Termination for convenience clauses are now present in many contracts. However, problems often arise where the employer has exercised his right to terminate for convenience in order to give the work to an alternative contractor – bringing with it a host of arguments dealt with differently in various jurisdictions.
This article is to be regarded as a taster; there is insufficient space in the KC Construction Update to do full justice to the issues arising in relation to termination for convenience clauses (a substantial main course will be published in due course). This article will identify the main issues arising on the international and domestic authorities and hopes to provide a guide through some of the more knotty arguments.
Termination for convenience clauses are now present in many standard form contracts, including some that include a good faith-type obligation, either as part of the standard form (such as NEC3) or as a bespoke amendment. They vary in format, but usually expressly provide that the employer may terminate on notice for any reason and at any time.
The contract usually provides for what will happen on a termination for convenience: often the contractor is entitled to be paid for work done; less often, the contractor is also entitled to a payment essentially compensating him for his loss of profits.
The main problem in practice arises where the employer has exercised or wishes to exercise his right to terminate for convenience in order to give the work to an alternative contractor, either because he is able to get a cheaper deal or because he has concerns as to the performance of his current contractor and wishes to avoid contention as to whether that performance is sufficiently bad to trigger the termination for default clause.
There has been much more discussion of the enforceability of these clauses in this context in the USA and Australia. Two main strands of attack emerge from the international authorities. These are:
- Where there is a duty of good faith, termination for the purpose of appointing an alternative contractor is in breach of that duty (USA and Australia).
- A construction of the clause that permitted termination in
order to appoint an alternative contractor would mean that the
employer's obligations were 'illusory' and in fact
provided no consideration, because it was entirely at the
employer's option whether he performed his obligations or
not.
The clause would, therefore, not be construed in this way (USA).
GOOD FAITH
United States
In the USA, it is generally accepted that there is an obligation to act in good faith in exercising contractual rights. (see Burton & Andersen on Contractual Good Faith: Formation, Performance, Breach, Enforcement (1995) and, for example, the Uniform Commercial Code §1-304). In most contexts, it has been accepted that the duty of good faith does not permit termination to obtain a better bargain elsewhere, as per the common law cases cited in Good Faith in the Termination and Formation of Federal Contracts by Federick W Claybrook Jr, 56 Md. L. Review 555 (1997). In relation to federal contracts, this may be limited to the situation in which the better deal was known about as at the date of the contract formation.
The conclusion seems almost to be assumed: the existence of the good faith duty appears to have led to a narrow construction of the clauses, despite references in judgments and commentary to the fact that good faith should not be used as "a tool for rewriting the parties' Agreement based on unspecified notions of fairness". (General Aviation Inc v Cessna Aircraft Co, 703 F. Supp. 637 at 644 (W.D. Mich. 1988))
Australia
A duty of good faith has also been recognised in numerous Australian authorities (although the question of whether it is a general duty or a term to be implied by reference to the usual tests has not been finally determined: see, for example, Kellogg v Australian Aerospace [2007] VSC 200 at paragraph 56).
In Pacific Brands Sport & Leisure v Underworks [2005] FCA 288 (Federal Court of Australia), the judge described the duty (obiter) as follows:
"... the duty of good faith is an incident (not an ad hoc implied term) of every commercial contract, unless the duty is either excluded expressly or by necessary implication... I presently incline to the view... that the duty is not an independent term of the contract the breach of which would give rise to a remedy, but that it operates as a fetter upon the exercise of the discretions and powers created by the contract, including the power of termination."
The Australian courts are, however, doubtful as to whether the existence of the duty (without more) means that termination to give the work to an alternative contractor is prohibited.
In Apple Communications v Optus Mobile [2001] NSWSC 365, Optus had exercised its right to terminate 'per any reason' on one month's notice its contract with Apple for the distribution of Optus's pre-paid mobile telephone products for a three-year term. Apple alleged that the termination was in bad faith because at the time of entering into the contract Optus knew it was going to restructure in such a way as would require termination of the contract very shortly. The judge held that, "Even if it were thought that there was a lack of good faith in entering into the contract, I am by no reason certain that this should affect the entitlement to exercise rights under the contract...".
