DTCI: Termination for convenience, remedies and good faith

Leone

By Joseph M. Leone
Almost all sophisticated construction contracts will contain a termination for convenience clause. A termination for convenience clause allows a party to terminate the contract without the other party being in default. The right to terminate for convenience does not exist in common law. Therefore, unless a termination for convenience clause is included in the agreement, a party may be terminated only because of a material breach of the contract.

In general, the contract terms allow only the project owner the right to terminate for convenience, not the prime contractor. The project owner is undertaking the development of the project and investing a great deal of capital. Understandably, the project owner desires the right to stop the project if the market changes or the project becomes unnecessary for some reason. Because termination for convenience is such a significant event, it is important for owners and contractors to fully understand the significance and effect of the termination for convenience clause, before execution of the contract.

Termination procedure

The contract or general conditions usually require the owner and contractor to comply with a specific procedure in a termination for convenience. A termination for convenience clause should contain three parts: the first is a notice provision; the second identifies the actions the contractor is obligated to take upon receipt of the notice; and the third and final part should enumerate the compensation to which the contractor is entitled as a result of the termination.

A typical termination for convenience clause is contained in the ConsensusDocs 200, Standard Agreement and General Conditions between Owner and Constructor 2011 Rev. 2014, which states:

“11.4.1 Upon written notice to the Constructor, the Owner may, without cause, terminate this Agreement. The Constructor shall immediately stop the Work, follow the Owner’s instructions regarding shutdown and termination procedures, and strive to minimize any further costs.

…

11.4.3 If the Owner terminates this Agreement, the Constructor shall:

(a) execute and deliver to the Owner all papers and take all action required to assign, transfer, and vest in the Owner the rights of the Constructor to all materials, supplies and equipment for which payment has been or will be made in accordance with the Contract Documents and all subcontracts, orders and commitments which have been made in accordance with the Contract Documents;

(b) exert reasonable effort to reduce to a minimum the Owner’s liability for subcontracts, orders, and commitments that have not been fulfilled at the time of the termination;

(c) cancel any subcontracts, orders, and commitments as the Owner directs; and

(d) sell at prices approved by the Owner any materials, supplies, and equipment as the Owner directs, with all proceeds paid or credited to the Owner.”

The standard American Institute of Architects (AIA) Document A201-2007, General Conditions of the Contract for Construction also contains a termination for convenience clause. It provides as follows:

Ҥ 14.4 TERMINATION BY THE OWNER FOR CONVENIENCE

§14.4.1 The Owner may, at any time, terminate the Contract for the Owner’s convenience and without cause.

§14.4.2 Upon receipt of written notice from the Owner of such termination for the Owner’s convenience, the Contractor shall

.1 cease operations as directed by the Owner in the notice;

.2 take actions necessary, or that the Owner may direct, for the protection and preservation of the Work; and

.3 except for Work directed to be performed to the effective date of termination stated in the notice, terminate all existing subcontracts and purchase orders and enter into no further subcontracts and purchase orders.”

In both clauses, the written notice requirement instructs the contractor to stop work. Each clause also allows the project owner to provide procedures for shutting the work down and gives the contractor the obligation to strive to minimize costs. The contractor is obligated to cancel subcontracts and other obligations related to the contract in a manner that reduces the owner’s cost as much as is reasonable.

As discussed above, the purpose of the termination for convenience clause is to provide the project owner flexibility to deal with changing market conditions. However, the question arises whether the project owner may terminate, for any reason whatsoever, including the opportunity for a lower price from the contractor’s competitor. Some jurisdictions allow the project owner to terminate regardless of the reason; however, some others require that the owner act in good faith when terminating a contract for its convenience. To this point, there is no caselaw in Indiana resolving this issue.

The good faith requirement (or lack thereof)

In most government contracting and in some state jurisdictions, there is a requirement that the owner act in good faith in order to terminate for convenience. Krygoski Construction v. United States, 94 F.3d 1537 (Fed. Cir. 1996); RAM Engineering & Construction v. University of Louisville, 127 S.W.3d 579 (Ky. 2003); Capital Safety v. State, Division of Buildings and Construction, 848 A.2d 863 (N.J. Ct. App. 2004); Questar Builders v. CB Flooring, 978 A.2d 651 (Md. Ct. App 2009); Interboro Packaging Corp. v. Fulton County Schools, 2006 WL 2850433 (N.D. Ga. 2006); Sigal Construction Corp. v. General Services Administration, CBCA 508, 10–1 BCA ¶ 34,442. Godwin v. Rogue Valley Youth Correctional Facility, 2013WL3712413 (D. Org. 2013). But see, Custom Printing Co. v. United States, 51 Fed. Cl. 729, (Ct. Cl. 2002) (no requirement that government show changed circumstances; government entitled to considerable latitude in its reasoning behind a termination for convenience).

