I. Introduction
The United States and Australia have been close military allies for over one hundred years. Australian service members have fought alongside American soldiers in every major U.S. conflict since World War I. The military alliance has closely related national security structures and strategic priorities, and each nation pursues value, competition, and transparency in defense procurement. Legislators in both countries continually strive to advance defense innovation which enables the warfighter and deters near-peer threats. Despite similar strategic and procurement interests, defense contracting practices vary between the United States and Australia. One area which warrants particular discussion relates to termination for convenience (TFC) in defense contracts.
A TFC clause exposes a power differential between the government and a contractor, enabling a contracting official to abruptly withdraw from agreed upon contractual obligations without penalty. It is a risk a contractor must consider when bidding for a government contract award. Given the detrimental outcome for a contractor should a TFC term be exercised, it can safely be argued that it is one of the most powerful terms of a government contract. From a comparative perspective, U.S. law permits liberal use of TFC clauses in government contracts, arguably to the detriment of its taxpayers. On the other hand, the use of TFC clauses in Australian government contracts is limited to exigent circumstances or where it is no longer practicable or in the public interest to continue the contract. In Australia, the duty to act in good faith appears inherent when terminating a government contract for convenience. This, in turn, promotes good procurement practices which supports relationships with Defence industry suppliers.
This article argues that the use of TFC clauses in U.S. government contracts is exercised too broadly. The rationale for the TFC is curbed only by the regulatory requirement that contract termination be in the “[g]overnment’s interest” and is tempered slightly further by the courts in that the government must not act in bad faith. The onus is on the contractor to prove bad faith. The legal threshold is not consistently applied as an objective bad faith standard; rather, emphasis is placed on the government’s subjective intent to injure the contractor. This effectively encourages poor procurement practices which lie on the outer bounds of bad faith. A minor change to the existing Federal Acquisition Regulation (FAR) would limit use of a TFC clause to times of exigency, or where performance of the contract is no longer practicable. This is likely to limit a contractor’s risk associated with fulfillment of a government contract and minimize policy harms. It could also further bolster the government’s position in the commercial marketplace.
II. Background and Key Principles
To understand TFCs in the procurement systems of both the United States and Australia, a brief discussion of their histories and evolution is necessary. This section outlines the century of U.S. TFC context that affects contracting officials and defense contractors alike. The U.S. approach to a TFC is rooted in an ardent need to protect the government’s fiscal interests. It champions sovereign flexibility with little regard for the effects on a defense contractor. The Australian approach is a more cautious one given that the government is regarded as a moral exemplar charged with the duty to serve the public interest. Extant jurisprudence suggests that termination of government contracts must only be exercised in good faith, which may indeed foster greater overall value in procurements given the lessened risk to the contractor.
A. United States
In the United States, a TFC is a long-standing government right. It permits the United States to evade its contractual obligations due to its sovereign interest with the objective of protecting taxpayer interests. The FAR promotes this mandatory, unilateral right under the auspices of conservatism to allow the government to end ongoing (but no longer necessary) procurements and prevent government exposure to breach damages (i.e., a contractor’s anticipated profit). After a TFC, a contractor may then recover only the costs and profit related to its work already performed under the contract. What results is a lopsided government right that likely drives up the cost of contracts and dissuades non-traditional contractors from considering government solicitations.
A guarantee unique to federal contracts, the TFC clause began as a way to limit continued contractual obligations after the cessation of hostilities (i.e., wartime requirements). Concerns that an abrupt end to World War II would cost the U.S. taxpayer inordinate sums accelerated the TFC’s prominence as a required term. Over time, the public’s definition of “war” changed, and so did the use of the TFC term.
Originally, war—and its impact to the contract—was a prerequisite for a TFC. In United States v. Corliss Steam-Engine Company, the U.S. Supreme Court held the government may suspend and settle contracts as expectations change due to war’s end. The war nexus for TFCs continued throughout the first half the twentieth century, and held a conspicuous place in the ensuing TFC legislation, such as the Urgent Deficiency Appropriation Act of 1917 and the Contract Settlement Act of 1944. Then, in 1963, the U.S. Court of Claims “read-in” and applied a TFC clause where one was wholly omitted from a peacetime contract. The government’s TFC right continued to evolve throughout the latter half of the twentieth century and now finds a place in all contracts governed by the FAR—regardless of the status of war.
Today, the government’s broad TFC right enables terminations tantamount to breach in the commercial market. Take for example the following government uses of TFC clauses: to obtain a lower supply price despite knowing the lower price at the time of the original contract award, to effectively fire contractor employees and then immediately re-hire them as federal civilian employees, to avoid contract obligations when it contemplated a TFC prior to award,or to compensate when agency personnel are inept and government plans and specifications are inadequate.
