Buyers sometimes cancel contracts. Indeed, some believe that they have a right to do so and that a seller who demands compensation is acting unreasonably. The law regards cancellation - unless one had an express right to do so or the seller is in serious default - as a breach of contract entitling the supplier to damages often including loss of profit on work not yet done. Buyers, however, look at it differently. If they cancel, it is normally because something has gone wrong in their own organisation, and what they want from their suppliers is co-operation and not claims for damages. Often, commercial negotiations that take into account prospects of future business between the parties can settle the problem. If not, one needs to look at legal rights.

In assessing the buyer’s legal liability, two situations need to be distinguished: first, where there is no right under the contract for the buyer to cancel for convenience; second, where the contract specifically gives the buyer the right but limits the compensation payable to the seller.

If cancellation occurs before ownership passes to the buyer, then (with one exception) the seller cannot sue for the price of the goods but has the right to bring action for damages for non-acceptance under the Sale of Goods Act 1979. A similar principle applies to the cancellation of works or services contracts and the contractor’s right to sue for damages.

The compensation is for loss of bargain and the amount depends on the particular case.

Goods that are not yet manufactured

Even if no manufacture had occurred, the supplier is entitled to loss of profit on the total contract value (plus reimbursement of costs incurred in part performance). Buyers have argued that if the cancellation allows the supplier to earn profits elsewhere, these should be set off against the cancelled contract - but the buyer must prove the supplier was incapable of fulfilling both the cancelled order and the other contracts because, for example, the factory was already working to capacity.

Questions of supply and demand

Where supply exceeds demand, the seller is entitled to loss of profit on the cancelled sale even though some of the goods may be resold to an alternative purchaser (as that would have been possible anyway).

English courts assume the second sale would have produced as much profit as the cancelled one. However, except in the case of items already in stock, this approach may be too simplistic. If goods had to be manufactured for that sale, it would have entailed risks and the estimate of profit should be discounted for that risk.

In the opposite situation, where demand exceeds supply the “lost volume” argument does not apply as the seller has not lost the benefit of a sale and so is entitled only to nominal damages.

Goods that are unique

A seller’s compensation will depend first on whether the goods have been manufactured or not. If not, compensation is limited to loss of profit. If they have, compensation will depend on the ability to resell them. If they have been made to the buyer’s specification and are useless to others, the seller will be entitled to recover the contract price, less any scrap value. However, the seller should try to mitigate the loss, and if the goods can be made saleable by making small modifications must do so.

If the goods are sold at a higher profit (after accounting for additional expense), the seller is not entitled to compensation. If they can be resold only at lower price, the compensation will be the difference between this and the contract price.

Manufacturer has spare capacity

If the contract is cancelled before performance, the manufacturer or contractor may have spare capacity which, despite best efforts, cannot be filled with additional orders. The damages will then include the gross profit that would have been made on the cancelled contract, that is, including overheads. The only allowable deduction from the contract price will be the direct costs that would have been expended in carrying out the work (i.e., costs that will now not be incurred).

In works and services contracts, if no work has been carried out, the contractor is entitled to loss of profit on the whole contract. If some has been performed, the contractor is entitled to be paid for this at contract prices plus loss of profit on the uncompleted portion.

Cancellation under the contract

Buyers sometimes stipulate a unilateral right to cancel for convenience. Usually the clause restricts their obligation to pay compensation to the costs incurred by the seller up to cancellation, plus any commitments entered into, but excludes loss of profit, at least as far as unperformed work is concerned.

As the contract will probably be on the buyer’s written standard terms of contract, the clause will be caught by the Unfair Contract Terms Act and will not protect the buyer unless it satisfies the act’s “test of reasonableness”. Factors taken into account include the parties’ bargaining strengths, the extent to which the contract was freely negotiated and the compensation offered.

A convenience clause presented on a “take-it-or-leave-it” basis that did not provide the supplier with fair compensation would be unlikely to be deemed reasonable. Anyone who wishes to include a convenience clause should, in their own interests, ensure its terms are fair.

SM

Peter Marsh and Frank Griffiths are associates at project strategy and contract management consultancy FGA Ltd (0116 279 3383)