For construction contractors, default termination is the worst-case scenario from both a financial and reputational perspective. Lost profits, sunk costs, broken relationships and diminished business prospects are all symptoms of default termination, regardless of whether the facts justify the owner's decision to terminate. Reflecting on the gravity of the default remedy, Bruner and O'Connor(1) counsel that "a valid termination of a contract for cause requires a termination decision made independently and in good faith by those authorized by the contract to make that decision".(2) Further, federal courts require the federal government to prove that termination of a public contractor was reasonable and justified under the circumstances. As admonished in JD Hedin Construction Co, "a default-termination is a drastic sanction which should be imposed (or sustained) only for good grounds and on solid evidence".(3)
Despite the requirement to use discretion, many owners operate as though default termination were both an absolute remedy and a tool for leveraging the contractor should the relationship become strained. While owners may have the ultimate burden of showing that termination is justifiable, the prospects of withheld retainage, prolonged litigation and a blemished record are too much to bear for many contractors. As a result, contractors may prefer to capitulate to the owner's demands than engage in a lengthy and expensive legal challenge on principle.(4)
What the aggressive owner may not know, however, is that its right to terminate for default can be forfeited. Whether intentionally or unwittingly, owners forgo their default termination rights in a variety of circumstances. This update begins by discussing the typical contractual language that gives rise to the owner's termination rights and provides a general overview of how courts address the propriety of default terminations. It goes on to explain the different ways in which courts have declared owners to have forfeited their termination rights, with a focus on:
- the owner's failure to meet a condition precedent;
- unreasonable delay in termination;
- express or implied waiver of contract requirement; and
- substantial completion and acceptance.
Assuming that a contractor can sufficiently establish the two key elements of a forfeiture argument – owner forbearance and contractor reliance – it can significantly diminish the threat of default termination.
Standard termination language
Default termination is a fairly intuitive concept, whereby an owner may dismiss a contractor that has not performed its obligations in a timely or contract-compliant manner.(5) Modern default language includes clauses such as:
- "The owner may terminate the contract if the contractor: (1) repeatedly refuses or fails to supply enough properly skilled workers or proper materials; (2) fails to make payment to subcontractors for materials or labor in accordance with the respective agreements between contractor and the subcontractors; (3) repeatedly disregards applicable laws, statutes, ordinances, codes, rules, regulations, or lawful orders of a public authority, or; (4) otherwise is guilty of a substantial breach of a provision of the contract documents."(6)
- "If the contractor persistently refuses or fails to supply enough properly skilled workers, proper materials, or equipment, to maintain the approved schedule of the work . . . or fails to make prompt payment to its workers, subcontractors, or material suppliers, disregards laws, ordinances, rules, regulations or orders of any public authority having jurisdiction, or is otherwise guilty of a material breach of a provision of this Agreement, the contractor may be deemed in default."(7)
- "Owner shall have rights to terminate this Agreement as provided in the General Conditions of Contract. If Design-Builder is in default under the Contract Documents, Owner may, without prejudice to any other right or remedy and upon written notice to the Design-Builder, terminate the Agreement."(8)
- "If the contractor refuses or fails to prosecute the work or any separable part, with the diligence that will insure its completion within the time specified in this contract including any extension, or fails to complete the work within this time, the Government may, by written notice to the contractor, terminate the right to proceed with the work (or the separable part of the work) that has been delayed."(9)
While each variant of the termination clause bestows the same fundamental right to end the contract, the examples above highlight three noteworthy issues. First, contract drafters (usually attorneys) are at liberty to include or omit language that creates an express condition precedent to the termination decision. The typical 'cure notice' requirement compels the owner to provide the contractor with formal notice and an opportunity to remedy any ongoing defects in performance. However, the parties are free to include or omit more stringent conditions. For example under the standard American Institute of Architects (AIA) General Conditions of Contract for Construction, the owner may not terminate until it receives written certification from a neutral initial decision maker that good cause exists to terminate.(10)
Second, despite referencing specific causes of default (eg, failure to pay subcontractors), termination language usually includes a catch-all provision for any "material breach of the agreement". This caveat appears to preserve the owner's right to end the contract immediately should the contractor violate a critical term not listed in the clause. In this context, the propriety of termination can hinge on the contractual, statutory or wider definition of what constitutes a 'material' breach.(11)
Finally, while virtually every form termination clause references the right to terminate for default, none expressly mentions the possibility that this right can be waived. This should not come as a shock. In commercial construction where owners typically have primary drafting responsibility, it is rare to find language that specifies the circumstances in which the owner expressly surrenders the right to terminate for default. Compare this to the contractor's right to additional money for changes to the scope of work. Most construction agreements expressly provide that the contractor waives its claim forever, without timely written notice of the condition giving rise to the claim. In short, termination language usually outlines the causes for termination by the owner, omitting entirely any reference to possible forfeiture.