These instances highlight the contractually uneven terms contractors are subjected to in FAR-based contracts. The current terms permit the government to exercise a TFC without any constraints unless contractors can demonstrate the government acted in bad faith or abused its discretion. Contractors savvy with their legal options are wise to pass on challenging a TFC. Over the years, the courts and boards have shown it is incredibly difficult for terminated contractors to prove bad faith or abuse of discretion. Courts and boards give deference to Contracting Officers (COs) that terminate for the government’s convenience and presume an implied duty of good faith and fair dealing. It follows that for over seventy years, courts have been “loath to find to the contrary [of good faith]” and require clear and convincing evidence in order to overturn a TFC. The high hurdle to prove a breach of the implied duty of good faith and fair dealing bolsters the government’s contractual powers over a contractor; no equivalent benefit transfers to industry members under the current TFC scheme.
In order to utilize this broad government right, a CO must only determine that the termination is in the government’s interest. The “government’s interest” is not defined by the FAR, thereby conferring significant authority upon COs in making such determinations. Once the CO tenders a TFC notice, the contractor must stop work, notify any subcontractors, and take measures to eliminate any further costs related to the contract. The parties then have one year to reach a settlement for the work performed.
B. Australia
A TFC clause is a term commonly found in Australian commercial (private) and government (public) contracts. Most Australian government contracts, particularly Defence contracts, include a TFC clause. For example, the standard Termination for Convenience Clause included in the Australian Standard for Defence Contracting (ASDEFCON) (Strategic Materiel) reads:
In addition to any other rights it has in relation to the Contract, the Commonwealth may at any time terminate the Contract or reduce the scope of the Contract by notifying the Contractor. None of the other provisions of the Contract limit the Commonwealth’s ability to terminate or reduce the scope of the Contract under this clause. If the Contract is terminated or reduced under this clause, the Commonwealth’s liability in respect of the termination or reduction is limited to: a) payments under the payment provisions of the Contract in respect of work performed before the date the termination or reduction takes effect; and b) any reasonable costs incurred by the Contractor that are directly attributable to the termination or reduction, and then only when the Contractor substantiates these amounts to the satisfaction of the Commonwealth Representative. In particular, the Contractor shall not be entitled to profit calculated by reference to any period after the date the termination or reduction takes effect.
Essentially, the term enables the government to terminate an agreement by notice without cause.
Notably, caution is exercised in utilizing the term, primarily because of its deep-rooted historical connection to the common law doctrine of executive necessity: the government can break a contract on the basis of acceptable government reasons (e.g. significant change in government policy, war). A TFC clause has been described as a contractual manifestation of this doctrine. A key point to note relates to the fact that the doctrine of executive necessity does not require the government to compensate the innocent party for early termination. A government contract containing a TFC clause, requires—much like in the United States—the government to provide payment for work performed prior to termination and to compensate the contractor for reasonable costs directly attributable to early contract termination.
Australian jurisprudence on the limits of TFC clauses is scant. Central to a discussion on the limits of a TFC clause is the concept of “good faith.” In Australia, the meaning of good faith has been recognized as not acting in bad faith—not acting capriciously, opportunistically, arbitrarily, or dishonestly. This is like the judicial interpretation of good faith by U.S. courts and sets parameters around how parties to a contract should not act. However, it has also been construed as a set of positive obligations—how parties to a contract should act.
A commonly referenced statement is that of Sir Anthony Mason. He postulated that good faith consists of three main criteria, including: a duty on parties to cooperate in achieving the contractual objects, compliance with honest standards of conduct, and compliance with standards of conduct which are reasonable having regard to the interests of the parties. A raft of Australian cases have accepted this interpretation of good faith. A long line of New South Wales cases treat the notion of “acting reasonably” as central to the duty of acting in good faith. The Supreme Court of New South Wales (Court of Appeal) stated in Vodafone Pacific Ltd v Mobile Innovations Ltd that “[r]easonableness can be seen as part of good faith, and acting in bad faith is hardly reasonable.” Honesty, too, is considered fundamental to the concept: “[t]he essence of the good faith requirement is honesty.” It has also been said that the proper exercise of the duty to act in good faith does not extend so far as to “require a party to act in the interests of the other contracting parties nor to subordinate their own legitimate interests to those of the other parties.”
