While most construction projects do not end up in contention and acrimony, some do. Unexpected costs or delays can cause strife, and if trust or confidence is lost, the Owner will naturally question the Contractor’s judgment, if not its motives. Payment applications that were routinely approved will face heightened scrutiny and will frequently be reduced. Retainage that was reduced or even eliminated will be reinstated, and the cash-flow to the Contractor will be reduced. Payments to lower-tier subcontractors and suppliers will be affected, and slowly but inextricably, the project will become a dysfunctional mess. As additional performance issues arise, default letters will be issued, leading to consideration of contract termination.
Contract termination is a very draconian remedy. It inevitably leads to delays in the completion of the project, the incurrence of added costs and the filing of lawsuits or demands for arbitration. For the Owner, termination will cause additional direct damages in the form of additional construction and financing costs, and likely result in the incurrence of consequential damages resulting from the delay in obtaining beneficial use and occupancy of the project.
For the Contractor, termination can be even worse, and is frequently characterized as a death sentence. At a minimum, the Contractor will be out of pocket the costs incurred since the last payment from the Owner, and the Contractor will also have direct and indirect overhead costs. The Contractor may also have consequential damages, as cash-flow from the project, as well as expected revenues, are no longer available. The Contractor may have no option but to draw on its line of credit or infuse additional capital into the company. It also has to worry about answering proposal requests that ask about any prior terminations, and if it has outstanding surety bonds, a termination can cause the surety relationships to founder.
Termination puts in motion a chain of events that is expensive and time-consuming, and it may also unleash a series of unanticipated consequences, not the least of which may be a judicial determination that the termination was wrongful and without basis. Before heading down this path, it is essential to understand that not every breach of a contract authorizes or entitles the non-breaching party to terminate the contract, and that only a total or material breach justifies the remedy of termination. This naturally raises the question of what exactly is a total or material breach, how does one determine whether a breach is total or material and what are the consequences of wrongfully declaring a termination for material breach?
What Is a Total or Material Breach?
Contract termination is only appropriate if there had been a total or material breach of the contract, so this naturally raises the question—what exactly is a total or material breach? Many courts have addressed this question, and while the definitions they provide vary slightly, a total or material breach is generally characterized as a (i) substantial failure to perform, (ii) a breach so substantial as to defeat the purpose of the contract or (iii) one so substantial as to defeat the object of the contract.1 Other courts characterize the breach as one that goes to the root2 or essence3 of the contract, or a breach of such significance or materiality as to preclude adequate compensation in money damages.4
According to Williston:
[A] “material” breach is a failure to do something that is so fundamental to a contract that the failure to perform that obligation defeats the essential purpose of the contract or makes it impossible for the other party to perform under the contract. In other words, for a breach of contract to be material, it must “go to the root” or “essence” of the agreement between the parties, or be “one which touches the fundamental purpose of the contract and defeats the object of the parties in entering into the contract.” A breach is “material” if a party fails to perform a substantial part of the contract or one or more of its essential terms or conditions, the breach substantially defeats the contract's purpose, or the breach is such that upon a reasonable interpretation of the contract, the parties considered the breach as vital to the existence of the contract.5
A breach that is incidental or subordinate to the main purpose of the contract, or one that is not so substantial and fundamental as to defeat the object of agreement, is not a material breach.6
Courts have also been asked to determine what constitutes a “substantial breach” since, according to widely utilized AIA forms, a substantial breach by one party entitles the other party to terminate a contract for cause.7 In attempting to make this determination, courts have noted that the AIA forms fail to define the term “substantial breach,” and courts have also held that the term is ambiguous.8 Consequently, some courts have interpreted the phrase to be the equivalent of a “material breach.”9
Thus, even when dealing with highly standardized construction industry forms, a court will have to evaluate the overall facts and circumstances to determine whether there has been a material, or substantial, breach entitling the owner to terminate the contractor. If—or perhaps more appropriately, when—the declaration of termination is challenged in court or in arbitration, a finder of fact (be it a judge, jury or arbitration panel) will decide after the fact whether the breach was sufficiently material so as to justify termination of the contract.10 When making this inquiry, the finder of fact will
look not at the subjective beliefs or understandings existing at the time the termination decision was made, but instead, will determine whether the decision was justified based on an objective evaluation of the facts as they actually existed at the time the termination decision was made.11
The Likelihood of Future Performance and the Adequacy of Money Damages
In recognition that the definitions or characterizations of a total or material default are not particularly helpful when determining whether a particular breach justifies termination, the Restatement (Second) of Contracts § 241 offers a list of significant circumstances to be considered when making this determination. As stated in the Restatement:
In determining whether a failure to render or to offer performance is material, the following circumstances are significant:
- the extent to which the injured party will be deprived of the benefit which he reasonably expected;
- the extent to which the injured party can be adequately compensated for the part of that benefit of which he will be deprived;
- the extent to which the party failing to perform or to offer to perform will suffer forfeiture;
- the likelihood that the party failing to perform or to offer to perform will cure his failure, taking account of all the circumstances including any reasonable assurances;
- the extent to which the behavior of the party failing to perform or to offer to perform comports with standards of good faith and fair dealing.12
Comment (a) to § 241 acknowledges the obvious: the standard of materiality is necessarily imprecise and flexible, and is to be applied in the light of the facts of each case and in such a way as to further the purpose of securing for each party its expectation of performance. The Comment also emphasizes that these are circumstances, not rules, to be considered in determining whether a particular failure of performance is material.13
A number of courts have applied the Restatement factors or circumstances when evaluating claims of material breach.14 Notwithstanding the guidance from the case law and from the Restatement, material breach remains a fact-based determination focused on the adequacy of performance to date and the likelihood that the non-breaching party will obtain substantial performance of the contract from the breaching party. As stated by Bruner & O’Connor:
[A]n unexcused breach is material only if it reasonably compels a clear inference of unwillingness or inability of one party to meet substantially the contractual future performance expectations of the other party. . . . 15
Another significant factor or circumstance is the adequacy of money damages as compensation for the breach. Any breach entitles the non-breaching party to recover damages for the breach, but a material or total breach is so significant that even the recovery of money damages fails to provide the non-breaching party an equivalent to full performance. Stated another way, if money damages can provide an equivalent to full performance, then the breach is not material and does not warrant or authorize termination.16 As stated by the Missouri Court of Appeals:
Where a party fails to perform according to the terms of the contract, it must be determined whether the breach is material. If the breach is material or if the breaching party's performance is a condition to the aggrieved party's performance, the aggrieved party may cancel the contract. If the breach is not material, the aggrieved party may sue for partial breach, but may not cancel. In determining whether a breach is material, an important consideration is the degree of hardship on the breaching party and the extent to which the aggrieved party has received the substantial benefit of the promised performance and the adequacy with which he may be compensated for partial breach by damages. [Emphasis added.]17
An Owner or Contractor considering contract termination should focus on the impact of the breach upon the future contract performance it is owed. What is the likelihood of the breach being cured, and the likelihood of the remaining contract obligations being performed? Also focus on the adequacy of money damages as compensation for the breach. The more egregious the breach, the more unlikely future performance will occur, and thus the more inadequate money damages as compensation for the breach.