A contract can be terminated in several ways. For example, in accordance with the termination clause or by relying on legal principles under Common Law. Learning how to terminate a contract is important. If a contract is terminated the wrong way, there can be serious legal and financial consequences.
This article will provide a detailed explanation of how a contract can be terminated. And don’t forget, if you need fast and affordable legal advice from a commercial contract lawyer, contact the team at Prosper Law.
Each of the ways in which a contract can be terminated is discussed below.
By agreement between parties
Parties to a contract can agree to terminate a contract. Such an agreement needs to be mutual (i.e. both parties must agree) and it is recommended that the agreement be recorded in writing.
If the mutual agreement to terminate a contract is not recorded in writing, it is open to a person to argue that the contract has not been ended by the agreement of the parties.
Rely on the contract terms
Contracts often contain termination clauses. A termination clause is a clause that describes when and how the contract can be terminated.
Typically, a termination clause will also cover the consequences of termination. This may include the return of property or confidential information, payment for services rendered up to the termination date, and any damages or penalties for breach of contract.
Termination clauses can give a party a right to terminate:
- because the other party has breached the contract; or
- for their own convenience.
If the contract is breached by a party and the contract gives the innocent party a right to terminate, that party must follow the process (if any) described in the contract.
A termination for convenience clause allows a party to terminate the contract without cause. This offers flexibility but should be used cautiously as it can lead to mistrust between parties.
If a party is relying upon a termination for convenience clause, they must still follow the process described in the contract. This process is often more straightforward than terminating based on the other party’s breach.
It is recommended that you have your contract reviewed by a commercial contract lawyer before relying upon a termination clause. Terminating a contract can be complex and because contracts operate in parallel with other laws, the process is usually more involved than simply reading the contract.
Breach of contract
Repudiation occurs when a party, through words or conduct, shows an intention not to be bound by the relevant agreement.
It is critical to ensure that the other party has actually repudiated the contract before taking steps to exercise your right to terminate. Here you can read more about repudiation of contract.
Breach of an essential term
If a term of the contract is essential, the innocent party can terminate the contract even if the consequences of that breach are minor.
Serious breach of an intermediate-term
If a party has breached an intermediate-term (rather than an essential term), then the innocent party can terminate the contract provided that the consequences of that breach are sufficiently serious. Minor or technical breaches are not enough to invoke this right to terminate.
You can read more here to find out how to classify contract terms and work out whether the term is an essential term or an intermediate term. Or you can simply ask a commercial contract lawyer for help.
Contracts may contain what is called an ipso facto clause (meaning by the fact of or act itself). An ipso facto clause entitles the innocent party to terminate a contract if the other party becomes insolvent.
The term insolvency is usually given a broad definition under the contract, so that it is not just the literal definition of insolvent that applies, but the ipso facto may also apply in circumstances where:
- a person becomes bankrupt
- a company enters liquidation
- winding up procedures are started
- a receiver, receiver/manager, controller, administrator or voluntary administrator is appointed
- a mortgagee takes possession of the party’s assets
- the party is placed under official management
- things that have the effect of any items in this list
It is important that, before exercising rights under an ipso facto clause, the innocent party considers whether the Corporations Act 2001 (Cth) operates to prevent the reliance on the clause.
For instance, the Corporations Act 2001 (Cth) prohibits reliance on an ipso facto clause where one of the following applies:
- a managing controller (includes a receiver) is appointed
- the company enters administration
- the company is undertaking a scheme of arrangement to avoid being wound up
Rights under law
Contracts cannot be read in a vacuum. Contracts operate in a complex legal environment (cue: the lawyer!) and it is important to consider whether, even though there is a termination clause, the law operates to override the rights and obligations set out in the contract.
For example, a contract may contain very limited rights to terminate a contract, but the Unfair Contract Terms law operates to grant a party a right of termination in certain circumstances.
The doctrine of frustration is a legal mechanism that can be used to bring a contract to an end. Sometimes, the doctrine finds its way into the term of the relevant contract either by:
- a standalone frustration clause; or
- being included as part of the termination clause.
Frustration according to the contract
A frustration clause usually looks something like this:
If an Event of Frustration occurs, then:
- each party must, as far as possible, continue to perform their obligations under the Agreement; and
- if the Event of Frustration continues for more than 90 days, either party may terminate this contract upon 7 days’ notice in writing to the other party, and each party will be released from any further performance of the Agreement.
Event of Frustration means war, terrorism, epidemic, pandemic, severe weather events or other acts of God which causes one or more of the parties to be unable to perform the Agreement.
Doctrine of frustration
The doctrine of frustration applies where the relevant event means that the performance of the contract has become something that is now fundamentally different to that anticipated by the parties at the time the contract was entered into.
If the event could have been anticipated and therefore dealt with in the contract, the doctrine of frustration is unlikely to apply. An example of this might have been the effects of COVID-19 on the performance of contracts entered into after the pandemic began.
If you need advice about the doctrine of frustration, it is always best to speak to a commercial contract lawyer.
Effect of frustration
- If the frustration clause is relied upon: the clause must be strictly followed (to avoid the risk of repudiation) and the effects will be as per the clause
- If the doctrine of frustration is relied upon: the contract terminates automatically and (subject to limited exceptions) the loss resulting from the termination lies where it falls
A termination clause is a vital part of any contract. It provides an exit strategy for parties, reduces uncertainty, and protects party interests. The clause should clearly define the grounds for termination, the notice period, the procedure for termination, and the consequences of termination. To ensure it serves its purpose effectively and to avoid potential disputes, it’s advisable to seek legal advice when drafting a termination clause.
No matter which method you choose to terminate your contract, it must be done properly and in accordance with the contract terms or relevant legal basis. If you do not properly terminate a contract, there can be significant consequences.
Frequently Asked Questions
What is a termination clause in a contract?
A termination clause is a provision in a contract that defines the conditions under which a party can legally terminate the agreement. It usually outlines the grounds for termination, the notice period required, the procedure for terminating the contract, and any consequences of termination.
Can a contract be terminated without a termination clause?
Yes, a contract can be terminated without a termination clause. This can occur through mutual agreement between the parties or due to a breach of contract. However, it’s more complex and can potentially lead to legal disputes. Therefore, it’s generally recommended to include a termination clause in all contracts.
What are the common grounds for contract termination?
Common grounds for contract termination include breach of contract, insolvency of one of the parties, and significant changes in a party’s ownership or control. Some contracts also include a termination for convenience clause, allowing a party to terminate the contract without cause.
What happens if a contract is not terminated properly?
If a contract is not terminated correctly, in line with its terms or relevant legal framework, it can lead to legal disputes, potential damages, and other significant consequences. It’s crucial to follow the termination procedures outlined in the contract or seek legal advice if there’s no termination clause.
How can I ensure that the termination of a contract is legal and binding?
To ensure that the termination of a contract is legal and binding, it’s recommended to provide written notice of termination, clearly stating the reasons for termination and providing evidence if required. It’s also advisable to seek legal counsel to guide you through the process and ensure all steps are correctly followed.