Commercial entities will, at some time or other, be faced with the termination of a contract they are a party to. Despite the parties’ best intentions at the outset of a contract, circumstances may change, whether through a change in the economy; rising cost of materials; an unforeseen situation whereby one party is unable to perform its obligations under the contract; or the effect of a global pandemic. In such circumstances, termination of the contract may become a consideration, whether for convenience or for breach.

Often the position on termination is more nuanced than might at first appear to be the case. This means careful consideration should be given to a number of issues, including:

1. is termination the right option and are there any alternative outcomes available?
2. whether a party is in fact able to terminate under the contract terms;
3. the practical and procedural steps that will need to be followed in accordance with the contract; and
4. the effects of termination.

Meaning of termination

Termination of a contract is where the contract is brought to an end, such that the parties are released from their continuing obligations effective from the termination date. Termination does not undo the contract and the contract will still be enforceable by both parties in respect of any historic rights or obligations which have accrued prior to the termination date. There are also often terms that will survive termination, for example, post-termination restrictive covenants and/or terms relating to misuse of confidential information. However, the future performance of obligations under the contract will cease on termination.

Entitlement to terminate

The starting point when considering termination is the terms of the contract itself. It may be possible to terminate for convenience, by either party giving notice in the required format and with the specified notice period.

If a party is looking to terminate based on the other party’s alleged breach of the contract, it is important to note that not every breach of a contract gives an entitlement to terminate. Often in commercial contracts, certain events will be specified as being a material breach which give rise to the ability to terminate, for example, the insolvency of the other party.

In the absence of any express termination provisions within the contact relating to breach, it is necessary to consider whether the breach committed entitles the innocent party to terminate. In doing so, it is necessary to consider whether the breached term is a condition, which will enable a party to terminate for breach, a warranty or an intermediate term.

A condition is a fundamental term of the contract, going to the heart of it, and a breach of which will enable the innocent party to terminate the contract and claim damages. Generally, a breach of a condition is not capable of remedy, for example, the main purpose of the contract has not been performed.

By way of contrast, a warranty does not go to the root of the contract and therefore if a warranty term is breached, this will not entitle the aggrieved party to terminate, but their remedy will be limited to damages for any loss suffered; the contract will continue.

There are other terms, which when breached, the remedy for which will depend on the nature and effect of the breach at the time it happens. In this sense the position following the breach will be fact specific and may give rise to an entitlement to terminate.

In the heat of the moment, it may be difficult for commercial parties to ascertain whether the affected term is a such that it gives rise to an entitlement to terminate the contract. Whilst parties will often seek to label a term as a ‘condition’ when looking to terminate a contract, whether or not a term actually is a condition will often require closer consideration. It is therefore often sensible, before taking the decision to terminate a contract, to seek independent legal advice as to your position.

Giving notice

Before taking any steps to terminate the contract, it is necessary to reconsider the specific terms around termination and the necessary steps that must be taken to ensure the termination is effective. Accordingly, it is necessary to have regard to:

• whether the party in breach must first be given a chance to cure a breach of contract;

• the time period within which notice can be given – commercially drafted contracts will often include provisions which preclude the termination of the contract where the innocent party has unduly delayed in exercising their rights under the contract, i.e. they will be taken to have affirmed the breach if the contract has not been terminated within the prescribed period;

• the content of the notice – if terminating for breach, it will be important when giving notice of the termination to clearly set out the grounds for termination, including details of the breach and with reference to the contract terms;

• another consideration on giving notice to terminate, including for convenience, is where a contract is subject to automatic renewal terms, it will be necessary for the party wishing to terminate the contract to consider the period of notice which it is required, so as to avoid the situation whereby the contract is automatically renewed for another period; and
• the means of communicating notice – it will be necessary to consider:

• who can give notice;
• the form of the notice required, i.e. is there a requirement for the notice to be in writing?
• the means of delivering the notice, i.e. is there a requirement for notice to be sent by email to a specified individual and/or by recorded delivery post, and/or by personal service?
• when the notice will be deemed delivered.

Effect of a failure to properly terminate

If a party elects to terminate a contract without sufficient grounds or fails to do so in accordance with the prescribed procedures, it will not be sufficient to terminate the contract and the act of purported termination can itself be a repudiatory breach of the contract entitling the other party to terminate the contract and sue for damages. This is why it is often advisable to seek professional advice when considering the termination of a commercial contract.

Alternatives to termination

By terminating a contract, you are effectively terminating, or at the very least potentially prejudicing, any ongoing business relationship with the other party. In addition, there may be reasons not to terminate a contract if there has been a breach, for example, if you are due to receive payments from the other party and there are no concerns as to their solvency.

