Contract Cancellation Options: What Are They?
A Contract Cancellation Option is an agreement between two or more parties to cancel an agreement. So, in the case of a real estate transaction, you would have one party agreeing with another party to provide the first party (the buyer) the right to cancel the transaction. So, for example, in a real estate transaction, if the buyer finds out during the inspection period that the furnace doesn’t work very well, he or she has the option, but has no obligation, to cancel the deal, get out of the contract and get the earnest money back.
Another example of a Contract Cancellation Option is in an insurance policy. Here (in Florida), most policies have what’s called "codification 627.7015". This basically says that if there is an insurance company denial as to a property and that denial cannot be resolved, that carrier will give an insured a "cancellation option", which the policyholder can elect by letter to cancel within 14 days of the denial. The effect of having this cancellation option as part of the policy is that the insured can avoid the waiting period to bring a bad faith claim.
A Contract Cancellation Option is not a waiver of rights. It is also not an option for an insurance company to get off of the hook for statutory timeframes. An example is the following. Let’s assume that an insurance company sends a "reservation of rights" letter to an insured after they first file the claim. A reservation of rights letter is a letter that an insurance company sends to the insured stating that they are investigating the claim and that they reserve the right to deny the claim later if they find out that it is not covered under the policy.
Well , let’s say that the insured argues that there is a duty to adjust under Florida Statute Section 627.70131. This Section requires insurance companies to begin adjusting the claim and communicating with the insured within 14 days of receipt of the claim. So, if the insured starts arguing about a reservation of rights letter and accuses an insurance company of being in violation of 627.70131 (and therefore that the insurance company has a statutory duty to adjust and has breached this duty by not doing so), it is very likely that the insurance company will then issue a "cancellation option" letter to the insured so that they can preserve their ability to deny a claim or to mitigate against attorney’s fees. Otherwise, the insurance company may create a serious problem for themselves by not complying with 627.70131.
I’m not saying that this type of conduct is the norm—this is just one possibility. Most if not all insurance companies have some really good people out there working hard that earn their pay and treat policyholders fairly. However, I have seen some crazy things going on lately.
Legal Basis and Conditions
The legal framework and requirements applicable to contract cancellation option agreements:
Chapter 3 of the National Credit Act (NCA) deals with obligations arising from credit agreements. Section 121 of the NCA, which is located in Chapter 3, provides for a consumer’s right to cancel a credit agreement at any time after the commencement date if the prescribed maximum interest-rate is exceeded. Section 121(1) of the NCA states that, where the NCA imposed maximum interest rates (as set out in Section 105 of the NCA), if the parties enter into a credit agreement at an interest rate that exceeds the prescribed maximum interest-rate, the consumer will have the right to cancel the credit agreement at any time after the commencement date.
The provisions of Section 121 of the NCA are vulnerable to abuse by consumers. The consumer, who is no longer obliged to repay the credit agreement and is now not liable for any future monthly payments, may seek to benefit by having the entire debt written off (or the debtor goes insolvent).
The case of Firstrand Bank Ltd v Odendaal 2011 (5) SA 1 (CC) ["Odendaal"] is the leading case in relation to Section 121 of the NCA. The NCA was found by the Constitutional Court to favour consumers unjustifiably by providing an unqualified right to cancel a credit agreement for any reason whatsoever. The Constitutional Court held that a section was required to regulate the cancellation of a credit agreement by a consumer for non-compliance with the provisions of the NCA. In turn, this was followed by the Protection of Consumer Rights Act 68 of 2008 which provided that consumers can only cancel credit agreements signed after 1 April 2011 if there is a material default in complying with the provisions of the NCA.
Contract cancellation option agreements allow a person to make the cancellation of a credit agreement subject to a right of cancellation by the lender if the NCA is contravened or where there is a material change in circumstances as agreed between the parties. There are specific clauses applicable to contract cancellation option agreements. These are clauses setting out the requirements (including the quantum) of the security to be provided, the length of the period before the loan itself must be repaid and the interest owing to the lender during this period. The agreement would also outline the mechanism by which the lender may exercise its right in terms of the agreement.
Advantages of Having Contract Cancellation Options
The incorporation of a cancellation option into a contract allows for flexibility and risk management for both contracting parties. Both parties entering into the contract are generally realizing a benefit from the cancellation option. A contracting party is usually required to have a reasonably binding obligation in order to establish the contractual relationship in the first place. The option to cancel gives the party an out from their obligation should circumstances alter the conditions of performance in an unreasonable and unduly burdensome manner. The other contracting party benefits from the option to cancel as they are receiving the contract consideration instead of no consideration at all should the contract not be performed.
When both parties do not consider circumstances to have altered in a significant way to justify performance, the option provides an avenue for recourse. If the contract is completed as promised, whether with or without the cancellation option, the contract consideration becomes due and payable. The cancellation option allows both parties the certainty that their contract will be enforceable so long as it can be reasonably performed. The consideration provided by one party is a legal consideration if legally sufficient to make a binding contract.
Typical Scenarios for Use
Contract Cancellation Option Agreements are beneficial in a number of situations. Here are a few examples of how they can be used.