Judicial evaluation of termination decision
Most courts consider termination proper where the contractor committed an act or failed to perform in a manner expressly designated in the bargained-for default clause. If the default clause authorises termination for "failure to promptly pay subcontractors", there is little doubt that the owner may terminate the contractor in light of overdue accounts to labourers and suppliers.(12) Where scheduling milestones are strictly enforceable under the contract, even a single missed deadline could warrant termination.(13) Anything expressly cited as a cause for termination will likely be construed as a product of the negotiations between the owner and the contractor and a clear indication of what aspects of performance the parties prioritised.
Further, legally contentious terminations can also arise out of unclear termination language. This raises questions such as the following:
- What indicates that the contractor has "failed to prosecute the work… with the diligence that will ensure completion within the time specified"?(14)
- At what point has the contractor "persistently and repeatedly failed or neglected to carry out work in accordance with the agreement"?(15)
- When does contractor action rise to the level of "material/substantial breach of the agreement"?
- How many employees are necessary to supply "enough properly skilled workers" to perform the contract on time?(16)
These are all loaded and nuanced questions that necessitate extraordinary amounts of time and money in litigation.
Analysing a contested termination for default is not a simple process. Judge Lettow of the US Court of Federal Claims ruminates that "[t]rying a default termination frequently takes on the character of a juridical autopsy, an after-the-fact effort to determine what went wrong and who was responsible".(17) The owner may come up with one or several bases for termination, any of which may be sufficient to justify the decision to end the contract. Notably, the owner is not restricted to the grounds for termination stated in a cure notice; "any extant reasons supporting a default termination are sufficient to sustain the default, even if not known or discovered until after the decision to terminate for default is made".(18) In most jurisdictions, the fundamental question is whether, in the totality of circumstances, the owner's decision was reasonable in light of the termination language included in the contract.(19)
This update does not purport to analyse the innumerable fact patterns in which owner termination of a construction project was found to be unjustified. Nor does it attempt to explain situations in which contractor default was found to be excusable. Instead, it goes on to focus on situations in which the termination decision can be voided after the fact in light of prior owner conduct dissolving the contractual authority to terminate. While some courts refer to this principle generally as 'waiver', that term is too narrow. This update uses the term 'forfeiture' to identify when an owner is stripped of the right to terminate based on its own prior conduct. As with wrongful or unjustified terminations, the remedy for a forfeited default termination is typically a converted termination for convenience.
Failure to meet conditions precedent
To safeguard against hasty or unfair terminations, the termination clause often compels the owner to meet conditions precedent to termination. Contract drafters have adopted a variety of prerequisites to termination, with notice and opportunity to cure being standard in most construction agreements. If an owner fails to fulfil any condition precedent, a reviewing court is likely to reject the termination as null. Bruner and O'Connor explain that in order "to encourage the exercise of the right of termination for default only upon independent discretion and only for fair and proper reasons, courts have rigorously enforced the procedural requirements of the termination clause".(20)
While conditions precedent are important, failure to fulfil preconditions is not a forfeiture in every case. Whether a forfeiture has occurred depends on the governing jurisdiction. For example, compare the holding of Ingrassia Construction(21) with the holding of Town of Plainfield v Paden Engineering Company.(22) In both cases, the prime contract included the AIA form requirement that the owner's termination right was contingent on the architect certifying that termination was warranted. In both cases, the owner terminated the contract without first obtaining adequate certification from the architect. In Ingrassia the New Jersey Superior Court held that although the architect's certificate was a condition precedent to termination, a defective certificate did not annul the owner's common-law right to terminate the contract "subject to the normal and traditional burden of proof of material breach".(23) In Plainfield the Indiana Court of Appeals held the opposite, finding that the common law right to terminate in Indiana is "constrained by compliance with certain conditions precedent—notice and architect's certification".(24) These disparate holdings reflect a disconnect between the states regarding whether missing conditions precedent equate to forfeiture of termination rights.
Failure to terminate within reasonable time Once an owner issues a notice of default or notice to cure, it has a duty to execute a termination within a reasonable timeframe. As the reasonableness of timing is a factual inquiry that depends on the specific issues in play, there is no fixed period by which the owner must commit to termination. In any event, the delayed termination argument is unlikely to succeed unless the contractor can demonstrate that it reasonably inferred that a termination would not occur and was deprived of the opportunity to mitigate its ongoing costs. In Westinghouse Elec Corp, for example, the Armed Services Board of Contract Appeals held that termination was unreasonably delayed when the government waited to terminate for 57 days following receipt of a letter indicating the contractor had cured alleged defects in performance.(25) The board stated:
"[The owner's] delay, for which it has furnished no explanation, deprived [the contractor] of the opportunity to stop work and to reduce the loss which it will sustain if the termination for default is permitted to stand. The unexplained delay was unreasonably long [The owner] may not, in light of continued efforts to perform, be heard to argue that such silence and inaction does not constitute an election to permit continued performance".(26)
The two key considerations for the contractor arguing unreasonable delay are:
- whether the owner failed to terminate under circumstances indicating forbearance of termination and;
- whether the contractor suffered prejudice attributable to the owner's apparent forbearance.
