Law in Action - Terminating Contracts – Practicalities and Pitfalls

In the current economic climate, contracts are being terminated more frequently than ever. This could be due to parties not being able to uphold their contractual obligations because of the current pandemic, or parties may see the current climate as an opportunity to escape contracts that they no longer wish to be a party to. Regardless of the motivating factors, the terminating party must be sure of its legal position before terminating the contract as the decisions made at the point of termination can have wide-ranging and serious consequences.

In this article, we provide a refresher of some of the practicalities of termination and the pitfalls a party needs to avoid when terminating a contract to avoid costly mistakes.

Legal basis of termination

Before terminating a contract, it is very important for the terminating party to consider the legal basis upon which it is seeking to terminate.

There may be an express (or implied) contractual right to terminate where a certain event of default occurs. This could be, for example, where there is an insolvency event (unfortunately all too common in the current climate) or where there has been a material breach of contract. There is no strict legal definition of a material breach (or of other defined breaches, such as serious/significant); it is fact specific and subject to the court’s interpretation, and so any termination based on a material breach of contract must be extremely carefully thought out.

If there is no contractual right of termination, then the terminating party will need to consider whether it has a common law right to terminate. Even if the contract in question contains contractual termination rights, it is still important to consider whether a common law right exists, as any damages awarded for breach of contract may be different depending on the basis for termination used (see further below).

The common law right to terminate is available to all parties who have entered into contracts whether or not a contractual termination clause exists (unless very clearly expressly excluded and this is rare). There is generally a right to terminate a contract pursuant to the common law if there has been a repudiatory breach of that contract.

Broadly, a repudiatory breach is a breach of contract so serious that the court considers it goes to the root of the contract or it deprives the innocent party of substantially all the benefit it was to receive pursuant to the contract. There is also a common law right to terminate when one party refuses to perform its obligations under a contract (called renunciation).

Practicalities

Termination is very rarely automatic. Once a party has decided to terminate a contract then it is important that clear and unequivocal notice is given and, if appropriate, that any contractual provisions governing notices are strictly complied with. In addition, it is important to state clearly in the notice on what grounds you are terminating the contract and it is critical to get this right at the outset.

It is also important to understand the effect that termination has on a contract. Often parties consider that once a contract is terminated then it is as if the contract never existed and the parties should be put back in the position they were in, had it never existed. However, that is not correct; once a contract is terminated the contract still exists, it is just that the parties are released from their main (primary) obligations. Any accrued rights (e.g. rights to be paid for goods or services supplied that have accrued prior to termination) continue post-termination as do secondary obligations, which may include duties of confidentiality or clauses, such as the governing law clause or the dispute resolution clause.

It is therefore important to consider whether there are any secondary obligations in the contract that would survive termination, which would render termination inappropriate or commercially unviable for the terminating party, such as an obligation to return equipment or data or an obligation to vacate premises. It would also be important for the terminating party to consider whether any obligations it requires to be preserved, such as any duty of confidentiality owed by other party, would survive termination.

In addition to the legal practicalities, a party considering terminating a contract should consider the commercial consequences of doing so. Terminating a contract is very likely to result in the end of the commercial relationship with the other party. If the terminating party wishes to avoid that, then it may be open to it for example, to suggest a renegotiation of the contract instead of termination. It is also open to an aggrieved party to affirm (continue) the contract but to claim for damages if it is has suffered a loss as a result of the other parties’ breach of contract, rather than electing to end the agreement. Once a contract is terminated, it is likely that the terminating party will then need to issue a claim for its losses that have occurred because of any breach of contract.

Pitfalls

It is vital to be careful of wrongfully terminating a contract. Wrongful termination can occur when the terminating party sets out the wrong grounds for termination or in fact does not have a right to terminate the contract at all. If this happens, the party who has wrongfully terminated the contract is itself in repudiatory breach of contract. The innocent party could then accept that repudiatory breach, terminate the contract and claim damages from the party who wrongfully terminated. This is why it is so important to carefully assess the legal basis of termination prior to serving a termination notice.

It is also important to note that failing to give clear and unequivocal notice and to follow any contractual notice provisions may result in the termination being ineffective and the contract continuing with the right to terminate being lost. Where a party has valid grounds for termination, it should not delay in terminating; any significant delay is likely to mean that the right to terminate for that specific breach/event of default could be lost.

A delaying party is also in danger of affirming the contract. This happens when a party who has a right to terminate continues to perform the contract after the breach or event of default occurs. The right to terminate for that specific breach/event of default will have been lost in those circumstances. A party may consider that it has a clear, express right to terminate pursuant to the contractual termination provisions and think, therefore, that the safest option is to use those rights to terminate the contract. However, the terminating party needs to assess whether or not it also has a common law right to terminate for repudiatory breach and if it does, the termination notice must expressly set this out. Failure to do so may mean that the opportunity to claim loss of bargain damages (i.e. future damages it would have received had the contract continued) is lost. This can be a very costly mistake for the terminating party and can result in millions of pounds of lost damages. If a party does have a right to terminate under the contract and by common law, then it can use both grounds for termination providing the contractual rights are not different and inconsistent to the rights pursuant to common law.

Summary

This article highlights that while in the current economic climate it may be extremely tempting to rush into termination and to terminate underperforming contracts, termination of a contract can be fraught with difficulty and must be carefully managed from the outset. Where a party to a contract wishes to terminate, it must first critically assess the background facts to ensure it has proper grounds to terminate. If it has grounds to terminate the contract, both under common law and pursuant to the contract, it must consider which ground to rely on and/or whether it can use both. The terminating party should also take great care when drafting the notice of termination and must be wary of wrongful termination at all stages.

It is advisable to seek legal advice as soon as you consider you may have a right to terminate a contract so that you can be confident in your position and to obtain assistance with drafting the notice of termination if required.