In Kellogg v Australian Aerospace [2007] VSC 200, (an injunction application to prevent Australian Aerospace from terminating its subcontract with Kellogg and taking over the subcontract works itself), Hansen J thought it "well arguable" that on the alleged facts there had been a breach of the duty.
In Leighton v Arogen [2012] NSWSC 1370 (another injunction case), the judge commented that it was "very hard to see how an entitlement to terminate 'for convenience' accompanied by the obligation to pay what the parties must be taken to have agreed would be fair compensation for the consequences of such termination, could be conditioned by any obligation of good faith. On the contrary, I would have thought, such a right was one to be exercised according to idiosyncratic or personal notions of convenience, and not necessarily one constrained by any concept of good faith...".
It will be seen that in Australia there has so far been no case in which it has been finally decided that a decision to terminate a contract in order to give the work to another contractor is in fact a breach of that duty. By contrast to the US position, the discussion in the authorities puts the emphasis firmly on an initial question of the proper construction of the contract.
England & Wales
Historically, the English courts have not accepted any general duty of good faith. There has been limited consideration of express duties. It is clear from Mid-Essex Hospital Services NHS Trust v Compass Group UK & Ireland Ltd [2013] EWCA Civ 200 and the application of that case in TSG Building Services Plc v South Anglia Housing Ltd [2013] EWHC 1151 (TCC) that such clauses will be construed narrowly where possible. The effect of clauses such as clause 10.1 in NEC3 remains interestingly unclear.
In Yam Seng v International Trade Corporation [2013] EWHC 111, Mr Justice Leggatt undertook a careful review of the authorities and identified some accepted principles which he says can be described as aspects of good faith, such as the implied terms of cooperation or not unreasonably withholding consent. In particular, he observes that a power conferred by a contract on one party to make decisions which affect them both must be exercised honestly and in good faith for the purpose for which it was conferred.
In Mid-Essex Hospital v Compass [2013] EWCA Civ 200, the Court of Appeal discussed the trial judge's reliance on various authorities in support of his conclusion that the clause in the contract permitting the employer to award 'service failure points' and thus deduct monies amounted to a discretion which was subject to an implied term that it would not be exercised in an arbitrary, irrational or capricious manner.
This type of implied term is one of those identified by Leggatt J in Yam Seng as falling within his definition of good faith (see paragraph 149).
Jackson LJ said, "An important feature of the above line of authorities is that in each case the discretion did not involve a simple decision whether or not to exercise an absolute contractual right.
The discretion involved making an assessment or choosing from a range of options, taking into account the interests of both parties. In any contract under which one party is permitted to exercise such a discretion, there is an implied term..."
He held that the service failure points regime in issue was subject to a contractual mechanism, which meant there was a right answer.
Accordingly, there was no discretion which could give rise to the implied term.
The exercise of a power to terminate for convenience is, surely, "a simple decision whether or not to exercise an absolute contractual right."
On the Compass approach, that power would not therefore be circumscribed in any way.
However, in Selkirk v Romar Investments Ltd [1963] 1 WLR 1415, the Privy Council considered a situation in which the vendor of land exercised his contractual right to rescind on the basis that he was "unable or unwilling" [emphasis added] to meet a particular inquiry as to his title made by the purchaser. The Privy Council held that the vendor must not act "arbitrarily, or capriciously, or unreasonably. Much less can he act in bad faith... Above all, perhaps, he must not be guilty of "recklessness" in entering into his contract, a term frequently resorted to in discussions of the legal principle and which their Lordships understand to connote an unacceptable indifference to the situation of a purchaser who is allowed to enter into a contract with the expectation of obtaining a title which the vendor has no reasonable anticipation of being able to deliver..."
This case was not cited in Compass. However, a right to rescind on the ground of unwillingness also looks like a power to exercise an absolute contractual right. A tension therefore exists between the judgments of the Court of Appeal and the Privy Council.
To a common lawyer, the question arises why an objectively tested good faith term (whether put as a duty to act honestly or not to act arbitrarily, capriciously or unreasonably, etc.) would be relevant, if on the proper construction of the contract the employer was entitled to terminate at his convenience for any reason at all.
