In this series we will provide a brief summary of a very complex topic: the termination of construction contracts. Termination should be a last resort on a difficult construction project. There are a myriad of reasons why termination can backfire if not executed carefully and thoughtfully.
This series will scratch the surface of selected legal issues arising from contractual terminations. Although much of this analysis is from the perspective of an owner, we hope the discussion will also be of use for other parties, including design professionals, general contractors and subcontractors.
Complex construction projects can be long, difficult and frustrating endeavors. Inevitably, things go wrong. Delays happen, unforeseen circumstances arise and costs increase. After months of interaction both on-site and during project meetings, personalities clash and patience wears thin.
In this charged atmosphere with large amounts of capital at risk, it can be tempting to consider the merits of terminating certain contracts. As we counsel our frustrated clients regarding the potential benefits of termination, and more importantly the potential pitfalls and liabilities that could end up in protracted litigation or arbitration, sometimes the best service we can provide is simply letting an exasperated client blow-off steam while reminding them to maintain written records of project-related communication and a back-up set of all project documents. Termination may sound viable in the heat of the moment, but it is hardly a decision that should be made without careful planning and detailed scrutiny of all the legal and practical implications.
Irreconcilable Differences and Practical Considerations
Unfortunately, certain differences are irreconcilable. In these circumstances, termination may be the only viable option to finish a project. However, even when a material breach occurs, clients should be counseled regarding several important practical considerations before even reaching the litany of legal concerns.
For example, even assuming an owner has the right to terminate a contractor for cause, the owner may not have an adequate replacement ready to assume the remaining contractual obligations. Or perhaps the owner has a replacement, but in order to assume the remaining obligations and walk onto the project and accept the risks of “cleaning up someone else’s mess,” the replacement is prohibitively expensive. In these scenarios, the termination “medicine” may be worse than the “disease” of maintaining a difficult relationship with an underperforming party.
A second critical decision is whether a client wants to deal with the stress and expense of mediation, arbitration or litigation. Further, the client should be advised to consider termination in the context of its relationship with the lender. Because construction projects are capital intensive, lenders may retain leverage, literally and figuratively, over significant project details. Making a unilateral decision without considering the lender is rarely a good idea.
Materiality and Termination For Cause
The law generally disfavors termination. Termination is a drastic remedy and the law has developed several hurdles before a party can justify terminating a contract for cause. First, the breach must be material. Second, the breach must be not be excused. Third, the breach must have been neither cured nor waived.
Many modern construction contracts contain “breach conversion” provisions. These powerful devices convert breaches from breach of contract claims into claims for relief under the contract. Breach conversion clauses may address common issues such as changes, owner’s misrepresentation of site conditions or suspension of work.
Not all breaches are material. While a material breach may provide grounds for a for cause termination, defining the outer limits of materiality is notoriously complicated. Hopefully the contract documents are detailed enough to provide specific guidance regarding triggering events, cure provisions and compensation. Contractual termination clauses are usually the starting point of the analysis.
Most standard form contracts appoint the architect or another design professional as the “Initial Decision Maker” pursuant to their construction administration responsibilities. The Initial Decision Maker essentially acts as the earliest referee of the formal dispute process. They may be forced to consider for cause grounds for terminations including defective work, excessive delays, the non-payment of subs or insufficient labor on-site. Another example may be determining when a work stoppage amounts to abandonment. Nothing can be more frustrating than a work-stoppage when a project is already behind. However, clients should be counseled that a court may not agree that a given work stoppage amounts to abandonment.
The stakes of deciding to terminate a contract due to a material breach are high. If an owner makes the wrong decision, they can open themselves up to significant liability. It goes without saying that an owner’s wrongful failure to pay is itself a material breach. Wrongful termination can lead to the discharged party receiving lost profits and other damages. In many jurisdictions, a bad faith termination can lead to extracontractual damages.
The Right to Cure
Even when a breach has occurred, most standard contract documents will provide important limitations on the right to terminate. One of the most significant limitations is the right of a breaching party to cure any material breaches capable of being remedied.
The right to cure provides the breaching party with the opportunity to address their mistakes. Sometimes this isn’t practical for logistical reasons, but the legal principle is important. For example, most jurisdictions won’t let a landlord evict a residential tenant without notice of default and other legal safeguards developed over time. The same basic concept applies to construction contracts. The right to cure is a common law concept grounded in the equitable principle that notice is an element of fairness and can promote the informal resolution of disputes.
A “cure notice” must be given by the non-breaching party. There are only limited exceptions to this general rule, including when a material breach clearly cannot be cured in time. Most standard form construction contracts will clearly specify that a cure notice must be given by the non-breaching party prior to termination. Independent of the explicit contractual language, courts usually find that unless expressly waived, a right to cure is implied in every construction contract as a matter of law.
The cure notice must adequately apprise the breaching party of the specific failures which, if not remedied, may lead to termination.
Providing cure notice is an essential prerequisite to a valid termination. If the contractor fails to cure or otherwise provide adequate assurances that it will do so within a reasonable period, the architect of record may certify that sufficient cause exists for termination.
But wait, there’s more. Waiver, mitigation and other defenses will be the topic of Part II of this series.