Contract Termination Determines Contract End-Value

Only at contract termination or contract close-out, you will know what the total value and profitability of the contract actually were.

Whether it was ended amicably or otherwise if you have measured this from the beginning, you at the end of the contract can know exactly how much you gained, lost, or retained.

Normally a contract ends automatically. The good or service was delivered, the payments were made, or the term expired.

But contracts also are often terminated. When parties mutually agree or when one of the parties defaults or if there is a dispute.

In this post, I will highlight the three main cases of contract close-out, the close-out processes, and the impact of continuing obligations on contract value.

Contract close-out is critical to your company meeting your contractual, financial, and fiscal responsibilities and requires coordination between contract management, delivery (program) management, legal, and finance.

Your contract must include wording om what happens in case of close-out or termination. Leaving such clauses out can cause enormous problems and also lead to huge legal bills.

And even if you don’t encounter such problems, the key risk – if you do not close out – is that there still may be loose ends. For example, you not having a clue what still has to be done. Or having to account for hidden costs and liabilities that may still occur in the future.

The Types of Contract Termination and Close-out

1. Final Acceptance

The close-out process, in this case, is the process to finish and resolve all contractual obligations when parties to a contract:

• have met all the terms and contractual obligations; and
• completed all administrative actions; and
• settled all disputes; and
• accepted the final milestone and paid the final payment.

The terms for final acceptance and related activities (for example inspection of goods) should be included in the contract. The statement of work or technical specification should have clear descriptions of the goods to be accepted.

Also, this needs preparation and planning. You can see it as the last amendment to your contract and most probably there will also again be some negotiation involved to get the customer to sign the acceptance documents.

If title needs to be transferred also he title documents need to be prepared and signed. The same goes for licenses and user rights if ownership remains with the supplier. The contract itself should contain a description of the user rights.

So you need to treat this as you did when you were writing your proposals or drafting your contract and preparing for negotiation.

2. Expiry of Contract

The contract can expire automatically at the end of the agreed term. There can be several reasons for this like the customer not needing the product or service anymore or the supplier not providing the service anymore after the agreed term. An example of this today is software companies moving their applications into the cloud and completely stopping with providing ‘on-premise’ software.

If you do not want the service or delivery of goods to stop at the end of the term, you should keep track of the contract expiration date to allow time for renegotiation or
cancellation within the stipulated time period.

Ideally, you also already agreed with the other party on renewal or extension wording into the contract before you signed it. It can be as easy as just agreeing with the other party to copy the existing contract and filling in new dates for the duration of the contract. This is what happens a lot with framework agreements.

Expiry of a contract can happen due to simply parties overlooking the renewal or extension date.

Another type is expiry by agreement which is called ‘termination for cause or convenience’.

3. Contract Termination for Convenience , Cause or Default

Termination of a contract can be voluntary or due to a disagreement. In both cases, the agreements is ending before the date agreed originally by the two parties.

Termination is not automatic and needs action of either one or all parties.

In this case, there is a disagreement between the parties a contract can be terminated due to ’cause’ or ‘default’ of one both parties. For example, one of the parties has not performed its obligations as was agreed on in the contract.

It can be related to disputes, non-delivery, or failure to perform in conformance with agreed product quality, acceptance criteria, regulations, the behavior of individuals, timeliness, or payments. But also bankruptcy, a party having been taken over by a competitor and such can be reasons for termination.

To prevent customers of ending the agreement for minor reasons you have to include wording in the main contract that termination can only be invoked for ‘material’ breaches or you as the supplier repeatedly failing to deliver the goods or services and taking too long to amend this.

You can agree in the contract whether you allow partial termination of whether termination can only be done for the complete agreement.

On the other side, you – as supplier- would want to have the right to terminate the contract if the customer is not paying its invoices whereas it contractually and legally is bound to do so.

Termination for ‘Cause’ means you are really harming your customer by not fulfilling your obligations.

Termination for ‘Default’ means you didn’t deliver the goods or services on time or ‘on spec’ ate the agreed time.

In the case of termination ‘for convenience’ or ‘at will’ the parties mutually agree to terminate the contract.

Termination for convenience means that by giving a period to notify the other party, one or both parties can terminate the contract without any particular reason.

