Possible Legal Issues of Unilaterally Contract Termination for Convenience

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1 Possible Legal Issues of Unilaterally Contract Termination for Convenience Seng Hansen Master Student of Construction Contract Management UTM Introduction The Malaysian Contract Act 1950 section 2(h) has defined a contract as an agreement enforceable by law. In construction industry, contract has become a very strong and powerful tool used by the parties involved in the contract to ensure and protect their rights and interests. One of the main functions of a contract is to set out the parties rights, duties and liabilities. Any breach of parties duties and liabilities will entitle the innocent party to terminate the contract. Under Contract Act 1950, there are four ways that entitling parties to terminate the contract, i.e. by performance (section 38-68), by agreement (section 63-64), by frustration (section 57), and by breach of warranty or conditions of the contract (section 40). However nowadays appear what have been called as termination for convenience. It is actually intended to allow parties to end their contract at any time for any reason. It was first introduced during the World War II by the United States government. In the US case of Torncello v United States 681 F.2d 756, 764 (Ct. Cl. 1982), there was a statement says, The concept that the government may, under certain circumstances, terminate a contract and settle with the contractor for the part performed dates from the winding down of military procurement after the Civil War. It originated in the reasonable recognition that continuing with wartime contracts after the war was over clearly was against the public interest. Where the circumstances of the contract had changed so dramatically, the government had to have the power to halt the contractor s performance and settle. 1 P a g e S e n g H a n s e n 2 /

2 The given case is illustrated below. Century Dev (Employer) 1 Decade Cont (Contractor) Century Dev engaged Decade Cont to carry out a 30-storey apartment project 2 There is a clause states the right of the employer to terminate for convenience Clause xx. Termination for Convenience 30 storey apartment 3 During construction, the economic condition is skyrocketing 4 The employer want to exercise the Termination for convenience clause Termination for Convenience in a Nutshell Termination for convenience is first developed in United States. However, due to the more globalization and thanks to the more complexity of construction industry, this type of termination has been introduced widely in other jurisdictions. Basically, the common law doctrine of freedom to contract has also contributed to the use of this termination. It means that as long as both parties use their freedom to contract to confer a contractual right upon one or both parties to terminate the contract without cause or no-fault, the contract is enforceable. This kind of right is considered as an exceptional right, which means that it must be embodied in the contract. Under civil law, termination for convenience is commonly recognized. However if the parties use this right, they can only do so under the constraints imposed by the law. For example, if the employer gives notice of his intention to terminate the contract for convenience, the contractor shall be entitled to the payment of the contract price with deduction of the saved expenditure. While under common law, the employer may face claims which do not result directly from the contract, but occur in connection with the contract. Normally, a termination for convenience in common law 2 P a g e S e n g H a n s e n 2 /

3 jurisdictions will oblige the terminating party (usually the employer) to pay the terminated contractor for the work done and perhaps some costs associated with the contractor s need to terminate his subcontractors or suppliers. Reasons which fall under the scope of termination for convenience are normally events out of the employer s control. One of the main legal basis and issue in executing termination for convenience is to what extent the employer can be deemed to execute it in a good faith. More explanation about this issue will be presented below. Procedure on Unilaterally Contract Termination for Convenience In Malaysia, we can find the termination for convenience clause in some of widely used standard forms of contract. CIDB and PWD clearly include this clause, while in PAM we cannot find it. FIDIC as an international standard form of contract also has this clause. Below are some procedures of termination for convenience as have been mentioned in some standard forms of contract. CIDB 2000 Clause 46 TERMINATION WITHOUT DEFAULT 46.1 Right of the Employer to Terminate The Employer may at any time, give to the Contractor 30-Day notice of termination of the Contract. Upon the expiry of 30 Days from the receipt of such notice the Contract shall be terminated Effects of Termination In the event of termination under Clause 46.1 the provisions of Clause 45.3 shall apply. PWD Form 203A (Rev. 2007) Clause 52.0 TERMINATION ON NATIONAL INTEREST 52.1 Termination (a) Notwithstanding any provision of this Contract, the Government may terminate this Contract by giving not less than thirty (30) days written notice to that effect to the Contractor (without any obligation to give any reason thereof) if the Government considers that such termination is necessary for national interest, national policy or national security. 3 P a g e S e n g H a n s e n 2 /

