If you do a thesaurus search of the word “termination,” you’ll find: “extinction, annihilation, execution, slaughter, and massacre.” “Termination,” Roget's II: The New Thesaurus, 3rd ed., Boston: Houghton Mifflin, 1995, Online Ed. (October 27, 2011). It is no wonder then, that when a contractor it told he is being terminated from a project, words of the four letter variety are quickly flying about the room and you are receiving messages from your secretary that your client has called four times, insists it is urgent and is inquiring “can they really do that?”
When embarking on a new construction project, termination is often the last thought that crosses the parties’ minds and is therefore often given relatively short shrift in the contract drafting and negotiation stage. In the current economic climate, however, given the uncertainties that can plague even the most well planned construction project, contract termination is a potential outcome parties simply cannot ignore. There are two bases to terminate a construction contract: cause and convenience. Termination for cause allows an owner or contractor to terminate the construction contract based upon the default of the terminated party. While the contract itself governs what conduct constitutes default, typical bases for “causal” termination are failure to properly man the job and/or keep up with the project schedule; failure to follow the project plans/specifications; repeated failed inspections; and failure to pay subcontractors. However, since most owners and contractors rarely intend to terminate a contract on the front end of a project, provisions regarding termination for cause are often overlooked in contract drafting and are seldom clear. For example, an A201 contract allows an owner to terminate when the contractor “repeatedlyrefuses or fails to supply enough properly skilled workers or proper materials.” What does repeatedly mean? Probably not once, but three times, five times? Additionally, contract documents almost always require notice and opportunity to cure. How much notice is required and how long does a contractor have to cure? What happens when a dispute arises regarding whether the contractor has successfully cured?
Since termination for cause can be financially devastating for a terminated contractor, contractors rarely walk silently into the abyss and owners or the terminating contractor often find themselves in costly and protracted litigation. Given the foregoing, the recent trend is for owners and contractors to avoid default disputes by instead terminating their contract for “convenience,” rather than for “cause.” In theory, this avoids the hassle of documenting the contract breaches, providing notice and cure periods, and arguing over definitional ambiguities. It also purportedly gives the terminating party certainty in regards to termination damages. As is discussed below, however, this is not always the case, in particular, where termination for convenience clauses have not been carefully negotiated and drafted.
Traditionally, without cause, an owner or contractor could not terminate another contractor without itself breaching the parties’ contract, thereby exposing itself to litigation and potential damages for anticipatory profits. The result was often disastrous for the owner/contractor because it led to significant budget overruns when the terminating party had to not only pay anticipatory profit to the terminated contractor, but also had to retain another contractor to complete the terminated contractor’s work.
During World War I, the federal government introduced the concept of termination for convenience as a way to allow it to avoid such costs by giving it the right to terminate a contract that had become “unnecessary” given recent developments in the war. Torncello v. The United States, 231 Ct. Cl. 20, 20, 681 F2d 756, 759 (1982). Upon termination, the contractor was entitled to recover some lost profit, but typically was not entitled to the full measure of damages available under a traditional breach of contract claim.
As the doctrine continued into World War II, the government’s basis to include these clauses was that they were “only intended to handle changed conditions, relieving the government of the risk of receiving obsolete or useless goods.” Torncello v. The United States, 231 Ct. Cl. 20, 20, 681 F.2d 756, 763 (1982). Post-war, the courts continued to allow the government to terminate contracts for convenience, but relied on the “risk allocation nature of the concept to allow termination for convenience only when the expectation of the parties had been subjected to a substantial change that made continuance of the contract clearly inadvisable.” Id. For example, if the job became impossible, too difficult or too costly to perform if pushed through to conclusion, the government could typically terminate the contract for convenience. Nolan Brothers, Inc. v. The United States, 186 Ct. Cl. 602, 606, 405 F.2d 1250, 1253 (1969). It was clear, however, that the government could not just terminate the parties’ contract for no reason whatsoever, despite what the untutored reading of the termination for convenience clause suggested. Rather, some change from the parties' original bargain was required. John Reiner & Co. v. United States, 163 Ct. Cl. 381, 325 F.2d 438 (1963); Brown & Son Elec. Co. v. United States, 163 Ct. Cl. 465, 325 F.2d 446 (1963); Nesbitt v. United States, 170 Ct. Cl. 666, 345 F.2d 583 (1965); Warren Bros. Roads Co. v. United States, 173 Ct. Cl. 714, 355 F.2d 612 (1965); Coastal Cargo Co. v. United States, 173 Ct. Cl. 259, 351 F.2d 1004 (1965); Schlesinger v. United States, 182 Ct. Cl. 571, 390 F.2d 702 (1968); G.C. Casebolt Co. v. United States, 190 Ct. Cl. 783, 421 F.2d 710 (1970).
