Contracts are entered into by parties with an intention to bind together in a legal obligation and thereby to serve the interest of the parties. The parties, in order to govern themselves and to safeguard their interest, make their own terms and conditions. Termination is an important stage in the life of any contract and therefore it is important that the parties should focus on the end of the contract before it has even begun, i.e., while the relationship between them is positive, for the parties to negotiate and agree on when and how to terminate a contract and deal with its consequences.
Meaning and Scope
When the parties enter into a contract, they become liable under law to perform their contractual obligations. Failure to perform the terms stated in the contract can result in a breach of contract, litigation or other legal liabilities. However, there are some conditions under which a contract can be legally terminated before the contractual duties have been fulfilled. This is known as “termination of contract” and may occur for many different reasons. To terminate a contract means to end the contract prior to it being fully performed by the parties. In other words prior to the parties performing all of their respective obligations required by the contract, their duty to perform these obligations ceases to exist.
In general, the effect of termination of a contract is to discharge the parties from their unperformed obligations under the contract. However, termination does not affect liabilities of the parties for breaches of the contract that occurred prior to the contract being terminated. And, despite the fact that future obligations to perform under the contract terms have been extinguished, if appropriate, the parties remain entitled to pursue claims for damages under the law and as provided by any termination provisions that may be contained within the contract.
Circumstances in which contract can be terminated
The decision to terminate a contract may be due to frustration, where it is not possible for the parties to perform the contract due to circumstances that are beyond their control and out of their realm of responsibility. More often it is due to breach or non-performance, in which case it may be appropriate to terminate the contract. A contract is said to be discharged when the rights and obligations created by it come to an end.
When is Termination of Contract Lawful?
Termination of a contract is considered to be lawful when a legitimate reason exists to end the contract before performance has been completed. As per the Indian Contract Act, 1872, (Contract Act) a contract may be discharged by following modes:
Section 39 of the Contract Act, provides that if a person indulges in any fundamental breach of the contract and the other party does not acquiesce to the breach, then the party not breaching is not bound under the liabilities of the contract. This would, therefore, enable a party to terminate a contract on the ground of substantial failure by the other party which goes to the root of the contract.
The breach of contract by one party does not automatically terminate the obligation under the contract; the injured party has the option either to treat the contract as still in existence or to regard himself discharged.
2. Termination by Frustration
According to Section 56 of the Contract Act, an agreement to do an impossible act in itself is void. The doctrine of frustration provides that if in a contract, certain events which are beyond the control of the parties take place and which make the performance of the contract impossible, then the contract is said to have been ‘frustrated’.
Conditions for the application of the Doctrine of frustration:
- There must be a valid and subsisting contract between the parties.
- Some part or whole of the contract must be unfulfilled.
- The contract becomes impossible to perform after it is made due to some supervening event.
3. Termination by novation, rescission, and alteration of contract
Section 62 of the Contract Act, states as follows:
“Effect of novation, rescission, and alteration of contract.- If the parties to a contract agree to substitute a new contract for it or to rescind or alter it, the original contract need not be performed.- If the parties to a contract agree to substitute a new contract for it or to rescind or alter it, the original contract need not be performed.”
The parties to a contract are free to substitute or rescind the entire contract, or to modify, alter, vary or rescind some of its terms. Novation or modification of a contract can take place in the same manner as the conclusion of a contract. If one party proposes a novation and the other party accepts this proposal in a qualified manner, there is no novation. Where, after the contract, one party made a suggestion to the promisee that in view of certain difficulties he should cancel his contract at par and receive back his advance, and that suggestion was accepted by the other party, a new contract was made.
4. Contractual Termination Clause
Commercial contracts often contain express termination clauses which provide for termination for breaches other than repudiatory breaches. Some contractual termination clauses work by expressly classifying terms as conditions or warranties so as to make clear those circumstances in which the contract can be brought to an end and those which only give a right to claim damages. Some contractual provisions attempt to give rights to terminate for “material or “substantial” breaches or for “any breaches (however minor) or for repeated breaches”. Termination clauses require to be drafted carefully and regard must be had to the way in which the courts approach such provisions.
5. Termination by Notice
If a contract contains a provision that one of the parties thereto may determine the contract by notice at the option of one of the parties or either of the parties, and may be made exercisable upon breach of contract by one of the parties (whether the breach amounts to repudiation or not), or on occurrence of any other specified event, or without requiring any reason simply at the will of such party entitled, such provisions may be express, or may be implied in the contract, or incorporated by usage or custom of trade.
