the contracts of the large and/or sophisticated and/or of those in a position to essentially dictate terms is a provision to allow a party to essentially terminate a contract upon one's own unilateral determination (or, whim) without warning or grounds and without consequence as to being exposed to claims for breach of contract damages.
EXAMPLES OF SUCH PROVISIONS
The first thing to keep in mind is that those who place these provisions in contracts do not necessarily want to let their contracting parties (victims?) know, in advance, that they intend on reserving the right to unilaterally terminate an ongoing contract without penalty (and without cause). Therefore, and even more creatively drafted (and placed) than the artful phrasing of a "no damage for delay" or "pay-when-paid" clause, one should examine all portions of a contract document to see whether or not there is such a provision. This type of provision need not be contained just in the basic contract form but could be contained in supplementary general conditions, special general conditions or the general conditions.
Here are a couple of examples from our files of what such a clause might look like.
The first example is a substantial contract between a national corporation and a general contractor whereby the general contractor would provide services.
Although the document is, in reality, a construction contract, it was titled "Service Agreement". In various provisions of the document and in various appendices, the general contractor was referred to as "The General Contractor" and the document was referred to as a "Construction Contract". However, the following language under the section heading 'TERM', was contained in the document:
"This Agreement shall continue in full force and effect for a period of one year from the date of this Agreement and from year to year thereafter. It is agreed and understood, however, that either party may cancel this Agreement by giving the other party thirty (30) days written notice of such cancellation, but neither party hereto shall, by termination of this Agreement, be relieved of its respective obligations and liabilities arising from or incidental to work performed or services rendered hereunder prior to the time this Agreement is terminated."
Some one and one- half years after this contract was entered into, and after the general contractor and one of its subcontractors had done preparatory work and undergone a significant amount of training, the national corporation sent a letter to the general contractor and attempted to invoke its right to simply terminate the contract, the actual construction work never having really begun. (Ultimately, we assisted the general contractor in collecting seventy-five thousand dollars in exchange for a release.)
In another contract form - again, with a national and extremely large organization - the contract in question was quite large with the basic contract form of ten pages being the least of all of the contract document elements. There were, additionally, various exhibits, including various forms that would be used and general conditions, which general conditions were twenty-nine pages in length. Contained in one of the general conditions was a clause that:
"Upon seven days' written notice to CONTRACTOR and ENGINEER, OWNER may, without cause and without prejudice to any other right or remedy of OWNER, elect to terminate the Agreement. In such case, CONTRACTOR shall be paid (without duplication of any items). . .for completed and acceptable Work executed in accordance with the Contract Documents prior to the effective date of termination, including fair and reasonable sums for overhead and profit on such Work . . . for expenses sustained prior to the effective date of termination in performing services and furnishing labor, materials or equipment as required by the Contract Documents in connection with uncompleted Work, plus fair and reasonable sums for overhead and profit on such expenses; . . .for amounts paid in . . .for reasonable expenses directly attributable to termination. CONTRACTOR shall not be paid on account of loss of anticipated profits or revenue or other economic loss or any consequential damages arising out of such termination." (Emphasis added)
THE SIGNIFICANCE OF THESE TYPES OF CLAUSES
Ordinarily, one cannot walk away from the performance of a contract without the other party’s agreement without suffering the consequences of being liable for breach of contract damages. What are those damages? An older Massachusetts case defines them as follows: "Upon any breach of contract, whether of warranty or otherwise, the defendant is liable for whatever damages follow as a natural consequence and the proximate result of his conduct, or which may reasonably be supposed to have been within the contemplation of the parties at the time the contract was made as a probable result of a breach of it." Thus, future prospective profits may be recoverable. Also, in Massachusetts - and by statute - a party who suffers a breach on the part of his contracting party is entitled to interest at the rate of 12% from the date of breach or from the date of initiation of court action to recover damages. Of course, the increased costs of completing the other party's performance - if applicable - which amounts are in excess of those monies remaining in the contract are also damages to be recovered.
In each of the two examples cited above, it goes without saying that the general contractor entered into the contract for the purposes of earning a profit. In a usual situation outside of the presence of such a clause, hopefully, after the expenses of the job have been paid, there will be a profit to be enjoyed as the benefit of having performed the contract work. After all, working for a living puts bread on the table but working for a profit puts a Ferrari in the garage! When one ceases to go ahead with the performance of a contract without contractual or legal right, one becomes liable for these types of damages. Legal writers reference the type of clause under discussion in this article as an "option to terminate".