In 1974, the courts first allowed termination for convenience for a different reason than risk allocation and allowed the government to terminate a contract as a matter of strategy in order to save the government money. Torncello v. The United States, 231 Ct. Cl. 20, 20, 681 F.2d 756, 767 (1982). The case was highly criticized, however, on the grounds that the ability to terminate a contract for no reason at all is nothing more than an illusory promise, and illusory promises are void and unenforceable for want of consideration. Id.; see also Restatement (Second) of Contracts § 77(a)(1981). In order to avoid consideration criticisms, the courts limited the termination for convenience clause by incorporating a good faith element. Kalvar Corp. v. United States, 211 Ct. Cl. 192, 298-99, 543 F.2d 1298, 1301-02 (1976), cert. denied, 434 U.S. 830, 98 S. Ct. 112 (1977). Still, courts struggled with lack of consideration issues and what constituted good faith.
Within just four years, the good faith limitation was interpreted to require the change of circumstances historically contemplated. Torncello, 231 Ct. Cl. at 20, 681 F.2d at 772. No doubt this frustrated the government, which had enjoyed much latitude regarding their contracts over the previous several decades. Unsurprisingly, the Competition in Contracting Act (CICA) was enacted, requiring a lenient standard in applying governmental termination for convenience clauses. Pub. L. No. 98-369, 98 Stat. 1175 (codified as amended in scattered sections of 10, 31 and 41 U.S.C; see also 41 U.S.C. § 401, 405(a) and 416 (1994); and Krygoski Constr. Co., Inc. v. The United States, 94 F.3d 1537, 1542 (1996). Application of CICA eliminated the “changed circumstances” requirement from federal contracts and relaxed the duty of good faith such that the government has almost an unfettered discretion to terminate a contract for its convenience, although at least one state has continued to apply the changed circumstances test in the governmental context. See RAM Engineering & Constr., Inc. v. Univ. of Louisville, 127 S.W.3d 579, 587 (2003).
As the use of termination for convenience clauses grew in federal contracts, the clauses started gaining acceptance in private contracts. In 1987, the A201 introduced the concept of termination for convenience, but limited it to suspension. AIA Document A201-1987 § 14.3. In 1997, termination for convenience was added and thereafter retained in the 2007 revisions. AIA Document A201-1997/2007 § 14.2.
Unlike federal government contracts, in the private context, the law remains that any decision by a party to terminate a contract must be made in good faith, as determined by the reasonable expectations of the parties at the time the contract was executed. Questar Builders, Inv. v. CB Flooring, LLC, 978 A.2d 651, 675-76, 410 Md. 241, 281-82 (2009). The question then becomes, what constitutes bad faith in terminating a contract and how far can you push the limits of one of these clauses before rendering your contract illusory?
In Questar Builders, Inc. v. CB Flooring, LLC, Questar Builders (Questar) was hired as general contractor to construct a luxury mid-rise apartment and townhome complex. 410 Md. 241, 245, 978 A.2d 651, 653 (Ct. App. 2009). After receiving bids from three flooring subcontractors, Questar selected CB Flooring, LLC (CB) to install carpeting for the project at a total contract price of $1,120,000.00. Id. After entering into the subcontract, however, the interior design firm working on the project changed the carpets to be installed in certain portions of the project. Id. at 249, 978 A.2d 656. Questar immediately sought a price quote from one of the previous bidders, Creative Touch Interiors (CTI), “assertively because it was trying to keep CB honest on any requested change order.” Id. Shortly thereafter, CB submitted a change order requesting an upward adjustment to the subcontract price for the carpet change. Id. at 250, 978 A.2d 656. CB’s change order request was for more than the price quote provided by CTI. Id. Questar terminated the contract with CB and issued the contract to CTI. Id. CB filed suit against Questar for damages, including lost anticipatory profits. Id. at 251, 978 A.2d at 657.
The trial judge concluded that Questar improperly terminated the subcontract and awarded expectation damages to CB, considering and rejecting Questar’s contention that “it enjoyed a right to terminate the subcontract for any reason based upon its termination for convenience clause in the subcontract.” Id. at 251, 978 A.2d at 657. Further, the trial judge specifically found that Questar’s assertion that its “subjective loss of faith in CB’s ability to perform satisfactorily satisfied whatever implied limitations there might be on the exercise of the termination for convenience clause” was without merit, and instead held that something more objective was required to satisfy the good faith limitation. Id.
