Do parties always need a valid reason to terminate a contract? The short answer is yes, you do need a valid reason to terminate your contract. This is generally referred to as “termination for cause” right, unless you have a “termination for convenience” clause in your contract that will enable you to exit the contract without having a reason for doing so.
A termination for convenience clause is often one of the most contentious clauses discussed during contract negotiations due to the power it grants to a contracting party, who is entitled to exit the contract at any time and for no specific reason.
Contracting parties view a termination for convenience clause as being risky for various reasons:
- Service provider’s perspective: if a customer terminates an agreement early for convenience, it may expose the service provider to various stranded capital costs and expenses that it had already incurred for purposes of providing a specific service to its customer, as well as foregoing the revenue forecasted for the duration of the contract. It may also have an impact on revenue recognition and the company’s overall valuation and marketability in the case of any future intended sale of the company.
- Customer’s perspective: an early termination right for the service provider may interrupt the customer’s business operations, and may result in the customer having to incur exorbitant costs to migrate or transition the services to a different service provider (especially if the services are critical to the customer’s business operations). It may also result in significant interruption and disruption to the customer’s overall IT environment, where the services being terminated are integrated into the customer’s wider IT environment.
To overcome the risks mentioned above, the contracting parties may generally request that additional provisions be included as part of the termination for convenience clause:
- Service providers may request a termination fee and/or that the customer pays any stranded capital costs and out-of-pocket expenses incurred by the service provider as a result of the early termination. This will ensure that the service provider is in a position to “claw-back” costs and expenses. In extreme circumstances, it may also include payment of the service provider’s fees for the remainder of the agreement or part thereof.
- Although very rarely accepted by customers, those who do agree to the inclusion of a termination for convenience clause in favour of the service provider will often request a longer notice period for termination, guarantees in respect of transition activities and costs, possible refunds or part refunds of any upfront investment costs, and that the service provider contributes to the (reasonable) costs incurred by the customer in migrating or transitioning the services to a different service provider, including any future data migration and IT integration costs.
There are many different ways to draft a termination for convenience clause, but the wording will depend on various factors including:
- the nature of the risks;
- whether the services are critical to the business operations of the customer;
- if there are any foreseeable stranded capital costs or out-of-pocket expenses;
- the history of the business relationship (whether it is a new or long-standing relationship) and whether the parties have successfully concluded and performed under other agreements during their business relationship; and
- the negotiating power of the parties.
A termination for convenience clause may be beneficial to the parties in the unlikely event that the business relationship deteriorates to the point of no return, or where they wish to exit the contract for a reason that has not been listed as a ground for termination under the termination for cause clause. For example, this may include where a contracting party has a change in strategy; or if a party no longer requires, can no longer afford, or can no longer render the services; or even where technology may be outdated and too expensive to run.
As contentious as a termination for convenience clause may be, from a customer perspective it is essential to include it in an IT contract, especially for longer-term contracts. From a service provider perspective, it is debatable whether such a clause is required, with some reasons having merit and others being dubious.