Traditionally, this type of clause was found in leases, employment contracts and other kinds of contracts, such as so-called "requirement contracts". "Requirement contracts", such as is codified in the Uniform Commercial Code, enacted in Massachusetts as Chapter 106 of the General Laws, may be: "A lawful agreement by either the seller or the buyer for exclusive dealing in the kind of goods concerned imposes unless otherwise agreed an obligation by the seller to use best efforts to supply the goods and by the buyer to use best efforts to promote their sale." (Chapter 106, § 2-306(2) of the General Laws.)
Massachusetts has enforced requirements contracts for a period of time. Where there seems to be litigation concerning these types of contracts is where there is a question as to whether or not one party or the other exercised good faith or where one party or the other either insisted upon (or refused to accept) a quantity that was "unreasonably disproportionate" (too little or too much) to either stated estimates or to normal or otherwise comparable prior requirements. In the construction context, many of the cases deal with material suppliers, such as suppliers of concrete.
It seems to us that for a fixed scope contract with a fixed price whereby a contractor is to supply both labor and materials to accomplish a certain goal, the employment by the party drafting the contract of an "option to terminate" is inappropriate, particularly where the circumstances under which a party might exercise this option are not fully disclosed and/or the clause is not negotiated but simply "buried" somewhere in the contract documents.
Two further points. First, such a clause in a contract allows one party to get rid of the other party where the bloom is clearly off the rose: incompetence, over-billing, ‘change orderitis’ without suffering any damages for so doing with regard to the work not performed.
Secondly, one has to remember the context of how such a contract provision originated. These clauses developed in federal procurement law for reasons such as the fact that when the building was designed many years ago, the building was needed. However, today, when that building is going to be constructed, the government no longer needs the building. Thus, developed the concept of ‘termination for convenience’.
One example – war story! - comes to mind in Massachusetts where a public building was designed to house large computers with significant cooling capacity and HVAC equipment. However, some years later, when the public owner was getting ready to construct the building, with most computers being small and without any particular need for cooling, the building, if built, would be anachronistic and of little value and too expensive. So, after there was a general contractor selected and ‘signed up’, this building was redesigned to be an ordinary office building. (The Law Offices assisted the general in getting a six figure settlement for delay damages in fewer than four months, notwithstanding that the contract clearly had a no damage for delay clause and the contractor’s claim was made significantly after the completion of the building and the execution of a release.)
WHAT IS A CONTRACTOR TO DO?
When confronted with such a clause in the contract, a resisting party might attempt by negotiation to mute its effect by making such a right a "conditional power" which could only be exercised by the happening of a certain condition precedent and that any attempt to exercise the power prior to the specified event(s) would be either inoperative or wrongful, causing the party exercising it to be liable for breach of contract damages. One such conditional event might be the unexpected loss of financing.
If "the party of the first part" - that is the guy with the money, the lawyers on retainer and a printed contract - insists on having an option to terminate contained in the contractual agreement, then it is appropriate - indeed, in most instances, necessary - to further add what specific costs will be compensable in the event that such clause is exercised. These costs are clearly and reasonably generously identified in federal procurement regulations.
What are the kinds of costs, then, that one should be looking for in attempting to dilute the otherwise potentially disastrous effect of an improvident or singularly selfish exercise of an option to terminate clause?
We would argue that the exercise of an option to terminate clause which is unilateral to one party – meaning, only one party can exercise such option - and which is not the result of actual negotiation between two contracting parties of essential bargaining power and strength as to this specific term is nothing more (or less) than what in federal government contracting is referred to as "termination for convenience". Therefore, one might look to the Federal Acquisition Regulations (FAR) for guidance as to what types of costs are typically compensable in the event that the government elects to terminate for its own convenience. These regulations are contained in 48 Code of Federal Regulations. With these ideas as guidance, one should extrapolate to one's own proposed contract such as of the following provisions make sense as areas of negotiation as to dealing with the effects of an option to termination clause in your contract.
