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July 20, 2017

Does a Termination for Convenience Clause Really Mean What It Says?

The standard purchasing terms and conditions of essentially every Original Equipment Manufacturer and Tier One supplier contains a termination for “convenience” provision. This clause states, in sum, that the buyer can terminate the contract at any time, at its option and in its sole discretion. These clauses typically state that if the customer chooses to terminate, it will only be responsible for finished products already ordered, usable work-in-process and other discrete costs. This can seem harsh and potentially unjust, particularly when the supplier was anticipating a long-term agreement, agreed to per-part pricing to reflect that understanding and has sunk hard costs into its manufacturing facility. But if the supplier takes a deeper look at the contract terms and conditions with its customer, more than likely it will find this provision included in the contract. 

Despite the straight-forward language of a termination for convenience provision—that the buyer can terminate for any reason or no reason at all—this can run counter to other aspects of the law governing supply agreements. This is where the law can get a bit muddled.  

Many supply agreements are set up as “requirements” contracts. These contracts are recognized as enforceable under the Uniform Commercial Code (UCC) even though there is not a set quantity that the buyer must purchase. The UCC recognizes the practical reality—particularly in the automotive world—that a buyer may not always know how much product to order. So under a requirements contract, the buyer commits to a per-part price to purchase all (or a percentage) of its requirements for that part from the seller. However, while the buyer has flexibility to only order what it needs, it must still order products in good faith. This means that the buyer must operate and conduct its business “according to commercial standard of fair dealing . . .” (UCC 2-306, Comment 2).  For example, “a shut-down by a requirements buyer for lack of orders might be permissible when a shut-down merely to curtail losses would not.” Id. As some courts have observed, to satisfy this good faith duty, a buyer cannot simply have second thoughts about the terms of the contract and stop ordering products to get out of it. But, if the buyer has a legitimate business reason for eliminating its requirements, as opposed to a desire to avoid its contract, the buyer acts in good faith. See Empire Gas Corp. v. American Bakeries, 840 F.2d 1333 (7th Cir. 1988).
 
But, what if a requirements contract also contains a termination for convenience clause, and the buyer simply decides to terminate the contract? Is that decision a failure by the buyer to order products in good faith, or merely one party utilizing an agreed upon provision to end the contract? The law is unclear, with courts answering this question differently.  

In Metal One America, Inc. v. Center Manufacturing., Inc., 2005 WL 1657128 (W.D. MI 2005), the court considered whether Center’s termination for convenience of a requirements contract constituted a breach. The court found that it did and concluded that Center chose to end the contract and stopped ordering parts, not for lack of orders but because Center was attempting to “curtail losses.” In the court’s view, this constituted a bad faith breach of the contract. The court was also swayed by the fact that the parties had an established course of performance. Center regularly placed orders for products and then abruptly terminated after placing its most recent order.  

In contrast, the court in Q.C. Onics Ventures, LP v. Johnson Controls, Inc., 2006 WL 1722365 (N.D. Ind. 2006) (applying Michigan law) took the opposite view. In that case, JCI was sued because it terminated a requirements contract, pursuant to a clear termination for convenience clause. The plaintiff argued that because the contract was a requirements contract, JCI could not terminate for convenience, and was required to exercise good faith when determining its requirements. The court flatly rejected this argument and concluded that the obligation to buy in good faith on one hand, and the contractually agreed upon right allowing JCI to terminate for convenience on the other, were two separate concepts. JCI was not claiming in bad faith that its requirements were now zero, but was instead relying on the termination clause for its decision. JCI was required to order its requirements in good faith while the contract was in effect, but it could properly end the contract for any reason. In reaching its decision, the court rejected the analysis in Metal One America.  

There have been few other decisions on this topic. So where does that leave suppliers? As the Q.C. Onics Ventures case recognized, it is difficult to conclude that a clear termination for convenience provision means something other than exactly what it says. A termination done the right way—with payment of costs and appropriate advance notice, none of which was done in Metal One America—will be much more defensible in court.  

But each situation is very fact specific. When deciding whether to terminate a supply agreement or face a situation where your supplier or customer is threatening to end the contract, it is prudent to examine the contract documents very carefully before making any decisions. Do you have a “requirements” contract? Are applicable terms and conditions properly incorporated into the contract and, if so, what do they say regarding termination? What was the parties’ course of performance and how will that impact the interpretation of the contract? The answers to these questions will dictate how to proceed in a way that makes the most business sense while complying with your legal obligations.

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