Termination Right in an Outsourcing Contract

Exit provisions are one of the most important contractual protections for a customer in an outsourcing relationship. The provisions provide the framework to allow a customer to continue its business during transition and provide leverage for the customer in renegotiating the contractual terms. It is important to carefully draft the exit provisions because they will be used when the relationship between customer and service provider is not at its best.

A well-drafted outsourcing contract enables either party to terminate the arrangement prior to the agreed-to end date in a fair and reasonable manner. This is not to say that the termination provisions should be mutual between the customer and the service provider because the risk two parties undertake in an outsourcing arrangement is very different. If an outsourcing contract is terminated, the service provider will lose revenue. On the other hand, the risk for the customer is substantially higher if an outsourcing contract is terminated. For example, the customer losing services for its call centre or IT infrastructure management or its business process (such as reconciliation or payment processing) translates into losing operational time, revenue and reputation. The difference in risk between customer and service provider means that the two parties need to have different termination right in an outsourcing contract.

One of the termination rights in an outsourcing contract is termination for material breach. While some may argue that such termination right should be reciprocal such that if there are material breaches by one party, the other party should be able to terminate. There are certain circumstances where a service provider should be able to terminate for breach by a customer but such termination right should be restricted to very few cases. For example, if there is a sustained failure by the customer to pay undisputed amounts or if there is an infringement on the intellectual property rights of the service provider by the customer. Some may argue that the service provider should also be allowed to terminate in the situation where the customer has failed to perform its obligation which hinders the service provider’s ability to perform its contractual obligations. This type of breach by a customer can usually be remedied by monetary damages and termination is not an appropriate remedy.

The other termination right is termination for convenience or termination without cause. This termination right is usually exercised when a party decides that the outsourcing arrangement no longer aligns with its business direction. Transitioning from a service provider involves considerable cost, risk and disruption to customer. Giving a service provider the right to terminate for convenience means the customer may be forced to migrate to another service provider at a time dictated by the service provider. This is highly disruptive for a customer. This will also force the customer to incur transition cost that it is not budgeted for.

Some service providers still argue the necessity of having a reciprocal termination for convenience provision on the ground that the outsourcing relationship may not work as planned and the service provider should be allowed to exit. It is for this reason that the customer should resist the reciprocity of this provision. If it turns out that the outsourcing contract is not as profitable as the service provider has originally anticipated, this termination right provides the service provider significant leverage in renegotiate the terms (including pricing) and the service provider will be able to extort higher pricing from the customer simply because the customer heavily relies on the service provider to keep its operation running. Unless the customer misled the service provider in the due diligence phase, it is the responsibility of the service provider in conducting proper due diligence and preparing an accurate cost model. The risk of not performing proper due diligence or preparing an accurate cost model should not be shifted to the customer through the leverage the service provider may have in threatening to terminate the outsourcing contract for convenience.