Chapter 1, § 52.249-2 of the same dictates the procedures to be employed when the government exercises a termination for convenience in a fixed-priced government contract. After receipt of a notice of termination by the government contracting officer, the contractor is required to proceed with the following obligations. First, the contractor must stop work as is specified in the notice. Secondly, the contractor is to place no further subcontractor orders for materials, services or facilities, except as are necessary to complete the to-be-completed portion of the contract. Thirdly, the contractor is to terminate all subcontracts to the extent they relate to the work terminated. Fourthly, the contractor is to assign to the government, as directed by the contracting officer, all rights, title and interest of the contractor under the subcontracts terminated, in which case the government shall have the right to settle or pay any termination settlement proposal arising out of those terminations. Fifthly, as required by the contracting officer, the contractor shall settle all outstanding liabilities and termination settlement proposals arising from termination of the subcontract. Next, the contractor shall transfer title and deliver to the government the fabricated or unfabricated parts, work in process, completed work, supplies and other materials produced or acquired for the work terminated along with all completed or partially completed plans, drawings and other property that would have been furnished to the government, had the contract been completed. The contractor will complete performance of the work not terminated. The contractor may take any action that the contracting officer may direct for the protection or preservation of the property relating to the contract that is in possession of the contractor and which the government has or may acquire an interest.
The contractor will use its best efforts to sell any property to reduce payments which will be required from the government to settle the termination of the contract. And, after the termination, the contractor shall submit a final termination settlement proposal, which proposal must be submitted no later than one year from the effective date of termination, unless extended in writing by the contracting officer upon the contractor's written request. The contractor and the contracting officer are to agree upon the whole or any part of the amount to be paid because of the termination, which amount may include a reasonable allowance for profit on work done. However, the agreed amount may not exceed the total contract price as reduced by the amount of payments previously made and the contract price of work not terminated.
The types of costs which can be compensated for include: the costs of performing the work terminated, including initial costs and preparatory expense allocable thereto; the cost of settling and paying termination settlement proposals under terminated subcontracts that are properly chargeable to the terminated portion of the contract; a sum to reflect the profit the contractor would have earned on the contract, which either will not be payable or will be reduced if it can be demonstrated that the contractor would have sustained a loss on the entire contract had it been completed; the reasonable cost of settlement of the work terminated, including accounting, legal, clerical and other expenses reasonably necessary for the preparation of termination settlement proposals; storage, transportation and other costs reasonably necessary for the preservation, protection or disposition of the termination inventory.
Apart from these types of costs, a contractor entering into a contract with an option to terminate provision should give some consideration to whether or not the disputes clause applicable to performance of the contract is sufficient to determine what the allocable costs should be in the event of the exercise of this clause. It may be that there should be a more immediate (and less expensive) way of determining at least the major incurred costs – e.g. mandatory mediation within a relatively short amount of time - so that a contractor already suffering the loss of income from the contract not performed need not wait, for example, three years for a case to come to trial (or, for that matter, necessarily have to incur the costs of litigating to determine these costs). It may be appropriate, for example, to designate arbitrators to establish the fair value of the work in place, which arbitration clause might contain specific references for how long the arbitrators have to do their work, and what appellate rights there are, if any, from their determination.
It seems that option to terminate clauses may be enforceable in certain circumstances, particularly to the extent that they can be likened to negotiated clauses and/or to the provisions of either service or requirement contracts. The fact that a party tries to "tuck it to another party" by including an option to terminate clause without specifically enumerated conditions precedent might be an indication that this is a contract one does not wish to enter into. One should look for this type of clause when entering into, among other contracts, contracts with unknown and larger general contractors and owners and those contracts which have an element of risk to their performance (or to you, if they are not performed).
Lastly, one should always read any contract one enters into, as it is axiomatic - and usually enforced by the courts - that ignorance of what is contained in a contract one executes is no excuse and contracts which are not understood (or even read) are nonetheless completely enforceable.
This article is not intended to be specific legal advice and should not be taken as such. Rather, it is intended for general educational purposes only. Questions of your rights and obligations under the law are best addressed to legal professionals.
Sauer & Associates sees as part of its mission the providing information and education to the contractors it daily serves, which will hopefully assist them in the conduct of their business. Articles are available on a number of construction subjects (e.g. rights under payment bonds, how to present payment bond claims, the mechanics’ lien law, how to file a demand for direct payment) on this website.
Copyright Jonathan Sauer 1999