The current state of the law in Australia reflects recognition of the existence of the duty to act in good faith, although there is some division as to whether the duty should be implied as a matter of law (into all commercial contracts of a particular class, although an express term can exclude) or as a matter of fact (on a case by case basis). Notably, in the case of GEC Marconi Systems Pty Ltd v BHP Information Technology Pty Ltd, the Court, commenting on use of a TFC clause, stated that “the exercise of such a clause would, as of course, be subject to a duty of good faith and fair dealing.” Thus, at a minimum, the case suggests that there is a duty for the government to act in good faith when exercising a TFC clause. Also important, the case of Kellogg Brown & Root v Australian Aerospace Ltd provides us with precedent that the government must exercise a TFC clause in good faith. The decision involved a Defence subcontract which included a TFC clause where the subcontract mirrored the TFC clause of the head Defence contract. Australian Aerospace (AA) (contracted with the Australian Commonwealth government to supply helicopters to the department of Defence) subcontracted with Kellogg Brown & Root (KBR) to provide training and support services in regard to the helicopters and flight control systems. The TFC clause was invoked once AA realized it had subcontracted out of a lucrative part of the contract. KBR argued wrongful termination on the grounds that AA had not exercised the TFC clause in good faith. The Supreme Court of Victoria acknowledged that “the case for the implied [good faith] term and for its breach [was] well arguable” and that the absence of the implied term could present grave consequences for future contracts. The Court noted that this duty could consist of: not depriving the other contracting party of the substantial benefit of the contract, acting fairly and reasonably for just cause, and not acting capriciously or for an improper or extraneous purpose. By that standard and in this instance, AA exercised the TFC for an improper purpose; it did not act in good faith.
Under this precedent, it is highly unlikely that a TFC on the grounds of pursuing a cheaper contract price or avoiding liability would be regarded as acting in good faith. Yet, a TFC would remain an available tool in circumstances amounting to genuine “executive necessity.” Proper exercise of the TFC clause and use of the clause in good faith may include circumstances where (1) the relationship between the parties has broken down so that contract performance is not feasible, (2) the cost to the contract can no longer be justified as serving the public interest, or (3) contract performance is no longer possible for practical reasons.
It is perhaps prudent to mention that TFC clauses are commonly included and exercised in private commercial contracts. In this context, the duty to act in good faith may be excluded by the express terms of the contract and inclusion of a “‘whole agreement’ clause,” which ensures that the written agreement defines all of the obligations agreed to by the parties. As a matter of public policy, the government is held to higher standards of conduct. This notion is supported by the fact that the government is viewed by Australian courts as a moral exemplar. In Hughes Aircraft Systems International v Airservices Australia, Finn J noted that the government should “act fairly towards those with whom it deals at least insofar as this is consistent with its obligation to serve the public interest.” In light of existing jurisprudence, a contractor is fairly well protected against unreasonable, dishonest, arbitrary, improper, or capricious exercise of a TFC clause. This fosters confidence in doing business with the government as a commercial market player and promotes continued growth in procurements with industry.
III. Adopting Australia’s Approach to TFCs Reduces Current Unintended Consequences
A. Potential Harms and Policy Considerations
The U.S. approach to TFCs is too broad; its breadth encourages COs to use a TFC clause as a fallback measure in lieu of steadfast, thorough acquisition planning. The FAR provides COs the authority to “enter into, administer, and terminate contracts.” It also makes COs responsible for “all necessary actions for effective contracting,” which one would assume includes fully understanding the acquisition before binding the government in a contract. Yet, easy access to a TFC fosters the notion that the government’s promise to uphold contract terms is illusory. All the CO must do is determine, against virtually no standard, that the TFC is in the government’s interest.
Under the U.S. system, good faith and fair dealing on the part of COs is presumed by courts and boards of contract appeals. This leads COs to use TFCs to the full extent of availability and it creates an uphill battle for contractor challenges. The only way for contractors to contest the propriety of a TFC is to file a claim with the very CO that issued the TFC. If the CO denies the claim, a contractor’s only recourse is to appeal to an agency board of contract appeals or file for an injunction at the Court of Federal Claims, both of which can be costly endeavors. Even so, unless a contractor can prove bad faith or breach of contract, the TFC will stand due to the strong presumption in favor of the government.
This flexible nature of the government’s obligations likely leads to considerable negative consequences that, while difficult to measure, reflect the harm caused by the lack of TFC limits.
1. The TFC Upcharge
The U.S. government likely pays more for its goods and services given that contractors may account for the possibility that the government may deploy a TFC clause when pricing a contract. Enormous contractual benefits flow from a TFC clause to the government without a commensurate advantage going to the contractor. The acquisition community acknowledges this contractual mismatch that leads the U.S. government to pay a premium for virtually all its contracts. Notably, this inefficiency likely holds true even with astute accounting and cost management. The price premium has been discussed by a number of legal scholars examining the added costs from the TFC clause. If the United States modeled a new TFC clause on the TFC clause found in Australia’s Defence contracts, the cost or price of U.S. contracting actions would likely decrease by default.
However, paying more over time is not the only consequence of the TFC clause. It also causes nontraditional contractors that could potentially yield cutting edge requirements to pass on government contracting opportunities.