4 (b) For the purpose of this clause, what constitutes national interest, national policy and national security, shall be solely made and determined by the Government and such determination shall for all intent and purposes be final and conclusive and shall not be open to any challenge whatsoever. FIDIC Red Book Clause 15.5 EMPLOYER S ENTITLEMENT TO TERMINATE The Employer shall be entitled to terminate the Contract, at any time for the Employer s convenience, by giving notice of such termination to the Contractor. The termination shall take effect 28 days after the later of the dates on which the Contractor receives this notice or the Employer returns the Performance Security. The Employer shall not terminate the Contract under this Sub-Clause in order to execute the Works himself or to arrange for the Works to be executed by another contractor. After this termination, the Contractor shall proceed in accordance with Sub- Clause 16.3 [Cessation of Work and Removal of Contractor s Equipment] and shall be paid in accordance with Sub-Clause 19.6 [Optional Termination, Payment and Release]. From the above clauses, we may conclude that the right to terminate for convenience shall be exercised by the employer by giving a written notice to the contractor within specified time. The notice must be clear and unambiguous in its terms. In Avofos Shipping Co SA v Pagnan [1983] 1 WLR 195, it was held that these procedural normally will amounted as condition precedent that shall be strictly complied with, before the effectively exercise the employer s right to terminate for convenience, otherwise the notice will be of no effect. Legal Issues on Termination for Convenience Since termination for convenience is a very unusual type of termination in which both parties actually do not breach any contract conditions and warranties, there are some legal issues regarding the validity of this termination. Below are some possible legal issues regarding this matter. 1. Is the termination for convenience a valid termination? 4 P a g e S e n g H a n s e n 2 /

5 2. What does good faith mean? 3. What are the consequences of termination for convenience? 4. Can the contractor claim for loss of profits? or Is the contractor entitled to compensation? 5. What if the employer finds defective works after the exercise of termination for convenience clause? Can he recover from the contractor the cost of remedying the defective work discovered after a termination for convenience? Is the termination for convenience a valid termination? Termination for convenience is a unilaterally termination which gives power to one or both parties (but normally only the employer) to end the contract at anytime and without reason. Reasons for such termination may include supervening financial problem of the employer, changing circumstances or simply the decision not to proceed with the project any more. Under common law, its clause is considered as an exceptional clause because it defies the basic principle of mutuality of contract. It is very difficult to see whether this kind of termination is a valid contract or not due to consideration inadequacy. The contractor may be challenged the employer for wrongful termination due to consideration inadequacy. However in today interpretation, termination for convenience is considered to have consideration. In the case of Hadley Design Associates v The Lord Mayor and Citizens of the City of Westminster [2003] EWHC 1617 (TCC), the court has confirmed the validity of termination for convenience clauses. Westminster appointed HDA as lead consultant on a construction project. Westminster then terminated its contract with HDA. It relied on a onemonth notice of termination clause that did not require reasons for termination. Westminster s motivation was to market test the current level of professional fees, i.e. to appoint a cheaper consultant. HDA had been appointed in 1987 and by 1996, when Westminster served the termination notice, compulsory competitive tendering had become the norm and it wished to test the market for surveying services. HDA claimed: 5 P a g e S e n g H a n s e n 2 /

