Friday, July 12, 2013

Termination – What happens after you have terminated a contract?

What process or steps do you need to take after issuing a notice of termination? There are two types of terminations. A termination for cause is used when there has been a material breach of the agreement and a failure to cure the breach within the agreed time frame to cure (correct) the breach. A termination without cause is a right that you need to negotiate and include in your agreement. What you need to do will depend upon the type of termination you made (with cause or without cause) and what the agreement obligates you to do. For example if your contract was for the purchase of products you might have a termination without cause such as:

“Buyer may, upon ___ days written notice to Supplier, terminate this Agreement without Cause. In the event Buyer terminates without Cause, Buyer will compensate Supplier for the actual and reasonable expenses incurred by Supplier for work in process up to and including the date of termination. Supplier shall use reasonable efforts to mitigate Buyer’s liability by returning to its suppliers, selling to others the canceled Products (including raw materials or works in process). In accordance with Buyer’s written direction, Supplier will immediately cease work and prepare and submit to Buyer an itemization of all completed and partially completed Products. Supplier shall deliver to Buyer all Products satisfactorily completed up to the date of termination at the agreed upon Prices. Buyer and supplier shall agree upon the disposition of any work-in-process or raw materials. If Buyer wants work-in-process or raw materials, failure to provide them shall void Buyer’s obligation to pay for those materials. Buyer’s total payment obligations on a per unit basis shall not exceed the purchase price for the completed product.”

In this language, you have the right to terminate the agreement without cause but you are also obligated to make payment to the supplier. The supplier is obligated to help you mitigate the cost of such termination. So under a termination without cause, the supplier must first try to take those steps to mitigate the cost by attempting to return unused materials to their suppliers and to try and minimize any restocking charge. If the item could be used in products that the supplier sells to others, you want them to consume that inventory so there is no charge. If the volume is high and it will take some time for them to consume what they purchased for you, you might agree to pay them an inventory carrying cost while the proceed to consume them. If the supplier has no use for the materials and their supplier won’t take them back, you may want to sell the materials through the broker market where even if they need to sell for less than what they paid for it as it reduces what you need to pay. One the terminated party has taken that action the they need to prepare an itemization of all that is remaining and all the costs involved. That list needs to show their actual and reasonable cost of purchasing that item. It needs to show any costs they recovered as part on mitigating the cost. You then need to review and potentially negotiate what’s on the list. Is the cost actual and reasonable? Were the quantities consistent with what you had committed and your orders or forecasts? Once agreement is reach on the amount to be paid you then need to have them invoice you. I would also have legal provide you with a “waiver and release of claims” document where the waiver and release is conditioned upon being paid. I would do that to makes it a final settlement for the termination’s payment obligation as the waiver and release prevents them from making further claims for payments resulting from the termination.

In other types of contracts you can have a variety of different termination without cause provisions that place different financial obligations on the buyer in the event of a termination without cause. For example, in a professional services agreement a supplier might want to be compensated for labor costs for a period of time to account for the period of time it will take for their workers to be deployed to work for other customers. For companies that provide contract workers, they may only want to cover what their financial obligations are to that customer. In contracts for construction, you probably would need to commit to pay de-commissioning or winding down costs, any costs they may have in terminating all their subcontractors, and any contractor costs involved in work in process (WIP). The process you would follow to manage would be the same.

In terminating a contract for cause, I do not believe that the breaching party should be paid anything. They breached the agreement and shouldn’t be rewarded for that by having their costs paid. In almost all cases when there is a breach you need to hire someone else to complete the work and the cost to complete the work will be more than they amounts remain unpaid under the contract. If you paid the breaching party for their costs associated with the termination, that’s money you don’t have to complete the work. You may also have incurred damages and the easiest way to collect on those is to offset those damages against payments. The only time I would make a payment would be if the cost to complete and the damages you sustained are less than what remains under the contract and probability of that happening is zero. If you had a performance bond or financial guarantee the first thing you would do is provide notice to the guarantor or bond issuer that there has been a breach of the agreement, the contractor failed to cure the breach and the contract has been terminate and you are making a claim against their bond or guarantee. In many cases as part of issuing the bond, they may have the right to hire someone else to complete the work. If they determine that the cost of the remaining work would exceed the bond or guarantee, they may waive that right and make payment of the bond or guarantee amount. What you next need to do is identify all the damages you sustained as a result of their breach. You must read your limitation of liability section to determine if there are any limits on the types and amounts that may be claimed. For the remaining amount you may try to negotiate your claim with the breaching party. If that fails you need to litigate the claim to recover those damages.

Terminating a contract for cause is not an action to be taken lightly. You need to be absolutely sure that they have breached the agreement, it is a material breach, you have correctly notified them of the breach and the need to cure the breach and they have failed to cure the breach. If you are wrong you can be sued for a wrongful termination of the agreement. Termination a contract without cause is not something that a supplier or contractor likes, but it’s a tool that buyer’s need as needs change, business changes, your company’s financial position may change and the last thing you want to do is pour more money into work that you don’t need, don’t want or can no longer afford.