Termination for convenience: when and is it free?

21 October 2021

Termination for convenience clauses have drawn recent media attention given the Commonwealth’s recent decision to terminate the Future Submarine Program contract with the Naval Group.

As the name suggests, exercising a termination for convenience clause does not require the terminating party to prove any breach of obligation by the terminated party.

These clauses are common in contracts, especially in large procurement projects involving governments.

Despite the common nature of such clauses, there is limited guidance as to whether the terminated party must be compensated and the amount of compensation (if any) on a termination for convenience is also often unclear.

A poorly drafted termination for convenience clause has the potential to be unenforceable.

We take a look at the most recent commentary and judicial considerations and set out some matters that are relevant to the negotiation of a termination for convenience clauses.

Should the other party be compensated where a right to terminate for convenience has been exercised?

While parties are generally free to strike whatever bargain they choose, there are some limitations on the enforceability of contracts in circumstances where a contract contains a right to terminate for convenience.

Unfair contract terms

Particular caution should be taken when negotiating an exclusive right to terminate for convenience without compensation being payable where the unfair contracts regime applies.^[1]

In ACCC v Servcorp Ltd,^[2]one party could terminate for convenience without paying compensation while the other party had no such rights at all. This gave rise to a significant imbalance in the parties’ rights and obligations and the clause was deemed to be an unfair contract term and was void.

Although the regime does not apply to all contracts, upcoming amendments will broaden the scope of the unfair contract term provisions and introduce civil penalties and further remedies.

Consideration

There is a difference between an agreement that provides an obligation to compensate for work done up until termination, from an agreement that does not provide for any compensation at all.

To ensure formation and enforceability of a contract, obligations must be supported by ‘consideration’ (which usually takes the form of an obligation to pay money and provide products or services in return).

Courts in the United Kingdom have taken the view that a termination for convenience clause that does not provide compensation for losses (including loss of profit and overheads) “risk[s] being treated as … unenforceable as unconscionable.”^[3] However, the Australian Federal Court in Anderson Formrite Pty Ltd v Baulderstone Pty Ltd (No 7),^[4] held that a $1 termination fee ensured the contract was supported by consideration.

Consequently, inclusion of a termination payment obligation will help avoid a dispute as to whether an agreement containing a termination for convenience clause is void for a lack of consideration. In some circumstances, payment for work completed up to termination may be sufficient consideration.

Good faith

The law in Australia is unsettled as to whether a duty of good faith can be implied into a contract. Some contracts expressly include such an obligation.

The duty of good faith can be relevant in the context of a termination for convenience.

The New South Wales Supreme Court has taken the view that a breach of the duty of good faith would be unlikely to occur where an entitlement to terminate for convenience is accompanied by an obligation to pay fair (as agreed between the parties) compensation.^[5]

Calculation of compensation

If it is agreed that compensation is to be payable in the event of termination for convenience, the next question is how that compensation is calculated.

There are many possibilities, including compensating the terminated party for one or more of the following:

works completed up to termination, including works that have not been invoiced for;
demobilisation costs;
contribution to overheads and profit margin;
compensation for lost profit; and
compensation for a forward commitment or liability to third parties (including, for, example subcontractor break costs).

Conclusion

Ultimately, the commercial viability of the agreement will likely depend on whether the parties are prepared to accept the risk of potential termination without fault, and an entitlement to compensation may reduce the risk of loss.

However it is a balancing act, as the compensation should be proportionate to the potential benefits of being able to terminate for convenience. Therefore, parties should carefully consider the drafting of termination for convenience clauses to ensure they reflect the commercial bargain and are enforceable. Clarity as to the losses to be covered through the compensation mechanism is critical.

_[1]_{The current regime applies to standard form contracts entered into or renewed on or after 12 November 2016, where:
(1) it is for the supply of goods or services or the sale or grant of an interest in land;
(2) at least one of the parties is a small business (employs less than 20 people, including casual employees employed on a regular and systematic basis); and
(3) the upfront price payable under the contract is no more than $300 000 or $1 million if the contract is for more than 12 months.}

_{[2] Australian Competition and Consumer Commission (ACCC) v Servcorp Ltd [2018] FCA 1044.}

_{[3] Abbey Developments Limited v PP Brickwork Ltd [2003] EWHC 1987 (TCC).}

_{[4] [2010] FCA 921.}

_{[5] Leighton v Arogen [2012] NSWSC 1370.}

Authors