Contract Cancellation in Procurement
A buyer may enter into a long-term procurement contract with a supplier as an outcome of the supplier evaluation, selection, and negotiation process. You have studied different modes of procurement agreements and contracts in the previous chapter.
For repetitive raw material purchases, a long-term agreement is concluded with the supplier and purchase orders or release orders are issued as per the agreement.
Table of Content
A purchase order becomes a contract when it satisfies the three legal requirements of a contract: an offer, acceptance, and consideration. If the purchase order is issued based on a quote received in response to RFQ from the supplier, it becomes an acceptance of the offer from the supplier and becomes a legal contract.
On the other hand, if the issued purchase order differs from the quote received (that is, any term and condition of the contract are changed by the supplier), then it becomes a counteroffer. Similarly, if the purchase order is issued without reference to any quote received from the supplier, it remains only as an offer.
In both the latter cases, the purchase order becomes a legal contract binding on both the buyer and the supplier only after its acceptance by the supplier either through an acknowledgment letter or through the delivery of goods. A long-term procurement contract or a purchase order contract can be canceled by one of the parties to the contract after it has been made. A contract cancellation can be in the nature of ‘cancellation’ or ‘termination’.
Cancellation occurs when either party ends the contract for breach of terms by the other party. The canceling party retains the remedy for breach of the whole contract or any unperformed balance.
When the contract is canceled by one party due to the violation of the terms and conditions of the contract, the entire contract may be turned back, payments formerly made may be refunded, and any remaining obligations are instantly terminated.
Cancellation can be differentiated from ‘Rescission’ which refers to the act of rescinding (i.e. undoing or unmaking) a contract. Rescission involves the right of parties (involved in a contract) to return to the same state as before entering into the agreement.
In contrast, for contracts under statutes like UCC (Uniform Commercial Code), termination occurs when either party ends the contract for reasons other than the breach of contract. In this case, parts of the contract that have already been completed will be left alone. However, obligations for the future (part of the contract, which has not been performed yet), will stop. Termination of contracts may allow either party to terminate for any reason (or for no reason) under certain conditions.
If either party suffers any hardship because of the actions of the other party, the suffering party will be reimbursed with a satisfactory and documented adjustment. If the amount of compensation cannot be determined by mutual agreement, it may be necessary to approach the court. Termination can also be based on mutual consent.
Termination differs from cancellation as the contract can be terminated (in accordance with the provisions of the contract) without the contract being breached by either side. Termination occurs when either party ends the contract for reasons other than its breach.
Termination can also be based on mutual consent. The difference between cancellation and termination is that in the case of a cancellation, the canceling party retains any remedy for breach of the whole contract or any unperformed balance.
Types of Contract cancellations
Contract cancellations can be of the following types:
- Cancellation Due to the Breach of Contract
- Cancellation for an Anticipated Breach
- Cancellation by Mutual Consent
Cancellation Due to the Breach of Contract
The cancellation due to the breach of contract occurs when one of the parties fails to live up to the terms and conditions of the contract.
For example, late deliveries, failure to meet product specifications, etc. can be considered a breach of contract. In case of contract cancellation, the supplier is required to compensate for the losses arising out of the breach of contract.
Cancellation for an Anticipated Breach
Cancellation for an anticipated breach (also termed cancellation for the convenience of the purchaser) may happen when there is a strong reason to believe that one of the parties to the contract will not fulfill its obligations.
An anticipatory breach denies the counter-party’s responsibility to perform its duties under the contract. In such cases, the counter-party by demonstrating the party’s intention to breach may also begin legal action.
Cancellation by Mutual Consent
Cancellation by mutual consent is done as per the agreement reached between the parties and it does not lead to any legal action for contract cancellation. A mutual agreement to cancel the contract implies the creation of another contract with the intent of nullifying the original contract agreement.
The purchase or services contract clauses should clearly spell out the reasons applicable for contract termination or cancellation. For example, if a purchase contract allows its ‘termination’ by either party ‘without need for attributing any reasons’, then either party can get into severe problems.
Suppose after a purchase contract is entered into, the price of the item to be purchased drastically comes down from the price agreed in the purchase order. In this case, the buyer may try to terminate the contract or find some loopholes in the purchase order to cancel the contract.
To deal with such situations, it becomes necessary that a contract is considered a binding obligation by either party. The terms and conditions for contract cancellation or termination should be defined clearly in the negotiation agreement and both parties should agree in advance on those conditions.
Some example clauses are given below:
A clause for “termination for convenience” normally resisted by suppliers for inclusion in contract clauses, may state as follows: The purchaser may terminate this contract for convenience. In the event of such termination, the purchaser shall reimburse the seller for all expenses incurred or committed up to the date of receipt of notice of termination.
A contract clause for cancellation may specify as follows: If the seller fails to fulfill any of the terms of this purchase order, the purchaser may by written notice to the seller, without prejudice to any other rights or remedies that the purchaser may have, cancel the contract and further performance by the seller.
If the contract cancellation occurs, the purchaser may complete performance of this purchase order by such means as he/she selects. The seller shall be responsible for any added costs incurred by the purchaser in doing so.
The introductory case is about a claim by a US firm of breach of contract against an Indian IT services firm. The US firm in a suit claims that the Indian IT services firm failed to meet project deadlines in spite of having a sufficient workforce.
Similar to this case, the USbased firm Conduent sued another Indian IT firm Cognizant Technologies for a ‘contract breach’ in April 2017. These are examples of service contract cancellations and how they can turn into a fierce court battle. Contract cancellation clauses and related terms and conditions become important when the buyer claims a breach of contract.
Liquidated Damages Clause
The supplier in breach of contract is liable to pay to the buyer a sum decided by the court, known as damages, to compensate the buyer for any loss actually suffered, including loss of profits due to breach of contract. However, obtaining damages through courts involves expense, delay, and uncertainty.
A practical alternative is to include in the contract a “liquidated damages” clause. Here, the term “liquidated” means “decided in advance and expressed in monetary terms”. If the sum specified can be shown to be a genuine pre-estimate of loss, the courts will enforce it in the unlikely event of litigation being required.
The liquidated damages clause is basically an agreement as to the amount payable by way of damages in the event of contract cancellation due to a breach of contract.
The liquidated damages clause can be used to motivate the supplier to deliver on time as any breach of contract can lead to a significant amount of money being paid by the supplier as liquidated damages in accordance with the contract agreement.
Force Majeure Clause
It is possible that a breach of contract can happen due to circumstances beyond the control of either party. A clause may be inserted to provide protection to the party concerned by exempting it from liability if the breach is due to reasons completely out of its control. The reasons could include government interventions, strikes, lock-outs, floods, fire, war, etc. This type of clause is called a force majeure clause.
An example of the force majeure clause that protects the supplier can be as follows: The seller is responsible for notifying the purchaser within three working days of occurrences that may prevent or delay the seller’s performance. The notification shall be in writing and the seller shall make every reasonable effort to resolve the Force Majeure occurrence as soon as possible. Reported occurrences could include…. Should the seller be unable to fulfill the contract after a one-month period, the purchaser shall have the right to terminate the purchase order, with its only liability being to pay the seller for products received by the purchaser.