New practice: Businesses reviewing contracts to see if they can get out of them if needed

First, the business needs to be absolutely sure it wants to get out of a contract. Could performance improve if it agreed different procedures? Could it renegotiate better terms? If it pulls out, can it still satisfy customer needs? Has it thought through the consequences if, for example, this could leave its employees, equipment and other resources idle?

If the business is sure, then it should make sure it exits pursuant to a legal right to do so, rather than by breaching the contract, or it may have to pay damages.

Contract clauses

One way out is to rely on a termination clause in the contract. The sort of clauses you might find include:

A right to terminate by giving notice

The contract may say the business can terminate at any time, provided it gives, say, three months’ notice (the notice period will depend on the contract).

Often, the notice period must expire on the last day of the relevant month. However, some contracts only allow termination to take effect on one date in each year, such as the anniversary of the day the contract took effect. If a business fails to give notice in time, it has to wait until next year.

The contract will specify how a business gives notice, and to whom. It is vital to follow the contract or the notice may be of no effect in law.

What you might have to pay

Before giving notice a business should check whether a payment has to be made to the other party on termination. This can be unlawful in certain circumstances, so the business might be able to challenge that clause. It’s prudent to take advice on this, as the law in this area has changed significantly in recent years, and can be complex.

If the only reason for the payment is to compensate the other party for a breach by the business of a ‘primary obligation’ under the contract (so the obligation to make the payment is ‘secondary’ or dependent on that), and the detriment to the business is exorbitant and unconscionable - out of all proportion to any legitimate interest of the other party in the enforcement of the primary obligation - it may well be unenforceable.

Also check for any other consequences, such as a requirement to return or destroy any materials, paperwork, etc owned by the other side, and clauses stopping you from making the reasons for the termination public.

A right to terminate for ‘material breach’

If the other side has breached the contract, the contract may allow the business to terminate for ‘material breach’. If so, the business can usually claim damages that put it in the position it would have been in if the contract had been performed.

What amounts to a ‘material breach’ is sometimes defined in the contract, eg failure to carry out work within a specified time. More often it is not (to make sure breaches the parties haven’t thought of are not excluded). If so, a business should always take advice on whether the particular breach or breaches (a series of minor breaches can, cumulatively, amount to a material breach) is material. Relevant factors include:

• The impact on the business, compared to the position it would have been in if the breach had not occurred. This means taking into account the nature and timescale of the contract and, importantly, the consequences of the breach to it.
• Whether the breach was intentional (as opposed to, eg a misunderstanding).
• Whether the amount involved was more than minimal or trivial.
• The surrounding circumstances.

If the breach is capable of being put right, the contract may say the business has to give the other party a specified period of time to put it right.

Businesses should take legal advice before terminating for material breach. If it turns out the breach is not material, the other side may be able to claim damages from the business trying to terminate, on grounds it has terminated the contract wrongly – so that the business trying to terminate has in fact committed a material breach itself.

If a business is also entitled to terminate on notice, it is often better to do that instead. The business can still make a claim against the other party for their breach of the contract, although it is prudent to do so at the same time (or even before) it terminates on notice. Take advice.

A right to terminate for any breach

Even if the contract says a business can terminate for ‘any breach’, termination for a trivial breach will usually be unenforceable. Courts are reluctant to allow parties to escape contracts ‘by the back door’.

Where meeting a particular deadline is critical, contracts may make time ‘of the essence’, ie critical, justifying termination if there is a breach. Take advice.

A right to terminate if specific events take place

Contracts may allow termination if, for example, control of the other party changes (eg it is sold to a new owner), it becomes insolvent or a creditor applies to wind it up. Check whether any of these events has occurred.

General right to terminate

There is also a general right to terminate a contract, whatever the contract says, if:

• there has been a breach that is so serious that it goes to ‘the heart of the contract’ (ie it deprives a party of the whole benefit of the contract); or
• there has been a breach of a crucial condition of the contract.

Lawyers call this a ‘repudiatory breach’. A business claiming repudiatory breach must make this very clear to the other party, and do so promptly, or the court may say that it has accepted the breach through its inaction or slowness.

If there is a repudiatory breach a business can normally set the contract aside, and claim compensation that puts it in the position it was in before it signed.

Always take legal advice before serving notice to terminate on these grounds because:

• If a business is also entitled to terminate for material breach, it will usually terminate on those grounds, as the test for repudiatory breach is stiffer.
• If the court decides the other side’s breach was not serious enough, the business could itself have committed a repudiatory breach, by terminating the contract.

Misrepresentations

A business can sometimes get out of a contract if it signed it in reliance on a statement made to it (whether in writing or oral) that turned out to be misleading or untrue - for example, if a supplier told a business their product performed a particular function, and it didn’t. In the legal jargon, these are called ‘misrepresentations’.

If the other side had no reasonable grounds for believing the statement was true, or were careless in making it (ie they made it ‘negligently’), or they deliberately lied or did not care whether it was a lie or not (ie they made it ‘fraudulently’), a business can:

• set the contract aside, and claim back anything it has already paid to the supplier, ie put itself in the same position as if it had never signed it; and
• claim damages for any loss it has suffered.

If it was made innocently, the business can either set the contract aside, or claim damages, but not both.

A business has to act promptly once it discovers the misrepresentation, or it will be treated as accepting it. Also, if a third party has acquired rights under the contract, or the business cannot be restored to its original position (because, for example, it no longer has the goods supplied to it under the contract), a court may refuse to set the contract aside.

Businesses should look out too for clauses in the contract that say it has agreed that it did not rely on any statements made to it before signing. These will stop it claiming negligent or innocent misrepresentation – although it can always claim for fraudulent misrepresentation, whatever the contract says.

Operative date

• Now

Recommendation

• Businesses for whom a downturn could really start to bite should review their supply and customer contracts to see if they can get out of them if needed.