In my review of software and IT vendor contracts over the past few years, I have seen a disturbing trend. Although they appear to provide clients the ability to terminate the contracts whenever they want, this can only be done after the client pays the vendor a fee which amounts to almost the full payment of the entire contract. More often than not, the client’s freedom to terminate is tied to a stiff penalty, and tremendous windfall to the IT or software vendor, regardless of when the contract is terminated. Any efforts to find savings or escape an underperforming vendor are quickly erased once this termination fee is calculated.

Careful review of the term of all such contracts should be undertaken when first presented and appropriate reasonable language should be negotiated in every instance. The typical termination fee clause says something to the effect of:

Early Termination Fee. The early termination fee (“Early Termination Fee”) is this fee payable by Client to Vendor if Client terminates a Service before the end of the initial Service Term (except pursuant to a Material Breach). The Early Termination Fee will be equal to the average monthly Recurring Fees (computed based on the average Recurring Fees paid by Client for Services during the three (3) month period preceding cancellation) multiplied by the number of whole or partial months between the date that the cancellation is effective and the expiration date of the initial Service Term.

Although this clause appears to essentially be a liquidated damage clause, courts across the U.S. have analyzed these types of clauses differently. Some courts have found these clauses to constitute illegal liquidated damages with no reasonable relationship to the actual damages expected by the vendor, while other courts have found them as an enforceable and negotiated term. Other courts upholding these clauses find them to present a situation of “alternative performance” where a party can agree to continue with accepting the services under the contract or, alternatively, pay the amounts identified in the termination fee.

To avoid problems when things do not go as expected, any termination fees should be renegotiated intelligently and fairly to both parties. Such a term can be modified in several different ways, including:

• Shortening the term of the contract thereby lessening the exposure period;
• Eliminating automatic renewals of terms;
• Limiting the recovery of any termination fee of one to three months of fee; or
• Limiting the recovery to the amortized and uncollected costs of the vendor.

For those vendors who tell you that the contract cannot be changed, ask them if you can do a separate rider which can be appended to the unchanged contract or remind them that if they want your business, you are limited in what exposure you are willing to accept. An ounce of prevention at the beginning of the relationship can save considerable cost and aggravation later.

If you need assistance in reviewing the contracts, please contact RKW for help.