Termination rights in IT services contracts – making sure you can get out when it all goes wrong

The termination provisions in IT services contracts have become such standard clauses that the rationale behind usage of particular terms can be often overlooked. Many drafters use phrases such as “material breach” and “capable of remedy” without having considered fully what the legal consequences of that drafting are. Given the importance of termination rights, it is certainly an area worth exploring.

It is extremely rare in any negotiation of IT services contracts for the parties not to delve into the issue of termination. Each party attempts to ensure that they are armed with the most favourable set of termination rights their bargaining power would allow. When a contractual relationship breaks down, having favourable or flexible termination rights could provide an easier exit and help manage costs.

What is termination?

Termination releases the parties to a contract from further performance of that contract. This is subject to the exception that any accrued rights are unaffected and may still be enforced and any rights and obligations expressed to survive termination (eg confidentiality) will continue.

A contract can be terminated:

• by agreement between the parties;
• by a party exercising a right to terminate under common law; or
• under an express contractual termination right.

Common law right to terminate

The common law recognises three broad categories of contractual terms: conditions, innominate terms:

Click here to view table.

A contract can also be terminated for repudiation where there is an absence of willingness or ability to perform the whole of the contract based on the defaulting party’s words, conduct or a combination of events, eg. a supplier withdraws all of its personnel from a project. A party can be considered to have repudiated a contract where it purports to terminate the contract but has no legal right to do so.

As with most common law rights and remedies, much of this determination is a matter of interpretation and therefore involves a lengthy and uncertain process as the parties need to go to court (or, at least get legal advice) to understand what their position is and to avoid accidently repudiating the contract. Accordingly, sole reliance on the common law rights may be undesirable.

Contractual right to terminate

It has become usual practice for the parties to a contract to negotiate and include their own set of express contractual rights to terminate. This is especially so in more complex transactions where termination rights are tailored to the particular IT project to give the parties more control over the conclusion of the contractual relationship. It is worth noting that common law termination rights may exist alongside contractual rights (though in some cases, where the contractual rights suggest that the parties intended for the contractual termination framework to be exhaustive, the scope of common law rights may be reduced).

Typical termination clauses

While the circumstances under which a party may wish to terminate a contract tend to vary with the nature of a transaction, there are some common situations where parties may want a right to terminate, including:

• if the other party commits a breach which is capable of remedy. This can be any breach, a material breach or breach of a material term. This kind of trigger generally allows for a remedy period;
• if the other party commits a breach which is incapable of remedy;
• if the other party becomes insolvent or bankrupt;
• in the event of a change of control where the identity of the other party is key. This is likely to be particularly relevant in an outsourcing situation where the supplier has been chosen following an RFP process and substantial due diligence and it is also often a termination right for suppliers under standard software licences;
• for convenience. The right to terminate for convenience comes in many shapes and sizes. It is often only exercisable after an initial period (particularly where one party will incur sizeable upfront costs which it will only recover over the term of the agreement) or on provision of a period of notice (this may be to allow the supplier to reallocate resources internally); and
• if a related agreement terminates. For example, where a customer has software licence, maintenance and professional services agreements with a supplier, it is likely to want the termination of the software licence to result in the termination of the maintenance and professional services agreements.

Material breach of a term vs breach of a material term

While the term “material breach” is frequently employed by contract drafters, the Victorian Supreme Court has, rather unhelpfully, stated that the term “does not appear to be a concept known to the law of contract”1. In the absence of a legal meaning, the construction of that term becomes a matter of discerning the intention of the parties behind its use and looking at the terms of the contract as a whole.2

The different courts in Australia are somewhat divided as to their interpretation of “material breach” and the Supreme Court of Victoria has adopted a particularly narrow reading which suggests that a material breach is equivalent to breach of a condition.3 However, the New South Wales Supreme Court favours an approach which emphasises materiality of the consequences, that is, whether the breach would substantially adversely affect the interests of the innocent party.4 This approach is supported by English case law and seems better aligned with the more commonly accepted understanding of “material breach”

The term “breach of a material term” or a “material obligation” is equally popular amongst drafters. As between the drafting choices:

• termination for breach gives the broadest right to terminate as there is no qualification that the breach itself or the term being breached is material;
• “material breach of a term” focuses on the significance of the breach and whether that breach amounts to non-compliance with the contractual obligations as a whole. This is the midway in terms of breadth of right to terminate; and
• “breach of a material term” focuses on the significance of the term or obligation, which is similar to breach of a condition (the narrowest right to terminate of these three options).

The distinction between the various drafting choices above is also important in relation to the standing of the parties to recover damages following termination, as loss of bargain damages may not be available to a party that has terminated by relying on a contractual termination right in circumstances where a termination right would not have arisen at common law (in this case, the loss of bargain damages may be treated as arising from the decision to exercise the contractual right, rather than any underlying breach by the other party).

When is breach of a contract capable of remedy?

Before a party can exercise a contractual right to terminate, it is often the case that a notice must be provided to the defaulting party requiring the latter to “remedy” a breach which is “capable of remedy”. But what does it mean (in the court’s mind) for something to be capable of remedy?

The courts have interpreted the word “remedy” to mean “cure so that matters are put right for the future”, “even though they have for some period not been right and may have caused some damage to the [innocent party].” The New South Wales Court of Appeal has even stated that a remediable breach does not have to be one which, on the evidence, was in fact capable of being remedied within the period of notice provided for.5

The cases provide a better understanding of when a breach is remediable and when it is not.

Click here to view table.

Given the courts’ general willingness to give effect to what is specifically set out in a contract, it is also likely that the courts will accept certain things expressly provided by the contracting parties to be irremediable as such. Accordingly, if you consider that a certain breach of contract should be considered to be irremediable (eg the decompiling of object code to ascertain the source code), you should include a statement to this effect in your agreement.

IT services contracts – what termination rights should we bargain for?

So, the next time you are negotiating a termination clause, it is worth giving a few moments thought to the usual words and phrases to see whether they are in fact a good safeguard of your rights or whether there is room to negotiate for a better position. In particular, consider whether:

• you want to rely on the general law and stay silent on termination rights or whether the termination rights in your contract should supplement or replace the rights at general law;
• there should be the right to terminate for convenience and, if so, whether there should be a cost to the party exercising that right;
• the parties should have an express contractual right to terminate for a material breach of any term of the contract (in which case, an exercise of this technical right may affect the parties’ rights to claim loss of bargain damages) or only for a breach of a material term (which is more likely to be treated as equivalent to the common law right to terminate for breach of a condition and, therefore, not affect the parties’ rights to claim compensation for loss of bargain); and
• there are things which should always be considered a material breach of the agreement / a breach of a material provision of the agreement (eg breach of the confidentiality provisions) / irremediable regardless of the court’s interpretation (eg disclosure of source code, even to a small group) and, if so, make sure you state these.

Parting notes: exercising your right to terminate

Having negotiated long and hard to achieve a strong set of termination provisions, make sure that you exercise your rights to terminate with caution so that you don’t inadvertently repudiate the agreement. In particular:

• make sure that you actually have the right to terminate in the circumstances. Document the reasons leading you to this conclusion and seek legal advice if you are unclear;
• if you are unsure whether you have the right to terminate for the other party’s breach, it may be safer to exercise your right to terminate for convenience (if you have that right); and
• take note of and follow any applicable notice procedures and time limits set out in your contract. The courts treat the pertinent procedures seriously and the failure to comply may lead to a finding that the purported termination and any subsequent conduct constitute repudiation.