On appeal, the Court reviewed the history of the clause’s development in the context of federal procurement and found that the case law supporting such a “broad termination right” was “too broad” in the private context. Id. at 270-71, 978 A.2d 669. The Court declined “to recognize for private parties the near carte-blanche power to terminate that courts have given the federal government under convenience termination clauses” on the basis that without special government legislation allowing it, such contracts are illusory, and therefore unenforceable. Id. Rather, the Court, following the historical analysis of termination for convenience clauses, found that “the right to terminate a contract for convenience is a risk allocating tool.” Id. at 277, 978 S.2d 672. To that end, the Court held that a contractor may terminate a contract, in its discretion, only if it first determines that continuing with the subcontract would subject it potentially to a meaningful financial loss or some other difficulty in completing the project successfully” (i.e., a change in circumstances). Id. Moreover, the Court specifically found that as it relates to the above, a contractor has an obligation to “act reasonably in ensuring that a subcontract does not become inconvenient.” Id.
One of the only courts to rule on termination for convenience clauses in the private context, and the most recent decision, Questar is concerning from a terminating owners and contractors perspective because it suggests that despite including a termination for convenience clause in your contract, you are still going to have to show some element of cause to get around the duty of good faith. Specifically, it suggests that even if you have a change in circumstances or the project requirements or scope, that may not be enough to justify termination. It further suggests that termination for convenience clauses in the private context are going to be carefully scrutinized with disfavor.
Questar is a Maryland state court decision and is therefore not precedent in this state. South Carolina courts have yet to rule on the issue. However, at minimum, it is clear that in South Carolina, a duty of good faith is going to be implied in the construction contract and therefore read into the termination for convenience clause. Adams v. G.J. Creel and Sons, Inc., 320 S.C. 274, 465 S.E.2d 84 (1995); see also U.S. for Use and Benefit of Williams Elec. Co v. Metric Constructors, Inc., 325 S.C. 129, 480 S.E.2d 447 (1997) (applying duty of good faith and fair dealing to construction contracts). Since we do not know yet how the courts will construe bad faith, savvy practitioners will advise their clients that there is no unfettered discretion to terminate and hopefully can clarify the parties’ expectations and rights on this point at an earlier drafting stage.
There are four primary issues to be mindful of when negotiating a termination for convenience clause. First, is the clause enforceable? Second, how do I invoke the clause? Third, if invoked, what are the parties’ obligations under the clause, and finally, four, what compensation is the terminated party entitled to under the clause?
Dealing first with enforceability, since it is likely the clause can only be exercised in good faith and in accordance with the expectations of the parties, it may be wise to have a specific acknowledgment that the parties understand the terms of the termination for convenience clause and that the inclusion of such clause was specifically negotiated. An owner or contractor may also want to expressly include an acknowledgement that utilization of the termination for convenience clause does not violate the owner or contractor’s duty of good faith to the contractor and that it is the express intent of the parties that the owner or contractor be allowed to terminate the contract for any reason whatsoever, should the owner or contractor deem it advantageous to do so. While this may appear to render the contract illusory, because you have already noted that these provisions are specifically negotiated, and because you are about to address compensation for termination by convenience and perhaps even a termination fee, it is unlikely a court will find the contract illusory. After all, you have just outlined your own separate consideration for this provision. Additionally, you will want to address the obligations of the parties upon termination and how the terminated party will be compensated. The more provisions in the contract that contemplate a termination for convenience result, the harder it will be for the terminated party to argue that such termination was outside the reasonable expectations of the parties. This leads to the next major group issue: obligations and compensation.
To state the obvious, no two contracts are alike; however, all contracts have fairly standard payment issues: actual costs incurred, overhead and profit. For purposes of this article and for illustrative purposes, we’ll consider the standard A201. Article 14.4.3 of the A201 provides
In case of such termination for the Owner’s convenience, the Contractor shall be entitled to receive payment for work executed, and costs incurred by reason of such termination, along with reasonable overhead and profit on the work not executed.
At first glance, the provision seems clear-cut, right? The contractor gets payment for any work it has performed up to the point of termination and a reasonable overhead and profit on work not executed. But how are you going to determine the actual costs incurred and percentage of work performed? What is “reasonable” in terms of overhead and profit? Additionally, what do you do when a contractor frontloads its billing by seeking and collecting payment for work not yet completed? A terminating party may find itself in the position of actually being owed, rather than owing, money at the time of termination.
In order to avoid these types of disputes, practitioners must advise their clients that they must directly and continuously contemplate termination as a possibility and adhere to a consistent and accurate payment application approval process. That process needs to consistently address actual costs incurred, delineate what those costs are for and regularly assess percentage of work complete. Additionally, if you are using an A201, you would be well advised to delete the word “reasonable” immediately and insert instead either a fixed sum or some percentage of the outstanding overhead and profit due.
At this point (assuming use of the A201) you may be wondering why anyone would even utilize the termination for convenience provision. The terminated party gets its actual costs, the terminating party still has to keep up with all its documentation or is going to be dealing with litigation over good faith, and the terminated party gets reasonable overhead and profit, which, if not modified, will be impossible to quantify absent litigation. You might be right. Which is exactly why these provisions of the A201 require modification, in particular the language concerning overhead and profit, which is typically the bulk of any termination claim.
Several options are available to address the overhead and profit ambiguities. One option is to utilize a cut-off method which allows for recovery of certain identified payments and overhead and profits up to and not exceeding a certain amount. This modified provision provides the owner with a level of certainty by fixing a cap on the amount of overhead and profit a contractor may recover. Another drafting option entitles the contractor to a percentage recovery of its contractor’s fee or overhead and profit based on the level of job completion. Of course, this option still leaves you litigating percentage of job completion, so you will want to set percentages in ranges. For example,
… if the level of work completion is less than twenty-five (25) percent complete at the time of Termination, Contractor shall be entitled to five (5%) percent of its unearned Contractor’s Fee; if the level of work completion is between twenty-six (26) percent and fifty (50 percent at time of Termination, Contractor shall be entitled to ten (10) percent of its unearned Contractor’s Fee;
and so forth and so on. Based on each project, an owner or contractor can determine the best breakdowns and most suitable level of detail. Yet a third option is to completely waive overhead and anticipatory profit and state that the contractor’s sole compensation when terminated for convenience will be its actual costs incurred to date of termination for work performed. While this option may seem harsh, it is being regularly used, and construction practitioners are well advised to instruct their clients to be on the lookout for it. Finally, a fourth option, and there are others, is essentially a hybrid. It provides the contractor with alternative bases of calculating recovery based on level of completion. For example:
Contractor shall be entitled to receive either payment for work executed, and costs incurred by reason of such termination, which costs shall include costs for materials, or contractor shall be entitled to be paid a pro-rata percentage of the total contract sum which is equal to its percentage of completion on the effective date of termination, whichever of the two methods is lower. The Contractor hereby waives and forfeits all other claims for payment and damages, including anticipated profits.
In contrast to the A201, this revised provision links the contractor’s recovery to work actually performed, rather than permitting the contractor to recover overhead and profit on uncompleted work.
In addition to addressing overhead and profit, carefully drafted termination for convenience clauses also must consider costs. That is, if we are going to provide that the terminated party may recover its “costs,” what costs are we going to allow and are there any that need to be excluded? Costs are not defined in the A201. However, costs to consider are cancellation costs, de-mobilization costs, interest on supplier accounts, materials incorporated into the project that were not purchased by the contractor but already in supply, and the list goes on and on.
Lastly, any well-drafted termination for convenience clause needs to include a deadline for the terminated party to submit its claim for damages under the termination clause. In some cases, this is critically important because the owner and/or contractor are going to want to retain another contractor to complete the terminated party’s work. They will not want to wait long to do so and are going to need some certainty as to how much the recent termination is going to cost them before entering into another contract. For that reason, it is advisable to include a deadline for the terminated party to submit its claim for costs and any allowable overhead and profit, along with back-up documentation. Additionally, while it goes without saying that all contractors keep excellent records and documentation for their costs and operations (insert sarcasm here), you’ll want to include a dispute and possible forfeiture provision, with yet another deadline to address any problems with documentation.
An experienced contractor negotiating with a sophisticated owner and/or contractor will not be surprised to learn that the owner/contractor likes having the unfettered right to terminate the contractor for convenience, but doesn’t care to pay unearned profit and overhead and believes the contractor should be satisfied to receive, upon its sudden, unprovoked termination, mere payment for work completed. But a contractor engaged in a substantial construction project of long duration with commitments to the project will be frustrated if it is terminated early. There may have been substantial investment in new equipment that will pay off only over the entire period of contract performance, and typically it will have foregone other significant projects in reliance on this contract. A contractor only needs to be terminated for convenience once in the first half of a multi-year project to realize quite painfully why getting paid for work completed, without more, is a recipe for financial disaster.
Contractors should protect themselves from the disaster of a capricious termination by securing detailed and unambiguous financial protection from its results. Likewise, owners and contractors who want the flexibility to terminate for convenience need to protect themselves, to the extent possible, from the risks the clause will not be enforced, and from costly and protected litigation over ambiguities within the clause, by careful negotiation and drafting on the front end. Though the subject of termination may seem unthinkable while undertaking a new construction contract, the stakes are simply too high and the possibility of termination too real to ignore. Owners, contractors and their counsel must actively negotiate termination provisions prior to contract execution in order to minimize its risks and financially protect all parties from its exposure.
This article originally appeared in the SC Bar Cosntruction Law Section's "News and Notes."