Material Breach (and Termination Rights)

Every failure to do what a contract requires is a breach, and every breach entitles the innocent party to damages for the loss it causes. What a breach does not automatically do is let the innocent party walk away. Whether it can end the contract depends on how serious the breach is and what the contract says.

"Material breach" is the phrase business contracts use for a breach serious enough to trigger a termination right. It is not a fixed legal standard. Its meaning comes from the clause that uses it, read in light of the whole agreement and the commercial context. A late report under a consulting agreement may be trivial; a late shipment under a just-in-time supply contract may shut down a production line.

The common law uses a stricter idea. The Court of Appeal for Ontario held in Spirent Communications of Ottawa Ltd. v. Quake Technologies (Canada) Inc., 2008 ONCA 92, that "a fundamental breach is one which deprives the innocent party of substantially the whole benefit of the contract", and that many breaches with material consequences are still compensable only in damages. That gap between "material" and "fundamental" is where most termination disputes are fought.

To decide whether a breach is fundamental, Spirent restates five factors that the Court of Appeal has repeatedly applied:

1. The ratio of the obligations not performed to the party's obligations as a whole.
2. The seriousness of the breach to the innocent party.
3. The likelihood that the breach will be repeated.
4. The seriousness of the consequences of the breach.
5. The relationship of the part of the obligation performed to the whole obligation.

For contracts for the sale of goods, Ontario's Sale of Goods Act draws a similar line between a condition, whose breach can justify treating the contract as repudiated, and a warranty, whose breach gives only damages. The supply agreement entry explains how those implied terms work and how contracts replace them.

One older use of "fundamental breach" is gone. In Tercon Contractors Ltd. v. British Columbia, 2010 SCC 4, the Supreme Court of Canada laid the doctrine to rest as a way to escape an exclusion clause. Whether a cap or exclusion applies after a serious breach is now a question of interpretation, unconscionability and public policy; see limitation of liability clauses.

Repudiation does not end a contract by itself. As the Court of Appeal put it in Spirent, it gives the innocent party the right to elect to treat the contract as at an end. If it makes that election, both sides are released from future performance and the innocent party sues for damages. As a general rule, the election must be made and communicated to the repudiating party within a reasonable time. If it chooses to affirm the contract instead, by continuing to perform or accepting performance without reserving its rights, it may lose the right to terminate for that breach.

The election cuts both ways. A party that terminates without a valid contractual or common-law right has itself repudiated the contract. That is what happened in Spirent: a subtenant walked away from a three-year sublease, mainly because occupancy was expected to start about six weeks late. The court held the delay was not fundamental, treated the subtenant's notice as its own repudiation, and awarded the sublandlord roughly $1.1 million. Wrongful termination is often the more expensive mistake.

The innocent party must also mitigate. Whether it terminates or carries on, it cannot recover losses it could have avoided by taking reasonable steps, such as finding a replacement supplier or customer. If the breaching party says the innocent party failed to mitigate, it bears the burden of proving that reasonable steps were available and were not taken.

Because the common-law threshold is high, well-drafted business contracts set their own rules for when a party may end the deal.

Define the trigger. Either define material breach or list the events that justify termination: non-payment continuing past a stated number of days, insolvency, breach of confidentiality, loss of a required licence, or a change of control. A list is more predictable than an adjective.

Build in a cure period. A typical clause lets the innocent party terminate only if the breach is not remedied within, say, 30 days after written notice describing it, with a shorter period for unpaid invoices. Breaches that cannot be cured, such as disclosure of confidential information or fraud, should allow immediate termination.

Follow the notice mechanics. Courts generally expect a party relying on a contractual termination right to follow its procedure closely. Send notice to the address and in the form the contract requires, identify the clause relied on, and keep proof of delivery.

Preserve other remedies. State that termination does not affect accrued rights, and list the clauses that survive, such as confidentiality, payment for work done, indemnities and dispute resolution. Agreed sums for early termination are governed by the rules on liquidated damages clauses.

Separate excused non-performance. A properly drafted force majeure clause suspends obligations during events outside a party's control, so a delay it covers is not a breach at all.

A right to terminate for convenience avoids the materiality debate entirely, but it must still be exercised honestly under the duty of good faith in contracts. Termination triggers and notice periods are among the clauses our contract red-flag checklist suggests reading before you sign.

1. Read the termination, notice, cure and dispute-resolution clauses together, including any exclusive-remedy language that limits you to service credits or an agreed sum.
2. Name the ground you rely on: a listed termination event, an uncured material breach as the contract defines it or, failing both, repudiation at common law.
3. Serve notice in the contractual form, let any cure period run in full and reserve your rights in writing while it runs.
4. Keep a record of your losses and your mitigation steps from the first day.
5. Diarize the limitation period in Ontario, generally two years from when the claim is discovered.

If the stakes are significant, have the notice reviewed before it is sent. Lamba Law's business agreements and contracts practice handles both the drafting of termination clauses and the steps when a deal goes wrong.

Tunde Okafor runs Harbourline Foods Inc., a Mississauga snack manufacturer. Harbourline has a three-year supply agreement with a packaging supplier owned by Mei Lin Zhao, worth about $1.2 million a year. The contract allows either party to terminate for material breach that is not cured within 30 days after written notice.

In the second year, two shipments arrive five days late. Harbourline pays $18,000 in overtime to catch up, and Tunde wants out immediately. His lawyer advises that two late deliveries in a three-year contract probably have material consequences but do not deprive Harbourline of substantially the whole benefit of the contract, so terminating without following the notice clause could make Harbourline the repudiating party.

Harbourline instead serves a notice of material breach that identifies both late shipments and requires on-time delivery. A third shipment arrives late within the cure period. Harbourline terminates in writing, signs with a replacement supplier charging 4% more, and claims its overtime cost plus the price difference for the 18 months left on the term, about $90,000. The supplier, facing a well-documented file, settles for $82,000.