Courts Uphold Good Faith Use of "Termination for Convenience"

Construction contracts commonly include termination for convenience clauses. Generally speaking, a termination for convenience clause permits the owner to terminate its contractor (or a contractor to terminate its subcontractor) at its discretion. Although courts have long recognized the validity of termination for convenience clauses in public contracts, courts have not always upheld such clauses in contracts between private parties. When courts have not upheld them, the reason has typically been that the power of one of the parties to escape its obligations under the contract means that the party with the power of termination has not made a binding promise to do anything, but only an illusory promise, and thus the contract must fail for want of consideration.

The Case
The law of private contracts is, of course, governed by state law. Recently, the Maryland Court of Appeals issued an important ruling on the validity of termination for convenience clauses in private construction contracts, holding in Questar Builders, Inc. v. CB Flooring, LLC, 978 A.2d 651 (Md. 2009) that such clauses in private contracts "may be enforceable, subject to an implied obligation to exercise the right to terminate in good faith and in accordance with fair dealing."

Questar Builders Inc. was the general contractor for the construction of an apartment and townhome complex in Owings Mills, MD. It solicited bids for carpeting, and CB Flooring, LLC was the low bidder. As the project progressed, a dispute arose over the type of carpeting to be installed, with Questar demanding a more expensive carpet than that upon which CB had based its bid. CB sent a proposed change order to Questar seeking an adjustment in the contract value of approximately $100,000. Questar refused to adjust the contract and, instead, announced that CB had breached the subcontract and purported to terminate CB for cause. CB subsequently filed suit against Questar.

The trial court determined that there had been no breach of the subcontract by CB. On appeal, however, Questar argued that the subcontract's termination for cause language contained a fallback provision that converted termination for cause into a termination for convenience if a court or arbitrator determined that the termination for cause was improper. Questar reasoned that it should escape liability because the termination for convenience language effectively converted the termination to one for convenience.

The Court of Appeals focused its attention on whether the termination for convenience clause in the subcontract transformed a promise to perform into an illusory promise. The court first noted that Maryland courts prefer interpretations of contracts that make the contract effective rather than illusory. The court further noted that one means by which the court can accomplish this objective is to place a general obligation of good faith and fair dealing on all parties to the contract. If the contractor cannot exercise its right to termination for convenience at its absolute discretion, but instead must act reasonably, the contractor has made a real promise that limits its rights.

The Ruling
Accordingly, the court viewed the termination for convenience clause in the Questar/CB contract not as "the right to terminate based on a whim," but rather as a tool for allocating economic risk reasonably. Thus, "Questar was permitted to terminate only if, in its discretion, it determined that continuing with the Subcontract would subject it potentially to a meaningful financial loss or some other difficulty in completing the project successfully."

The Court of Appeals concluded that "the right to terminate for convenience?provides adequate consideration for the other party to the contract, protecting that party's expectations in a binding enforceable agreement and prohibiting the terminating party from yanking out arbitrarily the carpet from underneath the agreement."

The Impact
Provided that the terminating party acts reasonably, a termination for convenience clause is a permissible and effective tool for allocating risk. Accordingly, if private parties wish to allocate their economic loss by using a termination for convenience clause, they may now do so in Maryland, as long as they act in good faith.