Contractor Termination: Don’t Make a Bad Situation Worse

In hindsight, the spiral toward contractor termination appears obvious. The project falls behind schedule. Subcontractors reduce their workforce, or stop coming to the jobsite. Notices of mechanics’ liens appear in the mail. The owner’s first inclination may be to withhold further payment. In return, the contractor stops work and refuses to continue unless payment is released. The owner stands firm; it will not release payment until the contractor commits resources to regain the schedule. The contractor doesn’t blink: it won’t return unless the owner accepts its claim, directs it to accelerate, and releases payment. At this point, the desire to terminate the contractor is understandable, and acting on that desire may even bring a certain satisfaction for the owner. Before acting on this impulse, however, the owner needs to pause and carefully consider its options, and recognize that a misstep may further delay the project, drastically increase the cost, and even expose it to liability.

Termination will, almost without exception, delay completion and increase the cost of the project. To say that a project on which the general contractor has been terminated is cursed may be melodramatic, but only a little bit. Following termination, the owner is in a difficult bargaining position with potential completion contractors, particularly in an active construction market. Unpaid subcontractors and suppliers must be wooed back to the job, or replaced. In either event, the owner may end up paying for work or materials twice. The process can take months. If the schedule can be regained, it comes at a premium.

The existence of a performance bond may provide the owner some measure of protection, but comes with its own special challenges and additional delays. The surety will not act until the owner declares the contractor in default in strict compliance with the terms of the contract and bond. Termination without sufficient cause, or without following the correct procedures, relieves the surety of its obligations altogether. Before taking action the surety will conduct an investigation, which takes time. Assuming it accepts the claim, the surety then has options as to how to proceed, including financing the defaulted contractor, tendering a replacement contractor, or simply paying the cost to complete, minus the unpaid contract balance.  Moreover, the surety and owner’s goals are not aligned in this choice. The owner wants the work completed as quickly as possible, whereas the surety wants to minimize the cost to the surety. The owner cannot proceed until the surety makes its decision, as any action taken in the meantime creates risk that the surety will claim its rights have been violated. All the while, the completion date slips further. For all of these reasons, before deciding upon termination, the owner should carefully evaluate whether it makes sense to assist the contractor to get through the current difficulties, and should involve the surety in this discussion. Compromise on a disputed claim, joint or direct payment to subcontractors, reduction of retainage, supplementation of the contractor’s forces, and other measures of assistance may ultimately be the most cost-effective path to completion.

Termination for cause is considered a drastic sanction, and will be upheld by a court only upon good grounds and solid evidence. Wrongful termination exposes the owner to breach of contract damages, including the contractor’s lost profit on the entire contract. A defaulted contractor may also claim that the wrongful termination caused it to be de-listed from eligible bidding lists, suffer reduced bonding capacity limiting its ability to obtain work, or even put it out of business altogether. Where the contractor is able to prove these consequential damages, it can lead to a substantial award against the owner.

While a contractor has many obligations under the contract for construction, not every breach justifies termination. In order for an act or omission to warrant termination, it must constitute a “material” breach. Whether a particular act or omission is “material” and warrants termination cannot be determined without a thorough factual analysis. For example, a mere subjective belief that the contractor cannot complete the work within the time remaining is not sufficient grounds for termination. To justify a termination for cause, the owner must be prepared to demonstrate, typically by schedule analysis, that the contractor’s lack of progress endangered timely completion. It must also be prepared to debunk the contractor’s claim that it could have caught up and finished on time if it had been allowed to continue. Most importantly, the owner must be able to prove that the delay is the responsibility of the contractor.    

Even where the cause and effect of a delay is clear, the owner must first give the contractor notice and opportunity to cure. The notice must describe the performance deficiency in sufficient detail, and unequivocally advise the contractor that it will be terminated unless the problem is abated. While some breaches are considered “incurable,” where a breach can be cured, the contractor must be given opportunity to do so, and the opportunity must be real and genuine – demands to do the impossible will serve only to fuel the contractor’s argument that the opportunity to cure was illusory and the termination predetermined.

Once the owner issues a cure notice, the contractor must actually cure the deficiency, or give adequate assurance that it will do so. Any assurance must be substantive and realistic; vague or qualified promises do not suffice. In evaluating the adequacy of the assurance, the owner may consider such things as the percentage of work completed versus the percentage of time expended, or the contractor’s failure to meet prior representations or promises. Where the contractor fails or refuses to address the deficiency, and does not provide adequate assurance it will do so, the owner’s case for termination grows stronger. In most circumstances, however, the contractor will attempt to excuse its lack of performance, and place blame on the owner or the architect. In such circumstance, sorting out exactly what happened and who is to blame can be difficult, and the risk of getting it wrong, significant. This is when the owner must diligently abide the contract and insist the contractor do the same.

Virtually all construction contracts require the contractor to proceed with the work notwithstanding a dispute with the owner. A work stoppage or refusal to proceed is a terminable offense, even if it is later determined that the contractor’s position in the dispute was correct. A conditional or qualified agreement to proceed – for instance, where the contractor says it will proceed if the owner accepts its claim – is tantamount to a refusal, and may also warrant termination. The duty to proceed does have limits, however, and the contractor may be justified in stopping work if the owner has materially breached its own obligations under the contract. Where a work stoppage is justified by a prior breach by the owner, termination of the contractor in retaliation may be considered wrongful.

When considering the termination of a contractor for cause, therefore, the owner must first assess whether it has fulfilled its own contractual obligations. Have all undisputed amounts been paid? Has the architect provided needed direction to the contractor, or issued the required determination on a request for change order? Regardless of the specifics of the dispute, every action and response by the owner should demonstrate that it has: (1) in good faith fulfilled its own contractual obligations; (2) abided the contract dispute resolution procedures; and (3) timely and fairly considered the contractor’s claims. When the owner is so positioned, it can force the contractor to choose between completing the work while they resolve their dispute, or refusing to continue and thereby providing the owner with an independent basis for termination.

Before terminating for cause, the prudent owner should first consider termination for convenience, if the contract allows. When an owner terminates for convenience, the contractor’s recovery is limited to payment for work completed, plus reimbursement of reasonable close-out costs. A properly drafted termination for convenience clause should also protect the owner against liability for lost profits and consequential damages. The major disadvantage of terminating for convenience is that it precludes the owner from recovering damages from the contractor, or from calling on the surety to complete the project. While giving up these rights is a significant concession, their enforcement is neither certain nor without cost. In deciding whether to terminate for convenience or for cause, the owner needs to consider such things as the percentage of completion of the work, the remaining contract balance, and the business loss from further delay to project completion. In some cases, the overall cost to the bottom line may be less with termination for convenience, even though it means giving up the ability to recover from the contractor or its surety. The timing of termination in relation to the progress of the work is often a critical variable in this calculation.

Project delays, claims, and payment disputes can be extremely frustrating for an owner, particularly where it appears that the contractor is unwilling or incapable of getting things back on track. At first blush, getting rid of the contractor may seem the obvious solution. It is at this moment that the owner must try to focus on the bottom line, and ask what is the fastest, least risky and least expensive path to completion? Where termination for cause is the proper course, the owner needs to proceed carefully to preserve its rights and maximize its ability to call on the surety to complete the project, and/or to recover damages from the contractor.

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