Early termination of a contract is not always the ‘best answer’

Disruptions, delays, and functionality issues are a common challenge faced by most businesses, particularly during complex IT projects such as a digital transformation initiative or new software implementation. While termination may seem like a straightforward solution to performance issues or disagreements, it can, however, carry legal, financial and operational consequences that outweigh the immediate benefit of getting out of a contract.

Early termination of a contract may create additional administrative and financial burdens for the business, for example, if it is forced to source alternative suppliers or write off unpaid invoices. Wrongful terminations may also lead to further disputes and contractual liabilities.

There are key legal and commercial considerations contracting parties may consider when deciding whether to terminate a contract.

What is termination of contract? 

Termination releases the parties from further performance of the contract. Typically, a contract can be terminated by agreement among the parties, by operation of rights under common law and under the express terms of the contract.

If a contract does not dictate the terms of termination and a dispute arises, courts will apply common law principles. An innocent party may have a common law right to terminate where there is a repudiatory breach – that is, when a party's actions demonstrate a clear intention to refuse to perform the contract, or when the breach is so serious that it deprives the other party of the substantial benefit of the contract.  

Legal considerations

Are there clear grounds for termination? 

Carefully review the contractual terms to identify any express termination rights, while assessing whether the current situation satisfies the triggers to terminate. Check the entire contract – including any related contracts – and not just the termination provisions for a comprehensive assessment.

Are there any notice obligations and cure mechanisms? 

Identify if there are any notice provisions for termination. Any failure to serve notice strictly in accordance with the terms may render the notice to terminate ineffective.

What are the dispute resolution obligations?  

A dispute resolution clause may include obligations to use ‘reasonable endeavours’ to resolve disputes. There may also be time-bound, tiered internal escalation mechanisms and specific referral to other alternative dispute resolution procedures before resorting to litigation or arbitration.

Are there any continuing obligations after post-termination?

Whether the termination will release the parties from all ongoing and future obligations is an important consideration. Be careful of agreeing to post-termination obligations that survive for a certain period after the contract ends. Common examples include confidentiality clauses or restrictive covenants such as non-solicitation clauses.

Are there risks of inadvertently affirming the contract?

Affirmation of contract occurs when the innocent party, knowing of the breach and their right to terminate, acts in a manner consistent with continuing the contract. While it is reasonable for a party to take some time to assess its options when facing a breach, exercise care to ensure that any conduct does not inadvertently affirm the contract and thereby result in the loss of the right to terminate.

Commercial considerations

Logistics to replace or find alternatives

Consider the impact of time and cost required to source and replace contracting parties.  Assess the potential impact on project continuity if there is no immediately available alternative contractor to complete any unfinished work. 

Cost consequences

Assess cost exposure and make sure that it does not outweigh the benefits of terminating the contract. For example, if there are no immediately available alternative suppliers at reasonable cost, or if the other party is litigious and decides to argue that the termination is wrongful, this may give rise to costly disputes and undesirable business disruption.

Strategies and business relationships

Depending on the relative bargaining power of a party, sometimes the threat of termination may be sufficient to prompt a change in behavior or a willingness to agree to a variation of the contract, which may avoid termination. There may be commercial benefits in maintaining ongoing relationships with the other party and protecting any business reputation instead of terminating.

Therefore, whether or not to bring a contractual relationship to an end depends on a mix of legal considerations and the practical realities of the commercial situation.  Early termination should not be treated as the default response when things go wrong.  Instead, parties should take a measured approach by evaluating whether preserving the relationship could deliver greater long-term value, operational continuity, and strategic benefit.