Termination for convenience clauses in government contracts

Termination for convenience clauses are commonly included in government contracts, sometimes thoughtfully but often reflexively. Their reflexive use can be a form of security blanket that is rarely necessary and potentially risky.

A termination for convenience (TFC) clause is a contractual escape hatch, giving the party with the benefit of the clause the right to walk away from what they promised to do even if the other party is not in breach of the agreement.[1]

Within legal limits, contracting parties are free to regulate their own arrangements, including when their agreement might end. Typically, an agreement will operate for a defined period (which might include the right to extend the period) but will provide for early termination on grounds that the counterparty is in default. The common law provides for termination rights based on a party’s breach of a condition, repudiation of the agreement and the like. For contracts of indefinite duration, the common law also allows parties unilaterally to terminate them on reasonable notice.[2] Otherwise, there is no common law right to terminate a contract unilaterally if its term has not expired.[3]

There are appropriate occasions for TFC clauses, particularly in long term or complex agreements in which there may arise foreseeable forks in the road or critical milestones that trigger a holistic reassessment of objectives. For larger or controversial projects, this might include the need to preserve public policy flexibility on change of government.[4] In these cases, some caution must be exercised to ensure that TFC clauses are enforceable as intended. However, it also is common for many standard government contracts to incorporate TFC rights as a matter of course. Reflexive TFC clauses of this nature are rarely necessary and potentially risky.

This note first examines some issues that arise when considering any TFC clause. It then considers the reflexive use of them in standard government contracting arrangements and the additional risks and issues that may result.

Appropriate use

A TFC clause is no more than an agreement to regulate a future termination event, albeit one triggered at the discretion of a single party. As such, it should be drafted, like any other clause regulating future termination events (such as for default or prolonged force majeure) after fulsome consideration of the consequences for all parties, including how the agreement is fairly to be unwound in the circumstances. It is inappropriate, in principle, to equate the consequences of TFC clauses with the consequences of default events because their purposes are completely different. Termination for default is a common law and (usually) contractual remedy for breach, from which damages payable by the affected party may flow. The exercise of a TFC clause is the exercise of a bargained for right, for which additional consideration of some description to the affected party is to reasonably be expected in exchange for the right.

Matters for consideration in drafting TFC clauses include:

• Fundamentally, the purpose for inclusion of the clause – even if the purpose will not be stated.[5]
• Whether there should be any constraints (as to timing, notice, circumstances or otherwise) on its exercise, including whether obligations of good faith are expressed or excluded.
• The full consequences of termination, including for outstanding liabilities, work-in-progress and the like. The affected counterparty may have entered into supporting third party contracts which also need to be unwound lawfully and equitably.
• The additional consideration for the termination right[6], the limitation of liability for early termination to the compensation payment and the right to set off moneys owing to the terminating party against the compensation payment. An arms-length negotiated payout amount will not be a penalty.[7]
• Caps or limitations and releases of other liabilities.
• Whether it is included as a codification and expansion of executive necessity rights.[8]
• Protection against wrongful repudiation claims if the TFC clause is held to be ineffective and against claims for payment of TFC consideration when termination is in the exercise of other rights.[9]

Matters for consideration in enforcing TFC clauses include:

• Strict compliance with formal enforcement requirements.
• Termination by specific reference to the TFC clause.
• Enforcement for a proper purpose, if the right is conferred for an express or implied purpose or if there is a collateral purpose.[10] Extreme caution must be exercised if the effect of termination will be to frustrate the counterparty’s other rights as this may amount to repudiation.
• The interaction with other termination rights, particularly if an event of default also subsists, including the potential ipso facto suspension of enforcement rights under the Corporations Act.
• Whether or not, given the price of exercising the termination right, termination by other means (such as repudiation) may be more cost effective.[11]

Reflexive use

Many standard government contracts include TFC clauses usually inserted as protection against the contract being seen to fetter a future discretion of government.

