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What are the consequences of terminating a commercial contract?
Rachel Hayward, Associate in Goodman Derrick’s Corporate team, looks at the potentially costly consequences of not getting a contractual termination right, and encourages a cautious approach to the entire process.
Common oversights when terminating a contract and their consequences are:
Terminating the contract on the mistaken belief that there is a right to do so. This could be treated as a repudiatory breach of the contract, entitling the other party to accept the repudiation, end the contract and sue for damages.
Failing to give the most favourable ground of termination in the termination notice, taking into account both contractual and common law termination rights. This could have a significant impact on the amount recoverable by the terminating party.
Failing to comply with the applicable contractual termination procedure. This could mean that the termination has no effect.
It is therefore always worth taking the time to ask the following questions before terminating a commercial contract:
- Do I have a contractual right to terminate?
- Do I have a common law right to terminate?
- Which termination rights should I exercise?
- Is termination the best solution for my contract?
- How can I terminate my contract in the best way?
1. Do I have a contractual right to terminate?
Many contracts give one or both parties the express right to terminate the contract if certain specified events occur, such as if the other party materially or repeatedly breaches the contract, or enters administration, becomes (or is at risk of becoming) insolvent or ceases to trade.
It is important to carefully review the relevant termination clause and not to jump to conclusions as to whether a termination right has arisen; this will be a question of fact and interpretation in each case and is commonly disputed between parties. Terminating a contract without the right to do so could have significant financial consequences for the terminating party (see “Which termination rights should I exercise?” below).
Particular care should be taken when terminating a contract in reliance of a contractual right to terminate for “material breach”, especially where the contract does not define what is meant by this term (as is often the case). Whilst the courts have provided guidance as to what might constitute a “material breach”, it is not always clear cut, and there have been cases where parties have been found to have wrongfully terminated a contract on the ground of “material breach”.
2. Do I have a common law right to terminate?
A party wishing to terminate a contract should also consider whether a common law right to terminate the contract has arisen. At common law, if a party commits a repudiatory breach of contract, the other party may elect to accept the repudiation, terminate the contract and claim damages. A repudiatory breach is a breach that deprives the aggrieved party of substantially all of the benefit of the contract.
It is important to identify any common law termination rights even where a contractual termination right has already been identified, as the financial consequences of terminating a contract under the contract and at common law may differ. In particular, damages for loss of bargain are generally recoverable following termination for repudiatory breach, but are not recoverable following termination under most contractual provisions.
Note that some contracts modify or exclude a party’s common law right to terminate the contract; the contract should therefore be reviewed prior to termination to ensure that this is not the case.
3. Which termination rights should I exercise?
Once all potential termination rights have been identified, the strength of each right should be vigorously tested. Terminating the contract without the right to do so could itself be a repudiatory breach of contract, entitling the other party to accept the repudiation, end the contract and sue for damages.
Particular care should be taken when terminating a contract for non-payment of sums due under the contract, where the ground of termination is “material breach” under the contract or repudiatory breach at common law. Disputes frequently arise between parties in relation to how many missed payments, or how long of a delay in payment, meets the threshold for “material breach” or repudiatory breach.
Consideration should then be given as to which right (or rights) it would be most advantageous to exercise. If more than one termination right has arisen, it will often be possible to exercise them concurrently. However, if the consequences of exercising the rights are inconsistent, it will be necessary to choose between them, or (preferably) to cite them in the alternative.
Importantly, the termination notice should clearly identify all of the termination rights being exercised (both contractual and at common law). In most circumstances it will not be possible to subsequently claim that the contract was terminated pursuant to a right not identified in the termination notice (even if that right was capable of exercise as at the date of termination). This could have significant financial consequences if a ground of termination that a party later wishes to rely on is omitted from the termination notice.
For example, if a party has accrued rights to terminate a contract: (i) at common law for repudiatory breach; and (ii) under an express contractual provision arising independently of the breach (such as the other party entering into administration), but only refers to the contractual termination right in the applicable termination notice (and does not refer to the breach), then the terminating party will not be able to subsequently claim that the contract was terminated at common law for repudiatory breach, and will not therefore be entitled to recover damages for loss of bargain.
Similarly, if in the above scenario the termination notice only referred to the repudiatory breach (and did not refer to the contractual termination right), and the court subsequently held that there was no such repudiatory breach, the termination notice could not then be interpreted as exercising the contractual termination right.
4. Is termination the best solution for my contract?
It is not possible to revoke or withdraw a termination notice; it is therefore imperative that a party assesses all of their options prior to terminating a contract. If a party ends a contract and later changes their mind, they may find themselves in the undesirable position of re-negotiating a new contract with the original counterparty, who may demand more favourable terms than those set out in the original contract.
Depending on the circumstances, it may therefore be worth considering whether it would be more advantageous to attempt to renegotiate the contract with a view to varying the contract, or to resolve the conflict through mediation, rather than terminating the contract. Existing termination rights should be expressly reserved whilst any such renegotiations or discussions are taking place, in order to minimise the risk of such rights being lost (see “How can I terminate my contract in the best way?” below).
5. How can I terminate my contract in the best way?
A party exercising a right to terminate a contract should give a clear and unequivocal communication of the termination to the other party. If the contract sets out a prescribed method for communicating the termination to the other party this should be followed exactly; otherwise the termination may not be effective.
It is also important to check that the applicable termination rights have not been lost before being exercised; both contractual and common law termination rights can be lost if there is a delay in their exercise or if the terminating party’s actions are inconsistent with their exercise.
As noted above, it is critical that the termination notice clearly identifies all of the termination rights being exercised (both contractual and at common law). In addition, the relevant provisions of the contract should be referred to and (if applicable) clear and concise information about each breach should be provided.
It is understandable why parties sometimes act in haste when terminating commercial contracts, for example if the counterparty becomes insolvent or has stopped performing their obligations under the contract. However, by failing to consider the above issues, a party may find that they are unable to recover damages that they would otherwise have been entitled to, or may even find that they have wrongfully terminated the contract, which could have adverse financial consequences.
This guide is for general information and interest only and should not be relied upon as providing specific legal advice. If you require any further information about the issues raised in this article please contact the author or call 0207 404 0606 and ask to speak to your usual Goodman Derrick contact.