The horrific events of Sept. 11 offer a painful illustration of how changing circumstances may necessitate that priorities be changed, resources reallocated and plans canceled. In the context of construction contracts, sophisticated consumers of construction services know the importance of protecting themselves from unanticipated changes in circumstances.
One of the best tools for an owner to utilize to protect itself against the unknown is the use of a "termination for convenience" clause. Such a clause is typically used in federal contracts to fortify the government's position. It also exists to a lesser extent in private contracts. Basically, the clause gives the owner unbridled discretion to terminate its contract without cause at any time the owner deems such a termination to be in its best interest. Limitations, however, need to be placed on an owner's ability to exercise such enormous power.
If an owner properly exercises the right to terminate a contract for its convenience, contractors must prepare and submit a termination settlement proposal that itemizes the costs it seeks to recover.
While the language of the contract will control, typically a terminated contractor should seek to recover (1) the costs of all direct and indirect work performed before the date of termination; (2) profit for work performed and material furnished before the date of termination; (3) the reasonable costs of preparing the contractor's settlement proposal, including professional fees for legal and accounting services; and (4) the issue of interest.
There is no doubt that the contractor is entitled to receive the costs of the work performed before the effective date of the termination. However, documenting actual costs is not as easy as it might appear. For example, a contractor may not in federal contracts submit a proposal based on percentage of completion. In addition, when an owner terminates for convenience, a lump sum contract is not converted into a cost-plus contract. The costs of extras are not necessarily recoverable unless there is a right to recover those extras under the contract. A contractor will, however, be able to recover its entire bond premium even though a portion of the premium could be considered an indirect cost of unperformed work. Material costs are recoverable even though materials were not used on the project if the contractor has no other use for them.
On federal projects, contractors will not be allowed to recover anticipated lost profits on that part of the contract not performed. On private projects, contractors should certainly attempt to negotiate clauses which would permit them to recover their entire anticipated lost profits in the event of a convenience termination. The rationale is that even if the contractor is losing money, it has lost the opportunity to work elsewhere for a profit by assuming the contractual obligation to work for a particular owner. Without specific language, the contractor will be limited to receiving only the profit mark-up on its direct and indirect cost of work performed prior to the termination.
Contractors are usually entitled to recover their cost of preparing a settlement proposal and negotiating a settlement with the government. These costs include attorney's and accountant's fees, as well as other experts whose services are reasonably necessary to complete the settlement process. The costs must, however, be related to services to negotiate an amicable settlement. If the dispute mushrooms into a formal claim, the costs related to services rendered in the prosecution of that claim are not recoverable.
While not always stated in the contract, the justification for allowing an owner to terminate a contract for its convenience is that circumstances may change. An owner should not be allowed to terminate a contract simply because it learns part way into the project that it made a bad deal. In addition, an owner who is in material breach of its contract should not be allowed to rely upon the termination for convenience clause to avoid having to pay the consequential damages of the breach, particularly the contractor's lost or anticipated profits.
Good drafting should include a provision which limits the owner's right to elect to exercise the power to terminate for convenience only if there is a significant change in circumstances occurring after the contract is awarded. Without explicit limiting language, there is a serious risk that the standard for determining whether an owner properly exercises its right to terminate for convenience is whether the owner acted in bad faith or abused its discretion.