The End of Termination for Convenience

​Are revised accounting rules just being used to deprive clients of termination rights...

... or is there more to it?

If it seems that your vendors are unwilling (they'll say unable) to accept a termination for convenience clause these days, you're not alone. Often this will be justified by citing their companies accounting rules and practices aligned to the 2014 revenue recognition changes post Enron where they'll refer as below:

• if an agreement (i) provides for termination for convenience and can be terminated at any time, and (ii) the supplier is not entitled to any compensation or the termination charges are insignificant, then the supplier is not permitted to recognise the contract revenue for the full contract term (technically they can only recognise revenue for the termination notice period e.g. 30/60/90 days).

What they don't refer to is the fact that where termination charges are provided full contract revenue can be recognised:

• If an agreement (i) provides for termination for convenience and can be terminated at any time, and (ii) the supplier would be entitled to “substantive” termination charges, then the parties’ rights and obligations are regarded to support and extend for the stated contract term and the supplier is permitted to recognise the contract revenue for the full contract term.

Of course the "substantive" qualification is the issue - just how substantive should it be?

Well there are no firm guidelines in that respect, other than simply compensating a supplier for services or deliverables provided up to the effective date of (early) termination will not be regarded as substantive. Guidelines only advise that "judgment has to be applied with consideration given to quantitative and qualitative factors". Government contracts typically require a termination for convenience clause and will  state (in part) something similar to the below:

• any reasonable costs incurred by the Contractor that are directly attributable to the termination;

thus (1) putting the onus of quantifying the charges on the supplier, and (2) vanquishing their argument for full revenue recognition.

Having negotiated the termination for convenience clause we're now comfortable that all is good right? Well no, there are further issues to contend with. If (and thats a big 'if') the matter gets to court there would likely be consideration as to whether the contract was 'illusionary' based on the very right to terminate at will, or that the termination was not enacted in 'good faith', or even as far as not following the termination right explicitly which opens the door to damages!

So what other options are there? Well that of course depends on what exactly is being contracted, but consider the following:

1. With a product or application allow a timeframe for a 'proof of concept' or 'fit for purpose' test on what's being acquired - if it doesn't meet your (stated) criteria allow for graceful termination before the contract really gets started;
2. While it can prove difficult associate the commencement of the contract with the 'productionisation' of the product or application;
3. Break the contract into "+" terms, eg. a 1 year followed by a 2 year commitment or similar to allow for non-renewal;
4. With consumption based models ensure there is a vary down option whereby you are able to reduce your usage to zero and pay only nominal costs through to expiry;
5. Ensure there is always a termination for cause provision that enables cancellation where the product or application does not meet its stated capability or function;
6. Similarly, with service based contracts ensure there is always termination for non-performance based on a level of (generally repeat) failure that degrades the service to an unacceptable level.

Key to all of the above is explicit language that clearly defines the criteria by which the clauses can be invoked - when things break down to termination your vendor will not be overly receptive to subjective positions, ambiguities, or plain old opposing points of view.

And while the lawyers are endlessly debating the virtues of limitations of liability and insurances and everything else basically immaterial just ask yourself when you actually last went to court, and then ask what typically goes wrong with your contracts - invariably its performance based and for that, you just need an appropriate provision for ...

... a hasty, unequivocal exit, at the lowest possible cost!