Thinking About a Contract Termination? Consider This…

Contract termination can be expensive, particularly in today’s environment. When delays and cost impacts occur, contractors might consider contract termination in hopes of achieving a better outcome on the project. However, in many instances, it is in both parties’ interest to work together to finish the scope of work. This article discusses considerations surrounding contract termination issues and identifies some leading practices to help inform your organization’s decision-making.

Identify the Driving Forces of the Project’s Issues

The pandemic has created new challenges, such as workforce, material, and equipment shortages. However, just because your project is experiencing delays or other challenges does not necessarily mean that those delays are a direct or a sole result of the pandemic. When your project is experiencing issues, a prudent first step will generally be to determine what is actually causing the issues. Are the delays a result of pandemic-caused restrictions or unforeseeable supply chain issues? Are the issues a result of poor performance or other potential acts of default? Or are the issues caused by something else entirely? Identifying why your project is experiencing issues can be helpful when deciding whether or not a contract termination should be explored.

Of course, having documentation to substantiate your conclusion will often serve your organization well. To the extent feasible, it is sensible to document and establish when the event impacting the project started and how the project is being adversely impacted. Maintaining up-to-date documentation of the project’s progress and productivity rates can help you identify any downward trends as soon as possible and help pinpoint specific issues. Impacts to labor availability and material delivery times should also be documented, which may require your organization to obtain letters from subcontractors and suppliers regarding their staffing and other productivity impacts. Finally, contemporaneously preparing and submitting an updated project schedule upstream reflecting the project impacts will often be sensible as it reflects proactive decision-making and may help minimize the risk of an unwanted contract termination.

An additional note on pandemic-related issues: If your business concludes that the project delays or other issues were a direct result of the pandemic (for example, due to government mandates or restrictions), you may be considering relying on a force majeure clause to avoid a default or a termination for cause. However, your organization may wish to consult with counsel prior to relying on a force majeure clause. How courts interpret and apply force majeure clauses is highly dependent upon what state law governs the contract, as well as any recent court opinions on force majeure clauses issued by that state’s judiciary.

Identifying Contract Documents and Terms

Another important and sometimes overlooked initial step to consider when parties are contemplating a contract termination in the wake of project issues is identifying the applicable contract terms and conditions. When your project is off-schedule or otherwise experiencing issues, a clear understanding of what terms do and do not imply can optimize your decision-making going forward.

Thus, an analysis of what documents are and are not part of the parties’ agreement should be completed. For example, is the downstream party’s bid and any applicable post-bid supplements part of the contract? Have change orders modified the original contract or subcontract? If the parties’ agreement is in the form of a purchase order rather than a formal subcontract, which party’s terms and conditions govern? Additionally, have the parties exchanged noteworthy letters or emails that may serve as a clarification or modification to the original contract?

Once you have your arms around the key documents, an analysis of the key terms relating to termination is prudent. For instance, does the contract permit termination for convenience under the present circumstances or only for cause? If your contract is vague, you may wish to consult with counsel, as contractual termination rights may supplement, modify or provide new rights not available under applicable state law.

If your business is strongly considering a contract termination, identifying what prerequisites, if any, must be satisfied is also generally imperative. For example, what notices may need to be provided before terminating? Is your counterparty entitled to an opportunity to cure? Do the contract documents state that the party terminating for convenience will owe a termination fee?

When identifying what documents are and are not part of the parties’ agreement, when determining how contract terms relating to termination should be interpreted, and/or when analyzing what prerequisites may be necessary to effectuate a termination, your organization may wish to seek the insight of counsel.

Also, if you are considering terminating a vendor contract, ensuring continuity of service is often valuable. It may be wise to consider whether your business has all the necessary information in its possession, as well as a plan for lining up a replacement vendor, prior to providing a notice of termination to ensure continuity of service.

In sum, an understanding of the issues on the project as well as an understanding of the applicable contract terms will often position your organization well when engaging in the ultimate analysis of whether or not to terminate.

