In these difficult economic times, it is not unusual to see projects cancelled before completion because of changed priorities, reallocated resources, increasing performance costs, lost financial backing or evaporating demand. This means now, more than ever, it is critically important to review and understand contractual provisions allocating risk and responsibility in the event of a project’s early termination.
The “termination for convenience” clause may be the most important of these contractual provisions. For an owner, this clause provides flexibility in uncertain times. For a contractor, it represents a risk that it will not earn its anticipated profit or recapture the overhead allocated to the project.
Traditionally, an owner could not terminate a contractor without cause. This meant an owner that later failed to prove the stated cause for termination was liable to the contractor for breach of contract damages—including loss of anticipated profit.
Within the last decade, however, owners began to include a termination for convenience clause in private contracts. The clause generally enables an owner to terminate a contract with or without cause, even if the owner already is in default. The clause also generally limits the amount of compensation the contractor can receive to something less than what otherwise might have been recovered for a breach of contract.
It is important to remember that the rights of the owner and contractor differ significantly depending on whether a termination is for cause or for convenience. Upon a termination for cause, the owner immediately can remove the contractor from the site; seize and use all of the contractor’s tools, equipment, machinery and materials without paying for it; withhold unpaid progress payments and use the unpaid contract balance to complete the work; and charge the contractor if the cost to complete the work exceeds the unpaid contract balance.
In contrast, after a termination for convenience, the contractor can access the site to secure the work and demobilize; is entitled to payment for the owner’s use of the contractor’s tools, equipment, machinery or materials; is entitled to receive unpaid progress payments and other compensation allowed under the termination for convenience clause; and has no additional liability for the work or the cost to complete the work.
Restrictions and Payment Methods
The first matter to consider when reviewing a termination for convenience clause is whether any restrictions are placed on the owner’s discretion in using the clause.
One method is to impose a duty of good faith on the owner’s decision to terminate for convenience. Also, the parties may agree the owner can terminate for convenience only based on a significant change in circumstances arising after the parties execute the contract.
The next matter to consider when re-viewing a termination for convenience clause is the sufficiency of consideration to be paid by the owner for the right to terminate for convenience. Generally, the consideration must be more than just the cost to complete the work completed to date. The methods of defining the consideration to be paid can be as varied as the parties desire.
Generally, the formula consists of payment for the work completed to date, payment for costs incurred to secure the work and demobilize, payment for costs of terminating contracts with lower tier subcontractors and suppliers, and possibly payment for some overhead and profit on work not completed. Care should be given in defining the method of payment for work completed to date. For lump sum contracts, the preferred method uses a schedule of values and a percentage completion.
If the method is based on costs of work completed plus reasonable overhead and profit, then the parties should establish a method for determining cost and define a reasonable overhead and profit as a percentage of those costs.
Most termination for convenience clauses exclude lost profits for work not completed. This represents a significant change to the general rule that a contractor may recover lost anticipated profits, in which an owner terminates the agreement before completion. This exclusion is akin to a limitation of liability clause, and provides the key to the clause’s value to an owner (or to a general contractor that terminates a subcontractor).
Good Faith Basis
A final matter to consider is the interaction between the termination for cause and the termination for convenience provisions in the contract. Contracts commonly state that an improper termination for cause automatically will be converted to a termination for convenience if it is determined the termination for cause was not justified.
Absent a limitation, such a clause creates an unacceptable risk that an owner, lacking factual or legal cause for termination, will terminate for cause to take advantage of the increased remedies. In this way, an owner can hedge its bets, retain the contract funds, and later argue the improper termination for cause must be converted to a termination for convenience, for which a contractor’s remedies are limited to payment for work performed and not for lost profits.
The better approach is to require an owner to have a good faith basis for the termination for cause before it can be converted to a termination for convenience. Many courts have held that an owner must exercise a termination for convenience in good faith, and not simply as a way to avoid liability to the contractor.
The same considerations and rules apply to a termination for convenience clause in the subcontract agreement. A prudent contractor should include the termination for convenience clause for its subcontractors, especially if there is one in its contract with the owner.