Contracts: dispute resolution and termination
This fifth article in the Back to Basics series focuses on escalation and dispute resolution and the parties’ rights of termination.
When creating a contract, the parties often don’t like to think about what is going to happen at the end, particularly if the end arises as the result of a dispute. However, well drafted contractual provisions relating to termination and exit management can help to ensure a smooth transition at the end of the contract and can avoid costly and time consuming litigation.
A dispute doesn’t always mean the end
Like any long term relationship, it is not unusual for disputes or grievances to arise during the life of a contract. But this does not have to mean the end of the contract. The chance of the parties being able to resolve a dispute is significantly increased if the contract contains a clear process for escalating and dealing with issues as they arise.
A dispute escalation path will provide each party with the opportunity to resolve an issue at management level within a pre-determined timescale before it is escalated to more senior levels within each organisation. Given that the contract managers will be keen to avoid a contractual issue being passed on to their boss, the escalation path can provide an incentive for the individuals concerned to resolve the matter at their level.
An early resolution by the management teams is not always possible so a successful escalation path will ensure that the issues quickly climb to the next tier of management in the event of an impasse.
An impartial third party can sometimes assist in resolving disputes where the parties themselves feel a deadlock has been reached. In view of this, it is often worth including a provision obliging the parties to attempt to resolve their dispute by mediation. However, the dispute escalation path should not have too many layers and the timescales should be kept relatively short because if one party has no intention of resolving the matter, having to follow a lengthy escalation process will result in unnecessary delays in obtaining restitution.
It is important to remember that for certain breaches, such as breaches of confidentiality obligations or intellectual property rights, the parties will need the right to initiate court proceedings quickly in order to obtain an injunction to prevent further damage being done. To enable this, it should be made clear that the dispute resolution clause will not prevent the parties from pursuing such remedies.
The term of a contract will generally be structured in one of the following ways:
(i) Fixed term, with automatic termination at the end of that term
(ii) Initial fixed term, after which the contract can be terminated on notice
(iii) Subscription basis, with the contract continuing for an initial period and automatically renewing for further periods of the same duration, unless terminated by notice at the end of a subscription period
(iv) No fixed term, enabling the parties to terminate the contract at any time by giving notice
As well as stating the term of the contract and giving the parties the right to terminate the contract on notice at certain times, most commercial agreements will give the parties the right to terminate the agreement before the expiry of its term, if the other party commits a significant breach of the agreement or if the other party suffers an event which prevents its due performance of the contract, such as insolvency.
Termination for breach
Contracts often include provisions giving the parties the right to terminate the contract for the other party’s breach of contract. The precise wording used can vary but common examples enable termination for:
- Any breach;
- Repeated or persistent breaches; or
- A material breach.
The first of the three variations set out above would appear to give the widest right to terminate for breach. However, the Court of Appeal has been unwilling to hold that any single breach will give rise to a right to terminate and has held that this would only apply if the single breach in question constitutes a repudiatory breach (see below for more information).
The Court of Appeal has accepted that the totality of repeated breaches could give rise to the right to terminate even if on their own they would not do so, although the application of this approach will vary depending on the type of contract in question.
The most common contractual right of this nature is a right to terminate for material breach. There have been a number of cases on the right to terminate for material breach in the last twenty years, but rather than adding clarity, these cases have shown that in deciding whether a breach is material, the courts will take into account all of the commercial circumstances of the case.
Given the different approaches taken by the courts, the parties to a commercial contract should consider spelling out expressly in the contract what they would consider to be a material breach and should set out whether, and in what circumstances, repeated breaches will give rise to a right to terminate, even if, individually, the breaches would not.
Take advice before terminating a contract for breach
A terminating party should exercise caution when terminating a contract for breach. It is advisable to take legal advice in advance as the possible consequences of seeking to terminate in circumstances where the materiality of the breach is questionable are potentially extremely serious. The party allegedly in breach may, upon receipt of a termination notice, seek to argue that the purported termination is itself a repudiation of the contract by the terminating party which could see the terminating party facing a substantial damages claim itself.
