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Contract Termination Fees: Are They Legal?

Contract Termination Fees: Are They Legal?

Find out whether or not contract termination fees are legal and everything you need to know about them.

23rd October 2020
Reading Time: 2 minutes

Imagine yourself entering into a contract with another person to start a hand-made clothing business. You agree to purchase the necessary tools. Your business partner says he will pay 50% of the costs after you have purchased them. However, you receive a call from your business partner that he does not want to do business with you anymore and decides to back out. Can you receive any compensation from him for backing out so unexpectedly? Find out whether or not contract termination fees are legal and everything you need to know about them.

What are contract termination fees?

Contract termination fees are payments which a person makes when they want to bring an end to a contract. The contract usually outlines the obligation to pay this fee. Contract termination fees are more common when one party decides to terminate the arrangement unexpectedly. Hence, contract termination fees are often referred to as ‘early termination fees’. 

The rationale behind this fee is to provide compensation to the other party who may have already invested time, money and effort into the arrangement or venture. However, this does not mean that all contracts must have a termination fee clause. Some contracts have ‘opting-out’ provisions which allow you or the other party to terminate the agreement early without paying a termination fee. For more information on terminating contracts, see here.

Read here, to learn about terminating fixed-term contracts. 

So, are they legal?

Yes, they are legal, but a poorly drafted one can be unenforceable.

It becomes problematic when the person paying the termination fee doesn’t know that the obligation to pay is in the contract or that the other party has added the term into the agreement without their knowledge. According to the Australian Competition and Consumer Commission (ACCC), these are classic examples of when a contract termination fee is unfair. Suppose a person can add a clause into the contract without the other party’s knowledge. In that case, there is a fundamental imbalance between your rights and theirs. As a result, it is essential to get the drafting of the contract right before you sign it.  

What if your contract termination fee is unfair?

If your contract termination fee is unfair, it may be unenforceable. In other words, you cannot force the other party to pay the fee if they choose to end the contract early. Suppose the other party decides to dispute whether or not the termination fee clause is enforceable. In that case, you could be fined by the ACCC for not complying with the Australian Consumer Law.

How to ensure that they are legal?

We recommend that:

  1. both parties to the contract must know that the early termination fee exists;
  2. both parties, including the person paying the fee, understand what a contract termination fee is, the amount required and how the fee is calculated; and
  3. the termination fee must represent genuine pre-estimate of loss. This will depend on how early the contract is terminated and your business structure. 

Need further assistance?

You must draft these clauses correctly to enforce them. We recommend you seeking legal advice from our lawyers to ensure this and to check whether your existing contract termination fee is fair. 

Chloe Yoo

Chloe is a Legal Technology Intern at Lawpath. She is currently studying a Bachelor of Laws/International Relations at Bond University. She is interested in Intellectual Property Law, Entertainment Law and how the law develops in the face of technological innovation.