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Disputes Essentials: Taking the sting out of terminating contracts

Posted on 23 October 2023

On Wednesday 27 September 2023, Mishcon de Reya hosted the first in a new series of Disputes Essentials breakfast seminars, which aim to provide the latest updates and practical insights on essential dispute-related topics.

This first seminar focused on the perennially tricky issue of termination of contracts, a particularly hot topic in the current economic climate, where once profitable contracts no longer work the way the parties intended, and businesses face financial difficulties which endanger performance obligations. A high-level summary of the discussion is set out below for those looking for a refresher or who were unable to attend.

What is termination?

Termination essentially ends a contract by bringing the parties' primary obligations to a close. However, it is important to be aware that the contract itself still exists, and the parties may remain subject to post-termination obligations, such as to make outstanding payments, confidentiality, or exit services.

Termination can arise under a contractual provision or under the common law, by acceptance of a repudiation. These different termination rights give rise to different remedies. Terminating for a repudiatory breach entitles the terminating party to claim damages, including for the loss of the contract, whereas terminating pursuant to contractual rights may yield remedies expressly given under the contract.

Why do parties to a contract terminate?

If a party has failed to comply with its contractual obligations, then terminating is one way to deal with the problem. However, not every breach of contract will entitle a party to terminate.

Under the common law, a party can only terminate if a breach is repudiatory in nature. Effectively, that means the breach must be a breach of a condition of the contract, or a breach which deprives the other party of substantially all the benefit of the contract. It is worth bearing in mind that non-payment (or repeated delays in making payment), will generally not be considered "repudiatory" unless you can show that the other party no longer intends to perform the contract.

Determining whether a breach is repudiatory in nature can be difficult, and so parties often prefer to include express termination provisions in their agreements, permitting termination for "material" breaches or for payment delays. Equally, parties may seek to include provisions permitting termination for convenience, or upon reasonable notice, which provide even greater flexibility.

Historically parties have also sought to provide for termination rights in the event of the insolvency of their counterparty. However, such "ipso facto" clauses have been inoperable in agreements for the sale of goods and services since the implementation of the Corporate Insolvency and Governance Act 2020, which came about as part of Government reforms intended to ensure supplies are not cut off and insolvent companies held hostage.

Termination is an extreme option, and the mere threat of termination can be effective in getting the other party to cure a breach. However, parties should be particularly cautious to avoid taking steps to affirm the contract, thereby inadvertently losing their right to terminate.

Drafting termination provisions

As with all drafting, clear wording is required when drafting termination provisions.

If providing for termination in the event of a "material" breach, it is important to remember that there is no legal definition of "material" breach and so parties may prefer to draft their own definition. If not, in determining whether a breach is "material", the court will look at all the circumstances, including the contract itself, the nature of the breach, any explanations for it, and its impact.

While ipso facto clauses (clauses that allow one party to terminate simply because the other party is insolvent) are generally no longer operable, parties may wish to include provisions enabling termination in the event of an insolvency-related event which arises before a company enters into a formal insolvency process, such as balance sheet insolvency, late payment or even where a company experiences financial difficulties.

Termination clauses also commonly provide for termination rights in the event of a change of control in the counterparty, and if so it may be appropriate to require written notice to be given of any change of control.

Particular thought should be given to termination for convenience clauses, which enable a party to terminate in the absence of any breach. Can the termination power be triggered by either party, what notice should be given, should the contract provide for a minimum term and is it appropriate to include a term providing for compensation in the event of early termination? All these matters will depend on the nature of the contract and the bargaining power of each party.

Exercising termination rights

Termination requires clear and unequivocal communication. It is advisable for that communication to be given in writing.

It is important to abide strictly with contractual requirements for termination notices, which may provide who the notice is communicated to, how many notices are required, and whether a cure period applies. A termination notice which fails to comply with contractual requirements will be invalid and ineffective.

The grounds upon which a party chooses to terminate, and in particular whether they are terminating on the basis of a contractual provision or under the common law, should also be considered carefully, to ensure that additional or preferable claims are not lost.

Practically, the terminating party may have to make transitional preparations ahead of time, such as lining up a new supplier or provider of services. It is also important to bear in mind that post-termination contractual obligations will also likely exist, such as confidentiality obligations and IP ownership rights, whilst dispute resolution and governing law clauses will govern any disputes that arise following the termination.

Wrongful termination

If a party purports to terminate without the right to do so, that in itself may amount to a repudiation, entitling the counterparty to terminate the contract themselves and claim for damages. An error in terminating may also result in the loss of remedies or lock a party into a contract they no longer wish to perform. Termination should therefore not be undertaken lightly.

While it may be possible to cure a defect in a termination notice by serving a fresh notice, in such circumstances it is also worth considering whether the parties can negotiate an exit from the contract, or alternatively new terms of agreement.

Our next Disputes Essentials seminar, on 22 November 2023, will address the perils and principles of Domestic and Cross-Border Enforcement.

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