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09 March 2017

Contract Termination: Cause and Effect

Termination describes a contract expiring or being brought to an early end. This article will focus on parties’ entitlement to terminate and the consequences that flow from terminating a contract early.

The effect of termination is to bring the contract to an end at a certain point and absolve parties of the majority of (though, depending on the circumstances, not necessarily all) ongoing obligations.  Accrued rights, being those rights to which the parties had become entitled during the term of the contract, are not affected. Such rights continue to be enforceable following termination.

A party wishing to terminate the contract should always consider the legal basis upon which they are entitled to terminate the contract and consider the practical and commercial implications of such termination.  The interests of the party seeking to terminate may be better served in allowing the contract to continue, for example, where there is an ongoing entitlement to receive payments under the terms of the contract. The terminating party should also be mindful of the potential risk of a claim against them for wrongful termination.  The terminating party must ensure that they comply with all procedural requirements to terminate of both common law and the contract.

How to Terminate the Contract  

A contract is terminated when one party to it elects to exercise a right to bring the contract to an end.  That right arises (1) at common law and/or (2) by the express terms of the contract. 

Generally, termination pursuant to common law and/or a contractual term will require a positive action from the terminating party.  It is extremely rare for automatic termination to be provided for in a contract. Unless the contract expressly allows for automatic termination, a positive action, such as serving Notice of Termination, will be required. 

Affirming the Contract

Affirming the contract refers to the situation where the non-defaulting party is aware of a breach and of its right to terminate or affirm but opts not to terminate the contract. Affirmation can be express or implied by the conduct of the non-defaulting party, for example, if the non-defaulting party continues to perform the contract as if it is continuing.

If a party affirms the contract they lose their right to terminate.

Termination at Common Law 

The right to terminate may arise pursuant to an implied term allowing termination by reasonable notice or in response to a repudiatory breach.  An implied term allowing termination on reasonable notice in commercial contracts will only to be implied where it is obvious and necessary to give business efficacy to the contract.  Far more likely is a right to terminate for repudiatory breach. 

A right to terminate may arise in common law depending on the type of term breached. A right to terminate may arise on breach of a “condition”.  A condition, in contractual terms, refers to a term of the contract that, if breached (no matter how small the breach), gives the non-defaulting party the right to either treat the breach as a repudiation (i.e. a breach entitling the non-defaulting party to accept the breach) and terminate the contract or affirm the contract.

Alternatively, a right to terminate can also arise in common law on a breach of an ‘intermediate’ term.  An intermediate term refers to a term for which the remedy for its breach depends on the nature and effect of the breach.  If the breach is so serious so as to have the effect of depriving the non-defaulting party of substantially the whole benefit of the contract, the non-defaulting party will be entitled to terminate the contract (Hong Kong Fir Shipping Co Limited -v- Kawasaki Kisen Kaisha Ltd [1961] EWCA Civ 7). The remedy will be that the non-defaulting party can treat the breach as a repudiatory breach and terminate the contract as if it were a breach of a condition.  In both cases (i.e. breach of a condition or intermediate term), the non-defaulting party is entitled to claim damages. 

If the breach does not go to the root of the contract and deprive the non-defaulting party of substantially the whole benefit then a breach of an intermediate term will be treated as if it was a breach of warranty. A breach of warranty does not give rise to a right to treat the contract as repudiated. The non-defaulting party will not be entitled to terminate but could claim damages.

A repudiatory breach does not automatically terminate the contract.  Instead, the non-defaulting party must expressly elect to accept the repudiation and terminate the contract or affirm the contract.  In both instances, the non-defaulting party is entitled to claim damages. 

Termination pursuant to a contractual term 

A clause in a contract may specifically allow termination for material breaches, persistent breaches or even for any breach at all.  It is therefore important when drafting a commercial contract to be aware of the events which could result in a right to terminate arising.   In the event of a breach, careful consideration should be given as to whether or not the right to terminate arises.  It is not uncommon for a commercial contract to include a term to allow the breach to be remedied within a reasonable time.  Again, clear drafting is necessary in order to make it clear as to what is a reasonable time for the breach to be remedied and to what length the defaulting party has to go before the non-defaulting party is entitled to terminate.

The non-defaulting party will be entitled to damages for breach whether or not the right to terminate arises and/or whether it is invoked.

Damages 

A non-defaulting party will be entitled to claim damages whether or not a right to terminate has arisen at common law or a contractual term.

In this regard, some losses will flow from early termination of the contract, for example loss of future income, rather than the breach directly.  Whether these are recoverable or not will depend on whether termination was as a result of a repudiatory breach or was pursuant to a contractual term which does not amount to a repudiatory breach. 

At common law, the non-defaulting party is entitled to claim damages for future losses (known as loss of bargain damages) provided the termination is as a result of a repudiatory breach. The non-defaulting party will be entitled to claim damages for future losses on the basis that the future losses were caused by the breach of contract rather than the termination. 

In contrast, if the contract is terminated by the non-defaulting party pursuant to an express contractual right and the breach giving rise to the right did not amount to a repudiatory breach, the non-defaulting party will not be entitled to claim future losses.  In these circumstances, the loss of future profits is caused not by the breach but by the aggrieved parties’ action in exercising its contractual right to terminate. 

If the contract is terminated by the non-defaulting party pursuant to an express contractual right and the breach giving rise to this right could also properly be classified as a repudiatory breach at common law, it is possible for the non-defaulting party to claim future losses.

The different level of damages available can cause difficulties when deciding on what basis the termination should be effected.  If the right to terminate arises both at contract and common law then the parties should generally make an election as to how the termination is effected.  If the contract sets out the consequences of termination and these are inconsistent with the rights arising on termination at common law then an election has to be made as to whether the non-defaulting party terminates under contract or common law.  If the contract does not provide for the consequences of termination or the consequences set out in the contract are consistent with the rights arising at common law then the non-defaulting party should, where possible, accept the repudiation at common law and rely on the contract term as an alternative.  This allows the non-defaulting party to claim loss of bargain damages as a result of the repudiatory breach as well as damages arising directly from the breach.

In the event that the non-defaulting party relies on a contractual right to terminate but does not make it clear that the breach amounts to repudiation, it will be a matter for the Court’s interpretation as to whether or not the non-defaulting party can recover future losses. This will result in a fact specific analysis being carried out by the Court.

Conclusion

Whether or not the contract is terminated at common law or in contract is an important distinction given the likely impact on the type and level of damages the non-defaulting party is entitled to claim.  It is imperative that a close analysis of the terms of the contract is carried out. If the express contract terms are inconsistent with the rights arising at common law then a careful assessment will need to be made as to what grounds the non-defaulting party relies upon when terminating the contract.   

The non-defaulting parties should always be mindful of wrongful termination.  Whether or not termination is wrongful will to some extent rely on contractual construction and interpretation as to what amounts to a material or substantial breach.   

If a party wrongfully terminates the contract, this can give rise to a repudiatory breach by the terminating party which in turn gives the other party a right to treat the wrongful termination itself as a repudiatory breach and to accept that breach, to terminate the contract and claim damages as appropriate.  So, always think carefully and seek advice!


For more information please contact Ben Moore on (0)1242 246352 or at ben.moore@crsblaw.com.

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