This is precisely the point made by the Australian court in Leighton. It is also the conclusion reached by Akenhead J in the very recent case of TSG Building Services Plc v South Anglia Housing Ltd.
That case involved an application for declarations under Part 8 relating to the scope of a termination for convenience clause (importantly, the reason for the termination is stated as not known). The judge considered Yam Seng and concluded, "I do not see that implied obligations of honesty or fidelity to the contractual bargain impinge in this case at all.
There is certainly no suggestion or hint that there has or might have been any dishonesty in the decision to terminate. So far as fidelity to the bargain is concerned, that depends upon what the bargain actually was..."
The judge had no difficulty in concluding that the employer was entitled to terminate. This conclusion feels entirely natural to an English black letter lawyer. However, it was not argued that the clause on its proper construction did not permit the relevant termination: as Akenhead J said, that is the crucial question.
CONSTRUCTION OF THE CONTRACT
In Torncello v United States 681 F.2d 756 (Ct. Cl. 1982) (en banc), the US Navy had let a contract to Torncello for grounds maintenance and refuse removal. Item 8 of the contract included the responsibility for pest control.
The Navy had a problem with gophers, but it did not call on Torncello to remove them. Instead, it let its gopher problem to an alternative contractor, which had been a competing bidder at tender stage and offered a cheaper price per pest control call out.
The relevant clause provided that on written notice the government "may terminate this contract, in whole or in part, when it is in the best interest of the Government". The Navy relied on the clause as a defence to Torncello's claim for damages, using a 'constructive termination' argument available specifically to the US government in which the conctractually required written notice is dispensed with: see Torncello at pages 5 & 16 and see also John Reiner & Co v United States 325 F.2d 438 (Ct. Cl. 1963).
The judgments in Torncello are somewhat contradictory. One of the judges described Judge Bennett's leading judgment as taking "a needlessly circuitous route to a destination we all agree on. In getting there, it tosses off needlessly sweeping dicta".
However, all members of the court agreed in holding that the Navy's defence failed, on the grounds that on its proper construction the clause did not permit termination to give the work to another contractor where the employer knew of the cheaper deal at the time of entering into the contract.
This must, therefore, be regarded as the true basis of the decision.
Interestingly, Torncello has subsequently been subject to some inventively restrictive readings by the Federal Circuit, including characterisation as a bad faith case which stands for the "unremarkable proposition that when the government contracts with a party knowing full well that it will not honor the contract, it cannot avoid a breach claim by adverting to the termination for convenience clause" (Caldwell & Santmyer Inc v Glickman 55 F.3d 1578 (Fed. Cir. 1995)).
Judge Bennett reviewed the US Federal Court cases before 1974 and pointed out that they are related to situations where there was a post-contract change in the circumstances of the bargain or in the expectations of the parties. (The 1974 case referred to, in which a termination in order to grant the work to a cheaper contractor known at the date of entering that contract was upheld, was overruled.)
He states that these cases recognised that the clause "was not to be applied as broadly as an untutored reading of the words might suggest".
The reason for this was that if the clause was construed broadly, there was a total failure of consideration and the whole contract collapsed. The Court would construe the clause narrowly in order to save the contract. Judge Bennett cites the US textbook Corbin on Contracts:
"If what appears to be a promise is an illusion, there is no promise; like the mirage of the desert with its vision of flowing water which yet lets the traveller die of thirst, there is nothing there. By the phrase 'illusory promise' is meant words in promissory form that promise nothing; they do not purport to put any limitation on the freedom of the alleged promisor, but leave his future action subject to his own future will, just as it would have been had he said no words at all."
Judge Bennett comments that "the government's promise to turn to [Torncello] for all of its pest control work, if it was also implicit in the termination for convenience clause that the government could have given [Torncello] none, was no promise at all. The contract would thus fail".
The court rejected all of the Navy's arguments that it had in fact given some consideration.
The consideration argument has not been expressly discussed in the context of termination for convenience in any other authorities, whether English or in other jurisdictions. This may well be in part because if a contract is in the form of a deed, there is no requirement for consideration.
However, readers of this article will be aware that contracts are occasionally not executed as deeds, and in relation to those agreements it is relevant to note that English law does indeed include a concept of 'illusory' consideration.