2. Inhibiting Nontraditional Solutions
Often an arduous undertaking regardless, TFC clauses make contracting with the U.S. government even less desirable for nontraditional contractors, such as a technology firms. Although nontraditional defense contractors (NDC) represent key actors in the future of defense innovation, until recently, the Department of Defense (DoD) did not prioritize solutions from NDCs.
A recent strategic push from the DoD’s highest levels highlights that NDCs are essential partners in need of leveraging. One method to utilize new technologies and NDCs is through non-FAR based contract vehicles known as Other Transaction Agreements (OTA). It is no surprise then that utilizing OTAs results in the DoD excluding, or at the very least rewriting, TFC clauses. In fact, the DoD OTA Guide recommends scrapping the standard TFC clause in favor of a commercially viable termination clause.
This practice evidences that TFCs are not appropriate for NDCs. A commercially viable TFC clause—like Australia’s approach—permits termination by either party and may be utilized with a penalty commensurate with the leverage it exudes.
IV. Reforming the United States’ TFC Clause
For the United States, reforming the acquisition system is a key priority. The United States must leverage innovations in technology and ensure its acquisition systems maintain comparable bargaining power with the commercial marketplace. Currently, the rules governing U.S. defense procurement overcomplicate contractual relationships with industry. This is not a new revelation. For years the DoD has undertaken seemingly continuous efforts—supported by Congress—to improve the acquisition process. In line with these efforts, U.S. lawmakers should consider the detriment that accompanies the U.S. government’s antiquated contract clauses, such as the TFC clause, and the relative ease with which modest, but impactful reform could be accomplished.
The standard TFC clause in the United States presently reads as follows: “The Government may terminate performance of work under this contract in whole or, from time to time, in part if the Contracting Officer determines that a termination is in the Government’s interest.” For the reasons explained above, the United States should adopt the Australian approach to TFCs by removing the “Government’s interest” language and replacing it with language to reference instances where emergencies or wartime contingency requirements interfere with contract performance. Thus, the standard TFC clause should be amended to read as follows: “The Government may terminate performance of work under this contract in whole or, from time to time, in part if the Contracting Officer determines that Government exigencies exist or where it is no longer practicable.”
Although the FAR does not define exigency, the word is understood to convey “a state of urgency” or a “situation requiring immediate action.” This general definition is commonly accepted and may be applied against the doctrine of executive necessity (as discussed previously) with a contractor’s implied duty of good faith and fair dealing. The removal of “government’s interest” and insertion of “government exigencies exist” will remove undue government leverage in U.S. procurement contracts while causing no undue harm to critical government interests. It may be prudent for procurement policymakers to consider defining these criteria in revised FAR text as meaning “unpredictable circumstances related to military conflict.”
A TFC clause ought to enable the government to terminate contract performance where the contract can no longer be carried out for practical reasons. This makes the reference to “where it is no longer practicable” an important component of a revised text. It would facilitate legitimate exercise of a TFC clause in instances where performance is no longer feasible. For example, the clause could be appropriately invoked where the relationship between parties has broken down or in instances where costs can no longer be justified on public policy grounds. Central to a TFC on this basis is that the government acts in good faith—it must act honestly and reasonably.
This minor change to the wording of a TFC clause has the potential to reduce the overall number of TFCs and require COs to bilaterally settle contracts on more equal terms with contractors. In turn, existing contractors and NDCs are more likely to willingly pursue government contracting opportunities.
V. Conclusion
Maintaining technological dominance on the battlefield while deterring near-peer threats is a never-ending, evolving challenge. Transforming today’s U.S. acquisition system is at the forefront of many military leaders’ minds.
This system, which partners with private commercial and defense industries, enables the DoD to procure solutions using acquisition rules established almost a century ago. Carried forward to today as a relic of a war-dependent acquisition system in the U.S. is the U.S. TFC clause. This clause raises the prices of defense contracts given the risk of government-initiated TFC that contractors assume, likely acting as a barrier to entry for NDCs, and does little to support efficient and principled acquisition planning.
The United States’ Australian ally takes a more reasonable, modern TFC approach. In Australia, government contracts are not readily terminated by convenience, which forces contracting officials to uphold even bargaining terms, allowing commercial market practices to prevail. This in turn eliminates undue contractual leverage, reduces contract litigation and, thus, incentivizes industry to contract with the government.
The United States would be wise to adopt Australia’s more restrictive approach to TFCs. Moving from a current standard of near absolute impunity to one of exigent circumstances that considers contractual practicability will lead to overall gains in acquisition policy. If the U.S. procurement system is to evolve with industry-provided defense solutions and the commercial marketplace, should not its contract clauses evolve too?
