COVID-19 and Contractual Obligations: Are You Excused?

So the main supplier of material for your key product got shut down in response to the COVID-19 pandemic, and it will cost you twice as much to import it on short notice.

Or your local government closed all “non-essential” businesses for a month, and half your tenants aren’t paying rent.

Or your customer just cancelled a big order (already in production) claiming it can’t use your products because the government closed all its facilities.

Or the city cancelled your three day concert for which you sold thousands of tickets and contracted with dozens of vendors and hotels.

What to do?

A little over a month ago, these would have been hypothetical questions. Today, it is the stark reality virtually every business in America faces.

Read Your Agreement and Related Documents

In every case, whether you own the business unable to fulfill its contract, the business that did not receive goods or services, or the business facing cancelled orders, you should first read the applicable agreements (including ALL amendments to those agreements, even if just done by subsequent emails).

Are there any preconditions to performance?

Does either party have the right to delay or terminate performance under specific circumstances? If so, what are those specific circumstances?

Did the parties modify the contract along the way? Remember, this “modification” may have only occurred via emails sent back and forth and not by a more formal document.

Is Force Majeure an Option?

Contracts often have what are known as “force majeure clauses.” These clauses are negotiated between parties to allocate risk in the event of certain unforeseen contingencies that are outside the control of both parties, such as Acts of God, war, terrorism, civil strife, riots, natural disaster, governmental order, destruction of property and more. Because the world has not seen a global pandemic since the Spanish Flu in 1918, few force majeure clauses, if any, specifically include “pandemic” as a force majeure event. In such cases, a party may seek to rely on any language that may relate to the slew of emergency declarations and government-ordered business closings that have been issued in recent days.

Exactly what those governmental orders say matters. Did they prohibit the non-performing party from performing (the materials supplier and the concert producer)? Or did they simply make it financially difficult to perform (as in the case of the factory and the shopping center tenants)? Or did they cause your customers to default (the shopping center)? Can your customer just back out because they are shuttered due to the government order or the pandemic itself?

Some courts have held that force majeure clauses should be construed strictly according to the text of the clause. Others have held that the force majeure clause should be construed to reflect the parties’ mutual intent, even if the language is less specific. As with all contract law (other than certain Federal government contracts), the governing law of the state specified in the agreement (or if silent on that point, the governing law of the states of respective parties to the agreement) would have to be considered to determine the answer. With the flurry of cases that are likely to spring out of this current COVID-19 situation, the range of judicial interpretations could be wide.

Assuming a pandemic or its wide-reaching consequence was contemplated by the force majeure clause, the next question will be whether the force majeure event actually prevented the non-performing party from performing as promised. And further, does the force majeure event excuse performance altogether, or does it only permit the non-performing party to delay performance for the duration of the force majeure event? How long is long enough? In the current situation, can a party delay performance for as long as COVID-19 maintains its pandemic status? When government-mandated closures end? Or longer?

Under any of these scenarios, is the non-performing party obligated to find alternative means of performing its contractual obligations?

Alternatives to Force Majeure

If the contract lacks a force majeure clause, or if it is likely that such a force majeure clause is not broad enough to cover a pandemic situation, there may be other defenses to non-performance. These include: impossibility of performance, impracticability of performance, frustration of purpose or supervening illegality. Each one of these defenses has its own elements. Courts in different jurisdictions may apply them differently. If the contract is silent on “force majeure,” or if an event such as the virus outbreak is not contemplated by the language of the force majeure clause, courts generally will look to the foreseeability of the event. This inquiry depends on the facts and history of the transaction. Further, the party seeking to be excused from performance will have to show the court that there was a direct causal link between an unforeseeable event (here, the virus or resulting government actions) and its inability to perform. Keep in mind that a disruption which only impacts the profitability of a contract may not be sufficient to prevent enforcement.

For contracts involving the sale of goods (as opposed to services), the Uniform Commercial Code provides that a seller is excused from timely delivery or for non-delivery of goods where its performance has become impracticable either by: a) the occurrence of a contingency the non-occurrence of which was a basic assumption on which the contract was made; or b) compliance in good faith with any applicable foreign or domestic governmental regulation or order whether or not it later proves to be invalid. So, in addition to carefully reviewing the language of the contract, it will be important to review the scope of any local, state or Federal governmental orders impacting such sales.

Once again, many courts hold that the applicability of each defense is a fact-specific inquiry. Therefore, it is important that each party collect and review its records (including all emails with the other party before and after signing the contract) regarding the expected performance, what the parties anticipated, the cost of performance as promised, the purpose of the contract, and anything else that bears on the actual performance. And once again, did the cited reason for non-performance, here a pandemic or its fallout, have a causal connection with the cited defense?

Giving Notice – Pros and Cons

In every case, the party who anticipates their performance will be delayed or prevented will need to decide when to notify the other party. This is especially important if the other party is taking steps to perform its end of the bargain, such as incurring expenses or foregoing other opportunities in reliance on full performance. Some contract provisions may require a formal advance notice within a specific time. A failure to speak up promptly could result in a court refusing to excuse the non-performing party from its contractual obligations. Advance notice gives the other party an opportunity to mitigate its damages by pursuing other arrangements. If nothing else, it gives the non-performing party the chance to argue that the other party could have mitigated its damages but decided to stand on its rights and should recover lower damages.

At the same time, if a company is uncertain about its ability to perform and gives notice that it will not be able to do so, does it face an immediate breach claim based on this “anticipatory breach?” On the other hand, if it fails to give that notice when it reasonably knows that it will not be able to perform, will the failure to give that notice ASAP result in claims that it caused additional damages by failing to enable the other party to secure a suitable replacement? And the ultimate relief may not be exactly what is requested. In some cases, such as complete frustration of purpose or intervening illegality, some courts may discharge both parties from their obligations and order restitution of any advance payments made by the party who did not receive the promised performance. These are all complicated issues to work through with your counsel in making the choices described above.

Besides the legal consequences, it’s good business to keep an open line of communication and be forthright with business partners. There may be substituted performance that the other party is willing to accept.Or perhaps refunding advance payments will entice the other party to release future obligations. Even if there’s nothing one can offer, it may lead the other party to take a more measured approach and not seek to extract legal vengeance.

Most importantly, it’s a down payment for the future.  One day, this crisis will end, and people will get back to business. Having a difficult conversation now may heal the business relationship and preserve it for the future.

Planning Ahead

While there is a great deal of uncertainty and the potential for claims with respect to existing agreements, when negotiating NEW agreements, it will be critical to have a more robust force majeure clause, including detailed notice provisions and, if desired, a provision that provides for the option of termination after the force majeure event has continued for a specified period of time. Our team is ready to assist you in navigating these unchartered waters.