Despite general principles, municipal contracts frequently differ from most private sector contracts in relation to the term of such arrangements and the manner in which they may be terminated.
For instance, very often the term of agreement will be stated as follows:
The initial term of this agreement shall be one year, commencing at 12:01 a.m. on May 1, 2022 and terminating at 11:59 p.m. on April 30, 2023.
Despite this clause the city may at its sole discretion extend the term of this agreement for an additional period of one year, by delivering a written notice to that effect to the supplier at or before 5 p.m. on March 31, 2023. Where such notice is delivered, this agreement shall remain in effect until 11:59 p.m. on April 30, 2024 on the same terms and conditions as set in this agreement, including with respect to price.
Initially, one might assume the problem with a clause of this nature is the lack of reciprocity.
The effect of a clause along these lines is to expose the supplier to a disproportionately long-term risk, relative to the benefit that the contract affords.
If the contract works out to the municipality’s interest (e.g., if price inflation over the first year of the contract is high), than the municipality will likely exercise its right of renewal, with the effect that the supplier will continue to be bound by what has proven to be a disadvantageous contract. On the other hand, if the contract works out for the disadvantage of the municipality, or it perceives that it can secure a better deal in the market, than the renewal clause will not be exercised.
In general, it is unwise for a municipality to seek to include language in a contract providing it with a unilateral right to extend or terminate the contract.
Although in theory discretionary rights to terminate a contract for convenience can be drafted so as to permit escape free of any breakage cost responsibility, for the following reasons this is almost an exceptionally unwise course:
Such a policy will almost certainly reduce the number of potential bidders. Reduced competition usually leads to a higher price.
Many suppliers will refuse to bid for a contract that is so uncertain in scope. Since good suppliers tend to attract good customers, a municipality that seeks broad unilateral rights of termination runs a serious risk of being serviced only by poor suppliers.
Most importantly, such a policy introduces additional risk from the supplier’s perspective. Prudent suppliers will price risk into their bid price.
While it is possible to sweeten the pot by providing further protection to the supplier (i.e., guaranteeing that the expected profit will also be paid on termination), such an approach usually makes the termination of a contract prohibitively costly.
To get out of the deal, the municipality will pay a very large portion of the total price and have little to show for having done so.
Where a municipality attempts to impose a clause that gives it exceptional unilateral rights, the municipality is to a large extent contracting against its own interests.
Presented with such an arrangement, a profit maximizing supplier will simply add a hedge into the price charged under the contract to protect itself against any early termination of the contract.
Much the same conclusion applies where a municipality contracts for a unilateral right to extend a contract that includes the use or delivery of a commodity that is subject to price volatility.
In such a case, the supplier will simply include a hedge factor in its bid price, to protect itself against any material adverse variation in the price over the anticipated life of the contract.
Stephen Bauld is a government procurement expert and can be reached at email@example.com. Some of his columns may contain excerpts from The Municipal Procurement Handbook published by Butterworths.