6 wrongful termination of contract, i.e. Westminster had promised HDA that it would terminate the contract only if HDA defaulted or if Westminster ran out of money and, either there was a collateral contract to this effect, or, alternatively, Westminster had made these representations to induce HDA to enter into the contract and HDA had relied on them; the contract included implied terms and/or terms for business efficacy which meant that Westminster could only terminate in good faith, or when it was fair or reasonable to do so; and HDA had contracted on Westminster s standard terms, and the termination clause was unreasonable and therefore unenforceable. The case of Abbey Developments v PP Brickwork (2003) was not referred to in this case and, surprisingly, it was not suggested that the clause was unconscionable, even though it did not provide for compensation. There appears to be no obvious reason for the difference in these two cases, other than their particular facts. The judge rejected all of HDA s arguments and found in favour of Westminster. In the case of Tenth Circuit v. Eastern District of Pennsylvania EDO Corp., 911 F.2d and T.I Construction Co. Inc. v. Kiewit E. Co. Civ. A. No , 1992 WL have held that the ability to terminate for convenience does not constitute lack of consideration where the contract requires the corporation to notify the subcontractor of the termination and pay damages after the termination. What does good faith mean? Termination for convenience basically has nothing to do with the contractor s performance, which is the subject of the termination for fault (or default) clause. Therefore, since it does not constitute a breach by the contractor, the employer can only execute this clause due to good faith. The concept of good faith can be defined as an obligation to act honestly, reasonably, and not capriciously. It has also been said that good faith precludes acting with ulterior motives and acting purely to injure another 6 P a g e S e n g H a n s e n 2 /

7 party s interest. Although it is a difficult concept to define, it has been considered applicable to termination clauses. The case in Court of Appeal of New South Wales, Australia between Renard Construction v Minister for Public Works (1992) shows difficulties in defining good faith termination. The fact was that the contractor in default for delays and the employer then served a show cause notice saying if the breach not remedied within the time stated in the notice, the employer could terminate the contract. The contractor however did not cure the breach in time and therefore the employer terminated the contract. It was of fact that the employer had also contributed to the delays. The court found that the decision to terminate was based on unfairly misleading, incomplete and prejudicial information. The court found that the employer had not acted in good faith, but for different reasons. However, Priestley JA found that there was an implied term to act in good faith and reasonably. Meagher JA found that as a matter of construction of the contract the clause required the employer to act on accurate information. In Kellogg Brown & Root v Australian Aerospace (2007), there was a termination for convenience clause in the contract. After the dispute resolution notice was served, it was followed by termination notice. The court found that there was a serious question to be tried as to the existence of an implied term of good faith and whether it had been breached. In Malaysia, the legal position of this doctrine can be seen from the case of Bains Hardings Sdn Bhd v Arab-Malaysian Merchant Bank Bhd & Others [1996] 1 MLJ 425, where Talalla J observed that where a termination for convenience clause in a contract is exercised not for convenience but for the purpose of employing another subcontractor so that the other subcontractor can enjoy whatever profits remain in the contract, then such use of the clause amounts to the employer acting in bad faith and in an unconscionable manner. What are the consequences of termination for convenience? Normally, the exercise of termination for convenience gives the right of the contractor to be paid for the work done. The other consequences such as the 7 P a g e S e n g H a n s e n 2 /

8 contractor shall stops the works and leave the site, and the employer shall repossess the site and stipulate the mode of payment and may be financial compensation are made after the termination. If the termination for convenience was exercised by the employer, we can refer the effect of termination without contractor s default (see CIDB Clause 46.2, PWD 203A Clause 52.2 and FIDIC 1999 Red Book Clause 15.5 and 19.6). In FIDIC the consequences of an employer termination may be similar, if not identical to, the consequences of a termination by the contractor for employer default. Can the contractor claim for loss of profits? or Is the contractor entitled to compensation? The typical clauses usually only provide the contractor to be paid for the cost of performance and profits up to the time of the termination for convenience, but he usually does not receive any compensation for the remaining work that he does not perform, meaning no recovery of lost profits. However, the American Institute of Architects provides the recovery of lost profits for the remaining work not yet performed by the contractor. In Malaysia, standard form of contract PWD 2010 mentions the composition for payment to the contractor after this termination shall be: the value all work carried out up to the effective date of termination the amount in respect of any preliminary items so far as the Works or services comprised therein has been performed and a proper proportion of any item which partially performed the cost of materials or goods reasonably ordered for the Works which have been delivered to the contractor or of which the contractor legally liable to accept delivery any reasonable cost of any suitable protection Works cost for demobilization the contractor s plan, equipment and sire facilities any expenditure other than cost mention above, reasonably incurred by the contractor directly because the termination Under CIDB form of contract, payment to the contractor after the termination without default is basically same with the composition of the 8 P a g e S e n g H a n s e n 2 /

