The Right to Walk Away: How to Agree Termination for Convenience
9 June 2020
The right to terminate a contract for convenience is probably one of the most valuable rights that a customer can secure in contractual negotiations. In fact, if we were to choose one clause that has proved most useful to our clients over the years, we would say it is the right to terminate a contract for convenience.
This is because of the flexibility it affords a customer to change its strategy, to move to a different supplier, or to change the services at any point. It also affords the customer an easy exit from the agreement should the supplier breach any terms or not comply with performance standards without requiring the customer to prove the breach or follow the stipulated breach procedure.
But while this sounds good for a customer, from the supplier’s perspective, a customer’s right to terminate for convenience can be extremely problematic. Suppliers often, for example, set their prices based on the full term of the contract and if the term is cut short by a customer exercising its right to terminate for convenience it effectively means that the supplier would have under-priced the services. Suppliers also often need to be able to recognise revenue for the full term of the contract and a termination for convenience may limit this ability.
Given the importance of this right to the customer and the impact it has on a supplier, the question then becomes, how do we ensure that the customer has the flexibility afforded by the right to terminate for convenience while at the same time ensuring that the supplier has some certainty as to the scope and duration of the contract? This requires balancing the interests of both the supplier and the customer and there are two common solutions to this.
The first is to include an initial term during which a termination for convenience right cannot be exercised by the customer. This would require a negotiation between the parties on what would be an appropriate initial term that would satisfy both parties’ concerns. This gives the supplier some level of certainty as to the fees it will receive, while also giving the customer some flexibility to exit for the reasons set out above.
The second (which is the more common solution) is the introduction of termination charges. This allows the customer to terminate for convenience but also protects the supplier against potential sunk costs and may provide supplier with a mechanism to disincentivise a customer from terminating the agreement.
If the parties have agreed that the customer may terminate for convenience but that termination charges will apply, the next question that often arises is how do they agree what those charges will be? The parties will likely have different views on what constitutes an acceptable charge. Sometimes parties will horse-trade on numbers or percentages (which will generally lead to unsatisfactory results in most areas of a contract negotiation. See our Quick Tips series for more on this topic.).
The following are a few points to bear in mind when trying to agree termination charges:
From the customer’s perspective:
Early termination charges should not be punitive.
The customer should not be required to reimburse the supplier for lost revenue or lost profits. If this happened, the supplier would effectively be paid for work it is has not had to perform.
Early termination charges should be linked to supplier’s genuine sunk costs and may include the ability to recover other upfront investments that the supplier would have made, for example where supplier smooths the fees for transition over the duration of the deal it would lose the fees for transition for the period following the termination.
The supplier should be required to demonstrate their sunk costs. For example, if the supplier bought certain hardware that it needed specifically for the services that it now cannot re-deploy, then the customer may be under an obligation to buy that hardware on exit. However, the associated cost needs to be based on the lower of the net book value or the market value for that hardware, each of which should be demonstrated by the supplier.
It’s also useful for the contract to oblige the supplier to use reasonable commercial efforts to reduce costs and expenses where possible. This includes a control point for the customer to ensure that the sunk costs are minimised.
Early termination charges should also reduce over time. This is primarily because the supplier’s sunk costs amortise over time but also because the risks which the supplier is trying to manage by introducing termination charges reduce as the term of the agreement continues.
Early termination charges should also be determined at the time of termination and not at the time the notice to terminate is provided by the customer.
Early termination charges should be dealt with separately from exit assistance charges. It’s usually important that customers have a clear understanding of what charges constitute exit assistance charges and what constitutes termination charges.
From the supplier’s perspective:
The supplier will generally want the ability to recognise as much revenue as possible when the deal is entered into. But this might be difficult if there is a high degree of flexibility for the customer to walk away from the deal. For this reason the termination charges should be set at a level that allows the supplier to still recognise revenue despite the termination. (See our article on Revenue Recognition for a fuller discussion on this issue.)
Early termination charges should enable the supplier to easily recover all costs incurred in entering into the deal that, by the termination date, the supplier has not yet had an opportunity to recover through the charges. This is not always easy to demonstrate. For this reason, the supplier should ensure that the customer commits to termination charges set at absolute amounts that are high enough to cover any of the supplier’s exposure.
Early termination charges can contain a punitive element to disincentivise the customer from exercising its termination right. One of the easiest ways to do this is to add an element of lost revenue or profit in the computation of the early termination charge. This acts as a disincentive to termination while at the same time hedging loss if it occurs through early termination by allowing the supplier to recover some of the revenue it would have received but for the termination for convenience.
If the parties are able to agree a clause that navigates and balances the competing interests set out above, it should drive reduced exposure to the risks associated with termination charges for the customer, while also allowing the supplier the financial protection needed if a customer exercises a termination for convenience right. Given the importance of this right to the customer and the extent of the risks it poses to the supplier, if the parties can come to an agreement which balances the interests of both parties, it will serve the relationship between the parties for the duration of the contract.
The information and views contained in this article does not constitute legal advice. If you do require legal advice, please contact us on hello@lighthouse.law.
