When negotiating terms at the start of any commercial relationship, focussing on how you and the other party can terminate that relationship might seem counterintuitive. However, businesses should always try to ensure they have contractual rights that allow them to exit from agreements that cease to be commercially/economically viable.
There are a number of termination rights which can be included in a commercial contract and some of the more important ones are set out in more detail below. Ultimately, it is for the parties to decide which termination rights should be included in their contracts and whether each termination right should be available to just one or both parties.
If you are currently negotiating a contract or looking for potential ways to exit from an existing contractual relationship, then please get in touch with one of the members of our Commercial team today.
Termination for Breach
One of the most common termination rights is the right to terminate when the other party has breached the terms of the contract. Usually, this right is exercisable by both parties.
To avoid a party being able to terminate the contract for the most minor of infringements, the right to terminate for breach is often limited to where there has been a “material” breach of the contract (i.e. a breach of an important term that goes to the heart of the contract). Where this is the case, the parties may wish to consider:
- specifying certain clauses that, if breached, will constitute a “material” breach and give rise to a right to terminate for breach (e.g. breach of data protection or confidentiality obligations or an obligation to comply with applicable laws); and
- a right to terminate for “persistent” breach. This will ensure that a party is still able to terminate the contract where the other party continually/persistently breaches the contract but none of those breaches on their own would constitute a “material” breach.
In the vast majority of cases, it is reasonable to expect that the party in breach should have a period of time within which to remedy such breach and, if successful, avoid the termination of the contract.
Termination for Critical Service Failure
Where a contract contains service levels, the customer may seek to include a right for it to terminate for breach in circumstances where the supplier repeatedly fails to meet those service levels and KPIs, in what is often referred to as a “Critical Service Failure”. In negotiating what constitutes a Critical Service Failure, the parties will need to consider:
- how many breaches of a specific service level will constitute a Critical Service Failure (e.g. failure to deliver goods on the delivery date on [2/3/4] separate occasions);
- how many combined breaches of any of the service levels will constitute a Critical Service Failure (e.g. failure to meet any of the service levels a combined total of [4/5/6] times);
- within what period of time breaches of one or more service levels must occur in order for a Critical Service Failure to be deemed to have occurred (e.g. a failure to deliver goods on the delivery date on 3 separate occasions within a period of two months).
Termination for Non-Payment
Rather than service levels, the breach that a supplier will be most concerned about is non-payment by the customer. Whilst one could argue that non-payment is just an example of a “material” breach, it is quite common to see termination for non-payment as a separate termination right available to the supplier.
Just as with the general right to terminate for breach, it is reasonable to give the customer a set period within which to pay and thereby avoid the termination of the contract.
A customer in a strong negotiating position may seek to secure a longer remedy period to correct any instance of non-payment than that for remedying other material breaches. It may also try to prevent the supplier from exercising its right to terminate for non-payment unless the outstanding amount passes a certain threshold.
Termination for Insolvency
This is another common termination right which is usually exercisable by both parties. Consideration should be given to the various ways in which a party could experience an “insolvency event”, with the parties ensuring that all of these are covered in the right to terminate for insolvency (e.g. negotiations with creditors, insolvency, liquidation, administration, receivership (etc.)). Where one of the parties is an individual, reference to bankruptcy should also be included.
Following the introduction of the Corporate Insolvency and Governance Act 2020, a supplier cannot terminate a contract if its customer enters any form of insolvency proceedings. To guard against this and ensure that it is does not end up locked into a contract under which it is required to continue to deliver goods or services to a customer who is unlikely to be able to pay, the supplier will often seek to:
- draft the mutual right to terminate for insolvency so that this can be exercised either: (a) where a party becomes subject to insolvency proceedings; or (b) where the terminating party reasonably believes that the other party will become subject to insolvency proceedings;
- include additional grounds for termination which allow either party to terminate the contract where the other party’s financial position begins to deteriorate, thus allowing the terminating party to step in early and terminate before the other party becomes subject to formal insolvency proceedings;
- enforce payment terms more rigorously throughout the duration of the contract.
Termination for Convenience
Parties can agree for either one or both of them to have a right to terminate the contract “for convenience”, in other words, without needing a reason to do so. This right to terminate is often one of the most hotly contested termination rights, as it creates significant uncertainty as to how long the contract will last.