A well-known example is paying off a bank loan earlier than stipulated in the loan agreement.

Contract Termination and Close-out Procedures

Contract termination and close-out is the final and last opportunity to establish that all contract obligations and requirements have been fulfilled to the satisfaction of all parties.

For all, you need to have formal written final acceptance, close-out, and termination procedures to be used upon final acceptance, contract expiry, or contract termination to ensure that the important elements have been verified.

The procedures should also be already agreed upon and included beforehand in the contract, including what activities will take place in case of close-out or termination.

The more complex the contract the more complex the close-out and termination procedure will be.

Most activities are related to performance and administrative termination and close-out procedures can be related to performance monitoring or administrative in nature.

Final acceptance procedures

In the case of final acceptance, you must ensure acceptance documents are formally signed and recorded. This is very important since these steps often are a condition for revenue recognition. In some cases, it is possible to add a condition in the contract to recognize the revenue even if the customer delays acceptance.

It is therefore surprising to see that many companies producing complex services and products I started working for often had nothing in place to close-out contracts.

For the final acceptance procedure, you should also describe what happens in the case of partial acceptance or total rejection. In the last two cases, the contract cannot be closed-out since there are still obligations open. In case of total rejection, there may be disputes and claims. Therefore it is very important to include acceptance criteria in your contract.

You, your contract managers, and your financial experts (like your accountant) should thoroughly read and understand IFRS-15 revenue recognition guidelines.

IFRS 15 establishes the principles that an entity applies when reporting information about the nature, amount, timing, and uncertainty of revenue and cash flows from a contract with a customer.

IFRS.org

Or – in the case of bank guarantees – the signed documents are needed to release payments from escrow accounts.

The supplier also has to release or have solved all liens and claims and liabilities before transferring the title.

Termination for convenience procedures

In the case of termination of convenience parties need to agree already in the contract on:

• Notification time?
• What actions should the parties put in place upon receipt of the notification?
• Who should it be sent to?
• Obligations related to shipments already in progress, work already performed and title to unfinished products already paid for?
• Responsibilities towards subcontractors, vendors and terminating the contracts you have with them?

Termination for cause procedures

In the case of termination for cause you also need already in the original contract to agree on the requirements (like notification and types and severity of breaches) needed for terminating the contract and the actions parties then need to take.

Make sure you include grace periods and the possibility to remedy the situation within agreed timeframes before the termination right kicks in.

Contract Termination Checklist

Checking against a comprehensive checklist of close-out procedures will ensure that all activities have been carried out successfully.

Following is a generic close-out checklist that provides a list of common activities, carried out in almost every contract, in the case of final acceptance or expiry.

Following is a generic termination checklist that provides a list of common activities, carried out in almost every contract, in the case of termination for cause or convenience.

Continuing Obligations after Contract Termination

The impact of contractual work doesn’t end with the contract and hence it is advisable for buyers to conduct post reviews of contracts to ensure that they are protected from possible liability in the future, arising from changes in the business environment or legal terms.

After all goods or services have been delivered in accordance with the contract it is essential to have formal procedures in place.

So, is it all over and out after the contract has been formally closed-out and terminated, and can you archive the contract forever and not look at it anymore? Not really.

After close-out or termination, there will be some obligations that ‘survive’ close-out or termination:

• warranties
• usage rights
• insurance
• confidentiality
• data protection
• intellectual property rights.

They still need to be complied with and monitored after termination.

Lessons Learned

A best practice often overseen is doing a final assessment and evaluation of the parties’ performance and effectiveness of your organization’s monitoring method.

This should follow a contract close-out to record lessons learned for future reference and to determine what needs to be done differently – or to be repeated because they were successful – the next time you enter into a contract with the other party.

Questions to ask yourself what worked well, what should not be repeated in the future, what did we learn more about the customer or industry we’re working in? What can we improve in our terms and conditions based on the experience of the closed-out or terminated contract? Do we need to adjust our standard templates?

Lessons learned should be captured during the complete lifetime of the contract. Together with the customer-, risk- and performance data.

Ideally, you have a contract lifecycle management system that is capable of tracking lessons learned. If not, you need to set up your own system and make the information easily accessible to your organization.