An agency cannot contract so as to fetter the future exercise of a statutory power or discretion, any such contractual undertaking being unenforceable as a matter of public policy. However, the agencies are taken to know this and the courts will presume that the agency is not purporting to do this. Unless the contract clearly prevents the due exercise of discretion, the provision will not be void but will be construed subject to the right not to perform the contract in the future if performance would be inconsistent with the proper exercise of the discretion.[12] Further, the courts have recognised the difference between fettering a future discretion and exercising a current discretion that might have downstream impacts on future decision making. Courts also will be reluctant to readily construe a commercial contract as fettering future action, particularly when the freedom of future action can be preserved by the payment of damages upon breach of contract.  In short, an “of course” TFC clause is not legally necessary for most government contracts.

If the clause is unilateral, and there is no price for early exit and no right at law to terminate the contract absent the TFC clause, the clause or its enforcement is at serious risk of being challenged as ineffective.

• Arguably, there is an illusory contract. If this is the case, the whole agreement (including its benefit to government) could come crashing down, not merely the offending clause.
• Courts may examine the agency’s termination motives (for example, whether the actions are an improper use of power) to limit or prevent the use of the clause. Cases in this area include terminations because the terminating party could do a better deal and terminations to frustrate the operation of other provisions of the agreement. In particular, governments must exercise every TFC clause in good faith.[13]
• If the agreement is a “small business contract”[14], the provision will be considered unfair on at least two grounds, lack of reciprocity and absence of termination payment, in the absence of the protection of legitimate agency interests.
• Its insertion or use may also be unconscionable conduct.

Unfairness aside, if government insists on inequitable contracting arrangements then (at a practical level) the commercial counterparty might extract other concessions as a trade-off for the agency retaining a clause that it is unlikely to need. Inflexible negotiation stances do not always make for value for money contracting.

Key takeaway

It is entirely reasonable for a government, in an environment of continually shifting priorities, to secure the flexibility to extract itself from commercial arrangements. But, other than in the rare Armageddon scenario when the singular public interest trumps everything, it is appropriate (and usually legally necessary) that the flexibility be documented on fair commercial terms, for which some considerable attention to detail is required.

[1] A TFC clause is to be distinguished from conditions precedent, which can operate to prevent substantive obligations from arising. A TFC clause facilitates relief from substantive obligations after the contract becomes operative.

[2] What notice period is reasonable depends, in no small measure, on the impact on the affected party, including its ability to reorder its affairs.

[3] Governments may assert a right not to perform contractual obligations based on executive necessity, discussed below.

[4] A specific clause may be required because the doctrine of executive necessity is unlikely to apply except in an Armageddon scenario; there is a distinction between executive necessity and convenience. The public interest in governments making contracts, and being held to them, has led the courts away from blanket executive necessity exculpations, including for changing policy priorities.

[5] The clause is better drafted to facilitate enforcement at the terminating party’s absolute discretion, acting in its sole interests and for any reason. The expression or implication of a purpose will limit its use to that purpose.

[6] The price can fit the circumstances and may be a fixed sum or calculated by formula. It will usually be in addition to unwinding costs incurred by the affected party. The price may not be financial but merely a period of notice that fairly enables the affected party to arrange its affairs in anticipation of early termination – in these circumstances, there is less risk of the clause being successfully challenged if the notice period is substantial or if the TFC clause cannot be triggered until after a minimum period of contract operation.

[7] As noted above, a TFC clause triggers payment obligations in exchange for exercise of a contractual right to terminate, not as a penalty for loss or damage suffered by the terminated party, even if it in effect partly compensates for early loss of bargain.

[8] The clause may operate to oust the (limited) application of executive necessity both because, as a matter of construction, the clause itself regulates the necessity and because it may also waive Crown privilege.

[9] The counterparty could seek to negotiate that a termination payment is triggered not only by a TFC clause but also by repudiation.

[10] See note 5.

[11] This may occur if the amount of damages payable on breach will be less than the termination fee. Note that it is improper, as well as a breach of contract, for governments to wilfully breach contracts. Private parties may not be so constrained.

[12] Additionally, many government contracts expressly state that nothing in the agreement fetters the proper exercise of a future discretion by the government.

[13] Governments, with a sole obligation to act in good faith in the public interest, almost certainly are bound to employ good faith contracting and contractual enforcement principles.

[14] See Competition and Consumer Act 2010 in relation to “standard form contracts”.