From a supplier’s perspective, a customer’s right to terminate for convenience poses a significant risk to the amount of income it will have anticipated generating under the contract and may also threaten its ability to recover any costs incurred in delivering the goods/services.
From a customer’s perspective, a supplier’s right to terminate for convenience poses a significant risk to continuity of service and may result in it having to pay above market rates to procure replacement goods and/or services at short notice if the supplier unexpectedly exercises this right.
It is therefore important for both parties that an appropriate amount of notice is provided by the party terminating the contract for convenience. The customer will want sufficient notice to give it enough time to appoint a replacement supplier and to transition the goods/services to the replacement supplier in an organised manner. The supplier will want sufficient notice to give it enough time to mitigate unrealised income (e.g. by selling off any leftover stock) and identify new customers/revenue streams. Depending on the circumstances, it may be that each party must serve a different period of notice in order to terminate the contract for convenience.
The supplier may also want to place additional conditions on the customer’s right to terminate for convenience. Such conditions could include:
- the customer only being able to exercise its right to terminate after a certain point in time in the duration of the contract (e.g. the customer may only terminate the contract for convenience after the third year of the five year term of the contract). This will help reduce the amount of stranded costs and unrealised revenue suffered by the supplier;
- the supplier being able to recover from the customer any stranded costs it has incurred (these could include unrecouped start-up costs, capital expenditure, investments and third party contract commitments). The mechanism for calculating such stranded costs can often be quite complex and will take into account factors such as the depreciation of any assets the supplier has purchased in order to perform the contract;
- the customer having to make a termination payment in respect of the supplier’s unrealised income/profit for the remainder of the contract. A mechanism for calculating the amount of such termination payment will need to be agreed and will largely be based on when the customer serves notice to terminate.
Termination in connection with a Change to the Charges
In long-term contracts, the parties may agree to include provisions which allow them to make changes to the supplier’s charges at fixed intervals throughout the duration of the contract.
For those provisions where the parties must agree any change that a party proposes to make to the charges, one question looms large: what happens if the parties cannot agree?
If the price of goods and/or raw materials has significantly increased since the contract was entered into, the supplier may consider that it cannot continue to provide its goods or services at the same rates without incurring a significant loss. Likewise, if the market rate for the goods or services has significantly dropped since the contract was entered into, the customer may consider the contract commercially unviable at the supplier’s current rates.
In either of the above cases, one of the parties would propose a change to the charges which may not be acceptable to the other. If that is the case, it is important that the parties have a termination right which allows them to terminate the contract at the end of such negotiations so as to avoid being locked into a contract which is no longer commercially viable.
Termination due to Change of Control
Either party may wish to include a right to terminate the contract if the corporate ownership of the other party changes.
The supplier will want to guard against the customer being acquired by one of its competitors and having to provide goods or services to a rival business, which may consequently learn valuable information about how the supplier provides its goods or services. Likewise, the customer will be keen to avoid a supplier being acquired by one of its competitors and having to pay such competitor for the receipt of goods or services. Such new supplier may not be as incentivised to deliver a high quality service.
Termination due to Force Majeure
Parties will often include a force majeure clause in their contracts which absolves them from any failure to perform their contractual obligations where this is caused by an event beyond their control.
Of course, if a force majeure event continues to prevent a party from performing its obligations, there may reach a point where it becomes commercially sensible for the parties to be able to terminate the contract, rather than continue to be locked into a contract that has little or no prospect of being performed.
As such, parties may wish to include a right to terminate the contract where a force majeure event continues to prevent or delay a party from performing its obligations for a specified period of time. What that period of time should be is open to negotiation and will depend on the commercial circumstances in each case, in particular how long the customer can cope without the goods or services being provided (assuming it is the supplier seeking to rely on the force majeure clause in the first place).
The above list provides a timely reminder that a written contract, professionally and properly negotiated, will stand a business in good stead if an event occurs that disrupts or changes its operations. Although it’s impossible to foresee every eventuality, having termination clauses in the contract will help to protect both parties – as was demonstrated during the Covid-19 pandemic when many businesses had to rely on these clauses to survive.
