Termination clause specifies the circumstances which lead to legal end of relationship defined in contract. Usually every contract contains some termination clauses. The typical termination clauses are:
- termination on notice - one party can notice other that contract ends; it can be instant or after some time, e.g. 30 days,
- termination on breach - if one party breaches contract, second can terminate it after fulfilling some defined procedure (e.g. sending information),
- termination on insolvency - if one party becomes insolvent, the contract is terminated
- termination on change of control - if company is taken over, the contract is terminated,
- termination on an event - if defined event happens (e.g. some objective is met), the contract is terminated.
The termination clause pinpoint all circumstances that if one side of contract would trigger, it will cause relationship's dissolution. Clause can be included not only in contracts between companies but even between employer and employee. In employment contract for example are statements explaining reasons of the possible laying off (A. Sen 1996, p. 1).
The termination clause included in long-term contracts between agent and principal is caused of that principal need to learn about its agent. By observing agents work it can measure results and learn about abilities. Principal may have alternative agent whose abbilities are not completely equal. By research it is learning which of them is the best to cooperate with. When principal make a choice it can use a termination clause. This way of using termination clause can be called reason of linked performance. In case of alternative agents we can describe antother reason of using termination clauses. Principal may not have opportunity to observe its agent whose actions can be covert and moral hazardous. Incentive effect of using the termination clause works as threat for the agent. That leads the person to take operations compatible with principal needs (A. Sen 1996, p. 2). Just like all contracts, in the termination clause all provisions need to be negotiated with both side of relationship (A. M. Michelsen 1993, p. 1014).
Positive side of termination clause
We can assume that partners can reach agreement and all their demands will be written in clause with circumstances of termination of contract. On the case of project failure partners are forced to terminate their contract. In this situation, the termination clause can prevent generating more costs. Firstly, some costs will be connected with project failure and lost of the opportunities to cooperate. Those costs are not connected with clause. However, without including termination clause, the court will have to decide about their litigation. Partners need to bear the costs of legal services, which makes the negotiations expensive. This can encourage partners of future contracts to make greater efforts preparing their project. Preparing good termination clause will protect them against generating costs. Other positive side of the termination clause is fact that each partner is obligated to fullfill all statements included in clause. The threat of failure leads partners to working harder (S. Comino 2006, p. 2-3).
Downgrade-triggerd termination clause
Downgrade triggerd termination clause is one of the controlling credit risk of company's counterparty tool that is using in management of credit risk. Using this clause give opportunity, to one party of an OTC (Over-the-counter) offshoot, to close off its position at MTM (Marked-to-market) price. It is happening when the credit rating of other party downgrades to alarming level (this level should be agreed in contract). The party that is non-defaulting may be suffering for losses after all. Risk can be reduced but other party may defaults triggering clause before default. Probability of default is the main computation of the credit risk adjustment valuation. This clause prevents occurrence of the counterparty credit quality getting worse or leading to non-fullfilment of obligation and causing losses to the entity that fails to perform its obligation. Od course this type of termination clause is not a protection to all risks of counterparty. The counterparty may defaults and carry losses without making the clause work (F. Runhuan 2012, p.1-4).
- Comino, S., Nicolo, A., Tedeschi, P. (2006). Termination clauses in partnerships. European Economic Review, 54(5), 718-732.
- Liang, Z., Wu, W., & Jiang, S. (2010). Stock loan with automatic termination clause, cap and margin. Computers & Mathematics with Applications, 60(12), 3160-3176.
- Michelsen, A. M., & Young, R. A. (1993). Optioning agricultural water rights for urban water supplies during drought. American journal of agricultural economics, 75(4), 1010-1020.
- Runhuan, F., & Volkmer, H. W. (2012). Modeling credit value adjustment with downgrade-triggered termination clause using a ruin theoretic Approach Insurance: Mathematics and economics, 51(2), 409-421.
- Sen, A. (1996). Termination clauses in long-term contracts. Journal of economics & management strategy, 5(4), 473-496.
Author: Maciej Soczówka