30 Oct 2014

Giving government some flexibility: making your Termination for Convenience clause work

by Alexandra Wedutenko

While Termination for Convenience clauses give flexibility rights, they need to be clearly drafted, exercised in good faith, and complied with.

While a contract sets out the ongoing rights and obligations of a party, many contracts provide for termination for convenience in whole or in part as a flexibility right. From a customer's perspective, the clause should provide the customer with an absolute unfettered discretion to terminate the contract for any reason whatsoever. This right is usually subject to an obligation to pay for work done up to the time of termination as well as compensation to the contractor.

Termination for Convenience (TFC) clauses are commonly used in government contracts; construction contracts and some private commercial contracts.

The inclusion of such a right in government contracts initially reflected the public policy consideration that a government should not be prevented from making future changes based on decisions made by its predecessor. In ICT and other services contracts the TFC often provides for flexibility given the evolving nature of services. A removal of services from scope clause (ie. partial TFC for any reason) is not uncommon.

Despite the inclusion of TFC clauses in most government contracts there has been very little judicial consideration in Australia of these clauses in the government context. Cases concerning the use of these clauses generally relate to private commercial contracts.

Good faith as a potential limitation on the right to terminate for convenience

While there is no clear case law on point, it is possible that courts may imply an obligation to act in good faith when exercising a right to terminate for convenience.

Examples of terminations that have been regarded as bad faith are those:

  • simply for the purposes of awarding the balance of work to a cheaper competitor (Hadley Design Associates Ltd v Westminster London Borough Council [2003] EWHA 1617 (TCC)); or
  • that attempt to defeat the dispute resolution process under the contract by exercising a TFC right after the commencement of a dispute resolution process (Kellogg Brown Root Pty Ltd v Australian Aerospace Limited [2007] VSCA 200).

Limitations in a standard termination for convenience clause

It is important to comply with any limitations in a TFC clause, such as notice requirements – if you don't, this could be considered as repudiation of the contract. Repudiation entitles the other party to recover damages, which will likely exceed the measure of compensation the contractor would otherwise be entitled to if the termination right been validly exercised.

Once the TFC right has been exercised, generally the contractor must stop work and comply with directions to ensure a smooth transition from the outgoing to the incoming contractor.

A contractor's right to compensation for termination

A terminated contractor is entitled to recover costs for work undertaken up to the date of termination. This will include payment for any milestones that have been met.

In addition to these rights of payment, adequate compensation is the cost of termination for convenience.

The compensation available to the contractor upon exercise of a TFC right will inevitably be a crucial matter for commercial negotiation. The types of compensation that are generally included in a compensation regime are direct substantiated costs resulting from the termination and usually exclude loss of profits. Recoverable costs may include:

  • redundancies;
  • lease cancellation payments;
  • materials/equipment payout; and
  • subcontractor termination costs.

A contractor's right to damages

Recoverable costs or compensation for TFC are to be distinguished from a liability to pay damages pursuant to a termination for a breach or repudiation of the contract. Unless the contract excludes it, a right to damages exists at law where a party has failed to perform its obligations under the contract.

The fundamental principle governing the award of damages is the compensation principle: the innocent party is entitled to be placed in the same situation, as far as money is capable of doing so, as if the contract had been performed.

The measure of damages, subject to the principles of causation and remoteness, will depend on the circumstances of the case. They may include:

  • expectation damages (loss of bargain damages);
  • reliance damages (expenditure by the innocent party in reliance of the contract) and
  • restitution damages.

Restitution, quantum meruit and the out of scope work

While a contractual compensation regime may aim to settle all circumstances where compensation will be available, the contractor may still have recourse to general rights to compensation in accordance with the law of restitution.

A claim in quantum meruit (a remedy available under the law of restitution) is a claim for fair and just compensation where a benefit has been accepted by a principal at the expense of the contractor. It's not available where a valid and enforceable contract governs the remuneration for the work to be done. Accordingly quantum meruit will not apply to work that is within the scope of the terms of the contract.

On the other hand a principal may be liable to pay for work that is out of scope if the contract doesn't cover the remuneration for it (ie. the work is not captured by the terms of the contract such as the statement of work).

Milestone payments

Where there is a valid and enforceable contract, there is a question whether a principal will be liable for payment of a partially completed milestone, particularly if the contract specifies the trigger for payment is completion of the milestone.

Arguably unless the contractual compensation regime makes provision for payment of a partially completed milestone, a contractor will not be entitled to compensation unless and until the milestone is completed. However the position may change if the customer has possession of all deliverables or the customer waited till a milestone was largely complete before exercising a TFC right.

Quantification of quantum meruit

It is difficult to anticipate the measure of quantum meruit as the work subject to a claim may not necessarily be contained within the terms of the contract, and the contract price is not necessarily a ceiling to the amount recoverable under quantum meruit.

Broadly, courts will determine the fair value of the benefit provided, using three potential measures to quantify the fair value:

  • by reference to the contract price;
  • by the value of the work to the principal; or
  • by the cost of the work to the contractor.

Practical tips for limiting liability

It is essential to clearly draft a TFC clause to ensure that it:

  • provides for an absolute and unfettered discretion; and
  • clearly articulates the components of losses or damages that are payable. This may include, for example, a cap on the measure of compensation equivalent to the unpaid balance of the contract price as at the date of termination.

It may also be valuable to expressly state that the compensation provided for in the TFC clause is the limit of any liability the principal may have in exercising the right.

Practical tips for exercising Termination for Convenience clauses

First, if Termination for Convenience is being contemplated, then all termination rights should be considered.

A TFC right that is validly exercised would not be a breach of the contract. Conversely an invalid exercise of a TFC right may amount to repudiation which will allow for the possibility of recovery by the seller of damages for breach by the customer. Exercising a TFC right prior to completion of a milestone to avoid payment would likely be regarded as bad faith and therefore potentially amount to repudiation of the contract.

To date the High Court has not expressly accepted that an obligation of good faith is to be implied in exercising a right to terminate a contract. As the law on this does not appear settled, it is advisable to seek legal advice before relying on a TFC clause.

We recommend that where a Termination for Convenience right is exercised, you:

  • act honestly;
  • do not act capriciously; and
  • are not using the right to get a cheaper deal elsewhere.

Finally, if you do exercise your right to Termination for Convenience, make sure you also enter into a Deed of Release to ensure that the termination is effective and releases you and the other party from all future actions.

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.