Terminating a Contract – getting it right
Terminating a contract is a surprisingly complex area of the law.
When a dispute arises regarding the performance of a contract, looking at the situation from your side of the equation it can seem obvious that the other contracting party is in the wrong and that you are justified in terminating the contract.
Unfortunately, it is rarely that straightforward and getting it wrong can leave you exposed. If you make the wrong decision and terminate the contract when you were not entitled to, you could be faced with a claim for damages for breach of contract yourself. This is why it is so important that it be done correctly.
A right to terminate a contract can arise from a contractual right or from the common law. There are different tests to be applied depending on how the right arises.
Contractual Rights to Terminate a contract
Most contracts will refer in some fashion to some of the circumstances in which a contract can be terminated. A well drafted contract will clearly define the circumstances in which a contract can be terminated:
- For any reason; or
- For breach
Terminating a contract for any reason
Where a contract contains a provision that allows you to terminate for any reason, it usually specifies that you must give the other party a certain period of notice of your intention to terminate in writing.
It is important to ensure that you comply strictly with these notice requirements, otherwise you risk being liable to complete your obligations under the contract for a longer period or to pay for services you have contracted to receive even though you are no longer receiving them.
Contractual rights to terminate for breach of contract
Many contracts specify certain circumstances in which a party will be considered to be in breach of a contract that gives rise to termination. These are contractual rights to terminate. Some common situations in which a contract will specify a party is in breach of the contract which gives the other party the right to terminate the contract are:
- Non-payment or delays in payment which remain unremedied for a certain period of time;
- A breach of confidentiality or intellectual property clauses;
- An insolvent event – either bankruptcy or liquidation or very often simply the issue of or failure to comply with a statutory demand;
- A failure to remedy a breach of an essential term within a specified time frame; and
- A failure to remedy a breach of a non-essential term within a specified time frame.
It is important to read the terms of the contract carefully.
One difficulty arises when it comes to working out what is an essential and non-essential term of the contract. A well-drafted contract should define the essential terms, but frequently they are not defined, leaving it open to interpretation. It can be difficult to judge whether a term is essential or non-essential. To a large degree, it depends on the type of contract and what it is intended to achieve. Commonly essential terms are defined to include payment, confidentiality clauses, intellectual property clauses, some warranties and sometimes the timing of delivery or performance of the contract. The description "time is of the essence" in a contract signifies that the time for performance of the particular obligation referred to is an essential term.
Where a contract is silent on the definition of an essential term, it falls to the party wishing to terminate the contract to decide whether the term breached is likely to be considered an essential term and to take the risk when terminating the contract that the term breached gave rise to the right to terminate.
Common law right to terminate for breach of contract
There are three circumstances in which a right to terminate a contract can arise in common law (these are set out in the High Court decision of Koompahtoo Local Aboriginal Land Council v Sanpine Pty Ltd (2007) 233 CLR 115):
- An essential term has been breached;
- There is a breach of a non-essential (or intermediate) term so serious that it "goes to the root of the contract" or "substantially deprives the innocent party of the benefit of the contract"; or
- The contract has been repudiated, this includes anticipatory breaches where a party shows an intention to no longer be bound by the contract or to fulfil it only in a manner substantially inconsistent with the party's obligations.
These common law principles are applied to the individual facts of each situation which is why it is such a complex and technical area of the law. When considering whether a party had a right to terminate a contract the Court looks at the following issues:
- The nature of the contract and the relationship it creates between the parties;
- The nature of the term(s) breached;
- The kind and degree of the breach(es);
- The consequences of the breach(es) for the other party; and
- The adequacy of damages as a remedy.
As you can see, this area of the law is very technical and terminating without a right to do so can have dire financial consequences. Further, as will be discussed in a future blog post, the effects of termination on your continuing obligations under the contract differ depending on whether the contract is terminated or rescinded.
It is important to get legal advice before making the decision to terminate a contract to avoid the pitfalls discussed above. If you are considering terminating a contract or consider the other party may be in breach and wish to discuss your options, please contact Fiona Henderson at firstname.lastname@example.org or (02) 4226 5711 to discuss.
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