Customers can always cancel services despite signing agreements that last for a fixed time. As a business who supplies services, you may struggle with an unexpected loss of cashflow. 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.

Background: How Do Unfair Contract Terms Work?

The Australian Consumer Law (ACL) bans the use of unfair contract terms. The law applies to all businesses who have contracts to sell goods, services or land to consumers and small businesses.

Consumers and small businesses are defined quite narrowly under the ACL.  A consumer is defined as someone who purchases goods, services or land for personal purposes. A contract with a small business is one where:

  • at least one party to the contract has less than 20 employees;
  • the contract is a standard form contract;
  • the up-front value of the contract is under $300,000 or $1 million if the contract is longer than one year; and
  • the contract is entered, renewed or varied after the 12th of November, 2016.

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:

  • would cause 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 detriment (financial or otherwise) to the other party if the term applied

Unfair terms can happen in situations where:

  • one party can terminate without notice and penalty but the other party is penalised if they terminate;
  • 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.

The unfair contracts regime was 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 services contracts contain a term that addresses termination fees. A fair term is when you charge termination fees that represent the ‘genuine pre-estimate of loss’ for your business if the contract ends early.

However, the term is likely unfair if the termination fees go beyond your expected loss to penalise the consumer or small business. 

Whether terminations fees represent a ‘genuine pre-estimate of loss’ will depend on your business model and when the customer terminates near start or end of the fixed-term contract.

Termination 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, you are a marketing agency that has signed a long-term contract with a client. You spend the first two months to create a set of branding materials that take up a lot of your time and money as you collaborate with the customer. The customer terminates after two months. You will not have recouped all of 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, 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 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, not just include 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 affects your profit margins even after taking into account 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 a major situation where a termination fee can be unfair. However, there are situations where you should not charge a termination fee as you will put the customer at an unfair disadvantage.  

In those scenarios, 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 you had breached 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?

If you have a termination fee in your contract that is deemed unfair, the term may not be enforceable (otherwise known as a court declaring the term void) when your customer disputes your term. The rest of the contract is likely to keep operating without the term. Therefore, you should ensure your termination fee term is fair. Otherwise, you are not able to impose termination fees if a customer ends the contract early. Furthermore, the Australian Competition and Consumer Commission (ACCC) can impose large fines on your business for non-compliance.

Bear in mind that if you also supply services for large businesses, your contracts will not have to comply with the law on unfair contract terms. Therefore, you can include more favourable terms on termination fees in those contracts that are unlikely to be allowed if the contracts dealt with consumers or small businesses. You may wish to create two versions of contracts for that purpose. However, ensure you use the right contract with the customer and keep track of what contracts you have in place. 

Key Takeaways

When you enter into contracts with consumers or small businesses, you should be aware of 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 have any questions, get in touch with LegalVision’s contracts lawyers on 1300 544 755 or fill out the form on this page.

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