Waiver of contract requirements
Construction projects often evolve based on the owner's changed preferences and/or the contractor's proposal to perform part of the work in a more cost-efficient manner. Under the right circumstances, changes to contract requirements or duration of performance may divest the owner of its right to terminate.
Waiver can occur "when [the owner's] words or conduct express an intent not to exercise a known contractual right and [the contractor] was misled and prejudiced by this behavior".(27) In construction, waiver may occur where the owner terminates based on failure to meet amended performance deadlines. For example, an owner may waive its right to terminate where it nullifies the contractual completion date and fails to establish a new one.(28) The owner may also waive its right to terminate where the parties mutually agree to an extension of the completion date of the contract and the contractor continues working thereon.(29) Even where there is no formal agreement to extend the time for performance, some cases have found waiver based on the owner's encouragement to continue work after the contractor's original deadline passed.(30)
Madden Phillips Construction, Inc v GGAT Development Corp is a good example of waiver in the construction context.(31) In that case the site work contractor wrongfully suspended its performance two months into a residential construction project, but returned to the site a month and a half later. The owner-developer allowed work to continue for an additional eight months and 90% of the work to be completed before it terminated the contract.(32) The Tennessee Court of Appeals held that the developer had waived its right to terminate the general contractor because the developer's "decision to modify the contract and continue performance under these circumstances waived its right to assert [the contractor's] suspension of performance as the first uncured material breach".(33) The court also held that the parties had waived the original completion deadline via an oral modification of the delivery date for fill material and subsequent acceptance.(34) While the owner could not terminate the contract due to missed deadlines, it retained its right to demand complete performance within a reasonable time.(35)
Madden notwithstanding, the doctrine of waiver is fairly uncommon in construction contracts. The waiver argument is complicated by the fact that virtually every construction contract provides for liquidated damages in the event of contractor delay. The contractor asserting waiver must prove that it reasonably believed the owner elected to forgo the original completion date or some other milestone. If the owner notifies the contractor of its intent to claim liquidated damages (which it almost always does in practice), the contractor is unlikely to be able to assert waiver with any success.(36) In other words, the ongoing potential for liquidated damages often serves to bar the contractor from claiming that time is no longer of the essence under the contract.
Substantial completion and acceptance
An owner may not terminate work that is substantially complete. A construction project is considered substantially complete when it is capable of being used for its intended purpose.(37) Under the doctrine of substantial completion, "the harsh penalty of default termination does not lie if the project as built has only minor deviations from the project as described in the specifications".(38) In other words, if the architect has certified that a project is substantially complete, the owner may not subsequently terminate any part of the finished work. Notably, however, substantial completion does not outright prohibit the owner from terminating unfinished punch list work.(39) Rather, substantial completion prevents the owner from terminating the contract without giving the contractor reasonable time to correct deficiencies.(40)
Default termination is ordinarily appropriate if the owner has a reasonable basis for termination and the contractor has no valid excuse for its underperformance or other deviations from the contract terms and conditions. The reasonableness of termination involves a hindsight determination of fault – a 'judicial autopsy' of the circumstances surrounding the owner's decision to end the contract. The typical defences available to the contractor challenging a default termination are that either:
- the owner's evaluation of performance was erroneous; or
- there was a valid justification for the contractor's underperformance.
In certain scenarios discussed above, a third argument is available to the contractor. Specifically, the owner's conduct may constitute forfeiture of the termination right, entitling the contractor to damages as though the owner terminated the contract for its convenience. As a general matter, forfeiture has two elements:
- owner conduct indicating forbearance of a termination right; and
- detrimental contractor reliance on the owner's conduct.
Accordingly, contractors and owners alike must ask the threshold question of whether the right to terminate still exists when tensions reach their apex. The owner contemplating default termination should first consider whether it has, by its affirmative conduct, waived its right to default termination. The contractor challenging a termination should explore whether there is any basis for arguing forfeiture, as a well-articulated forfeiture argument may compel the owner to rethink its ultimate decision. A well-crafted argument for forfeiture may compel the owner to reconsider whether default termination is a good idea, perhaps in favour of a less exacting resolution of the dispute.
For further information on this topic please contact Anthony LaPlaca at Seyfarth Shaw LLP by telephone (+1 202 463 2400) or email (email@example.com). The Seyfarth Shaw website can be accessed at www.seyfarth.com.
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