However, the analysis for private construction projects is more mixed. The theory is that private entities are free to contract in any manner they wish. Thus, if two private entities agree that one party may terminate for convenience without cause, then the court will not inquire as to reason or motives behind the termination. See Vila & Son Landscaping v. Posen Construction, 99 So. 3d 563 (Fla. 2d Dist. Ct. App. 2012) (termination for convenience to obtain a lower price is not contrary to the reasonable expectations of the parties); SAK & Associates v. Ferguson Construction, 357 P.3d 671 (Wash. App. 2015) (“covenants of good faith and fair dealing do not trump express terms or unambiguous rights in a contract”). But compare Questar Builders v. CB Flooring, 978 A.2d 651 (Md. Ct. App 2009) (party terminating the contract is required to act reasonably in ensuring that the contract does not become inconvenient and is not permitted to create an inconvenience in order to terminate the contract).

It is difficult to predict which side of this issue Indiana courts will choose. There is no obligation of good faith and fair dealing on private contracts in Indiana law except in limited circumstances. Allison v. Union Hospital, Inc., 883 N.E.2d 113 (Ind. Ct. App. 2008). In general, Indiana courts have strictly applied the terms of construction contracts. See Stelko Elec., Inc. v. Taylor Community Schools Building Corp., 826 N.E.2d 152 (Ind. Ct. App. 2005). However, where the contract itself contains a term requiring the parties to act in good faith and to deal fairly with each other, that may impose the obligation for the project owner to use the termination for convenience option only for a legitimate business purpose.

Remedies for termination for convenience

Most termination for convenience clauses, particularly those in standard forms, allow the contractor to be fairly compensated for its work on the project and for the opportunity cost lost by the termination. However, many custom contracts do not. It is important for contractors to recognize the situations in which a contract does not provide adequate compensation when the contract is terminated for the owner’s convenience. Consider the situation where the project owner terminates the contract for convenience after the contractor has mobilized but before any actual work being performed.

The two primary standard form contracts deal with this situation in slightly different ways. Regarding compensation to the contractor, the AIA A201 language referenced above states as follows:

“§14.4.3 In case of such termination for the Owner’s convenience, the Contractor shall be entitled to receive payment for Work executed, and costs incurred by reason of such termination, along with reasonable overhead and profit on the Work not executed.”

Thus, the AIA A201 obligates the owner to pay the contractor for the “reasonable overhead and profit on the Work not executed,” in addition to the value of work performed and other termination costs. Therefore, the contractor will receive the benefit of its anticipated overhead and profit had it completed the entire project. Not surprisingly, most project owners modify that provision such that the contractor is entitled only to overhead and profit on the work it actually performed.

The ConsensusDocs (CD) 200-2011 Rev. 2014 Standard Agreement and General Conditions Between Owner and Constructor requires the project owner to compensate the contractor for the value of work performed and termination costs, plus a termination premium included in the contract. §11.4.2 CD200-2011 Rev. 2014. Thus, the owner and contractor may agree to the value of a termination for convenience before execution of the contract. Often, the termination premium will decrease as the project is constructed. At the beginning of the project, the termination premium is valued such that it represents the lost opportunity cost in mobilization and dedicating resources to that project that it would otherwise have allocated differently. As the contractor completes the work and is compensated for the overhead and profit associated for that work, the termination premium is reduced accordingly.

Conclusion

There is much to consider regarding termination for convenience provisions. However, the three most important aspects of termination for convenience clauses for contractors and owners to consider when negotiating or analyzing the risk associated with those terms are: (1) to specifically identify the notice and procedure associated with the termination; (2) to identify whether the owner may terminate for any reason whatsoever or only for a good-faith basis; and (3) to plan for the lost opportunity cost to the contractor in case of an early termination for convenience. This will be critical whether one of the standard form agreements or an entirely new draft agreement is used.•

Mr. Leone is a partner at the law firm of Drewry Simmons Vornehm LLP, with offices in Carmel, Indianapolis and Crown Point. He focuses his practice on construction law. The opinions expressed in this article are those of the author.