Whilst circumstances may allow for termination of a contract, this does not mean it is always the most appropriate course of action to take. If the parties want or need to salvage their ongoing business relationship, other alternatives can be considered, including:

1. the renegotiation of the contract terms and a variation of the contract itself to reflect a change in circumstances; and
2. if an alternative remedy is available and/or if there are any prescribed procedures within the contract in the event of a dispute, for example, arbitration or mediation.

All in all, the termination of commercial contracts should not be rushed, and it is important to ensure that sufficient thought and consideration is given to the position before taking any steps. Seeking advice as to the position and exploring the commercial implications of taking such a step is important, before moving forward to terminate.

If you would like to discuss this blog, please contact Jonny Scholes on 07824 435665 or by email to jonny.scholes@pannonecorporate.com

English law upholds the principle of contractual autonomy, granting parties the freedom to negotiate and establish terms tailored to their specific needs and objectives. Contractual certainty is business critical in order to clearly delineate duties and obligations and to provide recourse for an innocent party in the event of a breach.

For contracting parties, it is important to note that contractual autonomy is not absolute and operates within legal frameworks aimed at ensuring fairness and equity in contractual relationships. This article explores the limitations designed to prevent abuse and safeguard parties from unfair or oppressive clauses.

Understanding Penalty Clauses

A contractual term that specifies predetermined consequences for a breach of contract is known as a “liquidated damages” clause. The purpose of this type of clause is not to punish the breaching party but rather to estimate, in a reasonable and realistic manner, the likely losses that would result from the breach. Importantly, the pre-estimate must be made at the time the contract was made (Clydebank Engineering v. Castaneda). This should not be confused with a penalty clause, which imposes excessive financial penalties to deter breaches and can be unenforceable if challenged in court.

The complexity of distinguishing between these two types of clauses often leads to legal challenges, with courts examining the true nature of the clause and the context of its inclusion in the contract. Factors that can be considered include the rationale behind the clause, the bargaining power of the parties, and whether the sum stipulated is excessively high or unconscionable.

Understanding whether or not a clause may amount to a penalty clause could have costly consequences. If a clause is deemed to amount to a penalty clause, it could be struck out as unenforceable.

Evolution of the Test for Penalty Clauses

The legal framework surrounding penalty clauses in UK law has significantly evolved, especially following key judicial decisions that have reshaped their assessment and enforceability.

Historical Perspective:

Historically, the assessment of penalty clauses revolved around the concept of exorbitance in relation to common law damages. In Dunlop Pneumatic Tyre Co Ltd v. New Garage & Motor Co Ltd [1915], the court held that a clause would be considered a penalty if it was not a genuine pre-estimate of costs or sought to impose a detriment on a party out of proportion to the innocent party’s legitimate interest in enforcing the contract.

Shifts in the legal test:

In recent years, the UK courts have moved away from the strict prohibition of penalty clauses. The Supreme Court judgment in Cavendish Square Holding BV v. Talal El Makdessi and ParkingEye Limited v. Beavis [2015] noted that the Dunlop test had taken on the status of a “quasi-statutory code”, which was never the intention.

Lords Neuberger, Sumption and Carnwath took a more nuanced stance, emphasising that the rule on penalty clauses does not permit the courts in every instance to review the fairness of a contractual term when parties can be said to have equal bargaining power. Instead, the focus will be on whether the term in question is a primary or a secondary obligation.

Key principles when assessing penalty clauses:

• Primary vs. secondary obligations: A primary obligation refers to an obligation that arises independently of a breach of contract, while a secondary obligation is triggered by a breach. The Supreme Court emphasised that the penalty rule applies only to secondary obligations. This distinction is crucial in determining the enforceability of penalty clauses, as primary obligations are not subject to the penalty rule.
• Legitimate interest and proportionality: The court highlighted the importance of assessing the legitimate interest in enforcement of the clause in question. The penalty rule will not be engaged if the clause serves a legitimate commercial purpose and is proportionate to the interest being protected. This requires courts to consider the context and commercial rationale behind the clause when determining its enforceability.
• Unconscionability or exorbitance: Even if a clause constitutes a secondary obligation, it may still be enforceable if it is not unconscionable or exorbitant in relation to the legitimate interest which is served by the clause. The courts will assess whether the clause imposes a penalty that is disproportionate to the loss suffered or the legitimate interest being protected. This requires a contextual analysis that considers the specific circumstances of the case.

The following can act as a checklist when considering whether or not a clause is likely to fall foul of the law of penalties: