The law of default terminations:

Except for instrumentation contractors, “termination” is a bad word, and default termination is worse; typically, but not always, a default termination arises from delay issues: The contractor is slow and will not increase his manpower, or completion dates have passed, and the job is not finished.

But what does termination mean? If the contract is terminated, it no longer exists, so what happens to warranties, liquidated damages or the arbitration clause? What does it mean in terms of valuing work completed and uncompleted? What is the contractor’s exposure when a follow-on contractor is more expensive?

These and other questions all need to be analyzed and answered in order for you to know the consequences of a default termination to your company. The following are guidelines for this inquiry. They are not definitive for your contract and they may not apply because your state’s laws are different. A default termination always justifies your consulting with a contracts attorney.

What is a default?

Not all breaches of contract have equal weight. To justify a decision by one party to cancel a contract, the breach must be one that affects the entire basis of the bargain. That is the reason most construction contracts state that “time is of the essence” (the essence or basis of the contract). For example, an abnormal delay strikes at this essential element and can support a claim of default.

Not wanting to leave the definition of default to the courts, many contracting parties spell out this kind of breach in the contract itself, usually in a clause labeled “Default.” If you read one of these clauses, it may appear fairly broad, with a menu of causes for termination. Even so, the courts strictly interpret these clauses as the power of nullification of a written agreement and must be treated seriously. In this regard, the cause for termination must be of a substantial nature, and the procedures, which are outlined in the contract’s default clause, must be carefully followed.

Reasonable time to cure

Your contract’s default clause may have a provision that the default not be issued until after a certain number of days following a notice of default. If the time for notice is not specified, reasonable notice time will normally be implied as a matter of law. For example, a demand to fix something within a short time may be considered unreasonable. In addition, you should not be hindered by the other party in effectuating the cure, according to Autrey v. Williams & Dunlap [343 F.2d 730 (5th Cir. 1965)].

An interesting side effect of this cure notice question is that the terminating party cannot later assert a different reason for the termination, as referenced in New England Structures, Inc. v. Loranger: “Where a party gives a reason for his conduct and decision... he cannot, after litigation has begun, change his ground... .” [234 N.E.2d 888, 891 (Mass. 1968)].

Depending on the issue, the courts have shown a marked inconsistency in how contract rights and remedies are treated after the contract is terminated. In a very real sense, a default termination extinguishes the contract. The question then is: If the contract ceases to exist, why look to the contract to determine the parties’ rights and obligations?

In one case, a court held that at termination, the parties’ arbitration agreement ceased to exist. That decision is wrong, but it underscores the uncertainties in post-termination litigation.

Liquidated damages, for example, may or may not continue to accumulate after default termination, depending on your state’s case decisions. Similarly, the status of contract warranties may or may not be determinable. There are even differences, state to state, over whether an owner can default terminate a contractor after substantial completion has been achieved.

Most cases dealing with default terminations focus on an evaluation of the costs to complete.

Liability for completion costs  

A determination of excess completion costs after termination is usually a complicated matter. Besides having to justify the termination itself, the terminating party must prove that the scope of work did not change after termination and that reasonable efforts were made to mitigate the damages. For these purposes, the terminating party will have to establish what work had been acceptably performed at termination, including change order work. All of these tasks can involve arduous accounting.

The general rule, as set forth in the Restatement (Second) of Contract, Sec. 348, is that the terminating party is entitled to recover its actual costs of completion that are in excess of what the owner would have paid the defaulted contractor. The burden of proving that this excess cost was unreasonable is on the defaulted contractor. In other words, it is not enough to argue that you could have performed the work for less than the replacement contractor charged.

Keep in mind that “completion costs” may go beyond the cost of construction. Claims have been upheld for extended interest payments on construction loans, lost profits, additional inspections and testing, and even attorney fees incurred in negotiating with the replacement contractor. The test is whether the damages flowing from the default were direct and foreseeable.

What you should do      

The following list is a basic guideline for you to add to and make into your own checklist. It does not apply in every instance of termination, and is not meant to itemize all steps you should take.

If you receive a termination notice:
  1. Review the default clause.
  2. Respond to the termination letter immediately with as much information as you can gather.
  3. If the notice letter demanded action on your part, send a letter noting the responsive actions you are taking.
  4. Send your subcontractors and suppliers a copy of the notice letter.
  5. Have your project manager walk the project making notes of the status of construction in general and of your work in particular.
  6. Take photographs of the entire project, especially all aspects of your work.
  7. Telephone the other party and ask for clarification of the reasons for the default notice. Remember, this is a call for information, so be careful what you say.
  8. Notify your attorney.
  9. Secure your equipment and materials, and inventory anything left at the project.
  10. Review any disputes procedures in the contract (such as mediation and arbitration) and abide by them.
  11. Investigate your rights to a mechanic’s lien or a claim against a bond. Find out if your state has a trust fund statute.
  12. Submit an invoice for contract billings through the date of termination, including change orders, even if not approved.
Conclusion

You may not always see them coming, but default terminations usually are not a surprise. If you can save the day by curing the default, go ahead and do so. But if you can’t, be prepared to document your work and protect your rights.          EC

ITTIG, of Ittig & Ittig P.C., in Washington, D.C., specializes in construction law. Contact him at 202.387.5508, USBuildlaw@aol.com, or through his Web site, www.ittig-ittig.com.