6. Termination on Happening of an Event
The parties may stipulate that the contract shall be determined or shall be ‘void’ on the happening of a certain event. If the event is such over which the parties have no control, the contract will cease to bind on the happening of the event. If such an event is within the control of any of the parties, such party cannot insist upon the stipulation who, by his own wrongful act or omission brings about that event, nor can he compel to other party to insist upon it, since it is a universal principle of law that a party may never take advantage of his own wrong.
Effect of termination on party at whose instance termination was affected
The termination of contract means the contract ceases to operate, i.e. the rights and obligations created by it come to an end. It might also amend or rescind completely such rights and obligations of both the parties. The effect of termination on the party at whose instance such termination was affected are as follows:
- If the contract was terminated on the basis of fraud or any other act which makes the contract voidable, the right to file a suit for the same is available.
- If the contract was terminated on the basis of non-performance by the party, liable to pay compensation and damages to the other party.
- If a contract of agency has been terminated, the obligation to indemnify.
Effect of termination on party against whom termination was affected
- Termination of the contract releases both parties from their obligation to effect and to receive future performance. But the party if aggrieved can file a suit for such grievance.
- A claim for damages for non-performance.
- Termination does not affect any provision in the contract for the settlement of disputes or any other term of the contract which is to operate even after termination.
Remedies available on termination of contract
- Specific Performance: Specific performance is an order by the court that requires the breaching party to carry out the contract as it was originally written. This type of remedy is rare. However, it may be ordered in certain circumstances. For example, specific performance may be imposed when the subject matter is unique, such as a famous painting or a specific piece of property. Courts are hesitant to order specific performance because it requires the ongoing monitoring by the court of the contract.
- Rescission: Rescission of the contract is a remedy that allows the non-breaching party to cancel his or her responsibilities under the contract. This remedy might be available when the contract was based on fraud or a mistake by one or both of the parties. It is also available if both parties prefer to cancel the contract and return any money that had been advanced as part of the contract.
- Reformation: Reformation allows two parties to modify a contract so that it more accurately reflects what the parties intend. This remedy requires that the contract to be valid. It may be available when one of the parties had a mistaken understanding of a material term of the contract.
- Legal Remedies: Legal remedies often take the form of monetary damages that are awarded to help make the innocent party whole. Some examples of legal remedies are discussed below.
- Compensatory Damages: Compensatory damages are those that are meant to compensate the non-breaching party for the breach. These include expectation damages and consequential damages. Expectation damages are those that give the non-breaching party the monetary funds that he or she would have received had the contract been performed. These damages are usually based on the contract itself or the fair market value of the subject matter of the contract.
- Consequential damages are those damages that reimburse the innocent party for indirect costs that resulted from the breach. They often result from special circumstances that are involved in the contract that may not be ordinarily predictable. For examples, an innocent party may ask to be reimbursed for the loss of business profits that derived from not having access to the necessary materials to produce a product for a third party.
- Liquidated Damages: In some contracts, specific damages are predetermined. These damages are called liquidated damages. They are typically part of contracts where it would be difficult to determine the actual damages caused to a party due to a breach, such as a breach of a contract not to compete.
- Punitive Damages: Punitive Damages are meant to punish a guilty party in order to prevent that party or others from engaging in similar conduct in the future. However, punitive damages usually require a stronger intent than is necessary for a standard breach of contract claims. For example, to be awarded punitive damages, a plaintiff may have to show that the breaching party acted in a malicious or fraudulent matter. Some jurisdictions specifically prohibit plaintiffs from recovering punitive damages on a breach of contract claims.
- Restitutio In Integrum: In India, the underlying basis for awarding contractual damages is to put the party suffering from a breach of contract in the same position as if the contract had been performed through payment of damages/compensation for losses. There has been very little development in relation to the law of damages in India. The courts have refrained from an extensive discussion about the factors that determine the extent of damages payable in case of a breach of contract. The courts seek to limit themselves to a simple application of the rule in Hadley v. Baxendale in most circumstances as the rule has been incorporated into section 73 of the Contract Act with little or no modification.
Contract termination is a drastic step and should be done with caution and with proper legal advice. When a contract is terminated, it is often said that it “comes to an end” or “ceases to exist”. However, these statements are somewhat misleading as the contract not only continues to exist but continues to have an operation in some respects. What is in fact “terminated” is the future performance of the contract – that is, the primary obligations of the parties that have been partially performed at the time of termination and those that would have fallen due for performance had the contract not been terminated.
Termination takes effect from the time a party exercise the right to terminate the contract, not from the time that party was entitled to terminate. This is in contrast to “rescission ab initio” (rescission from the beginning) which may be available if there is a defect in the formation of the contract, in which case the contract is annulled from its inception and the parties are substantially restored to the position they held before they entered into the contract.