How to Recover Early Termination Fees For Managed Services

IT service providers that include early termination fees in their contracts must decide if they want to seek reimbursement when a customer terminates a contract early. MSPs find themselves asking: Is anything owed? Can I collect? What is the cost? Here are key points to consider when determining whether to enforce an early termination fee.

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Many contracts between IT service providers contain a term, and a termination fee if the customer attempts to terminate the contract early.  When a Managed Service Provider (“MSP”) is faced with a customer that purports to terminate the relationship prior to the expiration of the contract term, the MSP must decide whether to pursue any early termination fees. Typically, this decision involves a cost-benefit analysis comparing the expense of seeking recovery against the probable amount to be recovered.

While legal fees can add up quickly, depending on the contract language, the MSP may be able to collect the early termination fee and also receive compensation for any attorney’s fees it incurs in the collection process.

The MSP should analyze the following to determine whether to pursue an early termination fee against a former customer.

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Consult the Contract

The first step should always begin with a careful review of the early termination provision, if any.  Does the contract give the customer the right to terminate for convenience?  If so, does it condition such a right on the payment of an early termination or cancelation fee?

Our master MSA template provides:

Early Termination by Client Without Cause

If Client has satisfied all of its obligations under this Service Attachment, then no sooner than ninety (90) days following the Service Start Date, Client may terminate this Service Attachment without cause during the Initial Term upon sixty (60) day’s advance, written notice, provided that Client pays Provider a termination fee equal to fifty percent (50%) of the recurring, Monthly Service Fees remaining to be paid from the effective termination date through the end of the Initial Term, based on the prices identified on the Order then in effect.

We recommend that our clients include a right to terminate for convenience, conditioned upon payment of an early termination fee and all third-party out-of-pocket expenses incurred on behalf of the client.

However, a contract for fixed-term that is silent on the issue of termination for convenience, may still allow the MSP to recover for early termination, but the legal analysis will of such a claim will be different and potentially less favorable to the MSP.  Where there is not right to terminate for convenience, the client’s purported termination for cause will be examined as a contract breach and therefore potentially subject to a liquidated damages provision.  Accordingly, if the contract is silent on early termination for convenience, the existence of a liquidated damages provisions will be important, as  such provisions shift the burden to the customer to prove that the liquidated damages provision is unenforceable.

If the contract contains an early termination provision, but does not give the customer a right to terminate for cause, enforceability of the cancelation fee could be adversely impacted.

Determine the Requirements for Termination

It is important to understand whether the agreement distinguishes a termination based on cause or without cause. Some termination provisions specifically define cause as a material breach of the contract or similar language. If the contract exempts a customer from paying a fee for terminating as a result of a breach, there are often additional requirements, such as an opportunity to cure.

It is important to determine whether the customer terminated with or without cause by reviewing the termination notice. Did the termination notice specifically cite a failure by the MSP to uphold its obligations pursuant to the contract? If so, does the contract require an opportunity to cure? Some contracts require a period of time (example, 30 days) to cure any failures by the MSP. If the customer does not provide an opportunity to cure, courts have determined that the termination is for convenience and therefore subject to an early termination fee.

Is the Provision Enforceable?

Early termination provisions that carve out an exception for termination for cause are usually enforceable if the amount of the termination fee is reasonable. Some legal experts argue that this constitutes a simple negotiated contract fee. However, some courts have rejected termination fees that were excessive (e.g., 300% of the remaining contract) regardless of whether an exception exists for termination for cause. Fees in the amount of 50% of the remaining contract have been upheld by courts and are typically enforceable provided that they are a reasonable estimate of the lost profits the MSP would have made but for the early termination.

Termination fees that do not distinguish between terminations with or without cause may be challenged as an unenforceable penalty, so it is important to carefully craft the contract language to maximize the likelihood of it being enforced.

Did the Customer Meet Termination Requirements?

Once an MSP understands the details of the termination provision, the next step is to analyze whether the customer met the requirements of the provision. Did the customer terminate for cause? If so, did the customer provide the MSP with an opportunity to cure the alleged breach following the required written notice? Did the customer terminate without specifying cause?

A failure of the customer to provide adequate notice of termination can potentially subject it to the early termination fees. Even if a customer abides by the specific requirements of the termination provision, the MSP should look at the definitions to decide whether the “cause” cited was actually a material breach as defined by the agreement.

However, if a customer strictly followed the termination procedures and the cause is likely a material breach, an MSP may decide not to pursue the fees.

Does the Contract Require ADR?

If an MSP determines that the customer failed to meet the termination requirements and owes an early termination fee, the next step is to review the contract for any Alternative Dispute Resolution (“ADR”) requirements. Sometimes, contracts may require the parties to either mediate or arbitrate prior to filing litigation.

Review Other Provisions

There are a few other provisions that are relevant once an MSP decides to seek early termination fees according to the contract. Additionally, many contracts contain provisions that allow the MSP to recover attorney’s fees for pursuing breach of contract claims.  Attorney’s fees provisions may be particularly important to MSPs considering pursuing early termination fees in court.

Managed services are generally priced for multi-year contracts that are not cancellable for convenience without payment of an early termination fee.  Historically, MSPs have been hesitant to pursue recovery of early termination fees in Court.  Our lawyers can help you evaluate whether early termination fees are worth pursuing and can help you update your customer contracts to make sure that you are maximizing your chances for recovery in the future.

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