Determining the “Materiality” of a Breach of Contract

It is likely that your business contract contains a provision that grants the customer the ability to terminate the agreement without payment of penalties in the event of a “material breach.” Unfortunately, many contracts fail to identify what constitutes a material breach. Without this clarification in the contract, the determination must typically be made by a judge when a dispute arises.

What does the court consider “material breach?” There is no standard test or bright-line rule to guide the court in making this decision, so you never want it to get that far. It is far better to protect both parties’ interests through careful negotiations and planning when drafting the contract. Below are a few considerations to include in a contract to help protect your company in the event of a material breach:

  • Set forth the exact performance-based termination rights. For example, the right to terminate the contract may be triggered if a service provider fails to meet a specified service level for three consecutive months. The more specific you can be in defining what constitutes a material breach, the better.
  • Define the damages available when a material breach occurs. If liquidated damages are used, remember that they will only provide an incentive to perform if they are set at levels equal to the value and cost of the services. In other words, make sure it is not cheaper to pay the liquidated damages than it is to deliver or perform. You want the remedies available to motivate performance, not provide a cheaper way to get out of the contractual obligations.
  • Reserve the right of election. You should also reserve the right to elect a remedy other than monetary relief if a breach occurs. This allows you to prevent the service provider from curing nonperformance by paying the liquidated damages. Examples of non-monetary remedies include the right to terminate the contract, injunctive relief and specific performance.
  • Conduct the relationship consistent with the contract terms. It is important to enforce or preserve your rights under the agreement. If you allow an exception for nonperformance, you must explicitly affirm your right to relief while simultaneously disclaiming that right for the specific circumstance. In other words, you want to provide written notice to your supplier that while you are permitting an exception in this one situation, you are not giving up your rights to enforce on time performance in the future. It is difficult to rely on the contractual breaches as the basis for contract termination if you have a history of turning a blind eye.

To learn more about how to effectively draft contracts or how we can assist you with other business-related matters, contact Leslie S. Marell today.