Manufacturing
Baker Hughes and Hallibuton entered into a Series of transactions that involved an asset exchange agreement, a stock purchase agreement and a software license. The industry condition precedent contained in the asset purchase agreement was the (i) uncoupling of Baker Hughes and Hallibuton’s joint service offerings and (ii) the purchaser’s confirmation that a competitively functioning stand alone entity could provide the required services to customers of the combined Baker Hughes/Hallibuton.
Oil & Gas and Mining
Dominion is a marketer of natural gas and energy products. It entered into a contract with the Commonwealth of Pennsylvania to buy from, and/or resell up to, 30,000 gallons of gasoline or ultra-low sulfur diesel fuel per month at a price the contract defined as "the supplier’s price for the same product plus a loading fee". The contract required Dominion to obtain a creditworthy third party guaranty if Dominion had less than perfect credit and ordered more than $150,000 of fuel per month.
Water and Waste Water
Exeter is a water services company that provides waste water services for residential and industrial companies. In conjunction with a new technology acquisition Exeter wanted to always be able to terminate its contracts with its customers. Therefore, each customer contract included a contract termination clause and Exeter was required to pay a small penalty fee.
Shipping and Storage
Container Corporation of America owned and operated containerized storage facilities. It proposed to build and lease a facility to Shell in anticipation of considerable business that might ultimately fail to materialize. Therefore, it offered Shell an option to cancel the lease agreement free of charge.
How to Write a Clause for Cancellation Option
Contract cancellation options come in various forms, such as:
Cancellation with a right to cure.
Straightforward cancellation rights.
Cancellation only upon mutual consent.
The inclusion of arbitration provisions.
No one option is superior to the others; they are simply different. When drafting — and reviewing — contract cancellation option language, there are some things to consider.
First, try to get the other side to agree to require a mutual (i.e., bilateral) agreement to cancel. This may seem like an obvious point, but attorneys often try to slip one-sided cancellation language into contracts and it is important that cancellation be mutual.
Also, be specific about the conditions that trigger the cancellation right. By being specific, the parties clearly define the triggers and know what they must address in order to exercise their cancellation rights. As one example , suppose you are about to sign a contract for a business partner or strategic deal. You do not want the economic shock of cancellation to disrupt your business. In that case, avoid cancellation rights that will trigger if there are any defaults or non-performance of any kind, or at least try to make the triggers to cancel less sensitive. Put yourself in the shoes of your counterparty if the shoe were on the other foot and consider whether you would be comfortable with each trigger as stated. Make sure it works both ways to avoid a situation where the "counter" party can cancel at its whim.
Unilateral or one-sided cancellation rights are not necessarily bad, but they are rarely easy to agree to or can be agreed to by both parties. So, regardless of the type of cancellation option, ensure your business and business relationship can withstand it.
Possible Risks and Limitations
Contracts that include the right to cancel have built-in risks, including the possibility that the party with the power to cancel will do so. While this risk can be reduced by the negotiating power of the parties or the terms of the contract, the threat of cancellation by the other party is always present. The party with the right to cancel has the ability to cause the other party to breach the contract by failing to perform its obligations. This threat imposes a certain amount of pressure on the party facing cancellation to perform the contract, even though the contract may be terminated on short notice, and results in an imbalance as the party with the right to cancel has the option to cancel the contract whether the other party performs or not.
The contract may require the party with the ability to cancel to provide a termination notice to the other party. Contract cancellation options usually specify a set period for exercising the right; however, the non-terminating party may not have enough time to comply with the conditions for avoiding termination. This could be particularly detrimental if the termination requirement leaves the non-terminating party with little choice but to breach the contract.
If contract damages are incurred as a result of cancellation, there may also be questions of mitigation by the cancelling party. If the cancelling party saved money or otherwise benefited when the contract was cancelled, a claim for breach of contract may result in an award of too much liquidated damages.
Examples and Real Cases
Case Studies have shown Contract Cancellation Options as regularly used, applied, and enforced as intelligently as any and all other rights and remedies adequately and properly available within the world of contract law in general, and real estate contract law in specific. When the "other real estate contract remed[y]" is expressed in broad terms, the other commonly recognized rights, which regularly accompany the right to cancel existing, otherwise valid real estate contracts, include the associated rights of order for specific performance or sue for actual damages.
The appellate court cases of Eastside, Inc. v. Moller, 70 Wn. App. 428, 854 P.2d 32 (1993), and Olsen v. Priddy, 192 Wash. App. 438, 365 P.2d 1261(2010), provide important insight and guidance with respect to the enforceability of real estate contract cancellation options. Notably, the Eastside contract cancellation option was expressed in broad terms , providing that if purchaser did not tender payment or notice of an extension of the time to tender per the contract, it automatically "shall be void…." See Eastside (1993). In Olsen, the appellate court held that "a contract requires at least three elements: ‘(1) competent parties, (2) a subject matter, and (3) legal consideration.’…" See Olsen (2010).
The appellate court in Olsen also specifically ruled that "[t]o be enforceable, a contract must be sufficiently definite that a court can ascertain its meaning and operation from the four corners of the agreement itself…." Id. The Appellate Court had previously indicated that "[a] contract modification does not require consideration so long as the modified agreement remains a bargain or exchange at the time the modification is made." Id., quoting Panag v. Farmers Ins. Co. of Washington, 166 Wash.2d 27, 53, 204 P.3d 885 (2009).