The editors of Chitty (3-025 & 2-176) suggest that, "Consideration would be... illusory where it was alleged to consist of a promise the terms of which left performance entirely to the discretion of the promisor... A person does not provide consideration by promising to do something 'if I feel like it or 'unless I change my mind,'" and "An agreement may give one party a discretion to rescind. That party will not be bound if his promise is 'I will only perform if I do not change my mind.'"
No authorities are cited for these propositions. However, the point can be understood from first principles: termination for convenience clauses do appear to make the contract into a promise to perform unless the employer changes his mind.
The editors of Chitty go on to say that, "...a promise which is subject to cancellation by A may nevertheless constitute consideration for a counter-promise from B where A's power to cancel is limited by the express terms of the promise: e.g. where it can be exercised only within a specific time".
Again, this proposition appears to be based on first principles.
It is suggested that the English courts, which in general take a robust approach to consideration, may well be willing to accept that the usual requirement for notice prior to terminating amounts to sufficient consideration.
Where the contract also provides for payment for the contractor's lost future profit, this may also suffice.
It is tentatively suggested that this may not work: such payment would be the employer's secondary contractual obligation if the termination were unlawful, and thus amounts to no more than performance of the employer's original obligations under the contract (which is no consideration).
As discussed above, any duty of good faith that exists in English law is unlikely to impose a limit on the scope of the clause within the meaning in Chitty.
It may be that in the face of a consideration problem, the courts will be willing to apply a broader Selkirk type approach in order to save the contract, although this does not necessarily mean that a termination for convenience would be found to be arbitrary, etc.
It is possible that a termination to take advantage of a better price, particularly one which was available at the time of entering the contract, might fall within the 'recklessness' ground identified in Selkirk.
There is a further possibility (also suggested in the 11th Edition of Hudson). That is to construe termination for convenience clauses as subject to certain inherent limitations, taking the contract as a whole.
This argument runs by analogy with the well-established principles that:
- a clause which on its face permits the instruction of any variation to the contract (whether by addition or omission or change) is construed so as to be limited to matters which fall within the original scope of the contract (R v Peto (1826) 148 ER 577, Thorn v Mayor and Commonalty of London (1876) 1 App. Cas. 120 (HL) at 127, per Lord Cairns; Blue Circle Industries plc v Holland Dredging Company (UK) Ltd (1987) 37 BLR 40; Costain Civil Engineering Ltd and anor v Zanen Dredging and Contracting Company Ltd (1998) 85 BLR 77 and Trustees of the Stratfield Saye Estate v AHL Construction Limited [2004] EWHC 3286) and
- clauses which permit omissions do not in fact permit the omission of work to be given to an alternative contractor (Carr v JA Berriman Pty Ltd (1953) 27 ALJR 273; Amec Building Ltd v Cadmus Investment Company (1996) 51 Con LR 105 and Abbey Developments Ltd v PP Brickwork Ltd [2003] CILL 2033).
It is suggested that if the termination for convenience clause is construed in a similarly limited way, it no longer renders the promise illusory. This would mean, at minimum, that such clauses did not permit termination so as to give the works to another contractor (unless expressly stated in the contract). However, the broader the express terms of the clause, the more acute the consideration problem.
CONCLUSION
This approach might be particularly interesting in the context either of an implied duty of good faith that involved a duty of fidelity to the parties' bargain, or a similarly construed express duty of good faith. Such a duty might impose a 'fetter' on a wide construction of the clause and correspondingly add weight to a submission made by analogy to the variation clauses cases.
Resolution of these points will no doubt have to await a full trial of a termination for convenience clause case. The interrelationship between good faith, consideration and the proper construction of the contract may well eventually be developed in the Court of Appeal.
The articles and papers published by Keating Chambers are for the purpose of raising general awareness of issues and stimulating discussion. The contents must not be relied upon or applied in any given situation. There is no substitute for taking appropriate professional advice.
This material is prepared for Chambers by our Director of Research and Professional Development, Professor Anthony Lavers (LL.B. M.Phil Ph.D. D.Litt MCI.Arb FRICS Barrister) Visiting Professor of Law, Oxford Brookes University.
