Customers can always cancel services despite signing agreements that last for a fixed time. As a business that supplies services, you may struggle with an unexpected loss of cash flow. Termination or cancellation fees can compensate you in this scenario. However, if you wish to include termination fees in your contract, you must ensure the term is not unfair to individuals or small businesses. Otherwise, you will not be able to ask your customers to pay the extra fees if they cancel services early. This article will explain when termination fees in contracts with consumers or small businesses can be unfair.
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How Do Unfair Contract Terms Work?
The Australian Consumer Law (ACL) bans the use of unfair contract terms in a standard form contract. The law applies to all businesses with contracts to sell goods, services or land to consumers and small businesses. Consumers and small businesses are defined quite narrowly under the ACL. Therefore, checking if your customers meet the definition is prudent.
A standard form contract is a contract that is entirely prepared by the other party and given to a consumer or business without any real opportunity to negotiate terms. Typical standard form contracts include gym memberships.
A contract term is unfair if it:
- causes a significant imbalance in the rights and obligations of each party;
- is not necessary to protect the legitimate interests of the party with the advantage; and
- leads to a detriment (financial or otherwise) to the other party.
Unfair terms arise where:
- one party can terminate without notice and penalty while the other cannot;
- one party can avoid or limit their obligations under the contract;
- one party is responsible for the other party’s actions or omissions under the contract; and
- the supplier can vary the contract without notifying or giving the customer an option to terminate without penalty.
It is worth noting that a varying term in a contract may still be acceptable if both parties have the mutual capacity to vary the contract. Even then, you should implement safeguards. The contract could state clear carve-outs as to the instances parties can rely on a varying clause. For example, where it is reasonably necessary to manage the costs or risks of a business.
The unfair contracts regime was ultimately developed to protect time-poor consumers and small businesses who were at a disadvantage when negotiating contracts with larger businesses.
When Are Termination Fees Fair or Unfair?
Many service contracts contain a term that addresses termination fees. Under the contract, the customer must pay a termination fee if they decide to end the contract early.
A fair termination fee is one that represents the ‘genuine pre-estimate of loss’ for your business if the contract ends early. However, the termination fees will be unfair if it goes beyond your expected loss to penalise the consumer or small business.
Whether termination fees represent a ‘genuine pre-estimate of loss’ will depend on your business model and when the customer terminates near the start or end of the fixed-term contract.
Continue reading this article below the formTermination Near Start of Contract
Costs: High Set-Up, Low Ongoing
If you are a business that supplies services with high set-up costs but low ongoing costs, your termination fees will compensate for your genuine loss of failing to recoup all your initial set-up costs.
For example, suppose you are a marketing agency that signs a long-term contract with a client. You spend the first two months creating a set of branding materials that take up much of your time and money as you collaborate with the customer. The customer then terminates after two months. It is highly unlikely your business will recoup all your set-up costs in two months of fees. Therefore, you can argue your loss is reasonably high.
Costs: Low Set-Up, High Ongoing
However, if the set-up for your service is easy, but you will have high ongoing costs, you will find it difficult to prove your loss.
For example, assume you run a Netflix-style business where the customer pays the first month of fees in a 12-month contract. The customer views pre-loaded content and chooses to terminate early. You have not made a loss because of the low set-up costs, and you may reach a profit for fees paid to date.
Terminations Towards End of Contract
Costs: High Set-Up, Low Ongoing
If your customer terminates towards the end of the contract, your termination fee must reflect your actual loss. It cannot simply reflect the fees for the rest of the terminated contract.
For example, your marketing business has low ongoing costs after set-up, because you offer live chat support and monthly newsletters with pre-written tips. If your customer terminates two months before the contract ends, you would have recouped your set-up costs, and your ongoing costs remain minimal despite the monthly fees. Therefore, your termination fee must reflect your actual loss, not just any leftover fees from a terminated contract.
Costs: Low Set-Up, High Ongoing
If your business had low set-up costs but maintaining the service is expensive, your termination fee is more likely to reflect a genuine loss.
For example, your customer terminates three months before the end of the contract for your Netflix-style product. You have high ongoing costs to create and upload quality content. The costs affect your profit margins even after considering your quality content. Therefore, your termination fee is a fair term that covers the expense of maintaining your quality content.
Other Reasons for Unfair Termination Fees
A termination fee that does not reflect a genuine pre-estimate of your loss is very likely unfair. Furthermore, there are situations where you should not charge a termination fee as you will put the customer at an unfair disadvantage.
You should not charge a termination fee:
- if a contract will end soon and the customer notifies you that they do not want the contract renewed;
- where the customer terminates because your business is in breach of the contract (such as failing to provide a proper service with skill and care); and
- where you choose to terminate the contract for your convenience.
What Happens if You Have Unfair Termination Fees?
The term may be unenforceable if you have a termination fee in your contract that is deemed unfair. This is the case when a court declares the term void. If this occurs:
- you are not able to impose termination fees if a customer ends the contract early;
- the rest of the contract is likely to keep operating without the term; and
- the Australian Competition and Consumer Commission (ACCC) can impose a large fine on your business for non-compliance.
Therefore, you must draft your termination fee clauses fairly to avoid commercially detrimental consequences.
Bear in mind that the type of business you are contracting with will play a crucial role in the determination of an unfair term. For example, if you supply services for large businesses, your contracts do not have to comply with the law on unfair contract terms. In such contracts, you may include more favourable terms on termination fees. This is in contrast to your contracts with consumers or small businesses. If you regularly contract with large and small businesses, consider creating two versions of your contracts.
Key Takeaways
When you enter into contracts with consumers or small businesses, you should know how the unfair contract terms regime can affect the types of terms you can draft in those contracts. Terms relating to termination fees should only reflect a genuine pre-estimate of your loss. Otherwise, the term is likely unfair and not enforceable.
If you need help with non-disclosure agreements, our experienced contract lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 1300 544 755 or visit our membership page.
Frequently Asked Questions
Unfair termination fees arise when the amount charged goes beyond your expected loss, penalising the customer.
Yes. You should not charge a termination fee in situations where doing so puts your customer at a disadvantage, such as terminating a contract for your own convenience or terminating a contract early after being notified by the customer that they won’t be renewing the contract.
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