Proactive Financial and Risk Analysis

Conducting a proactive financial analysis by assessing the costs and benefits of terminating the contract versus working through the issues, including how the project schedule may be impacted, can help you put your best foot forward.

When considering a contract termination, your organization may want to consider several questions. For instance, what costs might your organization incur if the contract is terminated? And how do those variables, such as cost uncertainty, completion costs, penalties and the cost of litigation, compare to working together to modify the contract in order to complete the project?

As the Upstream Party

If your organization is considering terminating a subcontractor for cause, identifying the potential financial and schedule impacts may be just as important as determining whether or not cause exists.

First, determining that there is, in fact, cause to terminate is sometimes overlooked. Even a termination later deemed for convenience may have financial implications, as the subcontractor may elect to assert a claim for, and be entitled to, its actual costs, plus overhead and profit, depending on your contract’s terms. If a claim seems likely, it is practical to analyze whether those expenses, plus potential attorney’s fees, will be the lesser of two evils when compared to working with the subcontractor to finish the job.

Additionally, hiring a replacement subcontractor to complete unfinished work (following a termination for cause or for convenience) may cause disruption to the project schedule and other challenges. Analyzing the potential impacts to the project schedule is generally necessary. Also, completing the subcontractor’s scope of work may require costs above and beyond the value of the subcontract. Therefore, prior to terminating a subcontractor, your organization may wish to assess whether excess completion costs are anticipated and, if so, the feasibility of recovering those costs from the subcontractor and/or its surety.

As the Downstream Party

When you are the downstream party, your organization will often not have the same termination for convenience rights as your upstream counterparty. However, if you get the sense or are concerned that your upstream counterparty may be considering exercising its termination rights, holding joint brainstorming sessions and risk review workshops may help facilitate open communication regarding project issues. These meetings can also strengthen the parties’ working relationship and foster collaboration with the goal of reaching a positive (or at least acceptable) outcome for both parties. However, if such joint sessions are not conducted, your organization should still consider conducting a financial, schedule, and risk review to evaluate the potential impacts.

Although a contractor may not be privy to all of the business and financial considerations that are on the owner’s mind, discussing the owner’s concerns while identifying options for completing the project may help the owner reach a favorable decision that may not have been previously considered. For example, industrial construction projects often need to be operational by a certain date so that the owner can produce the necessary products (equipment, chemicals, etc.) to meet necessary commitments. An analysis of the financial and schedule-related issues may need to include a discussion of whether the schedule needs to be extended past the original completion date and, if so, why. Other options to bridge the gap may include adding manpower, authorizing overtime or resequencing work, if appropriate. Other more drastic options to increase cost efficiency may include temporarily shutting down the project, depending on mobilization costs and other factors.

Other issues that are currently impacting many industries are supply chain disruption and material/equipment shortages. Therefore, taking proactive measures to help minimize these impacts on your project, as well as understanding the applicable product substitution requirements, may be prudent. Would the same material/equipment be available from another supplier? Can a product substitution be made? Will you incur additional costs if the necessary materials/equipment need to be expedited? Contractors should consider communicating these types of mitigation efforts to the owner, especially if the owner may be considering a contract termination for cause because the project is behind schedule.

These sorts of transparent discussions about the issues on the project will likely demonstrate collaboration and good faith to assist the owner in making strategic and proactive decisions. It may also reduce the likelihood of the owner asserting a purported termination for cause, resulting in a costly dispute. Implementing a modified plan for the project may end up being more cost-effective than terminating the contract.

Conclusion

For all of these reasons and more, including the value of long-term working relationships, your organization will often be well served by taking the time to think through the effects and potential consequences of a contract termination. Additionally, if your organization is considering terminating a contract or is potentially facing a contract termination, you may wish to consult with counsel.

This publication presents the views, thoughts or opinions of the authors and not those of their employers. Because it is intended for general educational purposes only, this publication does not constitute professional or legal advice and should not be relied upon as the basis for your business decisions.