Other contractual rights to terminate
In addition to termination for breach, commercial contracts often include clauses giving the parties the right to terminate the contract in the following circumstances:
- Where a party becomes insolvent or similar events occur that will affect a party’s ability to continue with the contract
- Where an event occurs which is beyond a party’s control (a force majeure event), which affects that party’s ability to perform the contract and which continues for a prolonged period of time
- Where there is a change of control of the other party
In each case, consideration should be given to what termination rights are appropriate having regard to the nature of the contract, whether the right to terminate should be mutual or only apply to one party and, if a party is a member of a wider group of companies, whether it is appropriate to enable the insolvency or change of control of another member of the group to trigger a right of termination.
Implied right to terminate
If a contract does not have a fixed duration, or if the original term has expired and the parties have continued to perform the contract, and the contract does not contain a right for the parties to terminate, a court may imply a term into the contract under which it will be deemed to continue for an indeterminate period, subject to a right for either party to terminate on reasonable notice. Given that this term will not be implied in every circumstance, and the fact that the period of ‘reasonable notice’ will vary depending on the facts of the case, it is wise to include express provisions in the contract dealing with termination rights rather than relying on an implied term.
Non-contractual rights to terminate
In addition to the termination rights set out in the contract, there are also common law mechanisms for terminating or ending a contractual relationship.
Repudiation occurs when a party commits a breach of contract that is sufficiently serious that it entitles the innocent party to treat the contract as terminated with immediate effect and to sue for damages for breach of contract. Whether a breach is repudiatory will depend upon the severity and effect of the breach, and whether it goes to the root of the contract. Examples include a refusal by a supplier to carry out the services under the contract or a continued failure by a customer to give the supplier access to the premises or materials necessary for the supplier to perform the contract.
The effect of a repudiatory breach is that the innocent party will gain the right to choose whether to either affirm the contract or to accept the repudiation and terminate the contract. By electing to terminate the contract, the innocent party is released from performance of its obligations under the contract and from any obligation to accept further performance by the party in breach.
If the innocent party elects to affirm the contract, it will remain obliged to perform its duties under the contract, but can seek damages from the party in breach.
Difficulties can arise if the innocent party inadvertently affirms the contract instead of accepting the repudiation by acting in a way that contradicts acceptance of the repudiation. Case law has shown there is a danger that if sufficient time passes without the innocent party making an election, it will be deemed to have affirmed the contract.
Frustration occurs when neither party has defaulted on its obligations under the contract but other circumstances have intervened to prevent the contract from being performed as originally intended. The result must be that further performance of the contract is impossible, illegal or radically different from what was contemplated by the parties when they entered into the contract.
Where a frustrating event occurs, the contract will be held to have automatically ended and the parties are excused from their future obligations under the contract. Because where a contract is frustrated no one party is at fault, neither party may claim damages for the other’s non-performance. However, any accrued liabilities will remain.
Consideration should be given to whether the parties should be given rights of partial termination if the services provided under the contract are capable of separation. If partial termination is permitted, the contract should make it clear how the services will be separated and how any corresponding elements, such as charges, will be dealt with.
There may be circumstances in which a party would wish to suspend performance of a contract, rather than completely terminate the contract. For example, a supplier may wish to suspend performance of a contract where a customer is in breach of its payment obligations or a customer may wish to suspend payment in response to an alleged breach by a supplier.
Suspension clauses in a contract can be very helpful – they can enable the parties to respond to a change of circumstances that makes continuing with the contract impossible in the short term or they can be used to give the parties space to consider how to proceed in the event of a dispute.
If a suspension clause is to be included in a contract, care should be taken to ensure that it adequately deals with the practical consequences of a suspension, how long the contract can be suspended for before termination may occur and what happens if services are to resume following suspension.
Termination is an important stage in the life of any contract. Although the parties may be reluctant to focus on the end of the contract before it has even begun, this is the best time, while the relationship between them is positive, for the parties to negotiate and agree how to deal with any disputes which may arise during the term of the contract and how the contract can be terminated in the event that a dispute cannot be resolved.
Continuing the life cycle of a typical commercial contract, the next article in this series will focus on contract management and exit and will take a look at the transfer of employees upon termination of a contract.
Reviewed in 2015