9 payments stipulated in the PWD form of contract. While under FIDIC, generally the contractor may claim for loss of profits or other loss or damage sustained by the contractor as a result of this termination. In Chiemgauer Membran v New Millenium Experience Company [2000] 1, the court determined that where the power under such a termination clause was exercised, and where the express provision of the clause identified the mode under which loss recovery was to be had, certain issues of causation were side-stepped (except the quantum meruit for the works done), unless the particular event was inevitably going to affect the execution of the contract in normal course. Therefore, in the assessment of financial consequences in termination for convenience, where the contract lays down what heads of loss can be recovered, the agreement of the parties set out in the contract is to be respected. The question of financial consequences has already been resolved by the contract. What if the employer finds defective works after the exercise of termination for convenience clause? Can he recover from the contractor the cost of remedying the defective work discovered after a termination for convenience? Reported decisions addressing the employer s right to recover for defective work following a termination for convenience in the absence of specific contractual language have been inconsistent. In other words, both parties must realize this and if agree, they must state the contractor s liability for defect works even after termination for convenience. In Layton Construction Co. Inc v Barclays Capital Real Estate Inc., No 2009 CV 606, slip op. (District Court, Eagle County, Colo., Sept 15, 2010), the court held that where the parties contract provided that the contractor s warranties and obligations survive termination (not specifically limited to terminations for cause), the contractor remained liable for corrective costs following termination for convenience. The court additionally held that the termination for convenience was not a waiver of any claims for corrective work which already may have existed prior to the date of termination. 1 In paper by John Tackaberry Qc Termination for Convenience, page Hong Kong. 9 P a g e S e n g H a n s e n 2 /

10 However, different decision was given in the case of New York Shipbuilding Co (1972). The board relied upon earlier decisions denying direct recovery for costs to correct defective work after a termination for convenience, rationalizing that a contractor who has been terminated for convenience did not have prior notice of defective work and therefore did not have the opportunity to perform its own corrective work. Thus, it would be unfair to charge the contractor with the employer s costs to correct any defects in the contractor s work after the termination for convenience. Therefore, it is suggested that the employer who terminates a contractor for convenience may only recover the cost of correcting defective work if he can show that the defects resulted from the contractor s under performance of its contractual obligations. Conclusion Termination for convenience clause is useful to employers undertaking speculative developments, where market movements may make employers wish to terminate the contract part way through. Moreover, this clause is also useful if there are potential problems between the parties and both wish to go their separate ways. Termination for convenience clause usually favours employers, therefore the contractors should ensure that they are aware of the consequences before they agree to sign the contract. Generally, the termination for convenience clause limits recovery to profits and expenses for the work done only, with loss of profits in some court decision was not allowed. If the employers do not have a good reason to exercise the clause or if the parties cannot agree on the price adjustment, disputes may arise. Based on the given case, Century Development can exercise termination for convenience clause since it has been stated in the contract. However, Century Development must show that he exercises it in good faith, follow the procedures, realize the consequences of exercising this termination, and understand some possible legal issues regarding this matter. 10 P a g e S e n g H a n s e n 2 /

11 References Contracts Act FIDIC 1999 Red Book. PWD 203A. CIDB Peter M. Kutil and Karl Silverberg. Contract Termination Clauses Part II Termination for Convenience. Tunnel Business Magazine, Dec Frederick Cohen and John S. Wojak Jr. Termination for Convenience of Construction Contracts. New York Law Journal Volume 245, no 30. ALM Publication, 15 February P a g e S e n g H a n s e n 2 /